Transfer Pricing in the ACCA F5 Exam

Two students looking at a laptop

How much should we charge one division of the company for goods being transferred from another division? This is question posed in many organisations and a topic from section E Performance Measurement and control of the ACCA F5 syllabus. I am going to be looking at the reasons and the logic behind setting a transfer price.

Why set a transfer price?

Surely if the goods are being transferred within the same company it doesn’t matter? It is true that these amounts will not be included in the final consolidated sales and profit figures; however by making managers accountable for the resources they consume we can do a better assessment of their performance.

Let me explain through a simple example, if you can help yourself to the stationary cupboard it doesn’t matter if you lose your pen or take more than you need. However, if you had to buy the pens yourself you might make one last much longer. The argument for charging therefore is that it makes managers use the resources more efficiently. It also provides an incentive for the selling division to control their costs as they can be appraised as a profit centre rather than just being a cost centre. Being able to fairly assess the manager of a division’s performance is important for allocating bonuses and for motivation.

What price to charge

We need to ensure that the price set encourages both the selling division to sell and the buying division to buy if this is in the company’s best interests. I.e. if this action is going to result in goal congruence.

A useful starting point is to consider if the company would want to the transfer to go ahead. We can then ensure that the transfer price will result in rational managers making a decision that is in the best interests of the company.

Suggest a price

When suggesting a price remember that there is no one universally acceptable price, instead we are often going to offer a range within which the transfer would be mutually acceptable. The final price is likely to be negotiated by the mangers of the divisions.

How to tackle questions

A useful way to evaluate the information in an exam question is to summarise the information in a diagram. When transfer pricing was examined in Q2 Bath Co in December 2011, digesting the detail in the scenario was one of the biggest challenges and I think a diagram would have helped. Splitting out the variable costs and fixed costs for each division as well as highlighting the capacity constraints.

You can use this for pulling out that the current transfer price of $75 is not going to motivate the manager of division B, because they are foregoing external sales of $80 to satisfy some of the demand. Equally the manager of A would prefer to buy externally for $65 rather than pay the internal price. If the managers are appraised on their performance, a transfer price is not going to result in goal congruent behaviour as the manger of A would source all of their supplies externally. Given that the variable cost to the company as a whole of making these in house is $20 contrasted with $65 if they are purchased externally the result is additional costs per set of $45 and a lack of goal congruence.

The best solution here is for the company to satisfy external demand first as the contribution is $60 per set compared with the additional costs of $45 per set. Once all of the external demand has been satisfied though, the transfer price should encourage the transfer to take place and so should be less than $65 to encourage division A to buy internally but also greater than $20 to encourage B to make the sale. A negotiation is likely to ensue and the price would probably be close to $65. In the exam ANY price in the range would have been acceptable as long as it was appropriately justified.

Question practice

If you want some question practice on transfer pricing try:

Q2 BATH CO DECEMBER 2011

Q4 HAMMER JUNE 2010

View further details on studying ACCA with BPP.

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