Transfer Pricing: formula sheet

Key formulas

Meaning of transfer price

Transfer price = internal price charged by the supplying division to the receiving division

It is revenue for the seller division and cost for the buyer division. It nets to zero for the company as a whole.

Divisional profit of the selling division

Profit = (Transfer price − Cost per unit) × Units transferred

Use this when a question asks you to show how the transfer price changes divisional profit.

Effect on company profit

Total company profit does not change because of the transfer price itself

Only the split of profit between divisions changes. Company profit changes only if the price leads to different decisions, such as rejecting a beneficial transfer.

Minimum transfer price (seller's view)

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

Opportunity cost is the contribution lost on outside sales. It is zero when the seller has spare capacity.

Maximum transfer price (buyer's view)

Maximum price = Lower of (net marginal revenue from using the item, price of the same item bought outside)

The buyer will not pay more than it would pay outside, or more than the item adds to its own revenue. Net marginal revenue is the buyer's revenue less its own further variable costs. If no outside source exists, the maximum equals net marginal revenue (revenue less the buyer's further variable costs).

Acceptable range

Minimum price ≤ Transfer price ≤ Maximum price

If minimum exceeds maximum, internal transfer is not worthwhile for the company.

Market-based price adjustment

Transfer price = Market price − Selling and distribution costs saved on internal sale

Use when a market exists. Deduct only the costs that are really saved.

Market-based transfer price

Transfer price = External market price − Savings on internal sale (selling, packing, collection costs)

Use the plain market price if no savings are stated.

Variable cost transfer price

Transfer price = Variable cost per unit

Seller's fixed cost is not recovered, so the seller shows a loss equal to fixed cost at full volume.

Full cost transfer price

Transfer price = Variable cost per unit + Fixed cost per unit

Fixed cost per unit depends on the volume used, so state the volume.

Cost plus transfer price

Transfer price = Cost per unit + Mark-up % × Cost per unit

Check whether the mark-up is on full cost, variable cost or on selling price.

Negotiation range (general rule)

Minimum price (seller) = Variable cost per unit + Opportunity cost per unit; Maximum price (buyer) = Lower of outside purchase price and net marginal revenue

Opportunity cost per unit is the contribution per unit lost on external sales given up because of the internal transfer. It is zero when the seller has spare capacity. A deal is possible only if minimum ≤ maximum.

Minimum transfer price (general)

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

Variable cost here means the cost the seller actually incurs on the transferred unit. Opportunity cost is the contribution lost elsewhere.

Minimum price with spare capacity

Minimum price = Variable cost per unit (opportunity cost = 0)

Applies only to units that can be made without cutting outside sales.

Minimum price at full capacity

Minimum price = Variable cost + (Outside price − Variable cost − Selling costs saved) = Outside price − Selling costs saved on internal sale

Selling costs such as commission or delivery are saved only if the internal sale does not incur them. If there are none, the minimum is simply the outside price.

Minimum price with partial spare capacity

Total minimum = (Units from spare capacity × Variable cost) + (Units displacing outside sales × Outside net price). Divide by total units for the average per unit.

Use when the buyer wants more units than the spare capacity.

Maximum transfer price

Maximum price = Lower of (Net marginal revenue of buyer; Outside purchase price of the same item)

Net marginal revenue = Final selling price − Further variable processing cost of the buyer.

Transfer decision rule

Transfer internally if Minimum price ≤ Maximum price

If the minimum is higher, the company is better off with the buyer purchasing outside.

Company gain from internal transfer

Gain = Outside purchase price × Total units − [Variable cost × Total units + Lost contribution per displaced unit × Displaced units]

Lost contribution is per displaced unit, net of selling costs saved, and applies only to units that displace outside sales. It is zero under spare capacity. Do not apply it to all units unless every unit displaces an outside sale. A negative result means do not transfer.

Quick revision

• Transfer price is the internal price charged for goods or services between divisions of one company.
• Transfer pricing shifts profit between divisions but does not change total company profit by itself.
• Goal congruence means divisional decisions should also help the company as a whole.
• Minimum transfer price = marginal cost to the seller + opportunity cost of the transfer.
• With spare capacity, the opportunity cost is nil, so the minimum price is the marginal cost.
• At full capacity, the opportunity cost is the contribution lost by not selling outside.
• Maximum transfer price for the buyer is the lower of the outside purchase price and the net value of the item to the buyer.
• Cost-based methods are simple but can pass on the seller's inefficiency.
• Market-based pricing suits a competitive market and gives a fair measure of divisional performance.
• Negotiated pricing works when the divisions are free to bargain and have good information.
• Always test the final decision for the company as a whole, not just for one division.
• Differences in tax rates or rules across locations can influence the price chosen.

Common mistakes

• Treating transfer price as a sale to an outside customer Fix: Say clearly it is an internal price between divisions of one company. Total company profit is not affected by it directly.
• Listing objectives with no explanation Fix: Write one line for each objective, saying what it means and why it matters.
• Using full cost as the minimum price even when the seller has spare capacity. Fix: With spare capacity, minimum price is variable cost only. Fixed cost is already incurred and does not change.
• Ignoring the lost contribution when the seller is at full capacity. Fix: Check capacity first. At full capacity, add the contribution lost on each outside sale given up.
• Taking full cost as variable cost only, or the reverse. Fix: Write variable cost and fixed cost separately first, then add them for full cost.
• Applying the mark-up on the wrong base in cost plus pricing. Fix: Check the base. On cost: price = cost × 1.20. On selling price: price = cost ÷ 0.80.
• Using full cost (including fixed overheads) as the minimum price under spare capacity. Fix: With spare capacity, fixed costs are not affected by the transfer, so they are not relevant. Use variable cost only.
• Ignoring opportunity cost when the seller is at full capacity. Fix: Always ask whether outside sales will be given up. If yes, add the lost contribution, which makes the minimum equal to the outside net price.

Exam tips

• Start every theory answer with a clear one-line definition. It earns marks quickly.
• Give each objective its own bullet with a short explanation. Examiners look for separate points.
• In numerical questions, always show each division's profit and the company total. The check that totals match is worth showing.
• For MCQs, remember that the transfer price alone never changes total company profit, and a higher price helps the seller and hurts the buyer.
• If asked about conflicts, mention goal congruence versus autonomy with a one-line example.
• Open every answer by naming the factors in the question, then apply each to the case. Marks go to application, not a copied list.
• Always check capacity first in numerical questions. It decides whether opportunity cost is zero.
• Show the minimum and maximum prices as two clear lines. Examiners give step marks for each.