CIMA P3: How to Calculate a Transfer Price – Matt’s Complete Guide

As you know on my blog, much of the content I create is in direct response to student questions, problems or challenges and this post is no different.

A number of people have been left confused when it comes to understanding the calculations needed when it comes to determining a transfer price.

This is nothing to be ashamed about as it’s easy to get lost with this particuarly difficult topic and you’re not supposed to understand everything on the CIMA syllabus right away.

It’s okay to get stuck. I was many times throughout my CIMA studies.

But you’ve got to ask for help otherwise you will never move forward.

My aim in this post is to give you a genuine understanding of transfer pricing, and particularly the calculations involved.  There are lots of other explanations on this topic elsewhere on the web but people seem to resonate with the way I teach.

As a heads up before I start, transfer pricing is not something I’ve looked at for a number of years.

So as with anything on the new CIMA syllabus that I want to learn for the first time or get a refresher on, I turned to my favoured study materials for a clear and easy to follow explanation of everything I need to know.  In this case it was the Astranti CIMA P3 Study Text.

Okay, so let’s explore what I found out…

Overview

When goods or services are transferred between different divisions within an organisation, there needs to be a value put on this transaction so that it can be recorded in the company’s accounts. This value needs to be an amount that benefits the company as a whole but also doesn’t disadvantage each division involved, as this would reflect badly on them when it comes to assessing divisional performance. The value used is known as the transfer price.

Having done some research on the internet, an example of this situation playing out in the real world is at the Ford Motor Company. Their engine plant in South Africa supplies the Duratorq TDCi diesel engines to the group’s global assembly plants which make the Ford Ranger pick-up trucks

Okay, so that’s the rationale, but how do we calculate a transfer price?

Well, as with most management accounting techniques, there’s more than one method.

Let’s have a look at some of them…

Usually, the transfer price will be set between two limits

  1. The minimum transfer price

The division providing the goods/services internally often has the opportunity to sell these same goods externally instead and so the minimum they will be willing to charge another division is cost plus their profit margin (i.e. the minimum they would normally charge an external customer).

Let’s say each of those diesel engines made at Ford’s engine plant above, cost £500 to manufacture. Let’s also assume they charge a mark up of £200 per unit. The minimum transfer price they would want to charge to an assembly plant within Ford is £700.

  1. The maximum transfer price

The division receiving the goods/services internally will only want to pay a maximum amount that is equal to the lowest price that the goods/services could be bought for from external suppliers.

Using our Ford example again, if the same diesel engine could be bought on the open market for £800, this is the maximum an assembly plant would pay the engine plant.

The ideal transfer price would need to fall between £700 and £800 per engine because the engine plant would not sell for below £700 (as they could receive a higher price externally) and the assembly plant will not pay more than £800 (as otherwise they could buy the engine cheaper on the open market).

Using a cost based approach to calculate the transfer price

Data Extract from F Car Company’s engine plant:

Variable cost per engine£400
Fixed overheads allocated per engine£100
Total cost per engine£500
Normal mark-up per engine£200
Market price per engine£700
Production capacity (units)1,000,000

1.Marginal Cost

Marginal cost is the cost of producing one more unit.

Using the data from above, we would assume that the marginal cost will be equal to the variable cost per unit of £400 (as fixed costs have to be paid whatever).

The engine plant will use this marginal cost as the transfer price to charge an assembly plant for each diesel engine if there is no opportunity cost. This would be the case if there was excess capacity at the engine plant.

For instance, if demand in the market for the diesel engine only amounts to 600,000 units, there would be no opportunity cost to selling the remaining 400,000 units at marginal cost to an assembly plant. This is because:

  • No sales would be lost
  • The cost of producing the engines would be covered

The assembly plant would get the units at an attractive rate compared to the open market.

However: If demand was at or above 1,000,000 units, the engine plant will not want to sell any of the diesel engines internally for anything less than market price.

2. Absorption cost

Absorption costing is where all of manufacturing costs are absorbed by the units produced, and so this includes both variable and fixed manufacturing overhead.

Under this method, the transfer price would be £500 per unit (£400 + £100).

The engine plant would be happy to sell units internally to an assembly plant at this price if there was excess capacity. The engine plant manager would have more of an incentive to sell internally at absorption cost rather than marginal cost because at least they would receive some contribution towards fixed overhead costs.   Of course, this is still less than external customers would pay at the market rate.

Where things get slightly more complicated is a situation where an assembly plant could find a cheaper price from an external supplier, say for £450.

This would be a poor use of the company’s resources as the assembly plant would be paying £450 for a product that can be produced internally for £400. The organisation as a whole would be losing money if there is spare capacity at the engine plant – as the company would be purchasing an engine for £50 more than it needs to.

If however, the engine plant is running at full capacity and selling its units at a market price of £700 each, the £200 profit made per unit would outweigh the £50 loss per unit above. The company as a whole would be better off with the assembly plants buying the units externally at £450 each.

3. Standard Cost

A standard cost is an estimated or predetermined cost of producing a good/service, under normal conditions.   Therefore, a standard cost transfer price would be fixed at an amount before the actual product being transferred is made.

