Transfer Pricing (Cost Management): formula sheet

Key formulas

Transfer price (basic rule)

Transfer price = Selling division's revenue = Buying division's cost

Company profit is unchanged by the price alone; only the split between divisions changes.

Minimum transfer price (general rule)

Minimum price = Marginal cost of the transferring division + Opportunity cost to the company of the transfer

Opportunity cost is the contribution lost by selling internally instead of externally, or by using scarce capacity. It is zero if there is spare capacity.

Maximum transfer price

Maximum price = Lower of (net marginal revenue to the buying division, external purchase price of the same item)

The buying division will not pay more than this.

Goal congruence test

Transfer is desirable for the company if Buying division's net benefit ≥ Company's marginal cost + opportunity cost

Use this to say whether a price leads to the right decision.

Minimum transfer price (seller)

Minimum price = Variable cost per unit + Opportunity cost per unit

Opportunity cost is the contribution lost on outside sales given up. It is nil if the seller has spare capacity.

Minimum price with spare capacity

Minimum price = Variable (marginal) cost per unit

The seller loses nothing by supplying internally, so any price at or above variable cost is acceptable to it.

Minimum price at full capacity

Minimum price = Variable cost + Contribution lost on external sale = External market price (net of savings on internal sale)

Deduct selling costs that are avoided on internal sales.

Maximum transfer price (buyer)

Maximum price = Lower of (external purchase price, net realisable value from using the item)

NRV = final selling price less the buyer's further costs. The buyer will not pay more than this.

Cost-plus transfer price

Transfer price = Cost per unit + Markup (% on cost) × Cost per unit

Check whether the cost is variable or full cost, and whether markup is on cost or on price.

Acceptable range

Seller's minimum ≤ Transfer price ≤ Buyer's maximum

If minimum exceeds maximum, no internal transfer should take place; the company is better off buying or selling outside.

Minimum transfer price (general)

Minimum price = Incremental cost per unit + Opportunity cost per unit

Incremental cost is normally variable cost. Add any extra fixed cost that the transfer really causes.

Minimum price with spare capacity

Minimum price = Variable cost per unit

Opportunity cost is nil because no outside sale is lost.

Minimum price at full capacity (outside sale lost)

Minimum price = Variable cost per unit + (Outside price − Variable cost per unit) = Outside price

Reduce the outside price by any selling or delivery cost saved on the internal sale.

Partial spare capacity

Opportunity cost per unit transferred = Contribution per outside unit × Outside units lost ÷ Units transferred. Minimum price = Variable cost per unit + (Contribution per outside unit × Outside units lost ÷ Units transferred)

Only the units that displace outside sales carry opportunity cost. Compute the total, then spread over all units transferred. The opportunity cost alone is not the minimum price; always add variable cost.

Maximum transfer price (buyer)

Maximum price = Lower of (Outside purchase price, Net realisable value per unit to the buyer)

Net realisable value = Final selling price − Buyer's further processing and other costs, before the transfer price.

Transfer decision rule

Transfer if Maximum price ≥ Minimum price

The range between them is the negotiating range. Company gain per unit = Maximum − Minimum.

Minimum transfer price (selling division)

Minimum = Marginal (variable) cost per unit + Opportunity cost per unit to the company

With spare capacity, opportunity cost is nil, so the minimum is variable cost. With full capacity, it includes the contribution lost on outside sales.

Maximum transfer price (buying division)

Maximum = Lower of (net marginal revenue from the final product) and (outside purchase price for an equivalent input)

The buyer will not pay more than it can recover or can buy elsewhere. Net marginal revenue = final-product selling price per unit less the buyer's own further processing costs per unit.

Company-level gain from internal transfer

Gain per unit = Outside price avoided − Variable cost of internal supply (spare capacity case)

If positive, the company should transfer internally whatever the divisions' reported profit shows.

Divisional ROI

ROI = Divisional profit ÷ Capital employed × 100

Transfer prices change the profit numerator, so ROI rankings can change without any change in real efficiency.

Residual Income

RI = Divisional profit − (Capital employed × Required rate of return)

Used alongside ROI to reduce the tendency to reject projects that earn above the cost of capital but below current ROI.

CUP method

ALP = price in a comparable uncontrolled transaction (adjusted for differences)

Best when the same or very similar product is sold to unrelated parties. Adjust for quantity, terms and quality.

