Question

The following question presents hypothetical data concerning transfer of cotton between departments as part of the Cotton On Group's production processes. The textile department produces cotton for use by various other production departments within the Cotton On Group. The costs incurred by the textile department to produce cotton are provided below:

	Cost per square metre
Direct materials	$2.10
Direct labour	$0.50
Variable overhead	$0.25
Fixed overhead	$0.15

The textile department can also sell cotton to external customers for $5.00 per square metre. Sales staff from the textile department are paid a sales commission of $0.10 per square metre for sales to external customers. No sales commissions are paid for transfers to internal customers.

Required

1. Provide and discuss an example which illustrates how poorly set transfer prices for cotton could result in a lack of goal congruence .
2. Based on a consideration of the pros and cons of the general transfer price rule, negotiated pricing and cost-plus pricing, identify an optimal internal transfer price policy for cotton .

Answer 1

Example: Transfer pricing set as per cost plus pricing Direct Material $2.10 Direct Labor $0.50 Variable overheads $0.25 Fixed overheads $0.15 Total cost $3.00 Add: Mark up at 20% $0.60 Transfer pricing per unit $3.60 Assume there is external demand for the units and if it is no considered in the transfer pricing Based on opportunity cost forgone for external sales Variable manufacturing cost $2.85 Opportunity cost $2.05 (selling price - Variable cost) Transfer price per unit $4.90 Selling price - Variable cost = $5-$2.95 = $2.05 Contribution per unit forgone (Opportunity cost) In the above case if transfer pricing is set at $3.60 as per cost plus method there is lack of goal congruence since the contribution margin lost is not considered in setting transfer pricing Optimal Internal Transfer pricing policy The Optimal Transfer pricing policy should be based on below policy i) Transfer pricing range The minimum pricing should be variable manufacturing cost incurred The maximum pricing should be external market price of the component that can be given by supplier ii) If there is idle capacity Transfer price should be equal to variable manufacturing cost iii) If there is no idle capacity Transfer price should be equal to variable manufacturing cost + Contribution margin forgone