This is seen as a fairer way of setting a transfer price than the two methods above, because any cost overruns that occur at the supplying division are not passed on in the price charged to the receiving division, as would be the case if an actual cost was used.

From a group point of view, this is also a good method as it incentives the supplying division to keep costs down to a minimum, otherwise they suffer from an adverse variance when actual performance is compared with expected results.

4. Two part tariff

This is very similar to the marginal cost method except the division receiving the goods/services pays a fixed annual fee on top.

This fee is included in the transfer price because it recognises that the supplying division has fixed costs to cover when they are producing the goods/services and is a gesture of goodwill by the division receiving the goods/services as they are getting them at the lowest cost possible.

Both divisions therefore benefit.

Alternatives to using a cost based approach to calculate the transfer price

1. Market based transfer pricing

This method appears logical when you think that a firm with a decentralised organisational structure wants each division to act like a standalone entity, with control over all its operations.

If each division were actually a separate company, they would have to buy goods/services on the open market and it makes sense to charge them a market based transfer price.

This sounds simple but there are a number of difficulties with this method:

  • Different suppliers in the market quote different prices
  • Different buyers ask for different prices (such as a special discount)
  • Current market prices can fluctuate so it’s hard to determine a true price
  • The product being transferred may not be available on the open market

2. Dual pricing

An organisation may choose to use the dual pricing method which is where two transfer prices are recorded.

This is an alternative to marginal costing where the selling division has no real incentive to supply the goods internally as they do not make a profit on the transaction.

Dual pricing looks to overcome this situation.

Here’s how it works…

  • The supplying division is credited at a price equal to cost plus a mark up
  • The receiving division is debited at marginal cost
  • The difference is debited to a group account called ‘transfer pricing adjustment account’ and is deducted from group profits at the period end.

The advantages of this method are:

  • The supplying division can record a profit and is incentivised to transfer goods internally
  • The receiving division gets the goods at the lowest possible price which in turn maximises group profit (as they’d incur higher costs otherwise).

3. Negotiated transfer prices

This is where divisional heads simply agree upon the transfer price themselves.

There are a few drawbacks to this method though:

  • Negotiations can be time consuming
  • Managers may not reach an agreement
  • One manager may have more experience in negotiating than the other which may lead to a price that favours one division more than another.

Transfer prices that maximise profits

Typically an organisation will want managers of each of their divisions to use transfer prices that maximise profit for the company as a whole. However, as we’ve already seen earlier, a transfer price that is best for the group is not always the best for each division (and vice versa).

Let’s look at why it’s not always easy to use a transfer price that maximises profits for both the group and its individual divisions.

The following data is available:

Engine Division

  • At a market price of £600, there is currently no demand for engines
  • However, demand increases by 60 units for every £30 reduced from the price.
  • The variable cost per engine is £120
  • There are no capacity constraints

Assembly Division

  • At a market price of £800, there is currently no demand for the finished truck produced
  • However, demand increases by 500 units for every £100 reduced from the price.
  • The variable cost per truck is £180 (excluding the cost of the engine)

Equations to use for calculations are:

P = a – bx

MR = a – 2bx

Where:

P = Optimum price

a = current price

b = change in price per unit

x = number of units

MR = marginal revenue

Note: Profit is maximised where MR = MC

Scenario 1: Profit maximisation for engine division only

Step 1:  find the optimum number of units to be made by the engine division

MR = a – 2bx

a = 600

b = 30/60 = 0.5 (therefore demand increases by 1 unit for every £0.50 reduced from the price.)

MR = 600 – (2 * 0.5) x

MR = 600 – 1x

Profit is maximised at MR = MC so:

600 – 1x = 120

480 = 1x

Therefore, at 480 engines, profit is maximised


Step 2:  find the optimum selling price to be charged by the engine division

P = a – bx

P = 600 – (0.5 * 480)

P = 600 – 240

P = 360

Therefore, at a price of £360 per engine, profit is maximised. This is the transfer price it would charge the assembly division.


Step 3: based on the above engine price, find the optimum number of trucks to be made by assembly division

MR = a – 2bx

a = 800

b = 100/500 = 0.2 (therefore demand increases by 1 unit for every £0.20 reduced from the price.

MR = 800 – (2 * 0.2) x

MR = 800 – 0.4x

MC per truck (without engine) = £180

Engine cost = £360

MC per truck (with engine) = £540

Profit is maximised at MR = MC so:

800 – 0.4x = 540

260 = 0.4x

650 = x

Therefore, at 650 trucks, profit is maximised


Step 4: find the optimum selling price to be charged by the assembly division for the trucks

P = a – bx

P = 800 – (0.2 * 650)

P = 800 – 130

P =670

Therefore, at a price of £670 per truck, profit is maximised

Group revenue would therefore be 650 trucks sold at £670 each = £435,500


Scenario 2: Profit maximisation for group as a whole

To maximise group profit we need to set the transfer price at the lowest price available.

In most cases, and in this example, the lowest transfer price is marginal cost – £120 per engine.

