Transfer pricing and divisional goal congruence

Compare contribution per unit to the group:

• External sale by P: £70 − £38 = £32 contribution per unit.
• Sale through Q: £150 − £38 − £60 = £52 contribution per unit.

Q's use of the component creates £52, which is £20 more than the external sale. The group should therefore prioritise Q, even though P has an external market.

Capacity is 25,000 units. If P transfers 6,000 units to Q, external sales fall to 25,000 − 6,000 = 19,000 units. Group contribution:

• External: 19,000 × £32 = £608,000
• Q: 6,000 × £52 = £312,000
• Total contribution = £920,000
• Less fixed costs = £300,000
• Group profit = £620,000

Alternative: sell all 22,000 externally and transfer only the remaining 3,000 to Q:

• External: 22,000 × £32 = £704,000
• Q: 3,000 × £52 = £156,000
• Total contribution = £860,000
• Group profit = £560,000

The group-optimal plan is to transfer 6,000 components to Q, with 19,000 external sales. It is £60,000 better than limiting Q to 3,000 units.

P's minimum price must cover variable cost plus the opportunity cost of the units transferred. P has spare capacity of 25,000 − 22,000 = 3,000 units. The first 3,000 units transferred do not displace external sales, so their opportunity cost is zero. The remaining 3,000 units displace external sales and lose £32 contribution per unit.

Minimum prices:

• First 3,000 units: £38 + £0 = £38 per unit.
• Next 3,000 units: £38 + £32 = £70 per unit.
• Weighted average minimum for 6,000 units = (3,000 × £38 + 3,000 × £70) / 6,000 = £54 per unit.

Q's maximum price is the final selling price less Q's additional variable cost: £150 − £60 = £90 per component. At £90, Q makes zero contribution; above £90, Q would refuse the business.

Bargaining range: £54 to £90 per component. At £54, P is exactly indifferent between transferring and selling externally, while Q earns £150 − £54 − £60 = £36 per unit, or £216,000. At £70, Q earns £20 per unit, or £120,000, and P is better off than with no transfer because it earns contribution on the 3,000 spare units. The group-optimal plan is achieved anywhere in the range, but the split of profit depends on the transfer price. P may reject £54 because it shows no divisional improvement, so a negotiated price slightly above £54 or a market-based £70 is more likely to secure P's cooperation.

The policy should align divisional decisions with group profit while giving managers a fair basis for performance evaluation. A market-based price of £70 is defensible because an external market exists and it is objective. At £70, Q still buys all 6,000 units because it earns £20 contribution per unit, and P is better off than with no internal transfer because it uses spare capacity. The group-optimal plan is achieved. However, P's manager may argue that £70 is merely the external price and gives P no reward for the first 3,000 spare units; in fact P does gain contribution on those units, so the objection is weaker. Q may argue that £70 transfers too much profit to P, but Q still benefits.

Alternatives include:

• Negotiated transfer price with a range of £54 to £90, supported by opportunity-cost data.
• Dual pricing: credit P at market price and charge Q at variable cost, with the difference eliminated on consolidation. This can encourage both divisions to trade, but it creates artificial divisional profits and may weaken cost control.
• A two-part tariff: Q pays variable cost plus a lump sum that compensates P for lost external contribution.

For performance evaluation, divisional profit should be adjusted for items outside the manager's control, and managers should be assessed on controllable contribution as well as group profit. The policy should be reviewed when capacity or external demand changes, because the opportunity cost of transfer changes. The finance director should not allow Q's request for variable-cost transfer, because at £38 P would lose £32 per unit on the 3,000 units that displace external sales and would refuse to supply, leaving the group worse off.