Transfer Pricing

Easy Practice Test

Easy Practice Test

Click the “Check Your Answer” box below each question to reveal the correct answer and explanation.

1. A transfer pricing system should be designed to

a. increase the value of inventory held by the total company
b. assist in evaluating management performance
c. assist purchasing managers who buy from outside suppliers
d. support a centralized organization

B. Transfer prices facility inter-company sales. Sales from one division to another will be part of each divisions profits and the system should be designed to allow for fair evaluation of management. Transfer pricing occurs in a decentralized organization (d.).
A transfer price is an internal price (c.). The value of inventory is the same regardless of which division owns the inventory (a.).

2. The maximum transfer price should be set once

a. the total costs of the product or service are determined
b. the external price for the product has been determined
c. the total variable costs have been determined
d. the full absorption cost of the product has been determined


B. The maximum transfer price should be equal to the lowest external price. The external price has to be determined before the maximum transfer price can be determined. Maximum transfer price is not dependent on cost to produce.

3. Idle capacity in the selling division should result in

a. a higher transfer price to the buyer
b. a lower transfer price to the buyer
c. no impact on the transfer price
d. a lower transfer price to the seller


B. Idle capacity means the cost to the seller is only incremental costs. The transfer price will therefore be lower than if fixed costs to add capacity have to be incurred or lost contribution margin from other external customers has to be covered also.

4. A significant advantage of cost-based transfer pricing is

a. costs are always accurately and easily determined
b. the purchasing division can include any cost when determining the price
c. it provides incentives to control fixed costs
d. there is only one definition of costs


C. The transfer price based on cost can vary based on which costs are included and how costs are allocated to individual products. The cost is not always easily determined (a. and d.). It is the selling division’s costs that are considered, not the purchasing division’s cost (b.). The selling division has incentive to control fixed costs because the more they can sell from the same fixed costs, the more profitable they will be.

5. The minimum transfer price is often determined by

a. the lowest external sales price
b. incremental costs of manufacturing
c. a negotiated price
d. the highest external sales price


B. The minimum transfer price should be equal to the incremental costs. The selling division should not sell the product below incremental costs. This would cause the selling division to earn less profit due to selling to another division in the same company.

6. When a division increases the selling transfer price to another division

a. total company profits always increase
b. profits in the selling unit increase
c. profits in the purchasing unit increase
d. total company profit always decrease


B. A higher selling transfer price will give a higher contribution margin and therefore higher profits to the selling division. Total company profits will be the same as the selling division profits will be higher by the same amount that the purchasing division’s profits will be lower. Paying a higher transfer price will increase costs and decrease profits in the purchasing division (c.).

7. A transfer price that gives the fairest evaluation of each segment’s performance is

a. the minimum transfer price
b. the maximum transfer price
c. the incremental costs of the selling division
d. the most common external sales price


D. A transfer price based on the most common external selling price will give the profit that would come from buying and selling from a third party. This is the fairest and most objective way to set a transfer price. The minimum transfer price gives 0 profits to the selling division and will increase the profits of the purchasing division because their costs will be less. The maximum transfer price is the lowest external sales price and gives the selling division the advantage by allowing them to earn added profit on the sale.

8. Which of the following should be a characteristic of a fair transfer pricing system?

a. it reflects organization goals
b. it is difficult to evaluation sub unit performance
c. transfer prices do not change once they are determined
d. prices are always based on incremental costs


A. Transfer pricing should encourage divisions to behave in a manner that accomplishes overall organizational goals. The other choices are not true statements.

9. A cost unit that desires to be a profit center should not set transfer prices based on

a. the external sales price
b. cost plus a predetermined profit %
c. the price other units would pay outside to purchase the service
d. incremental costs


D. Setting a transfer price based on incremental costs will not lead to profit. The price must be higher than incremental costs to give profit. The other choices are higher than internal costs and will lead to profits.

10. Transfer pricing is primarily used by companies that are

a. involved in one simple manufacturing process
b. decentralized
c. centralized
d. company’s exporting products


B. Decentralized organizations typically have several units or segments that provided services to each other. This type of organization typically uses transfer pricing.

