Transfer pricing I: methods and the general rule

When one division of a decentralized company supplies goods or services to another, the price charged for the transfer becomes revenue for the selling division and cost for the buying division. A transfer price does not change the company's total profit from a given set of transactions: it simply divides that profit between the divisions. But because divisions are evaluated on their own profit, ROI or residual income, the transfer price affects how managers decide what to buy, sell and produce, and therefore it can change the company's total profit after all. ACCT-102 introduced the idea briefly. This lesson sets out the objectives of a transfer pricing system, the main methods, and a general rule that tells us the minimum price a selling division should accept. Lesson 7 turns to capacity constraints, negotiation and dual pricing, and lesson 8 to transfers across national borders, where taxes dominate.

Cormorant's internal transfers

Components makes electric motors used in Appliances' water heaters and heat pumps. Components' standard variable cost is $60 per motor, made up of materials, direct labor and variable overhead. Its fixed manufacturing costs are $7,500,000 a year at a practical capacity of 300,000 motors, or $25 per unit, so full cost is $85. Components sells motors to outside manufacturers at $110, and incurs $5 per motor of selling and shipping costs on outside sales that it avoids on internal transfers. Appliances buys 100,000 motors a year. Its water heaters and heat pumps sell to dealers at an average of $400 a unit, and its other variable costs, excluding the motor, average $170, so at the current transfer price its variable cost is $260 a unit, the $26,000,000 of variable costs in its 2026 segment report. Cormorant's current policy transfers motors at $90, roughly full cost plus a markup, which produced the $9,000,000 of internal sales in Components' 2026 results in lesson 2.

What a transfer pricing system should do

A good transfer pricing system serves four objectives. Goal congruence: managers acting in their own divisions' interests should also act in the company's interest. Performance evaluation: the transfer price should allow a fair assessment of each division's contribution. Autonomy: divisions should be free to make their own decisions, which is the point of decentralization. Administrative simplicity: the system should be easy to understand and operate. For multinational companies, a fifth objective, compliance with tax and customs rules in each country, often overrides the others (lesson 8). No single method satisfies all objectives in all situations, which is why transfer pricing remains one of the most debated topics in management accounting.

The main methods

Market-based transfer prices use the price at which the product is sold in an outside market, sometimes adjusted for costs that are avoided on internal transfers, such as selling and shipping costs. Cost-based transfer prices use a measure of the selling division's cost: variable cost, full cost, or cost plus a markup. Negotiated transfer prices are set by bargaining between the divisions, within limits set by head office. Some companies use dual pricing, crediting the seller with one price and charging the buyer another (lesson 7).

# How the transfer price splits profit on 100,000 motors (thousands); company total unchanged
units = 100_000
var_cost = 60          # Components' variable cost per motor
other_var = 170        # Appliances' average other variable cost per unit
price = 400            # Appliances' average selling price per unit
for label, tp in [("Variable cost", 60), ("Full cost", 85), ("Current policy", 90),
                  ("Full cost + 10%", 93.5), ("Market less savings", 105), ("Market", 110)]:
    comp = (tp - var_cost) * units / 1000
    appl = (price - other_var - tp) * units / 1000
    print(f"{label:<20} TP {tp:>6.2f}  Components {comp:>7,.0f}  Appliances {appl:>7,.0f}  Total {comp + appl:>7,.0f}")

Variable cost        TP  60.00  Components       0  Appliances  17,000  Total  17,000
Full cost            TP  85.00  Components   2,500  Appliances  14,500  Total  17,000
Current policy       TP  90.00  Components   3,000  Appliances  14,000  Total  17,000
Full cost + 10%      TP  93.50  Components   3,350  Appliances  13,650  Total  17,000
Market less savings  TP 105.00  Components   4,500  Appliances  12,500  Total  17,000
Market               TP 110.00  Components   5,000  Appliances  12,000  Total  17,000

At every transfer price the two divisions together earn $17,000,000 of contribution on the 100,000 units, the $230 difference between Appliances' average selling price and Appliances' other variable costs, minus Components' $60 variable cost, times 100,000 units. The transfer price only shifts that contribution. At variable cost, Components earns nothing and Appliances everything; at market price, Components earns $5,000,000 and Appliances $12,000,000. At the current $90 price, Appliances earns $14,000,000, its 2026 contribution margin from lesson 2. If the divisions' decisions did not depend on the transfer price, its level would not matter to the company. They do depend on it, and that is the problem.

Market-based transfer prices

When a competitive outside market exists for the transferred product, market price is usually the best transfer price. It lets each division be evaluated as if it were an independent business, preserves autonomy, and generally leads to goal-congruent decisions: if the buying division cannot make a profit paying market price, the company would do better to sell the product outside. The conditions for this result are demanding, though. The market should be perfectly or highly competitive, so that the selling division can sell all it wants at the market price and the buying division can buy all it wants. Market prices must be available and reliable for the specific product. And the divisions must be independent, with no significant interdependence.

