Transfer Pricing

Quick Answer: Transfer pricing sets the internal price charged when one division sells goods or services to another division within the same company. The three main methods are market-based (external market price), cost-based (variable or full cost), and negotiated (divisions bargain). The ideal transfer price promotes goal congruence, divisional autonomy, and accurate performance evaluation.

Transfer pricing is a critical issue for decentralized organizations with multiple divisions that trade with each other. The transfer price affects how profits are distributed between divisions and can influence managerial decisions about internal vs. external transactions.

Why Transfer Pricing Matters

Objectives of Transfer Pricing

Transfer Pricing Conflicts

Consider this example:

• Selling Division wants a high transfer price → Higher divisional profit
• Buying Division wants a low transfer price → Higher divisional profit
• Company wants both divisions profitable AND optimal decisions

Transfer Pricing Methods

1. Market-Based Transfer Pricing

Definition: Use the price at which the product could be sold to external customers.

Formula: $\text{Transfer Price} = \text{External Market Price}$

Advantages:

• Objective and verifiable
• Simulates arm's-length transactions
• Encourages efficiency (must compete with external suppliers)
• Easy performance evaluation

Disadvantages:

• Market price may not exist for specialized products
• Market prices may be volatile
• Doesn't consider internal synergies

Best Used When:

• Active external market exists
• Selling division is at full capacity
• Intermediate product is standardized

2. Cost-Based Transfer Pricing

Transfer prices based on the selling division's costs.

Variable Cost

Formula: $\text{Transfer Price} = \text{Variable Cost per Unit}$

Advantages:

• Simple to calculate
• Optimal for short-term decisions
• No need for external market data

Disadvantages:

• Selling division earns zero margin
• No incentive to control variable costs
• Demotivates selling division managers

Full Cost (Variable + Fixed)

Formula: $\text{Transfer Price} = \text{Variable Cost} + \text{Allocated Fixed Cost}$

Advantages:

• Ensures all costs are recovered
• Better for long-term decisions

Disadvantages:

• Includes arbitrary fixed cost allocations
• May lead to suboptimal decisions
• Can double-count fixed costs

Cost-Plus

Formula: $\text{Transfer Price} = \text{Cost} + \text{Markup Percentage}$

Advantages:

• Selling division earns a profit
• Motivates cost control
• Balances interests of both divisions

Disadvantages:

• Markup percentage is arbitrary
• Still requires cost accuracy

3. Negotiated Transfer Pricing

Definition: Divisions negotiate the transfer price within acceptable ranges.

Range for Negotiation:

$\text{Minimum (Seller)} = \text{Variable Cost} + \text{Opportunity Cost}$

$\text{Maximum (Buyer)} = \text{Market Price or Value in Final Product}$

If Minimum ≤ Maximum, mutually beneficial trade is possible.

Advantages:

• Preserves divisional autonomy
• Both parties have incentive to negotiate fairly
• Can account for unique circumstances

Disadvantages:

• Time-consuming negotiation process
• Depends on negotiating skills
• May create inter-divisional conflict
• Requires clear information sharing

4. Dual Pricing

Definition: Different transfer prices for the selling and buying divisions.

How It Works:

• Selling division records revenue at market price
• Buying division records cost at variable cost
• Corporate eliminates the difference

Advantages:

• Motivates both divisions
• Selling division earns fair profit
• Buying division makes optimal decisions

Disadvantages:

• Complex accounting
• Inflates combined divisional profits
• Requires corporate adjustment

The General Transfer Pricing Rule

Formula for Optimal Transfer Price:

$\text{Transfer Price} = \text{Variable Cost} + \text{Opportunity Cost per Unit}$

Where opportunity cost is the contribution margin lost if the product is transferred internally instead of sold externally.

Scenarios:

Transfer Pricing Example

Situation:

• Selling Division: Variable cost = $30, Full cost = $45, Market price = $50
• Selling Division capacity: 10,000 units
• Internal demand: 2,000 units
• External demand: 9,000 units (at $50)

Analysis:

• If the Selling Division transfers 2,000 units internally, it can only sell 8,000 externally
• Lost external sales = 1,000 units (since 2,000 + 9,000 > 10,000)
• Opportunity cost per unit = $50 - $30 = $20

Optimal Transfer Price: $\text{TP} = \$30 + \$20 = \$50$

At full capacity with excess external demand, the transfer price equals market price.

International Transfer Pricing

International transfers add complexity due to:

Tax Implications

Regulatory Requirements

• Arm's-length principle: Price must be what unrelated parties would charge
• Documentation requirements: Detailed justification for transfer prices
• Advance Pricing Agreements (APAs): Pre-approved transfer pricing methods
• Country-by-country reporting: Multinational disclosure requirements

Other International Considerations

Choosing a Transfer Pricing Method