Question

Spark Ltd has two divisions, assembly and electrical. The assembly division transfers partially completed components to the electrical division at a predetermined transfer price. The assembly division's standard variable production cost per unit is $550. This division has spare capacity, and it could sell all its components to outside buyers at $680 per unit in a perfectly competitive market. Required: a) Determine a transfer price using the general rule.(2 marks) b) How would the transfer price change if the assembly division had no spare capacity? (2 marks) c) What transfer price would you recommend if there was no outside market for the transferred component and the assembly division had spare capacity? (2 marks) d) Explain how negotiation between the supplying and buying units may be used to set transfer prices. How does this relate to the general transfer pricing rule? (4 marks, maximum 200 words)

Answer 1

a) The general rule for setting transfer pricing :-

When there is spare capacity available in an internal division for selling of goods at standard variable production cost to another internal division of same company and the internal transfer of goods takes place at variable production cost then the company will be benefited because the electrical division fulfill its requirement of goods from assembly division rather than purchase it from the outside market.

b) The following facts are given in the questions:-

Standard variable production cost = $550

Now we compute Contribution as per formula mentioned below:

Contribution = Market Price - Standard variable production cost

                      = $680-$550

          = $130

If there is no spare capacity, transfer price will be computed as follows:-

Transfer price = standard variable production cost + contribution forgone

                        = $550 + $130

                        = $680

So, the transfer price if there is no spare capacity is $680

c) The transfer price in case of there is no outside market for the transferred component and the assembly division for spare capacity will be Standard variable production cost. The standard variable production cost is $550. So, the transfer price is $550.

d) The negotiation between the supplying and buying units may be used to set transfer prices and it also relates to the transfer price because negotiation between the supplying and buying units helps to set a transfer price that is acceptable by both units. The general transfer pricing rule generally provides the minimum transfer price, which helps to benefit the company as a whole, and the transfer price falls between this price and the market price.