About Me

• Prof. Mahesh Halale B.Sc. M.B.A. M.C.A.

• Worked with Maharashtra State Financial Corporation,
from 1985 to 2003
• Working with
Vishwakarma Institute of Management since 2003 as an
Assistant Professor (Approved by UoP)
Written books on
• Management Control Systems – Everest, Pune
• Management Information System – HPH, Mumbai
• Every year conduct a days workshop on Case Studies
in MIS and MCS for all MBA students
• Completed about 50 consultancy assignments of 11
 Essence of MCS -
 “However laudable strategic intentions
may be, if they do not become reality, they
usually are not worth the paper on which
they are written”
 “Conversely, High performing companies
excel at execution”
 Anthony & Govindrajan

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 Agenda

Topic - Transfer Pricing

Concept
Relevance of TP in MCS
Significance of TP
Methods of TP
• Market Price Based TP
• Cost Based TP
• General Rule for TP
3
 Transfer Pricing – The Concept

Division A ABC Co Ltd.

Division C

Division B
nsfer Pricing is applicable when ….
ompany is an Integrated Company
ompany follows “Profit Center” strategy to
manage its divisions/business units
en…..
ansfer Price is a Value charged by Div A to Div B
ansfer Pricing - Method followed to set TP 4
 Why Transfer Pricing in MCS
• MCS aims at evaluating & if needed control the
managerial actions/decisions
• Usually Profit is best performance measure &
it is a prime function of Price
• Inappropriate/Discriminatory Pricing draws
wrong performance picture
• Appropriate Pricing policy ensures realistic
assessment of performance
A well-set TP acts as a
Management Control Tool in itself. 5
Methods of Transfer Price
I) Market Price Based TP: -

A) Market Price as TP:

● Essentials -
* Div A’s product having open market.
* Market forces determine the PRICE.
* Then MP is best TP.

● Advantages -
* Div A can not pass its inefficiencies to Div B
* Acceptable to Div A and Div B.
* It is opportunity cost for Div A.
* Creates competitive environment.
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 Methods of Transfer Price
I) Market Price Based TP: -

B) Modified Market Price (MMP): -

● TP less/greater than MP may be set to compensate

various factors such as –
* Saving on selling and transportation costs.
* Guaranteed take off by Div B.
* Quantity, Quality and Delivery aspects
of transfer.
An unbiased negotiation may lead to acceptable
TP by both divisions.
Thus TP becomes an agreed upon price between them.
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 Methods of Transfer Price
I) Market Price Based TP: -

C) TP Lower than MP: -

WHEN - ● Div A is not able to sale its product at MP.
Div B is able to get it below MP.
Establishment of TP in such situation depends on the amount of
IDLE capacity Div A is having…..
If Div A operating at its full capacity- No question of reducing MP.
If Div A running with idle capacity – Opportunity cost of Div
A is zero, and whatever it can earn over and above its VC is
well and good. (Below BEP it FC recovery and above BEP it
is profit)
& Non reduction of MP in such situation leads to reduction
of firms profits. 8
 Methods of Transfer Price
II ) Cost Based TP: -

A) Variable Cost as TP: -

● TP be set at Variable cost of production of Div A

* Rational – This is the cost below which Division A
l be unwilling to sell, as it leads to net losses.
after all FC is a sunk cost for Div A, irrespective of
ther Division produce & sale at it has to incur this cost .

This TP forces Div A to not to earn any profit but also

not to recover its operating cost too.
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 Methods of Transfer Price
II ) Cost Based TP: -

B) Full Cost/Absorption Cost: -

● TP is set at VC + FC of production of Div A.

* In this approach FC of Div A acts as VC of Div B,

In a broader perspective of firm it is wrong conception.
* Such conception may leads to incorrect decision
on the part of Div B and subverts the firm’s goal.
* Do not provide any incentive for cost control.
(since actual cost = TP).
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 Methods of Transfer Price
II ) Cost Based TP: -

C) Standard Cost as TP: -

● Actual Cost as TP leads to passing

inefficiencies of Div A to Div B therefore …….

* Scientifically Predetermined product cost

would be a better yard stick to control actual cost.
* Ensures operating efficiency of Div A by motivating it
to contain its actual cost in predetermined limit.

