Strategic Cost Management · Transfer Pricing (Cost Management)

Methods of Transfer Pricing: Market, Cost-Based, Negotiated and Dual

Updated 11 October 2026 · Fact-checked

Transfer pricing sets the price at which one division sells goods or services to another division of the same company. The main methods are market-based, cost-based (variable cost, full cost, cost plus), negotiated, dual and opportunity cost pricing. To solve a question, find the selling division's minimum price and the buying division's maximum price, then choose the method that fits.

Understand Methods of Transfer Pricing

A transfer price is the internal price charged when one division supplies goods or services to another division of the same company. For the company as a whole it is only an internal entry: the profit of one division goes up and the profit of the other goes down by the same amount. But it decides how profit is split between divisions, so it affects divisional performance and manager behaviour.

A good method should support three things: goal congruence (divisions acting in the company's interest), fair performance measurement, and divisional autonomy. No single method does all three in every situation. That is why there are several methods, each with merits and limitations.

Market-based pricing uses the price at which the product sells in the outside market. It works well when the market is competitive and the product is standard. The selling division earns what it would earn outside, and the buying division pays what it would pay outside. It fails when there is no external market, or when the market price includes selling costs that an internal sale does not incur. In that case an adjusted market price (market price less avoided selling and distribution costs) is common.

Cost-based pricing uses the producing division's cost. At variable (marginal) cost, the buyer gets the product cheaply but the seller earns no contribution towards fixed cost and no profit. At full cost, fixed costs are recovered but inefficiencies of the seller are passed on to the buyer. At cost plus, a markup is added to cost so the seller earns a profit. Cost-based prices are simple, but they give weak efficiency incentives, and the markup can be arbitrary.

In negotiated pricing, the two divisional managers bargain and agree a price, normally between the seller's minimum and the buyer's maximum. It respects autonomy and uses local knowledge. But it takes time, can cause conflict, and the result depends on bargaining skill. In dual pricing, the seller is credited with one price (usually market price or cost plus) and the buyer is charged another (usually variable or full cost). Both divisions look good, but the difference must be adjusted at company level, and it can hide inefficiency.

Opportunity cost pricing sets the minimum transfer price as the seller's variable cost plus the contribution lost by selling internally instead of externally. If the seller has spare capacity, the lost contribution is nil and the minimum is the variable cost. If the seller is at full capacity, the minimum is the market price (adjusted for savings on internal sales).

Key rules to remember

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.

How to solve Methods of Transfer Pricing questions

Use this order for almost any numerical or theory question on transfer pricing methods.

1Identify the divisions, the product, the units, and whether an external market exists for the seller's product and the buyer's input.
2Find the seller's capacity position: spare capacity or fully utilised. This decides the opportunity cost.
3Compute the seller's minimum price: variable cost per unit plus contribution lost per unit on any outside sales given up.
4Compute the buyer's maximum price: the lower of the outside purchase price and the net realisable value of the item (selling price less further costs).
5Compare the two. If the minimum is below the maximum, transfer internally within that range. If not, do not transfer.
6Apply the method asked for (market, variable cost, full cost, cost plus, negotiated, dual) and calculate each division's profit under it.
7Check the company-level effect: total contribution with and without the transfer.
8Write a clear recommendation, then add one or two lines on merits, limitations and behavioural effects of the method.

Quickest way: Range first, method second

When to use it: Use this for 14-mark numerical questions and for MCQs asking the minimum or maximum transfer price.

Write the seller's minimum in one line: variable cost + lost contribution.
Write the buyer's maximum in one line: lower of market buy price and NRV.
Mark the range and check if it is positive.
Pick the price the question asks for and compute each division's profit in a small two-column table.
Add the company-level total and conclude in one sentence.

Common mistakes in Methods of Transfer Pricing

Using full cost as the seller's minimum price even when there is spare capacity.
Students treat the product's accounting cost as the cost of supplying, forgetting that fixed cost is already incurred.
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.
The market price is taken as given and the question's detail on avoided costs is missed.
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.
Adding the opportunity cost when the seller has spare capacity.
Students memorise the formula without linking it to capacity.
Fix: First ask whether the internal units displace outside sales. If no, opportunity cost is zero.
Showing dual pricing as if company profit is the sum of the two divisional profits without adjustment.
The two divisions use different prices, so the totals no longer reconcile with the company profit.
Fix: Show the difference between the two prices as a separate head and eliminate it when computing the company's profit.
Calculating the markup on the wrong base in cost-plus pricing.
Wording such as 'profit of 20%' is read as on cost without checking whether it says on selling price.
Fix: If the markup is on price, divide cost by (1 − markup rate). If it is on cost, multiply cost by (1 + markup rate).
Recommending a transfer when the buyer's maximum is below the seller's minimum.
Students stop after computing the transfer price and do not compare it with the buyer's alternatives.
Fix: Always compare the range. If the range is negative, advise outside buying or selling and explain why.

Worked examples

Example 1

Division A of Bharat Components Ltd makes a part with variable cost of ₹40 per unit and fixed cost of ₹10 per unit (at normal volume). It sells the part outside at ₹70 per unit. Division B can buy an equivalent part from outside at ₹68 per unit. Division A has spare capacity and wants to sell 5,000 units to Division B. Selling costs of ₹3 per unit are saved on internal sales. State the acceptable transfer price range and compare the transfer prices under (i) market price net of selling cost, (ii) variable cost, and (iii) full cost plus 20%.

