Transfer Pricing Methods and Minimum Transfer Price

Understand Transfer Pricing

Key rules to remember

Minimum transfer price (seller)

Minimum price = Marginal (variable) cost per unit + Opportunity cost per unit

Opportunity cost is the contribution lost on external sales given up because of the internal transfer. It is zero when there is spare capacity.

Minimum price with spare capacity

Minimum price = Variable cost per unit

Use this when the seller can supply the buyer without giving up any outside sales.

Minimum price at full capacity

Minimum price = Variable cost + Contribution lost per unit = External selling price (adjusted for savings)

If the seller can sell every unit outside, the contribution lost equals the external price less variable cost. Reduce for any cost saved on internal sales.

Maximum transfer price (buyer)

Maximum price = Lower of (external purchase price of the same item, net benefit per unit to the buyer from the item)

The buyer will not pay more than it would pay outside, or more than the item adds to its own contribution.

Acceptable range

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

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

Cost-plus price

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

State clearly whether the cost is full cost or variable cost.

How to solve Transfer Pricing questions

1. 1Read the question and note the seller's capacity, current sales, external price and cost data. Note what the buyer can do (buy outside or not).
2. 2Work out the seller's variable cost per unit and its contribution per unit on external sales.
3. 3Decide if the seller has spare capacity. If yes, opportunity cost is zero. If no, opportunity cost is the contribution lost on each unit diverted.
4. 4Calculate the seller's minimum transfer price = variable cost + opportunity cost (adjust for any cost saved on internal sales).
5. 5Calculate the buyer's maximum price from the outside purchase price or the net benefit per unit.
6. 6Compare the two. If minimum is below maximum, a price in between suits both and the company. Otherwise, advise buying or selling outside.
7. 7State the recommendation clearly and comment on behavioural effects, such as autonomy or the fairness of the divisional profit split.

Quickest way: Capacity check, then floor and ceiling

Common mistakes in Transfer Pricing

• Using full cost as the minimum price when there is spare capacity.

  Students think the seller must recover fixed costs on every unit.

  Fix: Fixed costs are already incurred. With spare capacity, only the variable cost is relevant, so the minimum is variable cost per unit.

• Forgetting the opportunity cost at full capacity.

  Students stop at variable cost because it is the first number they calculate.

  Fix: Always ask whether the transfer displaces outside sales. If it does, add the lost contribution per unit.

• Ignoring cost savings on internal sales.

  The market price is used directly without reading the note on selling or packing costs.

  Fix: Deduct costs such as selling expenses, commission or delivery that the seller avoids on internal sales.

• Saying transfer pricing changes total company profit.

  Students see profit moving between divisions and assume it is created or lost.

  Fix: The price only shifts profit between divisions. Company profit changes only through the decision to transfer or not (and possibly tax effects).

• Giving a single figure when a range is the correct answer.

  Students assume negotiation has one answer.

  Fix: State the minimum and maximum and say any price in between is acceptable, then comment on how the gain is shared.

• Skipping the behavioural comment.

  Students treat the topic as pure arithmetic.

  Fix: Add one or two lines on goal congruence, autonomy and divisional performance. Written answers often reward this.

Worked examples