Problem 7 (Transfer Pricing)

Requirement 1

Since the Valve Division has idle capacity, it does not have to give up any outside sales to take on the
Pump Division’s business. Applying the formula for the lowest acceptable transfer price from the
viewpoint of the selling division, we get:

Total contribution margin

Variable on lost sales
Transfer price +
cost per unit Number of units transferred
P0
Transfer price P16 + 10,000 =P16

The Pump Division would be unwilling to pay more than P29, the price it is currently paying an
outside supplier for its valves. Therefore, the transfer price must fall within the range:

P16  Transfer price  P29

Requirement 2

Since the Valve Division is selling all of the valves that it can produce on the outside market, it would
have to give up some of these outside sales to take on the Pump Division’s business. Thus, the Valve
Division has an opportunity cost, which is the total contribution margin on lost sales:
Total contribution margin
Variable on lost sales
Transfer price +
cost per unit Number of units transferred

(P30 – P16) x 10,000

Transfer price P16 + 10,000

=P16 + P14 = P30

Since the Pump Division can purchase valves from an outside supplier at only P29 per unit, no
transfers will be made between the two divisions.

Requirement 3

Applying the formula for the lowest acceptable price from the viewpoint of the selling division, we
get:

Total contribution margin

Variable on lost sales
Transfer price +
cost per unit Number of units transferred

(P30 – P16) x 10,000

Transfer price (P16 – P3) + 10,000

=P13 + P14 = P27

In this case, the transfer price must fall within the range:

P27  Transfer price  P29

Problem 8 (Transfer Pricing)

To produce the 20,000 special valves, the Valve Division will have to give up sales of 30,000 regular
valves to outside customers. Applying the formula for the lowest acceptable price from the
viewpoint of the selling division, we get:
Total contribution margin
Variable on lost sales
Transfer price +
cost per unit Number of units transferred

(P30 – P16) x 30,000

Transfer price P20 + 20,000

=P20 + P21 = P41

Problem 10 (Transfer Pricing Basics)

Requirement (1)

a. The lowest acceptable transfer price from the perspective of the selling division, the Electrical
Division, is given by the following formula:

Total contribution margin

Variable cost + on lost sales
Transfer price =
per unit Number of units transferred
Because there is enough idle capacity to fill the entire order from the Motor Division, there are no
lost outside sales. And because the variable cost per unit is P21, the lowest acceptable transfer
price as far as the selling division is concerned is also P21.

Transfer price = P21 + P0 = P21

10,000
b. The Motor Division can buy a similar transformer from an outside supplier for P38. Therefore,
the Motor Division would be unwilling to pay more than P38 per transformer.
Transfer price: Cost from buying from outside supplier = P38

c. Combining the requirements of both the selling division and the buying division, the acceptable
range of transfer prices in this situation is:
P21 : Transfer price : P38
 Assuming that the managers understand their own businesses and that they are cooperative, they
should be able to agree on a transfer price within this range and the transfer should take place.

d. From the standpoint of the entire company, the transfer should take place. The cost of the
transformers transferred is only P21 and the company saves the P38 cost of the transformers
purchased from the outside supplier.

Requirement (2)

a. Each of the 10,000 units transferred to the Motor Division must displace a sale to an outsider at a
price of P40. Therefore, the selling division would demand a transfer price of at least P40. This
can also be computed using the formula for the lowest acceptable transfer price as follows:

Transfer price = P21 + (P40 – P21) x 10,000

10,000

= P21 + (P40 – P21) = P40

b. As before, the Motor Division would be unwilling to pay more than P38 per transformer.

c. The requirements of the selling and buying divisions in this instance are incompatible. The selling
division must have a price of at least P40 whereas the buying division will not pay more than P38.
An agreement to transfer the transformers is extremely unlikely.

d. From the standpoint of the entire company, the transfer should not take place. By transferring a
transformer internally, the company gives up revenue of P40 and saves P38, for a loss of P2.

