UST - ALFREDO M.

VELAYO COLLEGE OF ACCOUNTANCY

Management Advisory Services

Transfer Pricing

Decentralization – Refers to the separation or division of the organization into more manageable units
wherein each unit is managed by an individual who is given decision authority and is held
accountable for his or her decisions. Decision-making authority is spread throughout the organization,
and lower-level managers are given the authority to decide how to manage their individual units.

Goal congruence – all units of the organization have incentives to perform for a common interest.
The purpose of a responsibility system is to motivate management performance that adheres to
company overall objectives.

Sub-optimization – Happens when one segment of a company takes action that is in its own best
interests but is detrimental to the firm as a whole.

Transfer Pricing
The amount charged by one segment of a firm for products or services that are supplied to another
segment of the same firm. It is also known as intersegment price.
• Primary objective: to evaluate performance by virtually transforming cost centers into profit
centers so that performance of the manager of mainly cost centers can be measured reliably
in terms of both revenues and expenses.
• Secondary objective: to save on costs involved in producing or buying by in-sourcing rather
than outsourcing.
• Other objectives: to motivate managers, to provide a basis to fairly rewarding the managers
and to provide an incentive for managers to make decisions consistent with the firm’s goals.

Basis of Transfer price

• Cost-based method – uses some measure of cost to set the transfer price. Instead of looking to
the market to see what outside parties would pay for the product or service, this method looks
internally to determine how much it costs to produce the product or provide the service.
o Variable cost – variable manufacturing costs unless additional variable non-
manufacturing costs are incurred
o Full (absorption) cost – variable and fixed manufacturing costs
o Cost plus some percentage mark-up – any one of the three above plus a certain mark-
up
• Market-based method
o Market price – regular selling price
o Modified market – selling price adjusted for any allowance for discounts, etc.
• Negotiated price
o Appropriate when there is no external market price, there are cost savings to the selling
division and the internal market price reflects a bargain price.
o Just make sure that the negotiated price is anywhere between the price ceiling and
price floor.

Relevant Costing Concept: Maximum vs. minimum transfer prices

For transfer pricing not to defeat its purpose, organizations normally set a limitation as to the transfer
price being charged by one segment to another. To minimize the effect of sub-optimization, a range
of transfer price must be set based on the following limits:
• Upper limit: Maximum transfer price = cost of buying from outside suppliers
• Lower limit: Minimum transfer price = additional outlay cost per unit + lost contribution margin
per unit
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Illustrative Problem 1. SOFTDRINKS Inc. has 2 segments, PEPSI and COKE. Segment PEPSI produces and
sells bottles while segment COKE produces and sells drinks. Each of the segments are evaluated
based on their individual performance.

Segment PEPSI has a capacity of 100 000 bottles each year. The demand for this product is unlimited,
meaning PEPSI can sell all the bottles it can produce. Selling price in the market for this product is P10.
Variable costs (including selling expense of PhP1.00) is P3.00. Fixed cost per unit based on the
capacity is P4.00. Segment COKE needs 40 000 bottles to contain its drinks. Segment COKE’s drink sells
for P30 a bottle. It can purchase bottles worth P5.00 each from an outside supplier. The selling
expenses will not be incurred if COKE will purchase the bottles from PEPSI. It is either COKE will
purchase all 40 000 bottles or none at all. In addition to purchase price of the bottle, COKE incurs P2
variable production cost per unit and P80,000 total fixed costs.
a. What is the maximum price? c. What is the minimum price?
b. Should they transact with each other? d. What is the appropriate transfer price?

Assume instead that the annual demand for PEPSI’s bottles is only 60 000 bottles. (i.e. Only 60 000
bottles can be sold each year).
a. What is the maximum price? c. What is the minimum price?
b. Should they transact with each other? d. What is the appropriate transfer price?

Assume instead that the annual demand for PEPSI’s bottles is only 70 000 bottles. (i.e. Only 70 000
bottles can be sold each year).
a. What is the maximum price? c. What is the minimum price?
b. Should they transact with each other? d. What is the appropriate transfer price?

Illustrative Problem 2. AUTOMOTO Inc. has 2 segments, TIRES and SEDAN. Segment TIRES produces
and sells wheels while segment COKE produces and sells cars. Each of the segments are evaluated
based on their individual performance.

Segment TIRES has a capacity of 80 000 wheels each year. Currently, TIRES sells 70,000 wheels to
outside customers. Selling price in the market for this product is P10. Variable costs per unit amounted
to P3.00. Fixed costs totaled P200,000. Segment SEDAN needs 10 000 wheels to manufacture its cars.
Segment SEDAN’s cars sell for P30 per unit. It can purchase wheels worth P5.00 each from an outside
supplier. It is either SEDAN will purchase all 10 000 wheels or none at all. In addition to the purchase
price of the wheels, SEDAN incurs P2 variable production cost per unit and P80,000 total fixed costs.

1. Should the two segments transact with each other?

2. Overall effects on profits if SEDAN buys from outside supplier.
3. Overall effects of profits if two segments transact at P3 per unit.
4. Overall effects of profits if two segments transact at P5 per unit.

