Page 110 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 5: Transfer Pricing

Notes
Example: It can safely take business decisions to sell less than its normal price under
certain circumstances.
Two-step pricing solves the problem by transferring a variable cost per unit basis and later
changing fixed cost and profit on a lump sum basis. Under this method, the transfer price will be
` 5/- for each unit that Y purchases plus ` 20,000/- per month for fixed costs and ` 10,000 per
month for profit.
If transfer of product A on a certain month is 5000, unit Y will pay variable cost of ` 25,000 (5000
 ` 5) plus ` 30,000 for fixed cost and profit totaling ` 55,000/- same as if the transfer price is
` 11/-.
If transfer is less than 5000 say 4000, unit Y will pay variable cost of ` 20,000 (4000  ` 5) plus
30,000 i.e., ` 50,000 as compared to ` 44,000 if the transfer price is ` 11/-. The difference of paying
extra is the penalty for not using the capacity of X which was reserved.
If transfer is more than 5000, say 6000, unit Y will pay variable cost of ` 30,000 (600 ` 5) plus
` 30,000 i.e., ` 60,000 which is less than ` 66,000 i.e., transfer price of ` 11/- per unit. This
represents the savings unit X would have because it can produce the additional units without
incurring additional fixed costs.

Prorating the Overall Contribution

Impose a variable cost transfer price but credit each division for a prorated share of the overall
contribution to corporate profit. The proportion may be negotiated in any number of ways. This
method may be appropriate if the demand for the manufactured product is not steady enough to
warrant the permanent assignment of facilities. There are several practical problems in
implementing such a profit-sharing system e.g. dispute over the way contribution is divided
requiring senior managements, intervention, valid information on the profitability of each
segment is not possible, sharing of contribution depends on marketing units’ ability to sell
which is perceived by manufacturing units as unfair.

Two Sets of Prices

The manufacturing unit’s revenue is credited at the outside sales price minus a percentage to
cover marketing costs, and the buying unit is charged with variable standard cost (or sometimes,
the total standard cost). The difference is charged to a headquarter’s account and eliminated
when the business unit statements are consolidated. This transfer pricing method is sometimes
used when there are conflicts between the buying and selling units that cannot be resolved by
one of the other methods. There are several disadvantages of having two sets of transfer prices:
(i) the sum of the business profits is greater than overall company profits, (ii) this system creates
an illusive feeling that business units are making money, while in fact, the overall company
might be losing after considering debits to headquarters, (iii) this system motivates business
units to concentrate more on internal transfer, (where they are assured of a good markup) at the
expense of outside sales, (iv) there is additional book keeping involved in the first debiting the
headquarters account every time a transfer is made and then eliminating this account when
business units statements are consolidated.

Self Assessment

Multiple Choice Questions:

1. For a profit centre selling the goods, the transfer price is the major determinants of:
(a) Sales and profits (b) Revenue and sales
(c) Revenue and profits (d) Sales and expenses

LOVELY PROFESSIONAL UNIVERSITY 105