LECTURE-5

TRANSFER PRICING
A transfer price is the price at which goods or services are transferred from one process or
department to another or from one member of the group to another. The established transfer
price is a cost to the receiving and revenue to the supplying division, which means that
whatever transfer price that is set, will affect the profitability of each division. In addition this
transfer price will also significantly influence each division’s input and output decisions and
thus total company profits.

Purposes of transfer pricing:

i. To provide information that motivates divisional managers to make good economic
decisions. This will happen when the actions that the divisional managers take to
improve the reported profits of their divisions also improve the profits of the company
as whole.
ii. To provide information that is useful for evaluating the managerial and economic
performance of the divisions.
iii. To intentionally move profits between divisions or locations.
iv. To ensure that divisional autonomy is not undermined.

Alternative transfer pricing methods:

There are four approaches to transfer pricing:
 Market-based transfer pricing.
 Cost-based transfer pricing
 Negotiated transfer prices.
 Central management based transfer prices

1. Market-based transfer prices-

This is a price that a selling division can get for its product in the external market or the price
at which the buying division can get the product in the market place.

The use of market based transfer prices allows each division to be evaluated on a stand alone
basis. The managers are therefore encouraged to treat their divisions as independent firms and
can buy or sell from whatever source that seems best under the current market conditions.

2. Cost-based transfer pricing- this includes:

i. Full cost method - under this method the full cost (including fixed overheads
absorbed) that has been incurred by the supplying division in making the intermediate
product is charged to the receiving division.

ii. Full cost plus- with the cost based transfer prices discussed above, the supplying
divisions do not make any profits on the products or services transferred. The methods
are therefore not suitable for performance measurement. To overcome this problem, a
mark-up is added to enable the supplying division to earn a profit on interdivisional
transfers.

iii. Marginal cost transfer prices- this involves charging the variable cost that has been
incurred by the supplying division to the receiving division.

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3. Negotiated transfer pricing-
This approach involves negotiations between two managers of the selling and receiving
departments/divisions. The selling manager quotes the price and delivery conditions which
may or may not be accepted by the receiving manager based on alternative sources.

4. Central management-based transfer pricing-

The central management may determine the transfer price and communicate this to the
divisional managers. In most cases the basis of this is to promote goal congruency and to
allow for a standard performance evaluation criteria.

Illustration 1: (market prices/value)

A company has two profit centres A and B. centre A sells half of its output on the open
market and transfers the other half to B. costs and external revenue in an accounting period
were as follows;
A B Total
Shs. Shs. Shs.
External sales 800,000 2,400,000 3,200,000
Cost of production 1,200,000 1,000,000 2,200,000
Company profits 1,000,000

Required:
Determine the profit made by each division using market value transfer price.

Solution:
Particulars A B Total
Shs. Shs. Shs. Shs. Shs.
External sales 800,000 2400,000 3200,000
Transfer sales 800,000 --------
1600,000 2400,000
Less: transfer costs ------- 800,000
Own costs 1,200,000 1,000,000 2,200,000
1,200,000 1,800,000
Profit 400,000 600,000 1000,000

Example-2
A company has two divisions X and Y. Division X sells half of its output on the open market
and transfers the other half to Y. Costs and external revenue in an accounting period were as
follows;
X Y Total
Shs. Shs. Shs.
External sales 1,800,000 4,400,000 6,200,000
Cost of production 2,200,000 2,600,000 4,800,000
Company profits 1,400,000

Required:
Determine the profit made by each division using market value transfer price.

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The merits of market-based transfer prices
i. It gives divisional autonomy to managers to make sale/purchase decisions
ii. It supports divisional performance measurement

The demerits of market-based transfer prices

i. The market price may be a temporary one induced by adverse economic conditions.

ii. The external market for the intermediate product may be imperfect, so that if the
transferring division wanted to sell more externally, it would have to reduce its price.

iii. Similar products may have different market prices.

Illustration 2: (transfer prices based on full cost)

A company has two divisions X and Y. Division X can only sell half of its maximum output
externally because of limited demand. It transfers the other half of its output to Y which also
faces limited demand.
Division X has a profit margin of 25% on external sales but it makes transfers to division Y at
full cost.
The following data has been provided:
X Y Total
Shs. Shs. Shs.
External sales 40,000 120,000 160,000
Production cost in the division 60,000 50,000 110,000
Profit 50,000
Required:
Determine the profits made by each division using full cost transfer price.

Solution:
If half of the sales are in the external market at market price, the cost of these goods which
represent the other half transferred to division Y is 75% of 40,000 = shs. 30,000

Particulars X Y Total
Shs. Shs. Shs. Shs. Shs.
External sales 40,000 120,000 160,000
Transfer sales (at full cost) 30,000 --------
70,000 120,000
Less: transfer costs ------- 30,000
Own costs 60,000 50,000 110,000
60,000 80,000
Profit 10,000 40,000 50,000

Example-3
A company has two divisions P and Q. Division P sells half of its output on the open market
and transfers the other half to Q at full cost. P has a margin of 30% on its external sales. Costs
and external revenue in an accounting period were as follows;

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 P Q Total
Shs. Shs. Shs.
External sales 1,800,000 4,400,000 6,200,000
Cost of production 2,200,000 2,600,000 4,800,000
Company profits 1,400,000

Required:
Determine the profit made by each division using full cost transfer price.

