Question

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?

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 per unit. When the internal transfer takes place between electrical and assembly division at variable production cost, organisation as a whole will benefit since the electrical division need not purchase the required item from the open market. The difference between market price and transfer price (variable production cost) is the savings that will accrue to the organisation as a whole.

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. Contribution foregone is difference of sales and variable cost of external sales. The assembly division will be forgoing contribution of external sales which is the opportunity cost involved in internal transfer. Hence in the given case transfer price should be equal to $680. Opportunity cost is a relevant cost and hence it is added to variable cost of production to determine transfer price.

c) The minimum transfer price should be variable cost of production to recover the cost of assembly division. 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.

d) When divisions are monitored based on return on investment (ROI) criteria negotiation for transfer takes place between the divisions. The objective of each division in transfer price negotiation is to ensure they get their target return on investment through transfer pricing. Accordingly price will be set based on various methods like full cost pricing, cost plus pricing, cost plus ROI 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 to ensure it incurs no loss and the electrical division will ensure it does not pay an amount exceeding the external market price to assembly division. The negotiated transfer price will take place in between these 2 ranges that will get accepted by each division based on target return on investment they want to achieve to meet their performance goals. The range of transfer price is $550 to external market price of component.