Student Question
“I thought the answer is B but why is it D??” – Shaymill.
MCQ – Transfer Pricing
Kem Manufacturing has several divisions and evaluates performance using segment income. Since sales include transfers to other divisions, Kem has established a price for internal sales as cost plus 10%. Red Division has requested 10,000 units of Green Division’s product. Green Division is selling its product externally at a 60% markup over cost. The corporate policy will encourage the Green Division to:
A) reject the sale to the Red Division because it does not provide the same markup as external sales.
B) transfer the product to the Red Division because all costs are being covered and the division will earn a 10% profit.
C) accept the sale to the Red Division if it is operating at full capacity and the sale will contribute to fixed costs.
D) transfer the product to the Red Division if it does not require the Green Division to give up any external sales.
Correct answer: (D) transfer the product to the Red Division if it does not require the Green Division to give up any external sales.
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Let us examine why answer B is not the best answer:
The main problem with choice B is that it does not indicate whether Green Division will have to give up external sales in order to
accommodate Red Division’s requirement.
Assuming answer B that indicates that Green Division has excess capacity to accommodate Red Division, the answer would be correct.
But if answer B indicates that Green Division has no excess capacity to accommodate Red Division, the answer would be incorrect.
Why? Because although Green Division will receive a transfer price of 10% above costs, it will give up the opportunity to sell the
product at 60% above costs. Therefore, Green Division will lose the additional 50% above costs (60%-10%) for selling the product to Red Division instead of selling it outside.
This is also why answer D is the best answer. Answer D will maximize Green’s Division’s capacity as well as earn additional 10% above cost on sale to Red Division.
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