(64)---TRANSFER PRICING (4).

Transfer pricing when there is no external market for the transferred item.

If there is no similar item sold on an if the transferred item is a major product of the transferring division, there is a strong argument that profit center accounting is a waste of time. Profit centers cannot be judged on their commercial performance because there is no way of estimating what fair revenue for their work should be.

It wild be more appropriate, perhaps, to treat the transferring division as a cost center, and to judge performance on the basis of cost variances.

I profit centers are established, in the absence of a market price, the optimum Transfer price is likely to be on based on standard cost plus, but only provided that the variable cost per unit and selling price per unit are unchanged at all levels of output. A standard cost plus price would motivate divisional managers to increase output and to reduce expenditure levels.

Profit maximization with no external market and changing costs/prices.

Profit maximization general.
If cost behavior patterns change and the selling price to the external market are reduced at higher levels of output, there will be a profit- maximizing level of output to produce more than an ‘optimum’ amount would cause reductions in profitability.
Under such circumstances, the ideal transfer price is one which would motivate profit center managers to product at the optimum level of output, and neither below nor above this level.

Profit maximization with an external market and changing cost/prices.

Imperfect external market.

The approach is essentially the same.Expect that the supplying division may also have income, and so its marginal revenue needs to be taken into account.
Perfect external market.

The approach is the same as that used for an imperfect external market expect that marginal revenue for the supplying division is constant at the market price.

Transfer process based on opportunity costs.

It has been suggested that transfer price can be set using the following rule.
Transfer price per unit =standard variable cost in the producing division plus the opportunity cost to the organization as a whole for supplying the unit internally.
The opportunity cost will be one of the following
(a). The maximum contribution foregone by the supplying division in transferring internally rather than selling goods externally.
(b). The contribution foregone by not using the same facilities in the producing division for their nest best alternative use.
If there is no external market for the item being transferred, and no alternative use for the facilities, the transfer price = standard variable cost of production.
If there is no external market for the item being transferred, and no alternative, more profitable use for the facilities in that division, the transfer price=the market price.

Identifying the optimal transfer price.

Throughout the posts we have been leading up to the following guiding rules for identifying the optimal transfer price.

• The ideal transfer price should reflect the opportunity cost of sale to the supply division and the opportunity cost to the buying division unfortunately, full information about opportunity cost may not be easily obtainable in practice.
• Where a perfect external market price exists and unit variable costs and unit selling prices are constant, the opportunity cost of transfer will be external market price or external market price less savings in selling costs.
• In the absence of a perfect extent market price for the transferred item, but when unit variable cost are constant, and the sales price per unit of the end-product is constant, the ideal transfer price should reflect the opportunity cost of the resources consumed by the supply division to make and supply the item and so should be at standard variable cost + opportunity cost of making the transfer.
• When unit variable costs and/or unit selling prices are not constant, there will be a profit-maximization level of output and the ideal transfer price will only be found by sensible negotiation and careful analysis.

(1). Establish the output and sales quantities that will optimize the profits of the company or group as a whole.
(2). Establish the transfer price at which both profit centers would maximize their profits at this company optimization output level.

There may be a range of prices within which both profits centers can agree on the output level that would maximize their individual profits and the profits of the company as a whole. Any price within the range would then be “idle” .