Page 114 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 5: Transfer Pricing

Fixed manufacturing cost 10 Notes
Fixed selling expenses 4
Selling price of finished product 240
Required:

1. If Division X could sell 125,000 units as ` 100 each in the outside market, what transfer
price, would the central management prefer in order to provide proper motivation to
Division Y?
2. As management accountant, would you advise Division Y to buy at the transfer price
determined in part (1)?

3. Assume transfer price as in (1) if selling price drops to ` 200, should Y buy at that price?
Would this be desirable from the point of the firm, why?
4. Assume that Division X’s product did not have an outside demand in excess of 100,000
units and its total fixed manufacturing cost could be reduced by 10%, if the volume of
production were reduced to 100,000 units, what is the appropriate transfer price?

5. Suppose that X division’s maximum outside demand is 110,000 units at ` 100 and there is
no other usage for the capacity. What transfer prices should the company management
prefer.
6. Suppose the unit selling price of Y’s product is ` 180; one of its customers is also a customer
of Division X; division Y refuses to buy the part from the outside market at ` 100 since the
selling price of ` 180 would not cover the variable costs, if Division X does not cover the
transfer price, Division Y will not sell to this customer, who in turn will probably cancel
the usual order of 50,000 units to Division X; there is no other demand for the product and
no other usage of X capacity; fixed costs would not change at either division. What is the
lowest transfer price that the Division X would be advised to accept? Support your
recommendation with computations.

Solution:
1. Fixing of transfer price:
Variable manufacturing cost of Division X ` 84
Opportunity cost (in terms of contribution foregone by transfer to division Y)

Selling price ` 100
Less total variable costs to make and sell (` 84 + 2) 86 14
98
In this case, if X could sell 125,000 units (both transfer to Division Y of 25,000 units and its
external sales of 1,00,000 units), it earns a contribution of ` 14 per unit which need to be
compensated by the receiver Division Y, hence, transfer price of ` 98 as worked out above
will be preferred by the central management.
4. Appropriate transfer price/unit
Variable cost ` 84

Plus opportunity cost (in terms of reduction of fixed
Manufacturing cost
Present cost of manufacturing 125000 × 6 = 750,000

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