Transfer Pricing Under Partial and Full Capacity: A Two-Division Negotiation
Meridian Auto Systems has two divisions. The Components Division (CD) makes a solenoid valve in a plant with a hard capacity of 90,000 units a year; variable cost is ₹310 a unit and annual fixed cost is ₹9.4 crore. External demand at the going market price of ₹480 is 70,000 units and CD sells exactly that. The Assembly Division (AD) buys 25,000 valves a year from an outside supplier at ₹455 and has asked CD to supply them instead. CD's manager has offered ₹470, arguing that anything below the market price would subsidise AD. AD's manager refuses to pay more than ₹430, pointing out that the outside quote is ₹455 and that CD visibly has idle capacity. Both managers are evaluated on divisional operating profit and residual income; the corporate cost of capital is 13%. The CEO wants a transfer price that is defensible to both divisional boards and that does not distort either division's reported performance.
1. Compute the range within which a negotiated transfer price can settle, and quantify the annual gain to Meridian as a whole if the transfer takes place.
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Step 1 - Capacity position. Capacity 90,000 less external sales 70,000 leaves 20,000 idle units. AD needs 25,000, so 5,000 units must be diverted from external customers.
Step 2 - Opportunity cost. Lost contribution on the diverted units = 5,000 × (480 − 310) = ₹8,50,000. Spread over the 25,000 units transferred, the opportunity cost is ₹34 per unit.
Step 3 - Range.
- Floor = outlay cost + opportunity cost = 310 + 34 = ₹344. Below this CD is worse off than today.
- Ceiling = AD's external quote = ₹455. Above this AD is worse off.
So any price between ₹344 and ₹455 is Pareto-improving. The managers' opening positions (₹470 and ₹430) are both outside the defensible range: ₹470 exceeds the market, ₹430 ignores the 5,000 displaced units.
Step 4 - Corporate gain (independent of the price chosen). Avoided outside purchase 25,000 × 455 = ₹1,13,75,000; less variable cost 25,000 × 310 = ₹77,50,000; less lost contribution ₹8,50,000 = ₹27,75,000 a year.
Note the asymmetry: the corporate gain is fixed, but how it is split depends entirely on where in the ₹344-₹455 band the price settles, which is why both divisions will bargain hard.
2. Assume instead that CD's external demand rises to 95,000 units while AD's requirement rises to 40,000. Advise whether the transfer should happen at all, and at what price.
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Capacity is now fully employed (95,000 external demand against 90,000 capacity), so every unit sold internally displaces one external sale. The opportunity cost is the full contribution of ₹170 per unit (480 − 310).
- Minimum transfer price = 310 + 170 = ₹480, which equals the market price.
- AD's outside quote is ₹455, so no mutually acceptable price exists.
Is that also right for the group? Compare the two allocations.
- All external: CD sells 90,000 outside for contribution 90,000 × 170 = ₹1,53,00,000; AD buys outside at 455.
- Transfer 40,000 internally: CD sells 50,000 outside (₹85,00,000) plus AD's avoided cost of 40,000 × (455 − 310) = ₹58,00,000, total ₹1,43,00,000.
External selling is better by ₹10,00,000, i.e. 40,000 × ₹25, the gap between CD's contribution per unit and AD's saving per unit. The transfer should not be made. The general rule: transfer internally only where the selling division's opportunity cost is below the buying division's external price; here it is above, so decentralised bargaining and group interest coincide. CD's manager's earlier 'subsidy' argument, wrong at 70,000 units of demand, becomes correct at full capacity.
3. Recommend a transfer pricing policy and performance-measurement design that would prevent this dispute recurring, and note the risks of your recommendation.
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Policy design
- Publish a formula, not a number: floor = standard variable cost + (contribution forgone on displaced external units ÷ units transferred), capped at the external market price. Recompute it each quarter from the demand forecast, so the price moves with capacity position rather than with bargaining power.
- Require the capacity data to be certified by corporate planning, so the selling division cannot inflate the opportunity cost.
- Use a central capacity committee to arbitrate when the floor exceeds the ceiling - the signal to buy outside.
Dual pricing, with eyes open. Credit CD at ₹455-480 and charge AD at ₹344, with the difference in a corporate suspense account eliminated on consolidation. This preserves both managers' incentives to trade, but it has real costs: CD is rewarded at market price regardless of its own cost efficiency, AD's product costs stop being comparable with outside benchmarks, divisional profits no longer add to group profit, and managers may hoard capacity to capture the higher credit. Use it only as a transitional device with a sunset date.
Measurement. Residual income is the better base here, but it must be computed on divisional capital that includes inter-divisional receivables, otherwise CD is charged 13% on capital it has effectively lent to AD. Add a group-level adjustment so that neither division is penalised for a price set centrally, and review the policy annually with the demand forecast.