Transfer pricing illustrated

Suppose, A company has two divisions: Division A and Division B. Division A sells to Division B and to other outside customers. Division B buys from only Division A. The following unit costs wrere incurred by Division A for the coming year:

Direct Materials = $10
Direct labor = $6
Variable manufacturing overhead = $3
Variable selling costs = $1
Total = $20

Suppose that for the year Division A produced 40,000 units, of which 30,000 were sold to Division B for $25 each. The outside sales were for $30. The fixed manufacturing costs for the year were $80,000.

After Division B receives the component from Division A, it processes it a little further and then sells it to customers. The variable unit costs of Division B are$5 and its fixed costs for the year are $50,000. Division B sells all the units received from Division A at $35 each.

Transfer pricing illustrated - explanation with example 1
* 10,000 units x $30 = $3,00,000 and 30,000 units x $35 = $10,50,000.
** 30,000 units x $25 = $7,50,000.
*** 40,000 units x $20 = $8,00,000 and 30,000 units x $5 = $1,50,000.
**** Transferred-In costs is the same as internal sales.

Exhibit 1 shows how transfer pricing affects each division’s income statement and the company as a whole. The 30,000 units transferred from Division A to Division B is shown as $7,50,000 of internal sales for Division A and as $7,50,000 of transferred-in cost to Division B.

Both these amounts are not taken into account in preparing the overall company income statement. This is done so as to provide the external users of financial statements with information relating to the economic activities of the company with outside parties and not internal transfers.

Suppose now that Division B is allowed to buy from outside suppliers. An outside supplier has offered to supply the same type of units for $22 to Division B. Division A does not agree to reduce its price even though it has no alternative use of its production capacity.

Transfer pricing illustrated - explanation with example external supplies

* 10,000 units x $30 = $3,00,000 and 30,000 units x $35 = $10,50,000
** 10,000 units x $20 = $2,00,000 and 30,000 units x $5 = $1,50,000
*** 30,000 units x $22 = $6,60,000

Exhibit 2 shows that Division B increased its net income by $90,000 when it purchased from an external supplier. However, the profit of Division A and the company as a whole went down when Division B purchased from outside.

Transfer pricing illustrated - explanation with example company as a whole

* 10,000 units x $30 = $3,00,000 and 30,000 units x $35 = $10,50,000
** 30,000 units x $22 = $6,60,000
*** 40,000 units x $20 = $8,00,000 and 30,000 units x $5 = $1,50,000
**** Transferred-In costs are the same as internal sales.

Finally, assume that Division A is willing to negotiate a transfer price with Division B for $22. Exhibit 3 shows the income statement for each division and the company as a whole with the negotiated transfer price. Comparing Exhibit 1 and 3, we observe that the overall income of the company remains the same when there are internal transfers and the transfer price reduced from $25 to $22. However, the profit of Division B increases and that of Division A decreases. Division B is pleased to have outside competition since its net profit increases under both the alternatives.

Hence, transfer prices affect the profitability of both the buying and selling divisions. Performance evaluation of the divisional managers can also be done in a realistic manner. The impact of transfer prices on the company as a whole should be examined carefully to fully assess the results of the decisions involved in transfer pricing.

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