Transfer pricing, idle capacity and divisional performance measurement
Division A of Arjun Industries makes component P. Its capacity is 50,000 units a year; variable cost is ₹600 a unit and annual fixed cost is ₹80 lakh. External demand for P is 30,000 units at ₹900, and Division A currently sells all 30,000. Division B needs 20,000 units of P a year to assemble a product that sells for ₹2,500; B's other variable cost is ₹1,300 a unit. B can buy P externally at ₹820. The current transfer price is ₹950, fixed as full cost plus 10% markup, and B has responded by buying all 20,000 units externally. Division A's manager is measured on divisional ROI and refuses to sell below ₹950; Division B's manager is measured on divisional operating profit and refuses to pay more than ₹820. Corporate management wants to know whether the internal transfer should be mandated and how the transfer price should be set.
1. Compute the company's gain or loss from B's external purchase and determine the minimum transfer price at current capacity. What would the minimum be if external demand for P rose to 52,000 units?
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Current capacity: idle 20,000 units
Division A has external demand of only 30,000 units, so it has 20,000 idle units. The minimum transfer price is the incremental cost: ₹600 per unit. There is no opportunity cost because no external sale is displaced. Any price between ₹600 and ₹820 creates a joint benefit; the company avoids an external purchase at ₹820 and uses capacity that otherwise earns nothing.
| Position | A contribution (₹) | B contribution (₹) | Total contribution (₹) |
|---|---|---|---|
| B buys outside | 30,000 x 300 = 90,00,000 | 20,000 x 380 = 76,00,000 | 1,66,00,000 |
| Internal at ₹700 | 90,00,000 + 20,000 x 100 = 1,10,00,000 | 20,000 x 500 = 1,00,00,000 | 2,10,00,000 |
The company gains ₹44,00,000, which equals 20,000 x (₹820 - ₹600). A transfer at ₹600 gives the whole gain to B; at ₹820 it gives the whole gain to A; in between it shares the gain.
If external demand rises to 52,000 units
A can sell all 50,000 units at ₹900. The opportunity cost of transferring a unit is ₹300, so the minimum transfer price is ₹600 + ₹300 = ₹900. B's maximum is ₹820. A voluntary transfer will not happen, and it should not be forced: internal transfer at ₹900 gives total contribution of 30,000 x 300 + 20,000 x 300 + 20,000 x 300 = ₹2,10,00,000, while A selling 50,000 externally and B buying outside gives 50,000 x 300 + 20,000 x 380 = ₹2,26,00,000. The company is better off by ₹16,00,000 without internal transfer.
2. Evaluate the ₹950 transfer price and explain why it produces goal incongruence. Recommend a better transfer pricing method.
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The ₹950 price is above market and causes sub-optimisation
The ₹950 price is full cost plus 10%. It includes A's fixed cost and a markup, but the relevant cost of using idle capacity is ₹600. B can buy at ₹820 and rationally does so: B's contribution is ₹380 per unit instead of ₹250 at ₹950. A's manager, measured on divisional ROI, prefers ₹950 because it converts idle capacity into a large divisional profit. Both managers are behaving rationally for their own scorecards, but the company loses ₹44,00,000 of contribution.
The transfer price has become a profit-allocation device rather than a signal of resource cost. A market-based price with a range of ₹600 to ₹820 would align both divisions: B gains by buying inside, A gains something on idle capacity, and the company captures the ₹44,00,000. A negotiated price with central arbitration can set the split. A two-part tariff is also suitable: B pays ₹600 per unit plus a fixed annual fee that shares the gain; for example, a ₹22,00,000 fee gives each division half the benefit. A dual price (credit A at ₹900, charge B at ₹820) can motivate both, but the ₹16,00,000 difference must be held in a corporate account and excluded from divisional profit to avoid a fictitious profit.
3. Discuss the behavioural and performance-measurement issues in mandating an internal transfer at ₹600, and how a dual transfer price would affect divisional ROI and corporate profit.
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Mandating ₹600: behavioural and measurement effects
At ₹600, A's contribution on the 20,000 units is nil. A's divisional profit stays at ₹10,00,000 (30,000 x ₹300 - ₹80,00,000), so A gets no reward for the extra work, quality control and scheduling. The manager may comply formally but deprioritise the internal customer, delay deliveries or cut service. B captures the entire ₹44,00,000 gain, which may be equally demotivating for A. A mandate without a gain-sharing mechanism treats transfer pricing as a control tool, not a coordination tool.
A dual transfer price can fix the motivation: credit A at ₹900 (market) and charge B at ₹820 (market purchase price). A's profit rises to ₹70,00,000 (₹10,00,000 + 20,000 x ₹300); B's contribution is ₹76,00,000; the ₹16,00,000 difference is a corporate subsidy. The sum of divisional profits (₹1,46,00,000) exceeds corporate profit (₹1,30,00,000), so the subsidy must be excluded from consolidated performance and from bonus pools. Otherwise managers can game the system.
Better practice: use a two-part tariff or a negotiated range, measure divisions on controllable contribution and residual income, and review the transfer price when capacity or external prices change. The corporate objective is ₹2,10,00,000 contribution, not the highest divisional ROI.