Mastery Problem: Transfer Pricing Transfer Pricing In many companies, one division may produce a product that is used by another division. When this happens, a price must be set for the product. This price is called the transfer price. The transfer price could be established by upper management or negotiated by division managers. In decentralized organizations, the transfer price is usually set by the managers of the divisions involved. The transfer price that is established will _ v affect the evaluation of a selling division, which is a profit center. There are three methods commonly used to established the transfer price: 1. Market Price 2. Cost 3. Negotiated Price Feedback Check My Work Roll over the underlined terms with your mouse to review the relationship between transfer prices and profit centers. Market Price Method If an established market price exists, this may be the best amount to use as a transfer price. How this transfer price affects the income of each division and the overall corporation depends on whether the selling division is operating at capacity and selling every unit it produces. Assume that Selling Division and Buying Division are both owned by Overall Corporation. Selling Division currently sells 100,000 units for $30 each. Each product costs $10 to produce. Fixed expenses are $150,000. Buying Division currently buys 15,000 units from Outside Company for $30 and sells each unit for $40. Fixed expenses for Buying Division equal $8,000. Click on each scenario to view income statements. 1. No Transfer 2. Market Price without Excess Capacity 3. Market Price with Excess Capacity Assume Selling Division has excess capacity of 15,000 units. If Selling Division sells product to Buying Division at market price, which of the following are true? Overall Corporation will benefit from the transfer of product from Selling Division to Buying Division. True Selling Division's net income will increase by selling 15,000 units to Buying Division. True Selling Division will give up sales to outside customers. False Buying Division's net income will increase if it buys the units from Selling Division. False Buying Division has no incentive to buy from Selling Division, because its net income will be the same if it buys True from Selling Division or Outside Company. Selling Division's net income will stay the same whether it sells the 15,000 units to Buying Division or not. False Feedback Check My Work Click on the links to the three scenarios and review the differences between each.Negotiated Price Method If excess capacity exists, market price is a good transfer price. Overall Corporation benefits from the transfer of product between Selling Division and Buying Division. However, there is no incentive for Buying Division to buy from Selling Division. Buying Division net income will be the same regardless of which supplier it uses. In order to give some incentive for Buying Division to buy from Selling Division, a negotiated price may be the best price to use as a transfer price. How this transfer price affects the income of each division depends on the price that is negotiated. When the transfer price is negotiated, there is a maximum price above which Buying Division will not buy. There is also a minimum price below which Selling Division will not sell. The maximum price is equal to the current market price The minimum transfer price can be calculated in one of two ways: Minimum Price = Market Price - Avoidable Costs. This formula ensures that the selling division is no worse off by selling to another division. When this formula is used, the range for the desirable transfer price is stated as: (Market Price - Avoidable Cost)