Question

Perfumes Ltd has two divisions: the Perfume Division and the Bottle Division. The company is decentralised and each division is evaluated as a profit centre. The Bottle Division produces bottles that can be used by the Perfume Division. The Bottle Division's variable manufacturing cost per unit is $3.00 and shipping costs are $0.20 per unit. The Bottle Division's external sales price is $4.00 per unit. No shipping costs are incurred on sales to the Perfume Division. The Perfume Division can purchase similar bottles in the external market for $3.50. The Bottle Division has sufficient capacity to meet all external market demands in addition to meeting the demands of the Perfume Division. Required: a) Using the general rule, determine the minimum transfer price. b) Assume the Bottle Division has no excess capacity and can sell everything produced externally. Would the transfer price change? c) Assume the Bottle Division has no excess capacity and can sell everything produced externally. What is the maximum amount Perfume Division would be willing to pay for the bottles? d) When is it more appropriate to use market-based transfer price rather than cost-based transfer price? (1 mark)

Answer 1

a). The transferring division i.e., bottle division has sufficient capacity to meet demands of outsiders and Perfume division. In this case the minimum transfer price has to be set at Variable Cost plus opportunity cost because of transfer. Hence the minimum transfer price in this case is $3.00. (Opportunity cost at excess capacity is Zero).

b). When the transferring division is operating at maximum capacity, the transfer price has to be set at Market Price for Transferring Division i.e., $4.00 less Shipping cost saved $0.20 = $ 3.80.

c). If the transfer price is set at $3.80, the Perfume division will be willing to pay maximum upto $3.50 as it can purchase similar bottles in the external market for $3.50

d). The company should consider whether the transfer pricing method has simplicity and transparency, which provide objective performance measurements for division managers. In particular, when companies use cost-based transfer pricing, it is difficult to evaluate division performance unless the transfer prices exceed full costs.

Generally, a company can save more money and effort through internal sales compared with external sales, due to the absence of customer credit checking or collecting. In addition, market-based transfer prices contribute to the evaluation of the economic viability and profitability of profit centers individually. Market-based transfer pricing portrays the real market supply and demand more clearly because, when supply exceeds demand, market prices may decrease, so market-based transfer prices decrease as well.