Tutorial Question – Transfer Pricing

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PCG Ltd is a company that manufactures and sells a wide range of laptops to domestic
market. It has two divisions, i.e., the Assembly Division and Battery Division. Battery
Division sells batteries to both Assembly Division and to other laptop manufacturers.
Assembly Division could also purchase batteries from other suppliers.

The following data is available for both divisions:

Assembly Division
Selling price for each laptop, including battery $1,800
Costs per laptop:
Battery from Battery Division $130
Materials (excluding the cost of the battery) $450
Variable overheads $350
Annual fixed overheads $5,460,000
Current production and sales of laptops (units) 150,000
Maximum production to meet the annual market demand for laptops 180,000
(units)
Battery Division
Transfer price per battery sold to Assembly Division $130
Selling price per battery to external customers $150
Costs per battery:
Materials $50
Variable overheads (Note 1) $20

Annual fixed overheads $2,200,000

Current annual production capacity and sales of batteries – both internal
and external sales (units) (Internal=350000-200000=150000) 350,000
Maximum annual external demand for batteries (units) 200,000
(Note 1: $20 if for external sales. Battery Division saves a variable overhead of $5 per
battery for all batteries it sold internally).(Internal=20-5=15)
Additional Information:
Currently, PCG’s purchasing policy restricts Assembly Division from purchasing
batteries from outside battery suppliers. The current transfer price of $130 was fixed by
the Head Office 2 years ago. However, Battery Division has refused to sell to
Assembly Division any quantity more than the current level of batteries it supplies to
Assembly Division, i.e., 150,000 units.
The manager of Assembly Division is unhappy because he cannot meet the market
demand of 180,000 units due to this policy. He has a potential external battery supplier
who could supply the batteries at $130.
After discussions with the divisional managers, the Head Office agreed to change the
purchasing policy to allow Assembly Division to buy externally without restriction,
provided it will optimise the profits of PCG Ltd as a whole.
Required:

(a) Under the current transfer pricing system, prepare a profit statement showing the
total net profit for each of the division.
Your sales and costs figures should separate the external sales and inter-divisional
transfer where appropriate. (6 marks)

(b) Discuss the range of acceptable transfer price for both divisions, assuming they have
freedom to set the transfer prices. Support your discussions with relevant
calculations.
(Note: 4 marks for calculation and 2 marks for discussion) (6 marks)

Answers:

(a)

Battery
Assembly Division Division
Sales: $000 $000
Internal (transfer price=selling price) $130*(350-200)k=19500
$1800*150k=27000
External 0 $150*200k=30000

Variable costs:
Material costs of batteries $50*350k=17500
Variable overheads - Internal transfer $15*(350-200)k=2250
Variable overheads - External sales $20*200k=4000
Battery purchase from Battery Division $130*150k=19500
Other materials costs (other than the cost of
batteries) $450*150k=67500
Variable overheads $350*150k=52500

Fixed overheads 5460 2200

Total costs 144960 25950

Net Profit 125040 23550

(b)

Battery Division:

Existing TP $130
Current max production and sales (units) 350000
Max market demand for batteries (units) 200000
Spare capacity of production of Battery Division 150000
The min TP of battery if based on the normal TP rules $50+(20-5)=65
(from Battery Division’s perspective)
The max TP of battery if there is no spare capacity $70+(150-70)-$5=145

Assembly Division:

Existing TP $130
Contribution if using existing TP $1800-130-450-350=870
Maximum TP acceptable $869
Potential external purchase price 130

Hence, the range of acceptable transfer price will be between $130 To $869.