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 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 Market Price Method If an established market price exists, this may be the best amount to use as a transfer price. How .his 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 uniti produces. Assume that Selling Division and Buying Division are both owned by Overall Corporation. Selling Division currently sells 100,000 units for 530 each. Each product costs 510 to produce. Fixed expenses are $150,000. Buying Division currently buys 15,000 units from Outside Company for 530 and sells each unit for $40. Fixed expenses for Buying Division equal $3,000. 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 is operating at capacity and has no excess inventory. If Selling Division sells product to Buying Division at market price, which of the following are true? Selling Division will give up sales to outside customers. V Buying at a price higher than the market price will decrease the net income of Buying Division. V Selling units at market price to Buying Division will increase the net income of Selling Division. V Overall Corporation will benefit from the transfer of product from Selling Division to Buying Division. V Selling at a price lower than the market price will decrease the net income of Selling Division. V Buying at market price will increase the net income of Buying Division. V Negotiated Price Method If excess capacity exists, market price is a good transfer price. Overall Corporation benets 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 V 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. 1.fvhen this formula is used, the range for the desirable transfer price is stated as: (Market Price Avoidable Cost]