Managerial Accounting 11.8: Transfer Pricing Between Divisions - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes the nature of  transfer pricing and how best to determine what  

transfer price to use between divisions within  the same company. So what is the transfer price. It is  

the price that is used to value the transfer  of goods or services, as I mentioned between  

divisions within the same company. And we often  use the term subunits, or segments, to describe  

divisions. Many approaches can be used to establish  the transfer price and we are going to talk about  

a few of those here. But the goal is to establish  a transfer price that encourages managers to do  

really two things, what is in the best interest of  the company, and also what is in the best interest  

of the division. And there can often be a conflict  between the two, so the goal then is to establish  

a transfer price that avoids that conflict. The  general economic pricing rule provides us with  

some guidelines that we can use to establish  transfer pricing between divisions that will  

not only help the divisions, but also maximize the  overall company profit. So the rule states, it is kind  

of a technical description here and we'll get  into an example in the next slide, but the rule  

states that the transfer price should be set at a  differential cost to the selling, the differential  

cost to the selling division, plus the opportunity  cost of making the sale internally. So instead of  

dwelling on that here, let me give you a couple of  examples on the next two slides and I think you  

will see how this falls into place. So here is an  example of applying the general economic pricing  

rule when we are below capacity, when the selling  division is below capacity. On the next slide we'll  

talk about what happens when the selling division  is at capacity. But right now we will talk about  

when the selling division is below capacity. In  this example, let's assume that we are Umbrellas,  

Inc. So we make umbrellas and we have two  divisions. We have the Assembly division, that  

is the basically the production department, and  we have the Marketing division. And so the  

Assembly department is the selling division and in  this example, and the Marketing department will be  

the buying division. Umbrellas, Inc. is currently  operating below capacity, so we have plenty of  

excess capacity. We are selling to the outside but  we are also selling to a division internally. And  

when we sell internally, we are not giving up  any sales on the outside. So that means that  

we are below capacity, we have plenty of excess  capacity. Our variable production costs are $6 per  

unit, that is in the Assembly department, for all the  parts and materials that go into the umbrella that  

are those variable production costs, that cost  is about $6 per unit. Our Marketing department  

sometimes purchases umbrellas from the Assembly  department. So the Assembly departments the  

selling department and the Marketing department  or division is the buying department. The transfer  

price then is calculated as follows using the  general economic pricing rule. And that is, it's the  

differential cost to the selling division which is  $6. So if I'm the selling division it cost  

me $6 for each, in variable costs, for each  umbrella that I produce. So that is my differential  

cost at $6, and add to that the opportunity cost  of selling internally, that is, is there any cost  

for us selling internally rather than selling  to the outside. And when we are below capacity  

the answer is no, there is no opportunity cost. As  I mentioned before we are not foregoing any outside  

sales to sell internally. Therefore the transfer  price is $6. It is really the differential cost,  

since there is no opportunity cost, it is the  differential cost to the selling division, to  

the Assembly division. And therefore the transfer  price should be $6, that is the price that the  

optimum price that the Assembly department should  charge the Marketing department when the Assembly  

department sells to the Marketing department. Now  we will take a look at what happens when we are  

at capacity. So really all of the facts from the  previous case are the same, with one exception, and  

that is that if we sell internally then we are  foregoing sales to the outside. So again we have  

got two divisions same two divisions Assembly and  Marketing, and we are now operating as I mentioned  

at capacity. The variable production costs are the  same for each umbrella that we produce, the cost  

for us is $6 per unit, and again the Marketing buys  on occasion umbrellas from the Assembly department,  

and the Assembly department that is the selling  department, and the transfer price is going to be  

a bit different. We are going to calculate the  transfer price here at the bottom. Same general  

economic pricing rule, but we are going to have  some additional information here. The transfer  

price is going to be equal to the differential  cost to the selling division, which is

still $6 per unit, and then we add to that as you  recall from the previous slide the opportunity  

cost of selling internally. And we do have an  opportunity cost in this example because for every  

unit we sell internally that is one less unit that  we sell to companies on the outside. So every time  

we sell internally we are foregoing $4 per unit  and if you look down below at the footnote you  

will see where that comes from. We typically  sell our umbrellas to the outside for $10, I  

am just simply giving you this information, and  our variable cost as you recall is $6. So we are  

forgoing $4 by, in revenue, by selling internally,  because we are at capacity. So the transfer price  

should be the differential cost of $6 plus the $4  opportunity cost, and therefore the transfer price  

in this example is $10 per unit. And that is how  much the Assembly department should charge the  

Marketing department when selling umbrellas  to the Marketing department, because we are  

at capacity. So the transfer price when we are  at capacity in this example is $10 per unit.