Illustration 3: (transfer prices based on full cost- plus)

A company has two divisions P and Q. Division P can only sell half of its maximum output
externally because of limited demand. It transfers the other half of its output to Q which also
faces limited demand.

Division P has a profit margin of 25% on external sales but it makes transfers to division Q at
full cost plus a mark-up of 10%
The following data has been provided:
P Q Total
Shs. Shs. Shs.
External sales 120,000 300,000 420,000
Production cost in the division 180,000 140,000 320,000
Profit 100,000

Required:
Determine the profits made by each division

Solution:
The full cost for the external sales in division P is 75% of 120,000 = 90,000

This represents the cost for the sales by division P to division Q before the mark-up.

After the mark-up, the value of the transfer is 110% of 90,000 = 99,000

Thus the overall profit will be as follows:

Particulars P Q Total
Shs. Shs. Shs. Shs. Shs.
External sales 120,000 300,000 420,000
Transfer sales 99,000 --------
219,000 300,000
Less: transfer costs ------- 99,000
Own costs 180,000 140,000 320,000
180,000 239,000
Profit 39,000 61,000 100,000

Example-4
A company has two divisions P and Q. Division P sells half of its output on the open market
and transfers the other half to Q at full cost plus 20%. P has a margin of 30% on its external
sales. Costs and external revenue in an accounting period were as follows;
P Q Total

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 Shs. Shs. Shs.
External sales 1,800,000 4,400,000 6,200,000
Cost of production 2,200,000 2,600,000 4,800,000
Company profits 1,400,000

Required:
Determine the profit made by each division using full cost-plus transfer price.

Illustration 4: (transfer prices based on variable cost)

A company has two divisions M and N. Division M can only sell two-third of its maximum
output externally because of limited demand. It transfers the remaining one third of its output
to N which also faces limited demand.

Division M’S cost per unit is shs. 150 of which shs. 50 is fixed and shs. 100 is variable.

The following data has been provided:

M N Total
Shs. Shs. Shs.
External sales 240,000 600,000 840,000
Selling price per unit 200 300
Production cost in the division:
Variable cost per unit 100 115
Fixed cost 100,000 150,000

Required:
Determine the profit made by each division

Solution:

Particulars M N Total
Shs. Shs. Shs. Shs. Shs.
External sales 240,000 600,000 840,000
Transfer sales 60,000 --------
300,000 600,000
Less: transfer costs ------- 60,000
Own variable cost 180,000 230,000 410,000
Own fixed cost 100,000 150,000 250,000
280,000 440,000
Profit 20,000 160,000 180,000

Example-5
A company has two divisions K and T. Division K can only sell two-third of its maximum
output externally because of limited demand. It transfers the remaining one third of its output
to T which also faces limited demand.

Division K’s cost per unit is shs. 400 of which shs. 150 is fixed and shs. 250 is variable.

The following data has been provided:

K T Total

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 Shs. Shs. Shs.
External sales 750,000 1,250,000 2,000,000
Selling price per unit 375 500
Production cost in the division:
Variable cost per unit 250 300
Fixed cost 200,000 450,000

Required:
Determine the profit made by each division if transfers are made at variable cost.

Advantages of negotiated transfer pricing

i. It brings together the managers of the various divisions to understand the cost details
of their units
ii. Eliminates the possible animosity that may arise between divisional manager

Disadvantages
i. It depends on the negotiating skills of the managers concerned
ii. It may be time consuming if a stalemate develops

ECONOMIC THEORY
Profit is maximized at the output level where MR=MC

Practice Question:
X ltd has budgeted that the production and sales quantity of a single product will be 100,000
units in the next year. At this level of activity, the budgeted unit variable cost and fixed cost
will be sh 50 and sh 25 respectively. The sales manager estimates that demand for the product
will increase by 1 000 units for every decrease of sh 1 in unit selling price (and vice versa)
and that at a unit selling price of sh 200, demand will be zero units.

Information about two price increases has been recommended by the supplier, one for
materials (included in the variable cost of x ltd) and the other is for fuel (included in the fixed
cost of x ltd). Their effect will be to increase both the variable cost and the fixed cost by 20%
in total over the budgeted figures.

X ltd aims to maximize profits from its business.

Required:
a) Calculate before the cost increases:
i. The budgeted contribution and profits at the budgeted levels of sales of
100,000 units.
ii. The level of sales at which profits will be maximized and the amount of the
maximum profits.

b) Show whether and by how much x ltd should adjust the selling price in respect of the
increases in the:
i. Fuel cost
ii. Material cost
c) Show whether and by how much is it worthwhile for x ltd following the increases in
costs to spend sh 1,000,000 on a TV advertising campaign if this were confidently
expected to have effect during next year (but not beyond) but demand would still fall

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 by 1 000 units for every increases of sh 1 in the unit selling price but it will not fall to
zero until the selling price was sh 210
d) Comment on the results which you have obtained in (a) to (c) above and the
assumptions underlying them.

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