In practice, outside markets are often imperfect. The product may be specialized, so no comparable market exists. Market prices may fluctuate or be temporarily depressed. Outside suppliers may quote low prices to win business they cannot sustain. And internal transfers usually avoid some costs, so the relevant market price is market less savings, $105 for Cormorant. Even then, market-based pricing remains the default in many companies for standard products.

Cost-based transfer prices

Cost-based transfer prices are common because cost information is readily available and many transferred products have no outside market. Variable cost leads to good short-run decisions when the seller has idle capacity, because it represents the true incremental cost to the company. But it gives the selling division no contribution toward its fixed costs or profit, which makes it useless for evaluating the seller and demotivating for its manager. Full cost recovers fixed costs but turns the seller's fixed costs into variable costs from the buyer's point of view, so the buyer may reject transfers that would benefit the company. Full cost plus a markup gives the seller a profit but compounds the distortion, and the markup is arbitrary.

Two refinements reduce the problems. Using standard cost rather than actual cost prevents the seller from passing its inefficiencies to the buyer: if Components' actual variable cost rises to $66 because of waste, Appliances still pays based on $60, and the variance stays with Components. And separating the fixed and variable elements, as in the two-part tariff discussed in lesson 7, lets the buyer face the true incremental cost on each unit while the seller recovers its fixed costs through a fixed periodic charge.

The general rule

A useful starting point for any transfer pricing problem is the general rule, sometimes called the opportunity cost approach. The minimum transfer price that leaves the selling division no worse off is its incremental cost per unit plus its opportunity cost per unit, the contribution it gives up by transferring the unit internally rather than using its capacity in the next best way.

The maximum transfer price the buying division will accept is the lower of its outside purchase price and the net revenue it earns from the final product. If the minimum is below the maximum, a transfer is good for the company, and any price between the two will leave both divisions willing to trade. If the minimum exceeds the maximum, the transfer should not take place.

When transfer prices cause bad decisions

The real test of a transfer pricing system is whether it leads managers to make decisions that are good for the company. Suppose an outside supplier offers Appliances motors at $95, a volume price below the $110 market price, while Components has idle capacity. From the company's point of view, internal production costs only $60 per motor in incremental cost, so buying outside at $95 would cost the company $35 per motor. What Appliances does depends on the transfer price.

# Appliances is offered motors by an outside supplier at $95. Components has idle capacity.
units, var_cost, outside = 100_000, 60, 95
for tp in (110, 90, 60):
    appliances_buys = "inside" if tp <= outside else "outside"
    company_cost = (var_cost if appliances_buys == "inside" else outside) * units
    print(f"TP {tp}: Appliances buys {appliances_buys}; company pays {company_cost:,.0f} for motors")
loss = (outside - var_cost) * units
print(f"Cost to the company if Appliances buys outside: {loss:,.0f}")

TP 110: Appliances buys outside; company pays 9,500,000 for motors
TP 90: Appliances buys inside; company pays 6,000,000 for motors
TP 60: Appliances buys inside; company pays 6,000,000 for motors
Cost to the company if Appliances buys outside: 3,500,000

At a transfer price of $110, Appliances buys outside, and the company pays $3,500,000 more for motors than it needs to. At $90 or $60, Appliances buys inside. The general rule shows why: with idle capacity, the minimum transfer price is $60, and Appliances' maximum is now $95, so any price from $60 to $95 would lead to the right decision. A rigid market-price rule, set at $110, causes a dysfunctional decision because the market price no longer reflects either division's alternatives.

Companies respond to such problems in several ways. Head office can override the decision, requiring Appliances to buy inside, at the cost of autonomy. It can let the divisions negotiate, with the general rule defining the bargaining range. It can set the transfer price at market less savings when capacity is full and at a negotiated or cost-based price when there is idle capacity. Or it can accept occasional suboptimal decisions as the price of autonomy, intervening only when the stakes are large.

Transfer pricing in service and shared-service settings

Transfers are not limited to physical products. Cormorant's Services division installs Appliances' heat pumps and charges Appliances for warranty repairs. Information technology, legal and engineering groups provide services to divisions, which raises the same questions as the shared-service chargebacks in lesson 2. For services, outside market prices are often available, such as hourly rates for technicians or contract engineering, but quality, availability and confidentiality differences make comparisons harder, and cost-based prices with service-level agreements are common.

What companies actually do

Surveys of practice in North America and elsewhere have consistently found that cost-based methods, especially full cost or full cost plus a markup, are the most common for domestic transfers, followed by market-based and negotiated methods. Many companies use more than one method, depending on the product and whether an outside market exists. Large multinationals often use one set of transfer prices for tax purposes and another, or adjusted figures, for internal performance evaluation, a practice lesson 8 examines.