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 Methods of Transfer Price
II ) Cost Based TP: -

D) Modified Cost as TP: -

ere recovery of Cost does not provide any profit

ctive to Div A. It lacks motivation for Div A to earn profit.
Therefore TP can be set as:-
TP = Cost + Mark up
{Markup = Certain % of cost or lump sum amount}
•-However taking cost as actual cost again introduces
its inherent drawback.
•Therefore best approach would be
TP = Std. Cost + Markup
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 General Rule for TP
Minimum TP = VC per unit + Contribution lost per unit

Div A must recover its entire VC and also the

Contribution lost.

(to the extent that Div A would

otherwise have recovered by way of outside sales)
● This makes Div A indifferent as to the sale to outsider or
inter divisional transfer

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 Conclusion on Transfer Pricing

* Highest TP = Market Price

* Lowest TP = Variable Cost

Both the divisions must settle for optimal TP i.e.

***********************************
Optimal TP = VC p.u + Contribution Lost p.u.
*********************************************

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 Problem on Transfer Pricing ( appeared in PU MBA-II, Exam 2003)
The Top Company Ltd has two divisions X & Y. One of the parts produced by
X is being used by Division Y in its manufacturing process. This part is not
unique and there is readily defined market such that X can sell to outside
firms and Y can buy from outside.
 The following data is available in respect of division X:
Capacity to Produce the part 125000 units
External Sales at Rs 100 per unit 100000 units
Transfer to division Y 25000
 Costs:
Variable Manufacturing cost per unit Rs 84
Variable Selling Cost per unit Rs 2
(on external sales only but not incurred on internal transfer)
Fixed Manufacturing Cost (based on 125000 units) Rs 6
Fixed Selling Cost (based on 100000 units) Rs 1
 The division Y represents the following data on the assumption of volume of
25000 units.
Variable manufacturing expenses per unit Rs 100
(excluding internal transfer price/outside purchase)
Variable Selling Expenses per unit Rs 6
Fixed manufacturing cost Rs 10
Fixed selling expenses Rs 4 15

Selling price per unit Rs 240

Top Company – Problem – contd…

Required –
1.If division X could sell 125000 units at Rs 100
each in the open market what transfer price,
the central management would prefer in order
to provide proper motivation to division Y?
2.As a management accountant would you
advise division Y to buy the product at the
transfer price determined in 1 above?
3.Assume transfer price as in 1 above and if
selling price for division Y’s product drops to Rs
200 should you buy at that price? Would this be
desirable from the point of the firm, why? 16
 Top Company – Solution

1.) X selling the product to outsiders at Rs.100

Selling Price 100 TP = Variable Cost +
Contribution Lost
-Variable Cost (Prodn) 84
= 84 + 14
-Variable Cost (Selling) 2
Contribution 14 = 98

-Fixed Cost (Prodn) 6

-Fixed Cost (Selling) 1
Profit 7
Justification for TP = 98
To supply the product to Div Y, X must get VC of Production - 84
also it must get its FC of Production - +6
even It must recover its FC of selling - +1
and X must earn the profit +7
Therefore X must charge a TP of 98
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 Top Company – Solution – contd…
2. As a management accountant of Division Y would you advise
the purchase at TP of 98

Y Purchases from Y Purchases from

X at TP 98 outside at Rs
100
Selling Price 240 240

-Variable Cost (Production) 100 100

-Variable Cost ( Bought Out 98 100

Item)
-Variable Cost (Selling) 6 6

Contribution 36 34

Since the option to purchase the item from X at TP of 98 gives

better contribution, division Y should go for this transaction.
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 Top Company – Solution – contd…
3. If sales price of division Y’s product drops to Rs 200,
whether the TP of 98 will be acceptable
Co. uses product Co opts to sell the
of X in division Product of X in
Y Open market at
100
Selling Price 200 100