11. Xing Corporation is comprised of two divisions, X and Y. X currently sells and produces a component part used by Y division. X is currently selling 75% of the units it can produce (total capacity of 30,000 per year) to external customers for $25 per unit. At this level of activity, X’s per unit costs are as follows:

Variable Production:          $7
Variable S G & A               $2
Fixed Production:              $6
Fixed S G & A                   $5

Y division wants to purchase 5,000 component parts from X division. Y Division currently purchases these units from an outside manufacturer for $27 per unit.

A. What is the minimum transfer price per unit that X division should accept from Y division and not lower the operating income of X division?

B. What is the maximum transfer price per unit that Y division should accept that will not lower the operating income of Y division?

C. What is the minimum transfer price per unit that X division should accept from Y if they were currently selling all 30,000 units to external customers?


A. The minimum transfer price that division X can sell to division Y and maintain current profits for division X is the total incremental costs incurred to manufacture and sell the unit.

Variable Production		$7
Variable SG & A		$2
    Total Incremental		$9   Minimum transfer price

The company currently produces 30,000 units and sell 75%, or 22,500 units, leaving
idle capacity of 7,500 to sell to division X. They can currently produce the
5,000 without adding fixed costs. When there is idle capacity the minimum price is the total incremental costs.


B. Y division should not pay more than the purchase price from an outside manufacturer or it will lower current profits. The maximum is their current external purchase price which is $27.


C. Minimum transfer price when at capacity is incremental costs + lost contribution margin from external customers.

 Sales				    $25
- Variable Costs		    $  9
= Contribution Margin	    $16
+ Incremental costs		    $  9
= Minimum transfer price	        $25

The minimum transfer price when at capacity will be the price that is currently sold to external customers.

12. A company has two divisions: Division 1 manufactures computer components for sale, and Division 2 assembles computers for sales to external customers. Management is currently in the process of deciding if the division that assembles computers should purchase a component from division 1 or from an outside supplier. Two outside suppliers have offered to supply the unit for $38 and $39. Information related to the component manufactured by division 1 is as follows:

Sales price to external purchasers $40
Variable cost of production $24
Fixed production costs $500,000
Fixed selling costs $100,000
Fixed administration costs $250,000
Annual capacity 250,000 units
Annual external sales 220,000 units
Units currently produced 220,000

Division 2 would like to purchase 20,000 units from Division 1.

A. Determine the minimum transfer price based on a full cost of production approach
B. Determine the maximum transfer price.
C. Determine the price that would be give the most objective performance of each division.


A. Full cost of production includes all product costs, both fixed and variable:

Variable production costs		$24
Fixed production costs		    $  2.27	
   Total costs				    $26.27

Minimum transfer price should be $26.27

Fixed production cost is $500,000 / 220,000 = $2.27


B. The maximum transfer price should be the lowest price the purchasing division can purchase from an external supplier:   $38

C. The most objective price is the most common price from an external supplier.
The company would most likely average the two bids and negotiate at a $39.50 price.

13. The company has 2 divisions that each operate as a profit center. Division A charges Division B $30 per unit. Other data follows:

Variable cost of production $20 per unit
Variable admin costs $3 per unit
Fixed cost of production $80,000
Annual sales to B 10,000
Annual sales to external customers 10,000
Annual capacity 25,000
Sales price to external customers $50

Division B can purchase each unit from an external supplier for $48. Division A has not been able to increase sales to external customers.

A. What is the minimum transfer price that should be in place?
B. What is the maximum transfer price that should be in place?
C. Should the corporation require Division B to purchase the units from Division A?


A. The minimum transfer price should be the total of incremental costs incurred.

Variable costs are incremental costs, current fixed costs are not incremental.

Total incremental variable costs are $23 per unit – this is the minimum transfer price

B. The maximum transfer price should not exceed the price the purchasing division can purchase from an external supplier: $48

C. Total corporate profits will be impacted as follows if B purchases from A.

Current price paid		$48
Minimum transfer price	$23
   Difference per unit	$25  

Total company costs will be $25 higher if the units are purchased from an external supplier

The company should require B to purchase from A

As long as A has external capacity, which they currently do, B should purchase from A at a negotiated price between $23 and $48.

When A no longer has capacity, the company will loose $2 in contribution margin if B purchases from A and A can not sell to external customers.