Transfer prices are the prices used for transactions within a company. A transfer price is an internal price. When one division of a company sells a product to another division of the same company, the price charged is called a transfer price. This is in contrast to external prices, or market prices, which are charged to customers outside the company.
In large multi-divisional corporations, where divisions are responsible for their own profits, divisions often transact with each other as if transacting with an outside customer. While internal transactions don’t affect the overall profit of the corporation, they do affect the profits of the relevant internal divisions. A high transfer price benefits the selling division to the detriment of the buying division. A low transfer price benefits the buying division to the detriment of the selling division.
The goal of the corporation is to establish transfer prices that provide incentives for divisional managers to act in the best interest of the corporation as a whole.
Transfer Price Calculation
A transfer price generally has two parts: the outlay costs and the opportunity cost. The cost of making or obtaining the product is known as the outlay cost. The opportunity cost is the profit the division could make by selling the product in the marketplace, as opposed to selling the product internally.
Transfer Price = Outlay Cost + Opportunity Cost
For example, consider a division that makes hats. The cost of making one hat is $2. That division can sell the hat in the marketplace for the market price of $5. Therefore, the opportunity cost of selling the hat internally instead of externally is $3. The transfer price would then be $5.
$5 = $2 + $3
In this simple example the transfer price is the same as the market price. In more complex examples this might not be the case. However, transfer prices are frequently based on or similar to market prices.
To learn how to price for profit, download our Pricing for Profit Inspection Guide.
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