What is Transfer Price?

Transfer price, which is also known as transfer cost, refers to the amount that is set for the transfer of goods and services from one branch of a company to another. It is the price of trade activities or goods and services transferred between different departments of a company.

What is the General Economic Transfer Pricing Rule?

Although there are different approaches for establishing a transfer price, the general economic transfer pricing rule states the transfer price should be set at differential cost to the selling division (normally variable cost) plus the opportunity cost of making the sale internally (none if the seller has idle capacity or selling price minus variable cost if the seller is at capacity). 

The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also doing what is in the best interest of the division manager.

Transfer Pricing and Conflicts of Interest

If division managers are evaluated based only on division results using measures, such as segmented net income, profit margin ratio, or return on investment (ROI), conflicts can arise causing managers to take a course of action that benefits the division but hurts the company as a whole. 

For example, a division manager may decide to purchase raw materials from an outside supplier even though the same materials can be produced at a lower cost by another division within the company (the other division’s manager refuses to sell the materials at a reduced price because she is evaluated based on her division’s profits!). 

A well-crafted transfer pricing policy will encourage managers to do what is in the best interest of the company while also doing what is in the best interest of the division manager (this is called goal congruence). Several common approaches are presented next.

Establishing a Transfer Price? 

The general economic transfer pricing rule attempts to establish guidelines for divisions to maximize overall company profit. 

Transfer price = Differential cost to selling division + Opportunity cost of selling internally

So, if the producing segment has capacity and the variable cost to product the good is $5, it should charge the other segment $5 for the good. 

If there is a shortage of capacity to meet the demands of the market, and the good would sell for $10 in the market, the cost should be $10.  The $10 represents the variable cost and the value of the opportunity (potential profit) when selling in the market. 

Using Cost to Set Transfer Price

Another approach to establishing a transfer price is to use the cost of the goods or services being transferred. 

Transfer prices can be based on variable cost, full absorption cost, or cost-plus. Each approach is described next.

Variable Cost

Some companies simply use the selling division’s variable cost as the transfer price. However, the weakness in this approach is the selling division will not be able to mark up its products or services, and as a result, will not be able to generate a profit. 

This is not a problem for selling divisions treated as cost centers, but profit center and investment center managers will not be satisfied with such an approach.

Full Absorption Cost

Companies sometimes set the transfer price at the selling division’s full absorption cost. 

The selling division manager prefers to cover all costs rather than only variable costs, and using full- absorption cost accomplishes this goal. 

However, the company’s concern is the buying division might choose to purchase from an outside provider at a higher price than the differential cost plus opportunity cost but lower than the selling division’s full absorption cost. The result is a decision that does not maximize company profit.

Cost-Plus

Companies often add a markup to the selling division’s variable cost or full absorption cost to set the transfer price. This enables the selling division to earn a profit on internal transfers. 

Again, the risk is that the buying division might buy from an outside supplier at a higher price than differential cost plus opportunity cost, resulting in lower company profit.

Negotiating Transfer Prices

If the general economic transfer pricing rule is not used, and the cost approach is not used, another alternative is to simply negotiate the transfer price. 

What are the potential weaknesses in negotiating a transfer price?

Investment center division managers are often expected to act independent of each other. In fact, many companies treat investment centers as separate businesses. 

To promote the autonomy of each division manager, companies often require the buying and selling divisions to negotiate a transfer price. 

Transfer Pricing and Taxation

Aside from being the price at which divisions of a company transact with each other, transfer pricing can also serve as means of regulating inter-company tax.

Tax authorities or the government place transfer pricing tax on inter-company transactions given that some multi-entity companies use transfer prices to evade taxation. 

Also, some companies use transfer prices for international business transactions so as to avoid import or export duties and tariffs. This gave rise to transfer pricing taxes as international tax laws regulated by the Organization for Economic Cooperation and Development (OECD). 

Financial auditors and regulators also take note of this when monitoring transfer prices in multi-entity companies.

Related Topics

• Job Costing vs Process Costing
• Assign Direct Material and Direct Labor to Job
• Assign Manufacturing Overhead Costs to Job
• Assign Overhead Costs to Products
• Plantwide Cost Allocation
• Department Cost Allocation
• Activity-Based Costing
• Weighted-Average Cost of Products
• Production Cost Report
• Fixed, Variable, and Mixed Cost Estimations
• Contribution Margin Income Statement
• Cost-Volume-Profit Analysis
• Margin of Safety
• Contribution Margin per Unit of Constraint
• Absorption Costing vs Variable Costing
• Differential Analysis and Decisions
• Cost Decisions for Joint Products
• Capital Budgeting
• Life Cycle Costing
• The Master Budget
• Activity-Based Budgeting
• Standard Costs
• Imputed Value
• Variance Analysis for Product Costs
• Absorption Pricing
• Price Variance
• Absorption Variance 
• Responsibility Centers
• Comparing Segmented Income
• Using ROI to Evaluate Performance
• Using Residual Income to Evaluate Performance
• Use Economic Value Added to Evaluate Performance
• Transfer Pricing