CIMA Paper P2

Advanced Management Accounting

Ian Kusano and Nathi Thela
 Chapter 9 Transfer Pricing

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 Session Content

Transfer
Pricing

Decision Performance
Making Evaluation

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 Objectives of Transfer Pricing

• Goal congruence
• Performance measurement
• Maintaining divisional autonomy
• Minimising global tax liability
• Recording the movement of goods and services
• Fair allocation of profits between divisions

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 Bases for setting transfer prices

1. Market based
2. Cost based
3. Negotiated

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 Selecting a transfer price

If there is an external market the market price will be the

ideal price (less any selling expenses)

If there is no external market then

- the selling division should accept a minimum price of
marginal cost plus any opportunity cost.
- the buying division should accept any transfer price
which will allow contribution to be made (positive net
marginal revenue)
- there may be a range of acceptable prices which will
be subject to negotiation
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 Example 1
A company has two profit centres, Centre A and Centre B. Centre A supplies
Centre B with a part-finished product. Centre B completes the production and
sells the finished units in the market at $35 per unit.

Budgeted data for the year:

Division A Division B

Number of units transferred/sold 10,000 10,000

Materials costs $8 per unit $2 per unit
Other variable costs $2 per unit $3 per unit
Annual Fixed Costs $60,000 $30,000

Required:
Calculate the budgeted annual profit of each profit centre and the organisation as
a whole if the transfer price for components supplied by Division A to Division B is:
1. $20 2. $25

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 Decision Making
The general rule for decision-making is that all goods and
services should be transferred at opportunity cost

There are 3 possible situations

1. Where there is a perfectly competitive market for an
intermediate product
OPTIMUM TP (DM) = MARKET PRICE + ANY SMALL
ADJUSTMENTS

2. Where there is surplus capacity

OPTIMUM TP (DM) = MARGINAL COST
3. Where there are production constraints
OPTIMUM TP (DM) = MARGINAL COST + SHADOW PRICE

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 Example 2
AB Ltd has two Divisions – A and B. Division A manufactures a product called the aye and
Division B manufactures a product called the bee. Each bee uses a single aye as a
component. A is the only manufacturer of the aye and supplies both B and outside
customers. Details of A’s and B’s operations for the coming period are as follows:

Division A Division B
Fixed Costs $7,500,000 $18,000,000
Variable Costs per unit $280 $590 (*)
Capacity – Units 30,000 18,000

* Note: exclude transfer costs

Market research has indicated that demand for AB Ltd’s products from outside customers
will be as follows in the coming period:
• the aye: at unit price $1,000 no ayes will be demanded but demand will increase by 25
ayes with every $1 that the unit price is reduced below $1,000;

• the bee: at unit price $4,000 no bees will be demanded, but demand will increase by 10
bees with every $1 that the unit price is reduced below $4,000;

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 Example 2 ( Cont….)

Required:

a) Calculate the unit selling price of the bee (accurate to the nearest $) that will maximise
AB Ltd’s profit in the coming period.

b) Calculate the unit selling price of the bee (accurate to the nearest $) that is likely to
emerge if the Divisional Managers of A and B both set selling prices calculated to
maximise Divisional profit from sales to outside customers and the transfer price of ayes
going from A to B is set at ‘market selling price’.

c) Explain why your answers to parts (a) and (b) are different, and propose changes to the
system of transfer pricing in order to ensure that AB Ltd is charging its customers at
optimum prices.

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 Decision Making
2. Where there is surplus capacity
OPTIMUM TP (DM) = MARGINAL COST
Possible Solutions
- 2 part tariff
The transfer price is marginal cost, but in addition a fixed sum is paid
per annum or per period to the supplying division to go at least part of
the way towards covering its fixed costs, and possibly even to
generate a profit.
- Cost-plus pricing
The transfer price is the marginal cost or full cost plus a markup.
- Dual pricing
Dual pricing is where one transfer price is recorded by the supplying
division and a different transfer price is recorded by the buying
division.

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 Decision Making
3. Where there are production constraints
OPTIMUM TP (DM) = MARGINAL COST + SHADOW PRICE
There are 2 possibilities:
(i) Where internal demand has to be met by foregoing external sales of
another product, the shadow prices reflect contribution foregone on that
other product. The resulting TP (DM) is also suitable for performance
evaluation.

(ii) Where the supplying division makes only one product which is only sold
internally, the shadow price must now reflect contribution from the final
production. The TP (DM) builds that contribution into the supplying division's
revenue.
Therefore all contribution will appear in the supplying division's books (and
none in the buying division's).
The problem is that the optimum TP (DM) is unfair to the buying division.

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 Example 3
Pool Group has two divisions that operate as profit centres. Each centre sells similar
products, but to different segments of the market:

• Division P makes product P29 which it sells to external customers for $150. Variable
costs of production are $45 per unit. The maximum annual sales demand for P29 is
5,000 units, although Division P has capacity for 7,000 units. Increasing output from
5,000 to 7,000 each year would result in additional fixed cost expenditure of $8,000.

• The manager of Division L has seen an opportunity to sell an amended version of

Product P29 to its own customers, and is interested in buying 2,000 units each year to
resell externally at $90 per unit. The costs of amending Product P29, for sale as Product
L77, would be $25 per unit. However, the manager of Division L will not pay more than
$40 per unit of Product P29. He argues that Division P will benefit from lower fixed costs
per unit by working at full capacity. The manager of Division P refuses to sell at a price
that does not cover the division’s incremental costs.

Required:
Suggest a dual transfer pricing arrangement that might overcome the disagreement
between the two divisional managers.

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