Transfer Pricing, Idle Capacity and a Below-Cost Export Order at Arvind Precision
Arvind Precision Ltd runs two divisions. The Components Division can produce 1,20,000 units a year; external demand at the market price of ₹1,450 is 90,000 units. Variable cost is ₹820 per unit and divisional fixed cost is ₹6 crore. Its manager is assessed on return on investment. The Assemblies Division needs 40,000 units and buys them outside at ₹1,380. Group policy fixes transfer prices at market. The Components manager refuses any internal price below ₹1,450; the Assemblies manager has escalated, arguing that group profit is ₹1.61 crore a year lower than it need be. Separately, an overseas OEM has offered ₹1,050 for 15,000 units, a one-time order that would need ₹6 lakh of tooling written off immediately. The CFO wants an internal pricing rule that 'works without a negotiation every quarter' and has asked whether the export order should be accepted in the same year.
1. Compute the minimum transfer price and the group-level gain from internal transfer. Why does the market-price rule produce the wrong decision here?
Read the worked answer
Capacity test first. External demand 90,000 + internal need 40,000 = 1,30,000 against capacity of 1,20,000. The division is capacity-constrained by 10,000 units, so an internal transfer of 40,000 units displaces 10,000 units of external sale.
Minimum transfer price = variable cost + opportunity cost per unit transferred:
- Lost contribution = 10,000 × (1,450 − 820) = ₹63,00,000
- Per unit transferred = 63,00,000/40,000 = ₹157.50
- Minimum TP = 820 + 157.50 = ₹977.50
Maximum TP = the Assemblies Division's external buying price = ₹1,380. Bargaining range: ₹977.50 to ₹1,380.
Group gain from transfer = (1,380 − 820) × 40,000 − 63,00,000 = ₹2,24,00,000 − ₹63,00,000 = ₹1.61 crore, which equals the surplus (1,380 − 977.50) × 40,000. The 40,000-unit quantity is right at group level because the internal saving of ₹560 per unit exceeds the ₹630 contribution lost on only one-quarter of a unit per unit transferred.
Why the market rule fails. The market price of ₹1,450 lies above the buyer's external price of ₹1,380, so a market-price rule makes the transfer impossible and forgoes ₹1.61 crore of group profit. Note also that at the minimum TP the seller is exactly indifferent - it earns the same ₹5.67 crore contribution with 80,000 external plus 40,000 internal units as with 90,000 external units and 30,000 idle - so the rule is fair to the seller as well as correct for the group.
2. Design a transfer pricing policy that avoids quarterly negotiation and corrects the divisional performance measure.
Read the worked answer
Rule-based, capacity-adjusted pricing. Announce in the annual budget: internal transfers are priced at standard variable cost plus a capacity charge, where the capacity charge = (unfilled external demand at budgeted market price × unit contribution) ÷ budgeted internal volume. Here that yields ₹977.50 for the year. Recalculate only if budgeted capacity, demand or variable cost moves by more than, say, 10% - otherwise the price stands for the year. That removes the quarterly argument while keeping the price economically correct.
Handle the residual surplus explicitly. Because the range is ₹977.50–₹1,380, pick a sharing rule up front - for example a 50:50 split, giving ₹1,178.75 - and state it in the policy. A two-part tariff (variable-cost price plus a fixed annual fee to cover the seller's fixed costs) is an acceptable alternative for stable, high-volume flows.
Dual pricing, with eyes open. Credit the seller at market and charge the buyer at cost, eliminating the difference on consolidation. It preserves both managers' incentives, but it hides the real cost of internal supply from the buyer and can encourage uneconomic internal sourcing; use it only where the group genuinely wants to steer volume internally.
Fix the metric, not just the price. A manager judged on divisional ROI will always resist a transfer that adds capital-employed volume at a thin margin. Move the Components manager to residual income or EVA, exclude mandated internal sales from the divisional capital base, and add a group-profit share of 10–15%. Otherwise the policy will be gamed through quality, delivery priority and 'capacity unavailable' claims.
3. Should Arvind accept the ₹1,050 export order for 15,000 units in the same year?
Read the worked answer
Financial test. Contribution = (1,050 − 820) × 15,000 = ₹34,50,000, less tooling ₹6,00,000 = ₹28,50,000 net gain. It is below full cost of ₹1,320 per unit (820 variable + 500 fixed absorbed at 1,20,000 units), which is irrelevant if capacity is genuinely idle - incremental business is judged on incremental cost.
But capacity is not idle if the transfer happens. With the internal transfer in place the division runs at 1,20,000 units. Accepting the export order would then displace either 15,000 units of external sale (forgoing 15,000 × 630 = ₹94.5 lakh) or the internal transfer (forgoing ₹1.61 crore). Either trade is worse than the ₹28.5 lakh gained. Take the transfer, decline the order - unless the order falls in a different period or the transfer is not proceeding.
If capacity is genuinely free, accept, subject to:
- Verifying the variable cost includes incremental freight, packing, credit insurance and any export inspection cost
- Price-referencing risk: domestic customers learning of a ₹1,050 price and demanding it (mitigate with a different specification, branded packaging or a clause prohibiting resale into India)
- Trade remedy exposure - a below-cost export price invites anti-dumping action in the buyer's market and can jeopardise export incentives
- Whether the tooling is truly order-specific or reusable, in which case amortise it and the case improves
- Strategic value: a reference customer in a new geography may justify a lower first-order margin
Presentation to the CFO: quantify both scenarios side by side and show that the order and the transfer are mutually exclusive uses of the same 15,000 units - that is the real decision.