Strategic Cost Management · Pricing Decisions and Strategies

Transfer Pricing and Special Pricing Situations Explained

Updated 11 October 2026 · Fact-checked

Transfer pricing sets the internal price at which one division sells to another. The acceptable range runs from the seller's minimum price (variable cost plus opportunity cost) to the buyer's maximum price (the lower of external purchase price and net marginal revenue). Special orders are priced above relevant cost, ignoring sunk and committed costs.

Understand Transfer Pricing and Special Pricing Situations

A transfer price is the price charged when one division of a company supplies goods or services to another division of the same company. The company as a whole earns nothing from the transfer. But the price decides how profit is split between divisions, and it shapes how managers behave.

A good transfer price does three things. It lets each division's performance be judged fairly. It keeps divisional managers free to act, and it leads them to decisions that are also best for the whole company. This last aim is called goal congruence.

There are three broad methods. Market-based pricing uses the external market price. It works well when the market is competitive and the product is the same. Cost-based pricing uses variable cost, full cost, or cost plus a mark-up. Negotiated pricing is agreed between the divisions, usually within the range set by the minimum and maximum limits. Market price is objective. Cost-based prices are simple, but they can pass on the supplier's inefficiency.

The key idea is the range. The selling division will not accept less than its minimum transfer price: incremental (variable) cost plus the contribution it loses by selling internally. If it has spare capacity, there is no lost contribution, so the minimum is just the variable cost. If it is at full capacity, the lost contribution equals the external selling price less variable cost, so the minimum becomes the external market price (adjusted for any saving in selling costs on internal sales).

Special pricing situations use the same relevant-cost logic. For a special order, include only future costs that change because of the order. Ignore sunk costs and fixed costs that will be incurred anyway. If capacity is limited, add the contribution lost on displaced sales.

Joint products share a common process up to the split-off point. The joint cost incurred up to that point is the same whatever you decide next, so it is not relevant to a decision to process a product further. Process further only if the extra revenue is more than the extra processing and selling cost. Joint cost is shared among products (for example, in the ratio of net realisable value) only for valuation and reporting.

Price discrimination means charging different prices to different buyers or markets for the same product. A lower price for a special order makes sense only if the markets are separate and regular customers will not demand the same price. Always comment on this risk in your answer.

Key rules to remember

Minimum transfer price (seller): Minimum price = Variable cost per unit + Opportunity cost per unit; Opportunity cost is zero with spare capacity. At full capacity it is the contribution lost on external sales.
Minimum price at full capacity: Minimum price = Variable cost + (External price − Variable cost) = External price; Adjust for any selling or distribution cost saved on internal transfers.
Maximum transfer price (buyer): Maximum price = Lower of (External purchase price, Net marginal revenue of the buyer); Net marginal revenue = Final selling price − buyer's further processing cost, per unit.
Acceptable range: Minimum price ≤ Transfer price ≤ Maximum price; A transfer is worthwhile for the company only if the minimum is not above the maximum.
Cost-plus transfer price: Transfer price = Cost per unit + Mark-up % × Cost per unit; State whether cost is variable or full cost. Mark-up is on cost, not on price, unless told otherwise.
Minimum price for a special order: Minimum price = Incremental cost + Opportunity cost of capacity used; Use only relevant costs. Ignore sunk costs and fixed costs that do not change.
Joint product apportionment (NRV method): NRV at split-off = Final sales value − Further processing cost − Selling cost after split-off; Joint costs are shared in the ratio of NRV. Joint cost allocation does not affect the decision to process further.

How to solve Transfer Pricing and Special Pricing Situations questions

Use this order for any question on transfer pricing or special pricing. It keeps your working clear and wins marks even if arithmetic slips.