Illustrative Problem 3. ALCOHOL Inc. has 2 Divisions, ISOPROPHYL and METHYL. ISOPROPHYL produces
A51020, a product that can be sold either to METHYL Division or outside customers. The Selling Price is
P125.00 for A51020, variable cost per unit is P90.00. ISOPROPHYL can produce 20 000 units a year.
Outsiders consume 16 000 of these, while METHYL requires 4 000 for the same period. Sales to METHYL
Division were at the same price as sales to outsiders. A51020s purchased by METHYL were used as
part of its product IC9870. One A51020 is used for each IC9870. METHYL incurs and additional P100.00
to produce IC9870 and sells it for P300.00. METHYL considers expanding its operations. Hence, it may
require an additional 1 000 units of A51020. A51020s are not available in an outside market.

a. Should ISOPROPHYL Division sell 1 000 additional A51020s to METHYL at the expense of outside
buyers? How much is the effect on overall profits if ISOPROPHYL will sell 1 000 of the units
allocated for outsiders to METHYL instead?
b. Assume that the additional 1 000 units be produced by requiring overtime work and hence
may be extremely high, what is the maximum price METHYL Division will accept for the
additional 1 000 units?

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QUIZZER:
1. The price charged by one segment of an organization for a product or service supplied to
another segment of the same organization is called the:
a. selling price
b. exchange rate
c. transfer price
d. outlay price

2. Transfer pricing works best in a decentralized organization. It should encourage goal

congruence and managerial effort. Goal congruence is:
a. the extent of an attempt to accomplish a specific goal
b. the desire and the commitment to achieve a specific goal
c. the agreement on the goals of the organization and/or the segment by both the superiors
and subordinates
d. the extent to which managers have the authority to make decisions

3. It is the extent to which a manager attempts to accomplish a specific goal. It may include
psychological, as well as physical commitment to a goal.
a. Goal congruence
b. Managerial effort
c. Motivation
d. Autonomy

4. It is the desire to attain a specific goal and the commitment to accomplish the goal.
a. Goal congruence
b. Managerial effort
c. Motivation
d. Autonomy

5. It is the extent to which managers have the authority to make decisions.

a. Goal congruence
b. Managerial effort
c. Motivation
d. Autonomy

6. An artificial profit center

a. is not responsible for the costs that it incurs
b. has no investment
c. does not provide its goods or services outside the entity.
d. could not be operated as a cost center

7. Given no idle capacity and a competitive market exists, that is, all goods transferred internally
can be sold externally, the optimal method for establishing the transfer is equal to:
a. outlay cost plus opportunity cost
b. outlay cost
c. opportunity cost
d. cost plus any markup

8. In a decentralized company in which divisions may buy goods from one another, the transfer-
pricing system should be designed primarily to
a. Increase in the consolidated value of inventory.
b. Allow division managers to buy from outsiders.
c. Minimize the degree of autonomy of division managers.
d. Aid in the appraisal and motivation of managerial performance.

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9. The minimum potential transfer price is determined by
a. the lowest outside price for the good.
b. incremental costs in the selling division.
c. the extent of idle capacity in the buying division.
d. negotiations between the buying and selling division.

10. The maximum of the transfer price negotiation range is

a. set by the selling division.
b. determined by the buying division.
c. influenced only by internal cost factors.
d. negotiated by the buying and selling division.

11. The optimal transfer price from the viewpoint of the corporation is
a. variable cost
b. absorption cost plus markup
c. variable cost plus opportunity cost
d. absorption cost plus opportunity cost
e. absorption cost plus selling expenses

12. To avoid waste and maximize efficiency when transferring products among divisions in a
competitive economy, a large, diversified corporation should base transfer prices on
a. full cost.
b. production cost.
c. market price.
d. variable cost.

13. The transfer price usually set by an absorption costing calculation is called the:
a. Selling price
b. Market price
c. Full cost price
d. Retail price

14. ABC, Inc. has two divisions: the Handles Division, which manufactures cabinet handles, and
the Assembly Division which assembles various parts to produce cabinets, the main product of
ABC, Inc.

The Handles Division currently has excess capacity of 1,500 units. It produces handles at
variable cost of P70. The handles can be sold in the outside market for P100.

The Assembly Division requires 1,400 handles for the cabinets that it produces. It can buy such
handles from outside suppliers at P100, or it can just buy them from the Handles Division.

What is the natural bargaining range for the two divisions regarding the transfer price of
handles?
a. Between P70 and P100
b. Between P100 and P170
c. Any amount less than P100
d. P70 is the only acceptable price

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15. The Eastern Division sells goods internally to the Western Division of the same company. The
prevailing external price of Eastern Division’s product is P500 per unit plus transportation. It cost
P100 per unit to transport the goods to Western.

