Question

Decision on Transfer Pricing

Materials used by the Instrument Division of XPort Industries are currently purchased from outside suppliers at a cost of $210 per unit. However, the same materials are available from the Components Division. The Components Division has unused capacity and can produce the materials needed by the Instrument Division at a variable cost of $160 per unit.

Assume that a transfer price of $190 has been established and that 60,000 units of materials are transferred, with no reduction in the Components Division's current sales.

a. How much would XPort Industries' total income from operations increase?
$

b. How much would the Instrument Division's income from operations increase?
$

c. How much would the Components Division's income from operations increase?
$

d. Any transfer price will cause the total income of the company to increase , as long as the supplier division capacity is used  toward making materials for products that are ultimately sold to the outside.

Answer 1

a. How much would XPort Industries' total income from operations increase?
Solution: $3,000,000

Working: ($210 - $160) * 60,000 units = $3,000,000

b. How much would the Instrument Division's income from operations increase?
Solution: $2,400,000

Working: ($210 - $190) x 60,000 = $2,400,000

c. How much would the Components Division's income from operations increase?
Solution: $1,800,000

Working: ($190- $160) x 60,000 = $1,800,000

d. Any transfer price will cause the total income of the company to increase , as long as the supplier division capacity is used toward making materials for products that are ultimately sold to the outside.

Solution: Any transfer price will cause the total income of the company to increase, as long as the supplier division capacity is used toward making materials for products that are ultimately sold to the outside. But the transfer prices need to be set between variable cost and selling price to ensure that the division managers proper incentives. A transfer price set below variable cost may lead the supplier division to incur a loss, and if a transfer price set above market price will result the purchasing division to incur opportunity costs. Both of these situation is not an attractive alternative for an investment center manager. Hence the general rule is to negotiate transfer prices among variable cost and market price when the supplier division has excess capacity. The range of acceptable transfer prices for the company would be between $210 and $160