1Identify the type of question: transfer price range, special order, joint product, or price discrimination.
2Write the per-unit variable cost, the selling price and the capacity position (spare or full) of the supplier.
3For a transfer, compute the seller's minimum price: variable cost plus opportunity cost. Show the opportunity cost separately.
4Compute the buyer's maximum price: the lower of the external purchase price and net marginal revenue.
5Compare the two limits. If minimum is above maximum, internal transfer does not help the company. If not, state the range and suggest a price in it.
6For a special order, list only incremental revenues and costs. Add the opportunity cost if existing sales are displaced. Compare total incremental revenue with total incremental cost.
7Check qualitative points: effect on regular customers, price cutting spreading to other buyers, divisional autonomy, tax and long-term relations.
8Write a clear recommendation in one or two lines with the rupee gain or loss to the company.

Quickest way: Range-first shortcut for transfer price questions

When to use it: Use it when the paper asks for an acceptable transfer price or whether a transfer should happen, and time is short.

Write the seller's minimum in one line: variable cost if spare capacity; external price (less saved costs) if full capacity.
Write the buyer's maximum in one line: lower of outside price and net marginal revenue.
Subtract: maximum less minimum. A positive figure is the company's gain per unit from transferring.
Multiply by units to get the total gain, then name the range and recommend.
With partial spare capacity, check the transfer quantity against the spare units. If the quantity is within spare capacity, the minimum is the variable cost. If it is more, only the excess units displace external sales, and those units carry the external price (less saved costs). The minimum is then a weighted average: [spare units × variable cost + displaced units × (external price − saved costs)] ÷ total transfer units. The company's gain = (buyer's maximum − this average minimum) × transfer units. Example: A has variable cost ₹140, external price ₹200 and 4,000 spare units. B needs 5,000 units and its maximum is ₹190. Displaced units = 5,000 − 4,000 = 1,000. Average minimum = (4,000 × ₹140 + 1,000 × ₹200) ÷ 5,000 = ₹7,60,000 ÷ 5,000 = ₹152. Gain = (₹190 − ₹152) × 5,000 = ₹1,90,000. Each displaced unit is worth ₹190 inside but ₹200 outside, so the company does better by transferring only the 4,000 spare units.

Common mistakes in Transfer Pricing and Special Pricing Situations

Using full cost as the seller's minimum price when there is spare capacity.
Students treat fixed overhead as a cost of the transfer, although it is incurred anyway.
Fix: With spare capacity use only variable cost. Fixed cost is not relevant to the transfer decision for the company.
Ignoring the opportunity cost when the seller is at full capacity.
Students stop at variable cost because it looks like a complete answer.
Fix: At full capacity every internal unit displaces an external sale. Add the lost contribution, so the minimum equals the external price (adjusted for saved costs).
Taking the buyer's maximum as the final selling price.
Students forget that the buyer has its own further processing costs.
Fix: Deduct the buyer's further processing cost from the final selling price to get net marginal revenue, then compare with the outside price.
Including sunk costs or committed fixed costs in a special order price.
Habit from absorption costing, where every unit carries a share of overhead.
Fix: Include only costs that change because of the order. Past research cost, existing depreciation and rent that stays the same are ignored.
Forgetting the opportunity cost of scarce material or labour in a special order.
Students check only cash costs of the order.
Fix: If the resource is fully used elsewhere, add the contribution lost on its alternative use. If the material is already in stock with no other use, count only its disposal value.
Recommending without any qualitative comment.
Students think the question is only numerical.
Fix: Add one or two lines on regular customers, price discrimination risk, divisional autonomy and long-term effects, then give a clear decision.

Worked examples

Example 1

Division A of Bharat Components Ltd makes a part with variable cost ₹140 per unit. It sells the part externally at ₹200 per unit. Division B can buy the same part outside for ₹190 per unit. B uses one part in a product that sells for ₹320 per unit, after further processing at ₹110 per unit. A has capacity of 10,000 units and sells 6,000 units externally. B needs 3,000 units. Find the acceptable transfer price range and the company's gain from the transfer.