Eastern incurs the following costs per unit in producing the goods:
Materials P250
Direct Labor P75
Storage and handling P60
Total P385

If the market-based transfer pricing method is to be used, the transfer price must be set at
a. P500
b. P600
c. P385
d. P325

16. XYZ Corporation has two divisions, X and Y, both operated as profit centers. X charges a
transfer price of P140 per unit of the products transferred to Y. Other data about Division X are
as follows:
Annual sales to outsiders 200,000 units
Annual sales to Division Y 20,000 units
Variable cost per unit P120
Fixed costs P40,0000

Division X is planning to raise its transfer price to P200 per unit. Division Y can purchase the units
at P160 each from outside sources. However, should Y buy from outsiders, the facilities used by
Division X to produce the units for Division Y would remain idle, because Division X cannot
increase sales to outsiders.

The company is a non-absolute decentralized organization. When sub-optimization is likely to

occur, the company president may intervene in the subordinate managers’ decision.

In this case, from the perspective of the company as a whole and assuming that Division Y’s
market is unaffected, from whom should it acquire the goods?
a. Division X, despite the increased transfer price
b. Outside vendors
c. Division X, but only at the variable cost per unit
d. Division X, but only until it reaches its break-even point, then from outside vendors

17. Division Uno of PQR Company is currently operating at full capacity of 5,000 units. It sells all its
production in a perfectly competitive market for P250 per unit. Its variable cost is P170 per unit,
while its total fixed cost amounts to P300,000.

The minimum transfer price that should be charged to Division Dos of PQR Company for each
unit of product transferred Division Uno is:
a. P230
b. P170
c. P250
d. P470

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 For items 18 and 19, please refer to the following information:
18. Division One of EFG Company is currently operating at 70% of capacity. It produces a single
product and sells all its production to outside customers for P70 per unit. Variable costs if P30
per unit and fixed costs is P20 per unit at the current production level.

Division Two, which currently buys the same product from an outside supplier for P65 per unit,
would like to buy the product from Division One.
Division One will use one-half of its idle capacity if it decides to provide the requirements of
Division Two.

What is the minimum price that Division One should charge Division Two for this product?
a. P70
b. 30
c. 50
d. 65

19. What is the maximum price that Division Two will be willing to pay for the product if it will be
purchased internally?
a. P70
b. P30
c. P50
d. P65

For items 20 and 21, please refer to the following information:

20. Wilcon, Inc. has several divisions operating as decentralized profit centers. Wilcon’s Shower
Faucet Division produces showerhead sets using subcomponents produced by two of Wilcon’s
other divisions. The Flexi Hose Division manufactures a flexible hose, one type that is made
exclusively for the Shower Faucet Division, while other types are sold to outside markets.

The Valve Division, on the other hand, sells its valves in a competitive market, although one
type of valve is also used by the Shower Faucet Division. The Valve Division is currently
operating at 50% capacity level only.

The market prices, as well as the costs per unit of the flexible hose and the valves supplied by
the two other divisions to Shower Faucet Division, are as follows:
Flexible Hose Valves
Market Price P125 P220
Costs per unit: Materials P 25 P 48
Labor P 47 P 60
Variable Overhead P 20 P 30
Fixed Overhead P 8 P 45
Total cost per unit P100 P183

Considering the given data, which of the following statements is incorrect?

a. If the Valves Division would transfer valves to Shower Faucet Division at a full-cost
transfer price of P183, there would be no incentive on the part of the Valves Division to
control or reduce production costs.
b. If the Shower Faucet Division could buy valves in large volume at P200 per unit, THE
Valves Division should reduce its transfer price to the same amount in order to optimize
the overall profit goal of Wilcon, Inc.
c. If the Flexi Hose Division has excess capacity and it has negotiated a transfer price of
P112 per unit with the Shower Faucet Division, this price will motivate both divisions to
buy and sell internally as profit is shared.
d. None of the above

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21. The managers of the Shower Faucet Division and the Flexi Hose Division want to set a transfer
price that will divide the resulting profit/savings equally between their divisions. Such transfer
price should amount to:
a. P108.50
b. P125.00
c. P100.00
d. P92.00

22. The First Division of HIJ Company produces Part 1 that is used by ABC as a key part in their
products. Costs and sales data of Part 1 are as follows:
Selling price per unit P100
Variable cost per unit 60
Fixed cost per unit (Based on 40,000 units capacity per annum) 24

HIJ Company’s Second Division is introducing a new product that will use Part 1. An outside
supplier has quoted Second Division a price of P96 per unit. This represents the usual P100
price less a quantity discount due to the large number of Second Division’s requirement.

If the Second Division would buy 15,000 units of Part 1 from the First Division, the effect on the
corporate profits would be
a. Reduce by P60,000.
b. Increase by P240,000.
c. Increase by P210,000.
d. Increase by P1,500,000.

23. Division P of PQR Corporation has the capacity for making 75,000 wheel sets per year and
regularly sells 60,000 each year on the outside market. The regular sales price is P100 per wheel
set, and the variable production cost per unit is P65. Division Q of PQR Corporation currently
buys 30,000 wheel sets (of the kind made by Division P) yearly from an outside supplier at a
price of P90 per wheel set. If Division Q were to buy the 30,000 wheel sets it needs annually
from Division P at P87 per wheel set, the change in annual net operating income for the
company as a whole, compared to what it is currently, would be:
a. P135,000.
b. P600,000.
c. P225,000.
d. P750,000.

-END-

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