Management Accounting- Transfer pricing

hello guys
this question is about transfer pricing, an area which a management accountant must be aware of.


A transportation equipment manufacturer is heavily decentralised.  Each division head
has full authority on all decisions regarding sales to internal or external customers. 
Division P has always acquired a certain equipment component from Division S. 
However, when informed that Division S was increasing its unit price to £220,
Division P's management decided to purchase the component from outside suppliers at a price of £200.

Division S had recently acquired some specialised equipment that was used primarily to make this component.
The manager cited the resulting high depreciation charges as the justification for the price boost. 
He asked the president of the company to instruct Division P to buy from S at the £220 price. 
He supplied the following:

                        P's annual purchases of component                   2000 units
                        S's variable cost per unit                                   £            190
                        S's fixed costs per unit                                      £              20

Suppose there are no alternative uses of the S facilities.


(a)     1.  Will the company as a whole benefit if P buys from the outside
              suppliers for £200 per unit?                                                                 
         2.  Suppose the selling price of outsiders drops another £15 to £185.
              Should P purchase from outsiders?                                                    
         3.  Suppose (disregarding Question 2 above) that S could modify the
              component at an additional variable cost of £10 per unit and sell
              the 2000 units to other customers for £225.  Would the entire company
              then benefit if P purchased the 2000 components from outsiders at £200
              per unit?                                                                                            
         4.  Suppose the internal facilities could be assigned to other production
              operations which would otherwise require additional annual outlays
              of £29,000.  Should P purchase from outsiders at £200 per unit?
(b)     "Cost plus is the only sensible method of pricing transfers". 
          Critically discuss this statement.                                                           


1.      S's fixed costs are apparently £40,000 per year and these costs will be unaffected by whether P purchases externally or internally.  (They are "sunk costs", and hence irrelevant to this decision.)  If P purchases outside, its cash cost will be £400,000 per year.  If P purchases internally, the incremental cost to the firm is £380,000 per year (2000 @ £190).  Therefore, the firm as a whole is £20,000 worse off with the external purchase.

2.      Now, the cash outlay for external purchase is only £370,000 (2000 @ £185) and it is more profitable to purchase externally than to build internally.

3.      a)  P purchases externally at £200; S modifies component and sells at

Net cash cost to firm:
                        P's purchase:    2000 @ 200                                           £400.000
                        S's variable costs:         2000 @ (190 + 10)                                   400,000
                        S's revenues:    2000 @ 225                                           (450,000)
Net cash cost                                                                                        £350,000

         b)  P purchases internally from S.

Net cash cost:  2000 @ 190 = £380,000.

Therefore, it is more profitable for both P and S to transact in the external market.

4.      Returning to the answer to question 1, if S (or another division in the company) can save £29,000 by using S's idle facilities, then the £20,000 cost disadvantage from external purchase of the component is transformed into a £9,000 cost savings.  The company will now benefit from having P purchase the component externally.

         This problem provides simple settings to reinforce the importance of opportunity costs (what else could the selling division be doing with its product or its facilities) when attempting to determine an appropriate transfer price or mediate a transfer pricing dispute.

b)      Points to Include

         Definition of Transfer Pricing
         Methods of pricing with good and bad points of each of them
         A balanced view is looked for and an ability to critically discuss the merits of each area.

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