Show the solution

Capacity check: A has 10,000 − 6,000 = 4,000 spare units. B needs 3,000, so A has enough spare capacity and there is no opportunity cost.
Seller's minimum price = variable cost = ₹140 per unit.
Buyer's net marginal revenue = ₹320 − ₹110 = ₹210 per unit.
Buyer's maximum price = lower of external purchase price ₹190 and net marginal revenue ₹210 = ₹190. Net marginal revenue is above the outside price, so the outside price of ₹190 is the cap.
Range: ₹140 to ₹190 per unit. The minimum is below the maximum, so the transfer is worthwhile.
Gain per unit to the company = ₹190 − ₹140 = ₹50, as B avoids buying outside at ₹190 while A bears only ₹140 of real cost.
Total gain = 3,000 × ₹50 = ₹1,50,000.

Answer: Acceptable transfer price: between ₹140 and ₹190 per unit. The company gains ₹1,50,000 by transferring 3,000 units internally; the divisions should negotiate a price in this range.

Example 2

Kaveri Engineering Ltd has received a one-time special order for 2,000 units at ₹95 per unit. Normal selling price is ₹130. Cost per unit: material ₹40, labour ₹25, variable overhead ₹10, fixed overhead absorbed ₹20. Spare capacity is available for the order, no extra fixed cost will arise, and regular sales will not be affected. Should the company accept? What is the gain?

Show the solution

Relevant cost per unit = material ₹40 + labour ₹25 + variable overhead ₹10 = ₹75. The fixed overhead of ₹20 is absorbed, not incremental, so ignore it.
Contribution per unit on the order = ₹95 − ₹75 = ₹20.
Total contribution = 2,000 × ₹20 = ₹40,000.
Full cost per unit is ₹95 (₹75 + ₹20), so the order shows nil profit on an absorption basis. That is misleading, because spare capacity means fixed cost does not change.
Minimum acceptable price is ₹75 per unit with spare capacity.
Qualitative check: the order is one-time and does not affect regular sales, so there is little risk of other customers asking for the lower price.

Answer: Accept the order. It adds ₹40,000 to profit, since the price of ₹95 exceeds the relevant cost of ₹75 per unit. The decision would change only if the stated assumptions did not hold, that is, if spare capacity were not available or regular sales were affected.

Exam tips

Always state the capacity position first. Most transfer pricing marks depend on whether the seller has spare capacity or not.
Show the minimum and maximum as separate lines with labels. Examiners award marks for each limit even if the final price differs.
Write the recommendation in plain words with the rupee figure, as this paper expects a decision and not only a computation.
In MCQs, check whether the question gives full cost or variable cost. Options often include the full-cost trap.
For special orders, list ignored costs by name (sunk, absorbed fixed overhead). It shows the examiner you applied relevant costing.

Practice questions from Pricing Decisions and Strategies

Transfer Pricing and Special Pricing Situations in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Transfer Pricing and Special Pricing Situations: frequently asked questions

What are the main transfer pricing methods for CMA Final?

The main methods are market-based, cost-based (variable cost, full cost or cost plus) and negotiated pricing. Dual pricing is also known, where seller and buyer record different prices. Choose the method on the facts given: market price suits a competitive market, while variable cost suits spare capacity.

What is the difference between market-based and cost-based transfer pricing?

Market-based pricing uses the price the product would fetch outside, so it is objective and rewards efficient divisions. Cost-based pricing builds the price from the supplier's costs, which is simple but can pass on inefficiency. Market price is preferred when a competitive external market exists.

How do I price a special order using relevant costs?

Include only the extra costs the order causes, such as material, labour and variable overhead. Add the contribution lost if the order displaces regular sales. Ignore sunk costs and fixed costs that stay the same. The order is acceptable if price is above this relevant cost.

When is the minimum transfer price equal to the market price?

It equals the market price when the selling division is at full capacity. Each internal unit then displaces an external sale, so the lost contribution is added to variable cost. If internal sales save selling costs, deduct that saving from the market price.