Page 112 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 5: Transfer Pricing

Notes
Example: A company has an opportunity to obtain a contract for the production of a
special component. This component will require 100 hours of processing on Machine X. Machine
X is working at full capacity on the production of Product A, and only way to fulfil the contract
is be reducing the output of A. This will mean a loss of revenue of ` 200/-. The contract also
involves the incurring of additional variable cost of ` 1000/-.

If the company takes on the contract, it will sacrifice revenue of ` 200/-. from the lost output
of product A. This represents an opportunity cost and should be included as part of the cost
when negotiating for the contract. The contract price should at least cover the additional cost
of ` 1000/-. plus the ` 200/-. opportunity cost to ensure that the company will be better off in
the short-run by accepting the contract.
It may be noted that opportunity costs only apply to the use of scarce resources. Where resources
are not scarce, there is no sacrifice from using these resources. If in the above case, machine X
was operating at 80% of the potential capacity, then acceptance of the contract would not have
reduced production of A. Consequently, there would have been no loss of revenue and the
opportunity cost would be zero.

This opportunity cost, as observed, is of vital importance for decision-making.
Transfer pricing per se does not affect the total profit of an organization since the receiver/user
department has to pay for the materials received and the giver department will receive the
payment on account of materials transferred to other departments-the transaction cancels out at
the time of calculating the total profit of the company. It only affects the profitability of both
giver and user departments. What matters is the effect of the transaction on the variable and
fixed costs of the respective departments.

Example: The MK Company had two decentralized divisions: A and B. Division A has
always purchased certain units from Division B at ` 7500 per unit. Because Division B plans to
raise the price to ` 10,000 per unit, Division A desired to purchase these units from outside
suppliers for ` 7500 per unit. Division B’s costs are as follows:

B’s variable costs per unit ` 7000
B’s annual fixed costs ` 15,00,000

B’s annual purchase of these 100,000 units for A
Required: If Division A buys from the outside supplier, the facilities Division B uses to
manufacture these units would remain idle. Would it be more profitable for the company to
enforce the transfer price of ` 10,000 per unit than to allow A to buy from outside suppliers at
` 7500 per unit?
Solution:

In this case, there are two options: (i) To enforce the transfer price of ` 10,000 per unit for 100,000
units transferred from Division B to Division A, or, (ii) To allow A to buy from outside suppliers
at ` 7500 per unit.

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