Transfer Price - Management Accounting Assessment Answers

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This is an assignment consisting of two parts , Part A and Part B. Part A Report format is to be used for this part Transfer pricing is used when products or services are transferred between different divisions of the same company. Explain what a transfer price is. What are the different types of transfer prices that can be used ? Why are these different types of transfer prices used? What are the purposes of using transfer prices? Part B This question is a practical question requiring answers to the questions at the end of the following information. The Complete Mining and Manufacturing Company has several divisions and two of these are involved in the transfer of products.The Cleaning and Scraping Division produces raw Cruden and transfers it to the Processing Division where it is processed into an alloy.The Processing Division then sells it on the open market for $160 per unit .Currently the Complete Mining and Manufacturing Company requires all of the Cruden to be transferred from the Cleaning and Scraping Division to the Processing Division . Currently the Cleaning and Scraping Division produces 400,000 units per year and transfers it all to the Processing Division at total actual manufacturing cost plus 10% . The Cruden can be purchased and sold on the open market for $95 and all that is sent to market can be sold on the market at this price.If the Cleaning and Scraping Division sells the Cruden on the open market it will incur a variable selling cost of $5 per unit . The following details show the unit costs for the Cleaning and Scraping and Processing Divisions Cleaning and Scraping Division Processing Division Transfer price from Cleaning and Scraping $77 Direct material 18 5 Direct labour 12 10 Manufacturing overhead 40 25 Total cost per unit 70 117 Manufacturing overhead in Cleaning and Scraping is 25% fixed,75% variable Manufacturing overhead in Processing is 60% fixed,40% variable Required: (a) Explain why transfer prices based on total actual costs are not appropriate as the basis fordivisional performance measurement (b)Using the market price as the transfer price, calculate the contribution margin for both divisions. (c) If the Complete Mining and Manufacturing Company were to institute the use of negotiatedtransfer prices and allow divisions to buy and sell on the open market determine the price rangefor Cruden that would be acceptable to both divisions. (d)Use the general transfer pricing rule to compute the lowest transfer price that would beacceptable to the Cleaning and Scraping Division? Will this transfer price be the one that themanager of the Cleaning and Scraping Division prefers? Provide an explanation for your answerto this question.

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Solution:TRANSFER PRICE

Summary Transfer price is considered to be a term which is used to describe the aspects of interdivision or intercompany pricing arrangement between the business organizations or entities relating to products, labors or services mainly related to non-market approach in determining the prices of services or product which are transferred from one department of the organization to another department. The important objectives of organization are to maintain a co-ordination between different divisional managers of organization and to increase the overall profit of organization. There are different types of transfer prices used in the organizations by divisional managers depending upon the circumstances, market forces and demand. Introduction The transfer prices are considered to be the values for intermediate services and products which are purchased from the independent division of companies. It is the internal prices of intermediate services and products which are created by the management of organization. It is also considered to be the price at which one company sells its products or services to its subsidiaries locating in any other country. It is also considered to be the price at which one division of an organization transacts labor or supplies with other department. It is used in organizations where the individual entities of large multi-international organizations are treated as separate entities. The transfer pricing is considered to be a major tool for avoidance of corporate taxes and it also impacts the purchasing behavior of subsidiaries. In the companies or organizations, it results in setting of prices among its divisions. Transfer price is also known as transfer cost One of the important functions of transfer price is to maintain a co-ordination between the management of both purchasing and selling division of organization. The major reason for the need of transfer prices in large organizations is decentralized organizations having divisional managers which are considered to be responsible for the measurement of performance of divisions and their profit and cost. The divisions within companies are mainly organized as profit or investment centers. In the profit centre, the managers of divisions in companies have the authority to decide about the whole operational activities of department and therefore the divisional managers are considered to be fully responsible for the profit of their divisions. Body Transfer Price is considered to be the price at which one division of an organization transacts labor or supplies with other department. It is used in organizations where the individual entities of large multi-international organizations are treated as separate entities. Objectives of Transfer Price

It helps management in maximizing the overall profit of the organizations.
The prices are to be set so that the divisional managers of organization desire to maximize the earnings of division in consistent with the objective of organization as a whole.
The transfer prices helps in maintaining the maximum autonomy of divisions so the benefits of decentralizations in organizations are maintained.

Types of Transfer Price There are different types of transfer prices that can be used in enterprises or organizations are explained below:

Market Rate Transfer Price: This method is considered to be the most simple and elegant method where market price is used. In this method, the upstream subsidiary will earn the same profit either by selling its goods or services internally within departments or externally within market. The highest possible profit can also be earned by using this method.
Adjusted Market Rate Transfer Price: If it is not possible for the divisional managers of organization to use market rate transfer pricing then the managers of division uses general concept after incorporating some type of adjustments to the price. For example the divisional manager can reduces the market price if the management will intervene that there is a risk of non-payment.
Negotiated Transfer Price: The companies using negotiated transfer prices in their department do not consider the market prices as baseline. The managers of department negotiate the transfer prices of intermediate products or services. This type of situations mainly arises where there is no discernible market price because the market in which the company is dealing is very small or goods are to be considered highly customized. This result in prices is basically based on the negotiating power or skills of departmental managers of organization.
Contribution Margin Transfer Price: The companies use contribution margin transfer price where it is not possible to determine market prices to derive transfer price then the departmental managers of organizations determine a price which is purely based on the intermediate product or services contribution margin.
Cost-plus Transfer Price: The divisional managers of organizations transferred its intermediate goods or services based upon the cost of its products or services. The transfer prices in this case are calculated by adding a margin above the cost i.e by compiling the standard cost of product or services and a standard profit margin.
Cost-based Transfer Price: In cost-based transfer price, the divisional managers of enterprises value their intermediate products or services at cost after which the successive departments add their cost to it.

