Transfer pricing fundamentals

When one division of a group supplies another, the price charged is a transfer price. It is revenue to the selling division and cost to the buying division, so within the group it cancels out: the transfer price itself doesn't change group profit. What it changes is how profit is split between divisions — and that split drives how managers are judged, paid and how they behave.

A good transfer price should: - promote goal congruence — divisional managers acting in their own interest also do what's best for the group; - allow fair performance evaluation of each division; - preserve divisional autonomy — managers can still decide freely.

Common bases: market price (where an external market exists); cost-based prices — variable cost, full cost, or cost plus a mark-up (use standard cost so the seller can't pass on its inefficiencies); negotiated prices; and dual pricing, where the seller is credited at one price and the buyer charged at another.

The range for a sensible price: - Minimum (the selling division's floor) = variable cost + opportunity cost of supplying internally. With spare capacity, the opportunity cost is zero, so the minimum is variable cost. At full capacity, every unit transferred displaces an external sale, so the opportunity cost is the contribution lost on that sale. - Maximum (the buying division's ceiling) = the external market price it would otherwise pay (or, if there's no outside supplier, the net revenue it earns from using the unit).

Any price within the range lets both divisions gain. A price outside it can cause dysfunctional decisions: the buyer goes outside even though the group has idle capacity, or the seller refuses internal work that would benefit the group.