Question

The supplying division of a company produces a component which is sold to the company's buying division and to external customers. The supplying division has incremental costs of $40 per unit and can sell the component to its external customers for $75. The buying division can purchase a similar component from an external supplier for $80. Which of the following is TRUE regarding Transfer Prices?

1. Assuming the supplying division has no excess capacity, the minimum amount it would charge the buying division is $40.

2. The supplying division would have to consider the amount of fixed costs related to the component before determining the transfer price.

3. The maximum transfer price that the supplying division could charge the buying division is $80 regardless of whether the supplying division has excess capacity or not.

4. Assuming the supplying division has excess capacity, the minimum transfer price it would charge the buying division is $75.

Answer 1

Answer is 3. The maximum transfer price that the supplying division could charge the buying division is $80 regardless of whether the supplying division has excess capacity or not.

Explanation:

The transfer price is decided on the following basis:

Minimum price for transfer price: The Supplying division will charge the tarnsfer price on following basis:

Case-1: when having excess capacity, the supplying division will transfer the components on the incremental cost incurred for producing the components i.e. Minimum transfer price will be $40.

Case-2: When no excess capacity exists, the supplying division will transfer the components on the price that will cover its variable cost and contribution foregone from regular customer i.e. Minimum transfer price will be $ 75.00

Maximum Transfer price: The Buying division will be ready to buy the components at the price maximum to the price at whcih it is available from outside suppliers.

Therefore, the relevant range for transfer price in particular case is:

Case-1 When excess capacity exists: Relevant range is minimum $40 and maximum $80.

case-2 When excess capacity does not exist, relevant range is minimum $75 and maximum $80.