Question

Week 8 Spark Ltd has two divisions, assembly and electrical. The assembly division transfers partially completed components to the electrical division at a predetermined transfer price. The assembly division’s standard variable production cost per unit is $550. This division has spare capacity, and it could sell all its components to outside buyers at $680 per unit in a perfectly competitive market. Required: a) Determine a transfer price using the general rule. b) How would the transfer price change if the assembly division had no spare capacity? c) What transfer price would you recommend if there was no outside market for the transferred component and the assembly division had spare capacity? d) Explain how negotiation between the supplying and buying units may be used to set transfer prices. How does this relate to the general transfer pricing rule? (4 marks, maximum 200 words)

Answer 1

a) The general rule for setting transfer pricing when there is space capacity is selling at standard variable production cost to internal division that is $550. When the internal transfer takes place at variable production cost organisation as a whole will benefit since the electrical division need not purchase the required item from the market. The savings that will accrue to the organisation is market price per unit minus variable cost of production. Also there will be spare capacity utilisation for assembly department.

b) If there is no spare capacity the transfer price should be equal to the standard variable production cost plus contribution forgone by not selling to outside customers. Hence in the given case transfer price should be equal to $680. Contribution foregone is difference of selling price and variable cost of sales.

c) If there is no external market for the transferred component and spare capacity available the transfer price should be variable cost of production since there is no opportunity cost involved in the form of external sales loss. When there is no external market for the component the only option left is to transfer internally.

d) When divisions are monitored based on return on investment criteria negotiation for transfer takes place between the divisions. The objective of each division in negotiation is to ensure they get their return on investment through transfer pricing. Accordingly price will be set based on various methods like full cost pricing, cost plus pricing, etc. The principles of general transfer pricing gets applied by each division in setting transfer pricing. The assembly division will ensure its minimum transfer price is equal to variable cost of production and the electrical division will ensure it does not pay an amount exceeding the external market price. The negotiated transfer price will take place in between these 2 ranges that will get accepted by each division based on return on investment they want to achieve to meet their performance goal.