Problem 11 (Transfer Pricing with an Outside Market)

Requirement (1)

The lowest acceptable transfer price from the perspective of the selling division is given by the
following formula:
Total contribution margin
Variable cost + on lost sales
Transfer price =
per unit Number of units transferred

The Tuner Division has no idle capacity, so transfers from the Tuner Division to the Assembly
Division would cut directly into normal sales of tuners to outsiders. The costs are the same whether a
tuner is transferred internally or sold to outsiders, so the only relevant cost is the lost revenue of P200
per tuner that could be sold to outsiders. This is confirmed below:

Transfer price = P110 + (P200 – P110) x 30,000

30,000

= P110 + (P200 – P110) = P200

Therefore, the Tuner Division will refuse to transfer at a price less than P200 per tuner.

The Assembly Division can buy tuners from an outside supplier for P200, less a 10% quantity
discount of P20, or P180 per tuner. Therefore, the Division would be unwilling to pay more than
P180 per tuner.
 Transfer price : Cost of buying from outside supplier = P180
The requirements of the two divisions are incompatible. The Assembly Division won’t pay more than
P180 and the Tuner Division will not accept less than P200. Thus, there can be no mutually agreeable
transfer price and no transfer will take place.

Requirement (2)

The price being paid to the outside supplier, net of the quantity discount, is only P180. If the Tuner
Division meets this price, then profits in the Tuner Division and in the company as a whole will drop
by P600,000 per year:

Lost revenue per tuner...................................................... P200

Outside supplier’s price.................................................... P180
Loss in contribution margin per tuner............................... P20
Number of tuners per year................................................ × 30,000
Total loss in profits........................................................... P600,000

Profits in the Assembly Division will remain unchanged, since it will be paying the same price
internally as it is now paying externally.

Requirement (3)

The Tuner Division has idle capacity, so transfers from the Tuner Division to the Assembly Division
do not cut into normal sales of tuners to outsiders. In this case, the minimum price as far as the
Assembly Division is concerned is the variable cost per tuner of P11. This is confirmed in the
following calculation:

Transfer price = P110 + P0 = P110

30,000
The Assembly Division can buy tuners from an outside supplier for P180 each and would be
unwilling to pay more than that in an internal transfer. If the managers understand their own
businesses and are cooperative, they should agree to a transfer and should settle on a transfer price
within the range:

P110 : Transfer price : P180

Requirement (4)

Yes, P160 is a bona fide outside price. Even though P160 is less than the Tuner Division’s P170 “full
cost” per unit, it is within the range given in Part 3 and therefore will provide some contribution to the
Tuner Division.

If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in potential profits:

Price per tuner.................................................. P160

Variable costs...................................................  110
Contribution margin per tuner.......................... P 50
 30,000 tuners × P50 per tuner = P1,500,000 potential increased profits

This P1,500,000 in potential profits applies to the Tuner Division and to the company as a whole.

Requirement (5)

No, the Assembly Division should probably be free to go outside and get the best price it can. Even
though this would result in lower profits for the company as a whole, the buying division should
probably not be forced to purchase inside if better prices are available outside.

Requirement (6)

The Tuner Division will have an increase in profits:

Selling price..................................................... P200

Variable costs...................................................  110
Contribution margin per tuner.......................... P 90

30,000 tuners × P90 per tuner = P2,700,000 increased profits

The Assembly Division will have a decrease in profits:

Inside purchase price........................................ P200

Outside purchase price.....................................  160
Increased cost per tuner.................................... P 40

30,000 tuners × P40 per tuner = P1,200,000 decreased profits

The company as a whole will have an increase in profits:

Increased contribution margin in the Tuner Division........................................... P 90

Decreased contribution margin in the Assembly Division...................................   40
Increased contribution margin per tuner.............................................................. P 50

30,000 tuners × P50 per tuner = P1,500,000 increased profits

So long as the selling division has idle capacity and the transfer price is greater than the selling
division’s variable costs, profits in the company as a whole will increase if internal transfers are
made. However, there is a question of fairness as to how these profits should be split between the
selling and buying divisions. The inflexibility of management in this situation damages the profits of
the Assembly Division and greatly enhances the profits of the Tuner Division.