-Variable Cost (Production) 100 84

-Variable Cost (Bought Out 84

Item)
-Variable Cost (Selling) 6 2

Contribution 10 14

Since from company’s point of view selling the product of division X

to outside buyer gives better contribution than transferring it to division Y.
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Que 6 2007 Backlog New- PUMBA
The Allison-Chambers Corporation, manufacturer of tractors and other
heavy farm equipments, is organized along decentralized lines, with
each manufacturing division operating as a separate profit center. Each
division manager has been delegated full authority on all decisions
involving the sale of that division's output both to outsiders and to other
divisions of Allison-Chambers. Division C has in the past always
purchased its requirement of a particular tractor engine component from
division A. However, when informed that Division A is increasing its
selling price to $ 150, Division C's manager decides to purchase the
engine component from outside suppliers. Division C can purchase the
component for $135 on the open market, Division A insists that, because
of the recent installation of some highly specialized equipment and
resulting high depreciation charges, it will not be able to earn an
adequate return on its investment unless it raises its price. Division A's
manager appeals to the top management of Allison-Chambers for
support in the dispute with Division C and supplies the following
operating data –
C's annual purchases of tractor engine component 1000 units
A's variable costs per unit of tractor engine component $ 120
A's fixed costs per unit of tractor engine component $ 20 20
Que 6 2007 Backlog New- PUMBA
The Allison-Chambers Corporation…
Required -
4. Assume that there are no alternative uses for internal facilities.
Determine whether the company as whole will benefit if Division C
purchases the component from outside suppliers for $ 135 per unit

2. Assume that internal facilities of Division A would not otherwise be

idle. By not producing the 1000 units for Division C, Division A's
equipment and other facilities would be used for other production
operations that would result in annual cash-operating savings of $
18000. Should Division C purchase from outside suppliers?

3. Assume that there are no alternative uses for Division A's internal
facilities and that the price from outsiders drops $20. Should Division
C purchase from outside suppliers?

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Que 6 2007 Backlog New- PUMBA
The Allison-Chambers Corporation…
Solution –
Given for Division A - Expects a increase in price for its tractor engine
component to $ 150, so that it earns adequate return on its investment in
view of its acquisition of highly sophisticated specialized machine.
Division C - Expects the price for the component be set at $ 135, as the said
component is available in open market at that price.
1.Cost to the Company if no alternative usage of facilities of Division A

Company's Options Optuon-1 Option-2

Buy from A Buy from Outside

Variable Costs p.u. 120 135 (Price Being Paid)
Fixed Costs p.u. 20 20 #
Total Cost 140 155

# Since the facilities of Division A remaining idle, irrespective of A

producing anything or not , Co & A has to carry/bare the FC of $20 .
In this situation buying from outside is not beneficial from Co's point of
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view, since the option is costlier by $15
 Que 6 2007 Backlog New- PUMBA
The Allison-Chambers Corporation…
Solution –
2. If Division A discontinues the production of engine component and
uses the facilities for other production operations, which shall lead to
annual cash savings (net inflow) of $ 18000

Division C's Optuon-1 Option-2 Buy from Outside,

Options Use facility for other
production
Buy from A
Variable Costs 120 Total Cash Outflow 135000
p.u.
Fixed Costs p.u. 20 Total Cash - 18000
Inflow/Savings
Total Cost 140 Net Cash Outflow 117000
Net Cash Outflow is $ 117 p.u. as against $ 140
Here buying from outside provides the net cash savings and thereby the net cash
outgo on the engine component reduces to 117 instead of 140, when the Division A
manufactures and supplies the same to Division C. 23

Here Division C can get this component at lesser price than Division A's variable cost .
 Que 6 2007 Backlog New- PUMBA
The Allison-Chambers Corporation…
Solution –
3. In case there is no alternative usage of Division A's facilities and
outside price drops by $20

Division C's Optuon-1 Option-2

Options
Buy from A Buy from Outside AT A REDUCED
PRICE OF 115 i.e. (135-20)
Variable Costs p.u. 120 115
Fixed Costs p.u. 20 20 (there is no use of facility at A)
Total Cost 140 135

For Division C this alternative is attractive if the outside price reduces to 115, Division
C should purchase from outside however;
From Company's point of view this is not beneficial, because –
Company by compelling Division A to produce the component and selling it to Division 24
C at price of $115, can at least recover the fixed cost at Division A to the extent of $15
 Thanks

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 ● I) Market Price Based TP: -
A) Advantages -
1. True representation of opportunity cost.
2. MP are easily available.
erformance of both the divisions is continuously harnessed.
4. Sales price variance gives a better control data.
A) Limitations of MP as TP –
1. Div A has no outside market.
competitive market for Div A’s product. (Div A is price leader)
3. Wide fluctuations in MP. ( leads to inconsistent results)
4. What is right MP? Ex-factory/ Wholesalers/Customers
P includes selling and distribution cost. (which is absent in TP.)
. Quantity discounts/special discount plays important role in MP.
7. After sales service do matters in MP.
Dumping price can be anything (when Div A builds idle stock) 26
 Significance of TP
• Measure realistic performance of the division.

• Grant full autonomy to divisional functioning

without subverting firm’s goal
• Achieve Goal Congruence
• Motivate all concerned divisions
• Ensure cost control at all divisions

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