Show the solution

Seller's minimum: A has spare capacity, so opportunity cost is nil. Minimum = variable cost = ₹40 per unit.
Buyer's maximum: B can buy outside at ₹68, so maximum = ₹68 per unit.
Range: ₹40 to ₹68 per unit. It is positive, so the internal transfer is worthwhile.
(i) Market price less selling cost saved = ₹70 − ₹3 = ₹67. This lies within the range. A earns a contribution of ₹67 − ₹40 = ₹27 per unit, total 5,000 × ₹27 = ₹1,35,000. B saves ₹68 − ₹67 = ₹1 per unit, total ₹5,000.
(ii) Variable cost = ₹40. A earns zero contribution. B saves ₹68 − ₹40 = ₹28 per unit, total ₹1,40,000.
(iii) Full cost = ₹40 + ₹10 = ₹50. Plus 20% = ₹50 × 1.20 = ₹60. This lies within the range. A earns ₹60 − ₹40 = ₹20 contribution per unit, total ₹1,00,000. B saves ₹68 − ₹60 = ₹8 per unit, total ₹40,000.
Company-level gain is the same under each price: B saves ₹68 − ₹40 = ₹28 per unit compared with outside buying, so 5,000 × ₹28 = ₹1,40,000. The transfer price only splits this gain between A and B.
Check: (i) ₹1,35,000 + ₹5,000 = ₹1,40,000; (ii) ₹0 + ₹1,40,000 = ₹1,40,000; (iii) ₹1,00,000 + ₹40,000 = ₹1,40,000.

Answer: Acceptable range is ₹40 to ₹68 per unit. Prices of ₹67 and ₹60 fall within the range, and ₹40 is at its lower limit. Total company gain is ₹1,40,000 whichever price is used; only its split between A and B changes. Cost plus 20% (₹60) or market price net of selling cost (₹67) gives A a fair profit while B still gains.

Example 2

Division P of Kaveri Industries Ltd makes a product with variable cost of ₹120 per unit. It operates at full capacity and sells all its output outside at ₹200 per unit, with a variable selling cost of ₹10 per unit that is not incurred on internal sales. Division Q needs 2,000 units. Q can buy the same item from outside at ₹195 per unit. Alternatively, Q can use the unit to make a final product that sells at ₹260, with further processing cost of ₹50 per unit. Find P's minimum transfer price, Q's maximum transfer price, and advise whether the transfer should take place. Then explain how dual pricing could be used.

Show the solution

Seller's minimum: P is at full capacity, so each internal unit displaces an outside sale. Lost contribution per unit = ₹200 − ₹10 − ₹120 = ₹70.
Minimum price = variable cost + lost contribution = ₹120 + ₹70 = ₹190 per unit. This equals the market price net of avoided selling cost (₹200 − ₹10 = ₹190).
Buyer's maximum: NRV of using the item = ₹260 − ₹50 = ₹210 per unit. Outside purchase price = ₹195. Maximum = lower of the two = ₹195 per unit.
Range: ₹190 to ₹195. It is positive, so transfer is worthwhile. Any price in this range is acceptable to both divisions.
Company gain check: if Q buys from P instead of outside, the company saves the outside purchase cost of ₹195 and gives up P's net outside revenue of ₹190 per unit (P's contribution is lost, but its variable cost of ₹120 is also saved). Net company gain per unit = ₹195 − ₹190 = ₹5, total 2,000 × ₹5 = ₹10,000.
Dual pricing: P could be credited at ₹200 (market price) and Q charged ₹190 or ₹192. P is then no worse off than selling outside, and Q gets the item at the lower price. The difference is adjusted at company level, so the divisional profits are not simply added.

Answer: P's minimum is ₹190 per unit and Q's maximum is ₹195 per unit. The transfer should take place at a price between ₹190 and ₹195; the company gains about ₹10,000 on 2,000 units compared with Q buying outside. Dual pricing is possible, but the difference between the two prices must be eliminated when computing company profit.

Exam tips

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.
Show company-level profit with and without the transfer. This is the test of whether the decision is right for the group.
End every written answer with a clear recommendation and a note on behavioural effects such as autonomy and motivation.

Practice questions from Transfer Pricing (Cost Management)

Methods of Transfer Pricing in other exams

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

Methods of Transfer Pricing: frequently asked questions

What are the main methods of transfer pricing?

The main methods are market-based, cost-based (variable cost, full cost and cost plus), negotiated, dual and opportunity cost pricing. Each suits a different situation, depending on whether an outside market exists and whether the seller has spare capacity.

What is the difference between market price and cost plus transfer pricing?

Market price uses the external price of the product, so it reflects what each division could earn or pay outside. Cost plus uses the seller's cost and adds a markup, so it is simple but may pass on the seller's inefficiency. Market price is preferred when a competitive market exists; cost plus is used when it does not.

What is dual pricing in transfer pricing?

Dual pricing credits the selling division with one price, often market price or cost plus, and charges the buying division another, often variable or full cost. Both divisions get a favourable result. The difference between the two prices is adjusted at company level, so it needs careful accounting.

What are the advantages and disadvantages of negotiated transfer prices?

Negotiation respects divisional autonomy and uses the managers' knowledge of their own costs and markets. The disadvantages are that it takes time, can cause conflict, and the result depends on bargaining strength rather than economics. It works best when the range between minimum and maximum is clear.

How do I calculate a transfer price in a numerical question?

Find the seller's minimum price as variable cost plus opportunity cost, and the buyer's maximum as the lower of outside price and net realisable value. Then choose a price within that range based on the method asked for. Finally check the company's total profit with the transfer.