Transfer Pricing When One Division Has Idle Capacity
Northline Manufacturing has two divisions. Components Division produces a part used by Assembly Division. Components has capacity for 100,000 units and currently sells 70,000 externally at $70. Variable cost is $40 per unit; fixed costs are $1.8 million annually. Assembly needs 20,000 units and can buy an equivalent part externally for $62. Components' manager is evaluated on divisional ROI; Assembly's manager on residual income. Corporate policy allows negotiation but requires internal sourcing when capacity exists. Components offered $68; Assembly counteroffered $58. The CFO asks you to review the dispute before setting next year's transfer-pricing policy.
1. Determine the economically justified transfer-price range and explain what each endpoint represents.
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Components has 30,000 units of idle capacity, so the 20,000-unit internal order uses capacity that has no alternative contribution. The minimum acceptable price is the variable cost of $40. The maximum is the external purchase price of $62, because above that Assembly should buy outside.
Any price between $40 and $62 keeps the transfer inside the company and creates total corporate benefit of ($62 - $40) x 20,000 = $440,000 compared with external purchase. The split of that benefit depends on the price: at $40 all benefit accrues to Assembly; at $62 all accrues to Components.
If Components later sells all 100,000 units externally, the opportunity cost becomes the lost contribution of $30 per unit, so the minimum rises to $70 and internal transfer is no longer economically justified versus the $62 external price.
2. Assess the behavioral consequences of the current performance metrics and recommend changes.
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Components' ROI-based evaluation encourages holding out for a high price even though any price above $40 improves divisional profit when capacity is idle. The manager may reject a transfer that benefits the company because it dilutes divisional ROI relative to the existing asset base. Assembly's residual-income metric encourages the opposite: minimizing the transfer price, even at the expense of Components' results.
Recommendations:
- Evaluate both managers on metrics that include total corporate contribution from internal transfers, or use residual income/EVA with a common capital charge.
- Use a dual transfer-pricing system: credit Components at market price and charge Assembly at variable cost, with a corporate consolidation adjustment. This preserves incentives but must be monitored for abuse.
- Set a policy range of $40-$62 when idle capacity exists, with a documented negotiation process and escalation to the CFO.
- Align capacity planning so transfer prices reflect real opportunity costs when capacity becomes scarce.
3. What qualitative and strategic factors should influence the final policy?
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The policy should consider supplier reliability and quality of the external part, the strategic value of keeping component production in-house, and the risk that a purely negotiated price damages division cooperation. It should also address fairness and motivation: a rule that shifts all benefit to one division will breed gaming. Consider whether external market prices are reliable, whether Components' fixed costs are truly unavoidable, and whether internal sourcing protects proprietary designs or delivery lead times. Finally, the policy should be simple enough to administer and auditable, with clear documentation of capacity assumptions so that the $40-$62 range is revisited when demand changes.