m. Since there is demand from external customers for 40,000 tons, this means that spare capacity is just 5,000 tons. that the Glass Bottles Division needs 10,000 tons per annum. Therefore, only half of its needs (5,000 tons) can be produced using spare capacity, and these transferred tons should be priced in accordance with Scenario 2. The Molten Glass Division were to also supply the Glass Bottles Division with the other half of its needs (ie, another 5,000 tons) then it would have to reduce sales to external customers by a corresponding amount. Therefore these units should be priced in accordance with Scenario 1. In this situation it is optimal to have two transfer prices, ie, a lower one for transfers which can be produced using spare capacity and a higher one for transfers which involve an opportunity cost because they involve foregoing sales to external customers. is important to resist the temptation in these circumstances to use an average price for all transfers, because it is sure to be suboptimal. Suppose, for example, that the following situation had been arrived at:
. For units to be produced using spare capacity (Scenario 2), the divisions agreed on the midpoint of the range of acceptable prices, ie, (? 65 +? 105) / 2 =? 85.
. As regards units which could not be produced using spare capacity, but would instead reduce the number of units available for sale to external customers, the division managers accepted (in accordance with the logic of Scenario 1) that the transfer price should be? 120 ( the price charged to external customers whom these transfers would displace). far, so good. The transfer pricing arrangement (involving the first 5,000 transfers being priced at? 85 per ton, and any subsequent transfers at? 120 per ton) is optimal for Cristal Ltd., In line with the logic of Scenarios 1 and 2. But suppose now that we decided to average these two prices, to come up with a single transfer price which would apply to all transfers:
Transfer price=(? 85 +? 120) / 2 =? 102.50.
It is easy to see that this transfer price is suboptimal. The Glass Bottles Division will want to buy all 10,000 tons of glass from the Molten Glass Division, since? 102.50 is lower than the price (? 105) which it is paying to its external supplier. But this is not optimal for Cristal Ltd. since (as we saw in Scenario 1) optimization is achieved only if transfers which displace sales to external customers are priced at the price charged to external customers.4: When negotiation failssaw in Scenario 2 that inter-divisional negotiations are likely to be needed in order to determine the transfer price which should apply to output produced using spare capacity. But this raises the question as to what should happen if the negotiations fail. have seen that the range of transfer prices which should be acceptable to both managers (for output produced using spare capacity) is? 65 to? 105. But suppose that each division tries to hold out for a transfer price very favourable to itself (eg, the Molten Glass Division refuses to go below a transfer price of? 100 and the Glass Bottles Division refuses to go above? 70). Because there is no agreement on transfer price there will be no inter-divisional transfers, and the Glass Bottles Division will continue to buy all of its molten glass from the external supplier at? 105 per ton. Since the compa...
