ICAEW BIP · Chapter 5
Transfer pricing MCQs with Answers
9 multiple-choice questions on Transfer pricing for ICAEW BIP Business Insight and Performance. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Which of the following is a main objective of a transfer pricing system in a divisionalised company?
- A) To encourage divisional managers to make decisions that are in the best interests of the group as a whole
- B) To maximise the reported profit of the supplying division
- C) To minimise the total number of internal transactions
- D) To make sure every division reports the same return on investment
Show answer & explanation
Answer: A) To encourage divisional managers to make decisions that are in the best interests of the group as a whole
A good transfer pricing system should promote goal congruence, keep divisional autonomy intact and allow divisional performance to be assessed fairly. Maximising one division's profit could cause decisions that harm the group, and transfer prices are not meant to equalise divisional returns.
Question 2
Division A makes a component with a variable cost of £26 per unit and a fixed cost of £8 per unit. It sells the component externally for £50. Division A has plenty of spare capacity, and fixed costs will not change if it supplies Division B. What is the minimum transfer price per unit that Division A should accept for supplying Division B?
- A) £50
- B) £26
- C) £24
- D) £34
Show answer & explanation
Answer: B) £26
Minimum transfer price = marginal cost of supplying + opportunity cost. With spare capacity there are no lost external sales, so the opportunity cost is nil. The minimum is the variable cost of £26. Fixed costs are not relevant because they do not change.
Question 3
Division A makes a component with a variable cost of £26 per unit and sells all its output externally for £50 per unit. It is working at full capacity. Variable selling costs of £2 per unit would be saved on any internal transfers to Division B. What is the minimum transfer price per unit that Division A should accept?
- A) £26
- B) £50
- C) £48
- D) £28
Show answer & explanation
Answer: C) £48
With no spare capacity, every unit transferred means one external sale is lost. Minimum transfer price = variable cost of the internal unit (£26 - £2 saved = £24) + contribution lost on the external sale (£50 - £26 = £24) = £48. This is the same as the market price less the selling costs saved.
Question 4
Division B buys a component from Division A, which has spare capacity. Division B can buy an identical component from an outside supplier for £44 per unit. Division B adds further variable costs of £30 per unit and sells the finished product for £90. What is the maximum transfer price Division B should be willing to pay Division A?
- A) £90
- B) £30
- C) £60
- D) £44
Show answer & explanation
Answer: D) £44
The maximum transfer price is the lower of the external purchase price (£44) and the net marginal revenue the buying division earns from the component (£90 - £30 = £60). Division B would not pay more than £44 because it could buy the same component outside for that price.
Question 5
If the buying and selling divisions are in the same tax jurisdiction, how does an increase in the transfer price for a component traded between them affect total group profit?
- A) Group profit increases only if the selling division has spare capacity
- B) Group profit is unchanged; profit is simply moved from the buying division to the selling division
- C) Group profit increases by the amount of the increase
- D) Group profit falls by the amount of the increase
Show answer & explanation
Answer: B) Group profit is unchanged; profit is simply moved from the buying division to the selling division
A transfer price is revenue for the selling division and an equal cost for the buying division, so it cancels out on consolidation. Changing it only reallocates profit between divisions, provided the volume traded and decisions taken stay the same. Group profit can be affected indirectly if the price changes managers' decisions, or where different tax rates apply.
Question 6
Which of the following is a practical limitation of using market price as a transfer price?
- A) A perfectly competitive external market for the intermediate product may not exist
- B) It cannot be used when the selling division is working at full capacity
- C) It gives the selling division no incentive to control its costs
- D) It always leads to sub-optimal decisions by the buying division
Show answer & explanation
Answer: A) A perfectly competitive external market for the intermediate product may not exist
Market-based transfer prices are often ideal when there is a perfect external market, because they are objective and keep divisions autonomous. In practice there may be no external market, or the internal product may differ from what is sold externally. Market price still gives the seller an incentive to control costs, and it is especially appropriate when the seller is at full capacity.
Question 7
A group sets transfer prices at full cost plus 20%. The full cost of a component is £34 per unit. What is the transfer price?
- A) £34.00
- B) £6.80
- C) £40.80
- D) £42.50
Show answer & explanation
Answer: C) £40.80
Transfer price = £34 x 1.20 = £40.80. A drawback of full cost-plus transfer prices is that the buying division sees the supplier's fixed costs and mark-up as a variable cost, which can lead to sub-optimal decisions.
Question 8
Division X sets a transfer price of £60 per unit for a component it makes for Division Y. Division X has spare capacity, and its variable cost is £30 per unit. Division Y has found an external supplier offering the same component at £55 per unit and decides to buy 4,000 units externally. What is the effect of Division Y's decision on group profit?
- A) Group profit falls by £100,000
- B) Group profit falls by £120,000
- C) Group profit rises by £20,000
- D) There is no effect on group profit
Show answer & explanation
Answer: A) Group profit falls by £100,000
From the group's point of view, making the component internally costs only the variable cost of £30, because X has spare capacity. Buying externally costs £55. Group profit therefore falls by (£55 - £30) x 4,000 = £100,000. Division Y's profit improves by £20,000, which shows a lack of goal congruence caused by a transfer price set too high.
Question 9
Under a dual pricing system for transfers between divisions, what happens?
- A) The buying division pays a fixed annual fee plus marginal cost for each unit
- B) Transfers are made at market price in the first half of the year and at cost in the second half
- C) Two transfer prices are negotiated and the higher one is used by both divisions
- D) The selling division is credited with one price and the buying division is charged a different, usually lower, price, with the difference held in a group account
Show answer & explanation
Answer: D) The selling division is credited with one price and the buying division is charged a different, usually lower, price, with the difference held in a group account
Dual pricing records the transfer at different prices in each division, for example market price for the seller and marginal cost for the buyer, so that each makes decisions that suit the group. The difference is eliminated in a central adjustment account on consolidation. The fixed fee plus marginal cost arrangement is a two-part tariff, which is a different approach.