Transfer pricing methods and behaviours - Capacity constrain...

Learning Outcomes

This article explains how transfer pricing should be set when divisions face capacity constraints, focusing on the opportunity cost approach for group profit maximisation. You will be able to: identify when opportunity cost is relevant, calculate minimum transfer prices under different capacity scenarios, distinguish between marginal and opportunity costs, and evaluate typical behaviours of divisional managers under internal transfer pricing policies.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand the principles that underpin transfer pricing decisions, especially in divisionalised structures where internal supply and demand are present. This article covers:

• The need for transfer pricing policies and criteria for their design
• Use of alternative bases for transfer pricing, including marginal cost and opportunity cost methods
• Recognition and calculation of opportunity cost in setting transfer prices
• Analysis of how capacity constraints affect transfer pricing decisions
• Evaluation of group profit versus divisional autonomy and potential dysfunctional behaviour

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which element is always included in the minimum transfer price when the selling division is at full capacity?
   1. Fixed cost per unit
   2. Variable (marginal) cost per unit only
   3. Opportunity cost per unit
   4. Administrative cost per unit
2. Division Alpha produces a component at a variable cost of $10. It can sell all units externally for $16 or transfer to Division Beta. If Alpha has spare capacity, what is the minimum transfer price it should accept?
   1. $0
   2. $10
   3. $16
   4. $6

3. True or False? The opportunity cost in transfer pricing reflects the lost contribution from external sales when internal transfers displace external customers.

4. Briefly state how a group can be worse off if transfer prices are set above or below optimal levels when there is a capacity constraint.

Introduction

Internal transfers between divisions in decentralised organisations require setting a transfer price. When a selling division has limited resources or is already operating at full capacity, simply charging variable cost does not align divisional behaviour to the group's best interests. The opportunity cost approach ensures the transfer price reflects both the direct resource usage and any contributions sacrificed due to capacity limitations. Understanding how to apply this method—and the managerial behaviours it triggers—is essential for group profit maximisation.

Key Term: transfer price
The notional price at which goods or services are transferred between divisions within the same group of companies.

Key Term: capacity constraint
A situation where a division cannot produce enough output to meet both internal and external demand at the same time.

Key Term: opportunity cost
The value of the next best alternative foregone as the result of a decision; in transfer pricing, it is often the contribution lost by not selling externally.

Capacity Constraints and the Opportunity Cost Approach

When setting transfer prices, start by asking whether the selling division has spare capacity. The answer determines whether there is an opportunity cost to supplying internally.

When the Selling Division Has Spare Capacity

If the supplying division has unused resources, serving the internal customer does not require giving up external sales. In this context, the minimum transfer price equals variable (marginal) cost per unit:

Minimum transfer price = Marginal cost per unit

No contribution is lost, so no opportunity cost is present.

When the Selling Division Is at Full Capacity

If the supplying division can sell all its output externally, any unit transferred internally means an external sale is lost. The opportunity cost is the contribution margin lost on the forgone external sale:

Minimum transfer price = Marginal cost per unit + Opportunity cost per unit

Calculate the opportunity cost per unit as:

Opportunity cost per unit = External selling price per unit – Marginal cost per unit

This ensures the supplying division is indifferent between selling externally or internally.

Key Term: group profit maximisation
Setting policies so the total profit across all divisions is maximised, even if some individual divisions earn less.

Worked Example 1.1

Division A manufactures a component at a marginal cost of $5 per unit. The external market price is $8. Division B wants to buy 2,000 units. Division A has the following situations:
a) Spare capacity for 2,000 units
b) Full capacity, with external demand for 10,000 units (it can sell every unit it produces externally)

Required: Calculate the minimum transfer price per unit for cases (a) and (b).

Answer:
a) With spare capacity, minimum transfer price = $5 per unit (marginal cost). There is no lost external sale, so no opportunity cost.
b) At full capacity:
Opportunity cost per unit = $8 (external price) – $5 (marginal cost) = $3
Minimum transfer price = $5 + $3 = $8 per unit
The division should only transfer internally if it receives the same as from selling externally.

Managerial Behaviour and Potential Group Losses

If transfer prices ignore opportunity cost, managers may make decisions contrary to the interests of the group. For example, a division may refuse to supply another division at variable cost when capacity is scarce, or, conversely, divisions may transfer at below the true group cost, making the group worse off.

Worked Example 1.2

Division X can sell 5,000 units externally at $20 per unit (variable cost per unit is $12). Division Y wants to buy 1,500 units for further processing. X is at full capacity. If group policy enforces a transfer price at $12 per unit, what may happen?

Answer:
X will prefer to sell all units externally since $20 > $12. If forced to transfer 1,500 units at $12, the group loses the opportunity to sell 1,500 units externally and loses ($20-$12) × 1,500 = $12,000 in contribution.
The correct group-maximising price should have included this opportunity cost, incentivising X to prioritise group profit.

Common Calculation Formats

• Minimum Transfer Price = Marginal Cost + Opportunity Cost
• Opportunity Cost (when at full capacity) = External Selling Price – Marginal Cost

If the buying division cannot source externally at a lower price, and group profit is to be maximised, the transfer price must at least match the contribution the supplying division would forfeit.

Exam Warning

When the supplying division is not at full capacity, do NOT add opportunity cost to the transfer price calculation—this is only appropriate when an internal transfer displaces an external sale.

Revision Tip

Always determine whether spare capacity exists before calculating the opportunity cost. A transfer price set without considering capacity may result in incorrect conclusions in exam scenarios.

Summary

The opportunity cost approach ensures transfer prices align divisional decisions with group profit objectives when capacity is limited. The variable cost is always included, but the opportunity cost applies only when an internal transfer displaces external sales. Ignoring this principle can cause divisions to act in ways that reduce overall group profit.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain how capacity constraints affect transfer price calculations
• Distinguish situations where opportunity cost applies in transfer pricing
• Calculate minimum transfer prices including opportunity cost when relevant
• Identify potential group profit losses from misaligned transfer pricing
• Recognise common behaviours of managers under different transfer pricing regimes

Key Terms and Concepts

• transfer price
• capacity constraint
• opportunity cost
• group profit maximisation