Reason of Using the types of Transfer Prices Transfer prices are mainly related to non-market approach in determining the prices of services or product which are transferred from one department of the organization to another department. In spite of the pricing fixed by administration, the operations in companies are conducted on the market principles. The different types of transferring price are used because every division of organization can sell its services or products to customers located outside of the organization. The price of products which one department receives as income is also considered as an expense for other department of organization. Transfer price had created a conflict in the economic interest of different departments or divisions of organization. Therefore the different types of transfer prices are used by the management of organizations depending upon the requirement, situations, market forces and demand of the product. Purpose of Using Transfer Price The important purposes for instituting the scheme of transfer price in various organizations or company are:

With the help of transfer price, it becomes easy for the management of organization to evaluate the performance of each and every department separately on the basis of separate profit figures generated by them.
Transfer price helps in the co-ordination, sales, production and pricing decision of different departments or divisions of organization. It helps the management to remain aware about the value of products or services provided by other segments of the firms.
It allows the departmental managers of organizations to generate profit percentage or figures for each department separately.
The transfer price in organizations not only affect the profit reported in each division but also had affected the allocation of resources of organization.
In multinational organizations the firms transfer their services or products across international borders, the use of transfer prices are relevant in the income tax calculations and also sometimes considered to be relevant in connection with the regulatory issues and international trade.

Conclusion Transfer Price is very important for organizations where there are various departments as it helps in deriving a price which is suitable for the profit or investment centre divisions. The divisional managers of organizations have the full authority relating to operational activities of department therefore the managers are considered fully responsible in determining the transfer price. Transfer price co-ordinates the managers so that they can perform efficiently and meet up with the objective of organizations. Part B

The departmental managers of the organization can set up the transfer price of intermediate product or services based upon the cost incurred on them. The cost taken in calculation of transfer price can be variable cost only or total cost.

In market, the cruden can be purchased and sold in the open market for $ 95 therefore the processing department can purchase cruden from market at $95 however the processing department can purchase the cruden from cleaning and scraping division at $ 77. So, it is profitable for the organization to purchase the crude internally as there is saving of $17 per cruder to the organization. However fixed cost are the cost which are fixed in nature whether the product will be manufactured or not and variable cost varies with the production. Even the cruden will not be manufactured by the cleaning and scraping department, the fixed cost will be incurred. Fixed costs are fixed and it does not vary with the production. If the cruden will be transferred on full cost to the processing department then the fixed cost of cleaning and scraping department will become the variable cost of processing department therefore the transfer prices based upon total actual cost are not appropriate as the basis for divisional performance measurement.

Using the market price as transfer price, the calculation of contribution margin for both divisions is provided here under:

Particulars	Cleaning & Scraping Dept Amount ($)	Cleaning & Scraping Dept Amount($)	Processing Dept Amount ($)	Processing Dept Amount ($)
Revenue		95		160
Variable Cost
Direct Material	18		5
Direct Labor	12		10
Variable Manufacturing Cost	30		10
Transfer Price	-		95
Total Variable Cost		(60)		(120)
Contribution margin per unit (a)		35		40
Total no of units (b)		400000		400000
Total Contribution Margin (a*b)		1,40,00,000		1,60,00,000

The Complete Mining & Manufacturing Company has two divisions, the cleaning and scraping division and the other division is processing. The cleaning and scraping division can sell its product cruden in the open market for $ 95 but has to incur $5 per cruden sold in market as selling expenses therefore effective revenue per cruden is $90. However for processing department, if the cruden is purchased from outside market then the divisions have to incur $95 per cruden. So, the price ranging between $ 90 to $ 95 would be considered acceptable for both the managers of divisions as it would generate additional revenue or helps in cutting the cost.
Using the general transfer pricing rule, the lowest transfer price that would be acceptable to the Cleaning & Scraping division is $ 90. The departmental manager of this department will prefer $ 90 as the acceptable pricing for transferring the cruden to process department as it will not affect the profitability of department.

The Cleaning and Scraping division can sell all its product cruden in the open market as there is no excess capacity left to this division. As there is no extra capacity left in the department therefore the transfer price will be variable cost plus the opportunity cost for transferring the cruder to processing department. The variable cost for Cleaning & Scraping division is $60 excluding the variable selling overhead and the opportunity cost for the department is ($95 - $60 -$5) i.e $30. Therefore the minimum transfer price which is acceptable is ($60 + $30) = $90.

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