Pricing Decisions, Transfer Pricing and Life Cycle Costing — Practice

Question 1

What is the formula for cost-plus pricing?

Accepted Answer

Price = Cost Base x (1 + Mark-up %).

Question 2

Does a transfer price between two divisions of the same company create new profit for the company overall?

Accepted Answer

No — it only redistributes the company's total profit between the selling and buying divisions.

Question 3

At which stage of a product's life is most of its total lifetime cost typically committed?

Accepted Answer

The research, design and development stage.

Question 4

A firm has a 90% learning curve, and the first unit takes 50 hours. Find the cumulative average time per unit after 4 units.

Accepted Answer

Average time for 2 units = 90% x 50 = 45 hours. Average time for 4 units = 90% x 45 = 40.5 hours.

Question 5

A product's marginal cost is Rs. 300. The firm wants a 40% margin on marginal cost. Compute the selling price.

Accepted Answer

Price = 300 x 1.40 = Rs. 420.

Question 6

Explain one weakness each of the cost-based and market-price-based transfer pricing methods.

Accepted Answer

Cost-based: the selling division has no profit incentive from internal transfers, reducing its motivation to control costs or prioritise internal supply. Market-price-based: it requires a genuine, observable external market price for the exact good or service transferred, which may not exist for a specialised internal component.

Question 7

Using the data in the previous learning-curve question (90% learning curve, first unit 50 hours), find the total time for all 4 units and the time taken for units 3 and 4 combined.

Accepted Answer

Total time for 4 units = 4 x 40.5 = 162 hours. Total time for 2 units = 2 x 45 = 90 hours. Time for units 3 and 4 combined = 162 - 90 = 72 hours.

Question 8

Division A can produce a component at a variable cost of Rs. 500 and has spare capacity. Division B needs the component and can buy it externally for Rs. 650, or receive it from Division A at a negotiated transfer price. Explain the range within which a transfer price would be acceptable to both divisions and support goal congruence for the company as a whole.

Accepted Answer

Since Division A has spare capacity, its minimum acceptable transfer price is its variable cost of Rs. 500 (any price above this adds to its contribution). Division B's maximum acceptable transfer price is Rs. 650, the external price it would otherwise pay. A negotiated transfer price anywhere between Rs. 500 and Rs. 650 makes both divisions better off than their respective alternatives (Division A earns a contribution above Rs. 500; Division B pays less than the Rs. 650 external price), and importantly, the company as a whole is also better off by internal transfer at any price in this range, since it avoids the extra cost of Division B buying externally at Rs. 650 when Division A can supply at only Rs. 500 variable cost — this alignment between both divisions' incentives and the company's overall interest is exactly what goal congruence requires.

Practice — Pricing Decisions, Transfer Pricing and Life Cycle Costing

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