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Transfer Pricing

  Transfer Pricing

Illustration 90

The manufacturing section of an electronics industry manufactures a component that it sells internally to the marketing section of the industry. Electronics which does the packaging endorses sales and distributes it through its sales channels.

Presume that there does not contain any external market for any surplus manufacture of the component nor the marketing section can purchase the component from outside supplies. The marketing section’s demand function for the commodity is provide by,

                        Rm      =          200 – 0.001Vm

The marginal cost of the marketing section is $20 per unit of the commodity and marginal cost of manufacture of the component is provided by

                        MCr     =          30 + 0.001Vr

Determine the profit optimising volume of productivities of marketing and production sections by the electronics industries and optimal transfer rate of the component.


For optimising profits the marketing section will equate its marginal revenue with the aggregate marginal cost.

The provided demand function is

                        Rm      =          200 – 0.001Vm

                        TR       =          RmVm             =          200Vm – 0.001Vm^2

                        MRm   =          dTR                 =          200 – 0.002Vm           …..(1)

Aggregate marginal cost MC of the marketing section is

MC      =          MCr + MCm

            =          30 + 0.001Vr + 20

            =          50 + 0.001Vr                                                   …..(2)

Recognising that Vp = Vm and fixing MRm = MC we have

200 – 0.002Vm           =          50 + 0.001Vr

0.002Vm + 0.001Vm  =          200 – 50

            0.003Vm         =          150

                        Vm      =          150 / 0.003

                                   =          50000 units.

As per presumption,    Vr        =          Vm

Thus,                           Vr        =          50000 units.

The optimal transfer price of the component parities to the marginal cost of manufacture section;

Therefore, optimal transfer price of the component can be obtained by ascertaining the marginal cost of productivity of the component of the manufacture section by substituting the value of productivity Vm in the MC function of the component.

Therefore, transfer price          Rx       =          MCr

                                                Pt         =          30 + 0.001Vr

                                                            =          30 + 0.001*50000

                                                            =          30 + 50

                                                            =          $80 per unit.

Illustration 91

A company manufactures paper and also uses paper to produce writing note books. Its manufacturing section also sells paper in the external market which is perfectly rivalled. The demand faction for note books is provided by

                                                Vn       =          300 – 20Rn

The marginal cost function of manufacturing of paper and note books are:

                                                MCr     =          2 + 0.1Vr

                                                MCn    =          0.1Vn

Presume the price of paper in the external rivalled market is $12. Ascertain the optimal levels of productivity of paper and note books and also the transfer price.


Demand function of the final commodity that is note book is

                                                Vn       =          300 - 20Rn

                                                20Rn   =          300 – Vn

                                                Rn       =          30 – 0.1Vn

                                                TRn     =          Rn * Vn

                                                            =          30Vn – 0.1Vn^2

                                                MRn    =          dTR     =          30 – 0.2Vn

Price of paper in the perfectly rivalled external market is $12. To procure the optimal productivity level of intermediate commodity we equate marginal cost of manufacturing paper with $12.


                                                MCr     =          Rr

                                    2 + 0.1 Vr        =          12

                                                0.1Vr   =          12 – 2  =          10

                                                Vr        =          10 / 0.1

                                                            =          100

To optimise profits, the note book section will equate aggregate marginal cost of manufacturing note book with its marginal revenue. In the present case when there is perfect rivalry in the external market for the intermediate commodity the transfer price Pt will be equal to $12 i.e. price existing the external market.

            Total marginal cost of manufacturing notebook MCt                        =          MCn + Pt

            Or        MCt     =          0.1Vn + 12

            Equating total marginal cost of note books MCt with their marginal revenue MRn, we have,

                        0.1Vn + 12      =          30 – 0.2Vn

            0.1Vn + 0.2Vn            =          30 – 12

                                    0.2Vn  =          18

                                    Vn       =          18 / 0.2

                                                =          90

The note book section will manufacture 90 units of note books. To procure rate of note books we substitute Vn = 90 in the demand function for note books,


                                    Rn       =          30 – 0.1Vn

                                    Rn       =          30 – 0.1*90

                                                =          21

Therefore, optimal price of note books is $21.

The manufacturing section of paper manufactures 100 units of paper and its sell 90 units of it internally to the note book section at transfer price of $12 which is the rate existing in the perfectly rivalled external market and the rest 10 units are sold in the external market. 90 units of note books are manufactured by the note book section and sold at a rate of $21 per note book.

Transfer Pricing with External Perfectly Rivalled Market for the Intermediate Product

  1. The accurate pricing of intermediate commodities is significant for the efficient working of the individual sections of the enterprise as well as of the big enterprise entirely.
  1. This is for the reason that the price by a division for an intermediate commodity from another section of the enterprise will affect the productivity of each division and thus the overall productivity of the enterprise entirely.
  1. Apart from the transfer rates of the intermediate commodities paid by one of the section to another section of the enterprise affects the profitability of the divisions among whom transactions occurs and consequently serve as incentives and rewards for the efficient working of various divisions of the enterprise.
  1. If transfer prices are fixed at too less scale, it will badly the profitability of manufacturing the intermediate commodities and likely influence the profitability of the purchasing sections.
  1. The improper transfer pricing serves as a disincentive for the managers and other personnel to better the effectiveness of their sections.
  1. Further more, such improper transfer pricing is not equitable for the reason that the increments in salaries, grant of bonuses and sometimes even the job sanctuary of top mangers, supervisors, labourers employed in a section based on the profitability of the section.
  1. Thus, it is required that right transfer rates are determined so that maximum rate and productivity decisions are made by the enterprise entirely.

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