Question

Describe how transfer prices are computed (you must consider excess capacity, no excess capacity, and partial capacity).?

Answer 1

For better knowledge first of all let’s know something basic about transfer price.

Transfer price refers to selling price of the product & service which are charged by a division from another division of same firm & company. Practically we see that a lot of transfer sales are made inside the company & firm hence determining correct price of sale inside sale becomes very necessay otherwise both divisions of the firm & company may suffer with some losses.

Now come to main point, how transfer prices are computed under various cases?

1. In case of excess capacity;

This condition refers to the situation of idle capacity avaialble to fulfill additional demands of product & service. In other words we can say that in such case a specific division does not need to make additional fixed investment for fulfill additional sales order. Thus under this case transfer price will be as follow;

Transfer price = Marginal cost of product & service

Marginal cost refers to additional cost of making a specific product & service hence in case of excess capacity a division only incurr some marginal costs hence for transfer price we can charge such marginal costs from buying division.

2. In case of no excess capacity;

This condition refers to the situation of shortage of capacity to fulfill additional demands of product & service. In other words we can say that in such case a specific division need to make additional fixed investment for fulfill additional sales order. Thus under this case transfer price will be as follow;

Transfer price = Marginal cost of product & service + Oppurtunity costs of arranging capacity

3. In case of partial capacity;

This condition refers to the situation inadequate capacity to fulfill additional demands of product & service. In other words we can say that in such case a specific division need to make some additional fixed investment for fulfill additional sales order. Thus under this case transfer price will be as follow;

Transfer price = Marginal cost of product & service + Oppurtunity costs of arranging partial capacity

Note:

Sometime it may happen that specific division need some basic profit margin on inside sale that is necessary to survival of such division. Hence in such case selling division can add minimum required profit margin to transfer price but as we know that both seller and buyer both are part of same firm & company hence profit margin is ignored hence transfer prices are computed on the basis of actual costs incurred.