What is Transfer Pricing?
Transfer pricing is the price one division of a company charges another division for goods or services transferred between them. The method chosen affects each division's reported profit and overall tax efficiency.
Transfer pricing sets the internal price for goods/services moved between divisions, typically using market-based, cost-based, or negotiated methods.
- •Uses the selling division's production cost as the base
- •Often adds a markup for profit
- •Simple when no external market exists
- •Can hide inefficiencies of the selling division
- •Uses the price charged to outside customers
- •Reflects true opportunity cost
- •Requires an active external market for the product
- •Preferred when a competitive market price exists
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Step-by-step worked examples
Division A's variable cost per unit is $50, agreed markup is 20%. Find the transfer price.
TP = VC + Markup% × VC = 50 + 0.20 × 50 = 50 + 10 = $60
An external market sells the same component for $75. Under market-based transfer pricing, what price should Division A charge Division B?
Market-based method uses the external market price directly TP = $75 (the price outside customers pay)
Two divisions negotiate a transfer price between the cost floor ($40) and market ceiling ($70), settling on $55. Confirm this is valid.
Negotiated price must satisfy: Cost ≤ TP ≤ Market price Check: 40 ≤ 55 ≤ 70 → valid negotiated price
Flashcards
Quick quiz
Q1.Which transfer pricing method uses the price charged to outside customers?
Q2.A transfer price is set at variable cost plus a markup. This is the…
Q3.Negotiated transfer prices are typically bounded by…
Q4.Why does transfer pricing matter for multinational companies?
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Common mistakes
Assuming one transfer pricing method fits every situation. — Correct: Choose the method based on whether a competitive market exists, whether divisions can negotiate freely, and tax considerations.
Ignoring the cost floor and market ceiling when negotiating. — Correct: A negotiated price should stay between the seller's variable cost and the external market price to be fair to both sides.
Using cost-based pricing even when an active market price exists. — Correct: Prefer market-based pricing when there's a reliable external price — it better reflects opportunity cost.
Thinking transfer pricing has no tax consequences. — Correct: Because it shifts profit between divisions (often across countries), transfer pricing is heavily regulated for tax purposes.
FAQ
What are the main transfer pricing methods?
Market-based, cost-based, and negotiated transfer pricing are the three main methods used between company divisions.
What is the transfer pricing formula?
For cost-based pricing: Transfer Price = Variable Cost + (Markup % × Variable Cost).
How do you calculate a transfer price example?
With a $50 variable cost and 20% markup: TP = 50 + 0.20×50 = $60.
How is transfer pricing used in practice?
Companies use it to price goods/services moved between divisions or subsidiaries, affecting divisional profit and tax allocation.