Resale Price Method

ALP = Resale price to independent buyer − (Resale price × Normal gross margin %)

Used for distributors who resell without much value addition. Margin comes from comparable distributors.

Cost Plus Method

ALP = Direct and indirect cost of production × (1 + Normal gross mark-up %)

Used for manufacturers or service providers selling to related parties. Mark-up comes from comparable independent firms.

TNMM

Net profit margin of tested party = Operating profit ÷ Base (sales, cost or assets); compare with comparables

Tests the net margin of one party, usually the less complex one. Then work back to the ALP.

Tax effect of transfer price

Tax saved = Profit shifted × (High tax rate − Low tax rate)

Group profit is unchanged. Only the tax cost changes. Add or subtract duty effects separately.

Import duty effect

Duty = Transfer price × Duty rate %

A higher transfer price into the importing country raises duty but lowers its taxable profit.

Arm's length adjustment

Adjustment = ALP − Price charged (for a sale by the Indian entity, if ALP is higher)

Taxable profit of the Indian entity rises by this amount if ALP exceeds the price charged.

Quick revision

• Transfer price is revenue for the seller and cost for the buyer.
• Aim of a transfer price: goal congruence, autonomy and fair divisional performance measurement.
• Minimum price = marginal cost + opportunity cost to the company of the transfer.
• With spare capacity, the opportunity cost is usually nil, so the minimum is the variable cost.
• Without spare capacity, the opportunity cost is the contribution lost on outside sales.
• Maximum price is the lower of the external purchase price and the buyer's net benefit from the item.
• Market price is often best where a competitive external market exists.
• Cost-plus pricing can pass on inefficiency, so check which cost base is used.
• Dual pricing credits the seller and charges the buyer at different prices, and the difference is adjusted at head office.
• Negotiated prices depend on bargaining skill and can be time-consuming.
• Group profit decides whether a transfer should take place, not divisional profit alone.
• In international cases, related-party prices should follow the arm's length principle.

Common mistakes

• Saying transfer pricing changes the company's total profit directly. Fix: State that the price only reallocates profit; company profit changes only if the price leads to a different decision.
• Treating goal congruence and autonomy as the same thing. Fix: Define goal congruence as decisions aligned to company profit, and autonomy as managers' freedom to decide. Note they can conflict.
• Using full cost as the seller's minimum price even when there is spare capacity. Fix: For the minimum price, use only variable cost plus opportunity cost. Fixed cost matters only when it is part of the stated method, such as full cost pricing.
• Ignoring the savings on selling and distribution costs when using market price for internal sales. Fix: Read the question for costs such as commission, packing or delivery that do not arise on internal sales, and deduct them from the market price.
• Using full cost instead of variable cost as the minimum price under spare capacity. Fix: Fixed costs that stay the same whether or not the transfer happens are not relevant. Use variable cost, and add only fixed cost that actually increases.
• Ignoring opportunity cost at full capacity. Fix: Always ask what the seller gives up. At full capacity, that is the contribution on the outside sale, so the minimum becomes the outside price.
• Saying the transfer price changes total company profit. Fix: State that the price only shifts profit between divisions. Company profit changes only through the quantity and source decisions it triggers (and tax or duty effects, if any).
• Using full cost as the minimum price when the seller has spare capacity. Fix: Use variable cost when capacity is spare. Fixed cost is not relevant to the company's decision.
• Treating the transfer price as changing the group's total pre-tax profit. Fix: Always add both entities. The price shifts profit between them. Only tax and duty change the group result.
• Using the resale margin on cost instead of on resale price in RPM. Fix: In RPM, deduct the margin as a percentage of the resale price. In CPM, add the mark-up on cost.

Exam tips

• Write definitions in one clear line, then move to objectives; examiners reward structure.
• In case questions, always check capacity first. It decides whether opportunity cost is zero.
• Name the conflict between goal congruence and autonomy; it is a frequent discussion point.
• For MCQs, remember that the price nets to zero across the company; options claiming it raises total profit are wrong.
• End every written answer with a recommendation and one condition.
• Always start with the range (seller's minimum, buyer's maximum). Examiners award marks for this step even if the final price differs.
• Read the capacity statement carefully. Spare capacity versus full capacity changes the minimum price completely.
• In theory questions, give each method with one merit, one limitation and a situation where it fits. A short comparison table written as lines (method, merit, limitation) is easy to mark.