Step 1: Based on the above engine price, find the optimum number of trucks to be made by assembly division

MR = 800 – 0.4x (already derived above)

MC per truck (without engine) = £180

Engine cost = £120

MC per truck (with engine) = £300

Profit is maximised at MR = MC so:

800 – 0.4x = 300

500 = 0.4x

1,250 = x

Therefore, at 1,250 trucks produced, profit is maximised


Step 2: find the optimum selling price to be charged by the assembly division for the trucks

P = a – bx

P = 800 – (0.2 * 1,250)

P = 800 – 250

P = 550

Therefore, at a price of £550 per truck, profit is maximised

Group revenue would therefore be 1,250 trucks sold at £550 each = £687,500

This is clearly higher (by £252,000) than the group revenue of £435,500 calculated in scenario 1.

The effect of opportunity cost on transfer pricing

Okay so as we learned earlier, the minimum transfer price will usually be marginal cost (where there is no opportunity cost) and the maximum transfer price will be the market price.

No division will transfer their goods/services at less than marginal cost as they will make a loss and no division will receive them at a price that is above what is available on the open market.

To find a transfer price somewhere in the middle, we need to factor in opportunity cost. The division supplying the goods/services will sell at marginal cost plus any contribution they’ve missed out on by not selling elsewhere.

This is approach is considered the most mathematically accurate.

Here’s why…

The following data is available:

Engine Division

  • The variable cost per engine is £100
  • They sell the engines on the open market for £200

Assembly Division

  • The variable cost per truck is £60 (excluding the cost of the engine)
  • They sell on the trucks on the open market for £240

Scenario 1 – Unlimited capacity

Assembly DivisionMarginal Cost
Method
Market Price MethodOpportunity Cost Method
Transfer price of an engine
(paid to engine division)
(£100)(£200)(£100)
Marginal cost of finished product
(without engine)
(£60)(£60)(£60)
Selling price of finished product£240£240£240
Contribution£80(£20)£80

Under this scenario, both marginal cost and opportunity cost methods of transfer pricing lead to an ideal outcome where the Engine division doesn’t forgo any profit, the Assembly division make a profit and so does the group as a whole.

However, under a market based transfer price, the Assembly division make a loss and so their manager would not want them to produce the product. This conflicts with goal congruency as the company as a whole would make a profit using this method, the £100 profit made by the Engine division outweighing the loss of £20 by the Assembly division.

Scenario 2 – Limited Capacity

Assembly DivisionMarginal Cost
Method
Market Price MethodOpportunity Cost Method
Transfer price of an engine
(paid to engine division)
(£100)(£200)(£200)
Marginal cost of finished product
(without engine)
(£60)(£60)(£60)
Selling price of finished product£240£240£240
Contribution£80(£20)(£20)

In this scenario, there is the opportunity cost of limited capacity where the Engine division would have to forgo £100 contribution for each unit if it sold the engines internally to the Assembly division.

It would therefore be more profitable for the group as a whole for the Engine division to sell externally, earning £100 contribution per unit, and the Assembly division not to manufacture the finished product as this leads to a loss for them and the group as a whole.

Using the opportunity cost method results in the correct outcome under both scenarios.

This is because:

  • It takes into account capacity and ensures the supplying division does not suffer a loss
  • The acquiring division receives a price that is lower than any market rate
  • The supplying division receives the same amount whether a unit is sold internally or externally and so no profits are lost by the company as a whole

However, opportunity cost transfer pricing is often seen as difficult to implement because it’s a complicated exercise to try and determine what capacity and market prices really are as they change all the time.

A Quick Summary

  • The minimum transfer price will usually be marginal cost unless there is an opportunity cost to factor in (such as limited capacity where profit would be lost by the division selling internally).
  • Marginal cost is usually the same as variable cost
  • As marginal cost is the lowest transfer price available, this should lead to profit maximisation for the organisation as a whole
  • The maximum transfer price will be the market price because the buying division will not pay a higher price on an internal transfer when they can purchase the goods for a lower price externally
  • It may be better for the group as a whole for goods/services not to be transferred internally if more profit can be made by buying and selling them externally
  • The optimum units to be sold and selling price to be charged for finished products to achieve group profit maximisation can be calculated using the following equations:
  • (Marginal Revenue) MR = a – 2bx -> to find number of units
  • (Profit maximisation) MR = MC
  • (Price) P = a – bx
  • a is the market price, b is the change in price, x is the number of units

What to do next

I hope you enjoyed this post. It came out much longer than I anticipated but I wanted to cover everything you ought to know so that you have the best chance of owning this element of the syllabus.

Now, the next step is to test your understanding of what you’ve read by tackling a few questions.

Remember it’s not real studying or learning if you don’t actively test yourself on the information you’ve covered.

This is even more important with every learning outcome now being tested on each CIMA paper in the objective test exams.

With this in mind I’ve found a few questions for you to attempt so please click here.

Cheers,

Matt

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One thought on “CIMA P3: How to Calculate a Transfer Price – Matt’s Complete Guide

  1. do you have experience in financial reporting and audit where l can gain experience to just like costing management. your article was more helpful thou am still doing my undergraduate degree. i really needed this thank you.

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