CALCULATING COST-BASED TRANSFER PRICES

EXAMPLE AND EXPLANANTIONS

Information:
Olympus, Inc., has a number of divisions, including Kappa Division, producer of various
types of pressure pumps, and Beta Division, a computer printer manufacturer.
The Kappa Division produces the ipa-211 model that can be used by the Beta Division in
the production of ink jet printers that use the high pressure pump to direct liquid ink through
a reservoir. The market price of the ipa-211 is $20. Cost information for the ipa-211 model
is:
Variable Product Cost
Fixed Cost
Total Product Cost

$6.00
9.00
$15.00

Beta needs 50,000 units of model ipa-211 per year. Kappa Division is at full capacity
(150,000 units of ipa-211).
Required:
1. If Olympus, Inc., has a transfer pricing policy that requires transfer at full product
cost, what would the transfer price be? Do you suppose that Kappa and Beta
divisions would choose to transfer at that price?
2. If Olympus, Inc., has a transfer pricing policy that requires transfer at full cost plus 20
percent, what would the transfer price be? Do you suppose that Kappa and Beta
divisions would choose to transfer at that price?
3. If Olympus, Inc., has a transfer pricing policy that requires transfer at variable
product cost plus a fixed fee of $18.00 per unit, what would the transfer price be? Do
you suppose that Kappa and Beta divisions would choose to transfer at that price?
4. What if Kappa Division plans to produce and sell only 100,000 units of ipa-211 next
year? The Olympus, Inc., policy is that all transfers be at full cost. Which division
sets the minimum transfer price, and what is it? Which division sets the maximum
transfer price, and what is it? Do you suppose that Kappa and Beta divisions would
choose to transfer?
Solution:
1. The full cost transfer price is $15.00. Beta Division would be delighted with that
price, but Kappa Division would refuse to transfer since $20.00 could be earned in the
outside market.
2. The cost-plus transfer price is $18.00 ($15.00 + $3.00). Again, Beta Division would
be delighted with that price, but Kappa Division would refuse to transfer since $20.00
could be earned in the outside market.

3. The variable product cost plus fixed fee is $24.00 ($6.00 + $18.00). In this case,
Kappa Division would be delighted, but Beta Division would refuse, since it can buy
all it needs on the outside market for $20.
4. Minimum transfer price = $15.00 (the full cost of production). This price is set by
Kappa, the selling division. Maximum transfer price = $20. This is the market price
and is set by Beta, the buying division.
Yes, both divisions would be willing to accept the transfer price of $15.00 per unit.
Explanations:
1. Full-Cost Transfer Pricing: In the majority of full-cost transfer pricing situations,
the opportunity costs are inaccurate reference points that fail to provide optimal
outcomes. Because the outside market price is $20.00 per unit, Beta Division would
choose to transfer at the full cost transfer price of $15.00. Beta, the buying division,
would save $5.00 ($20.00 - $15.00) per unit and a total of $250,000 ($5.00 x 50,000
units) per year purchasing the model ipa-211 at full product cost. Kappa Division
managers would never have considered transferring internally if the model ipa-211
price had to be full product cost. Kappa Division would be much better off selling the
model ipa-211 in the outside market at a price of $20.00 per unit. The full product
cost is below Kappa Divisions minimum transfer price.
2. Full Cost plus Markup: When using this method, the cost base is the full price and
a markup is added to create a profit margin for the supplying division. The advantage
comes from the methods simplicity and ease of use. It is calculated by adding the
full cost and a decided percentage of the full cost. The percentage is designed as to
create a profit margin. This method provides Beta Division with the advantage of
saving $2.00 per unit. Kappa Division would sell in the external market to profit the
extra $2.00 per unit selling the ipa-211 at $20.00 per unit.
3. Variable Cost Plus Fixed Fee: With this method, variable costs are used as the base.
The fixed costs and profit contribution are covered by the markup. Variable cost is
the opportunity cost when the selling division is operating below capacity. Because
of this, the variable cost plus fixed fee method has a slight advantage over the full
plus markup method. The variable cost is $6.00 and the fixed fee is $18.00. Adding
the variable cost and the fixed fee gives a transfer price of $24.00. Beta Division is
better off buying the product in the external market. If it bought from Kappa
Division, Beta Division would lose $4.00 ($20.00 - $24.00) per unit. Because of this,
transferring internally using this method would be inefficient for Olympus, Inc.,
overall.
4. Propriety of Use: When deciding whether or not to use one of the forms of costbased transfer pricing, a company must consider the overall advantages and
disadvantages. Many times, the simplicity of use may be of greater value than
exhausting large amounts of time on negotiated transfer prices. Although cost-based
methods may often seem inefficient, lacking consumer and competitor considerations,
there are occasions when using these methods can be the best option.
Reference: Hansen, D.R. & Mowen, M.M. (2011). Cornerstones of Cost Accounting.
Mason, OH: South-Western, Cengage Learning