Transfer pricing

Transfer pricing
A transfer price is the internal selling
price used when goods and services
are transferred between profit
centres and investment centres in a
divisionalised organisation
the revenue of the selling division and
the cost of the buying division
Allows the selling division to record
revenue and earn profit to reflect their
effort in producing the product

Transfer pricing
Allows the buying division to record the
cost of that product to match against
the revenue when it is eventually sold to
external customers
The transfer price should
Result in divisional profits that are a reliable
and accurate measure of divisional
performance
Preserve and encourage divisional
autonomy

Transfer pricing
Who sets the transfer prices?
Managers of profit centre and investment
centre's usually have considerable autonomy
in deciding whether to accept or reject orders
for goods or services and where to source their
materials
They may also have autonomy on whether to
set and accept transfer prices
Direct intervention by corporate managers to
establish transfer prices may be inconsistent
with philosophy of decentralization
Corporate management may set a general
policy for transfer pricing

Transfer pricing methods

Cost based Transfer Pricing
Marginal Cost Method
Transferor Division does not have
idle capacity- transfer price at
variable cost
Transferor Division has idle
capacity- transfer price includes
cost plus fixed cost of transferor
division

 Full Cost Method

When there is no idle capacity of the
transferor division

Standard Cost Method

When the price of the inputs
fluctuates

Cost -Plus -Mark-up Method

When the product of the transferor
division has an perfect market, the
plus should be equal to the
opportunity cost of contribution loss.

Transfer pricing methods

Market-price-based Transfer
Pricing
This type of pricing is set when
there is a perfect market for the
product of the transferor division.

A company is organized in to two divisions. Division A manufactures an

intermediate product which can be sold in the market at Rs. 300 per unit.
The manufacturing capacity of division A is 2,400 units of the product per
annum. Division B uses the intermediate product in assembling it in to a
finished product which is sold at Rs. 490 per unit. Division B needs 2,400
units of the intermediate product in a year. The cost structure of the two
divisions is as under:
Division A (Rs)
Division B (Rs)
Direct materials

102

58*

Direct wages

62

100

Variable overheads

38

18

Fixed overheads

60

34

*Does not include the transfer-in price.

Division B offers a transfer price of Rs. 240 per unit of the
intermediate product. Division A is not agreeable to supply the
product at the transfer price set by Division B because at this price
Required:
division A will incur a loss.
(i) Determine the division-wise profitability and the profitability of
the company as a whole if the transfer price of Rs. 240 for the
intermediate product is implemented.
(ii) Division A suggests the use of market price for transferring the
product as otherwise it can sell the entire quantity of the
intermediate product to the external buyers for which there is
adequate demand. Prepare the statement showing the division-wise

Profitability Statement when Transfer price at Rs. 240 per unit:

Particulars

Division A
Division B
Company
Transfer to B: 2,400 x Rs. 240 576,000
Sales: 2400 x Rs. 490
1,176,000
Variable costs:
Division A: 2,400 x Rs. 202
484,800
576,000
Division B: 2400 x Rs. 176
422,400
Total
484,800
998,400
Contribution
91,200
177,600
Fixed costs
144,000
81,600
Profit (Loss)
-52,800
96,000 43,200

Profitability Statement when Transfer price at

Rs. 300 per unit:
Particulars

Division A
Division B
Company
Transfer to B: 2,400 x Rs. 300 720,000
Sales: 2400 x Rs. 490
1,176,000
Variable costs:
Division A: 2,400 x Rs. 202 484,800
720,000
Division B: 2400 x Rs. 176
422,400
Total
484,800
1,142,400
Contribution
235,200
33,600
Fixed costs
144,000
81,600
Profit (Loss)
91,200
-48,000
43,200

Transfer pricing methods

Negotiated Transfer Pricing
The manager of the transferor division
should possess equal bargaining power
and competent in using accounting
information to derive maximum
advantage for the company as a whole.

The Assembly Division of SLOWCAR Company has offered to

purchase 90,000 batteries from the Electrical Division (ED)
for Rs.104 per unit.
At a normal volume of 250,000
batteries per year, production costs per battery are:
Direct materials(Rs.) 40
Direct labor 20
Variable factory overhead
Fixed factory overhead

Total Rs. 114

12
42

The Electrical Division has been selling 250,000 batteries

per year to outside buyers for Rs.136 each. Capacity is
350,000 batteries/year. The Assembly Division has been
buying batteries from outside suppliers for Rs.130 each.
Should the Electrical Division manager accept the offer?
Will an internal transfer be of any benefit to the company?

Solution
ED manager should accept.
There is surplus capacity. So the relevant costs to
the ED is the VC = Rs.72 / battery.
The increased Contribution to the ED would be
90,000X(Rs.104 72) = Rs. 28,80,000
The company would be better off with an internal
transfer. Currently paying Rs.130 for batteries that
could be made internally for incremental cost of
Rs.72. The company would save 90,000 X (130
72) = 52,20,000 per year
The TP range = max. of Rs.130 to low of Rs.72

Transfer pricing methods

Dual-rate of Transfer Pricing
This system permits to use two rate
One for transferor division- market price
Another for transferee division- cost price

Shared Profit in relation to cost

The profit or the contribution of the company
as a whole is computed and shared among
the divisions on the basis of total cost or
variable cost.

The Box Co. has two divisions: bottle manufacturing division

and product manufacturing division. The company decided to
transfer the empty bottles from the bottle manufacturing
division to product manufacturing division at a proper price.
Show the levels of volume 8,00,000 and 12,00,000 bottles, the
profitability by using share profit in relation to cost.
Cost of manufacturing of the bottle manufacturing division:
volume of empty bottles
total cost (Rs.)
8,00,000
10,40,000
12,00,000
14,40,000
The cost and sales value of product manufacturing division:
volume of empty bottles
total cost (Rs.)
sales value of end product
8,00,000
64,80,000
91,20,000
12,00,000
96,80,000
1,27,80,000
*excluding the cost of empty bottles.

Overall profitability of the company

Output level (units) 8,00,000

12,00,000

Sales (Rs.)

91,20,000

1,27,80,000

Bottle division

10,40,000

14,40,000

Product division

64,80,000

96,80,000

Total cost

75,20,000

1,11,20,000

Profit

16,00,000

16,60,000

Costs(Rs.):

Share of profit in relation to cost: 8,00,000 units

units
Bottle division:
10,40,000/75,20,000 X 16,00,000 2,21,000
14,40,000/1,11,20,000 X 16,60,000
2,15,000
Product division:
64,80,000/75,20,000 X 16,00,000 13,79,000
96,80,000/1,11,20,000 X 16,60,000
14,45,000

12,00,000

Profit on the basis of shared profit- Bottle

Volume of output
8,00,000
12,00,000
division
(units)

Manufacturing cost

10,40,000

14,40,000

Profit share

2,21,000

2,15,000

Sales value

12,61,000

16,55,000

Selling price per

bottle

1.58

1.38

Profit on the basis of shared profit- Product

division
Volume of output
8,00,000
12,00,000
(units)
Sales value

91,20,000

1,27,80,000

Costs: bottle division

12,61,000

16,55,000

64,80,000

96,80,000

Total cost

77,41,000

1,13,35,000

Profit

13,79,000

14,45,000

product
division