Transfer pricing

A transfer price is the internal price charged when one division, subsidiary, or responsibility center of a company sells goods or services to another part of the same company. Although no money leaves the organization as a whole, the transfer price becomes revenue for the selling division and a cost for the buying division, so it directly determines how much profit each division reports.

Companies set transfer prices using several common methods. A market-based price uses the price the product would fetch from outside customers — ideal when a competitive external market exists. Cost-based prices transfer at variable cost, full cost, or cost plus a markup. Negotiated prices let the division managers bargain within a range. A widely used guideline sets the minimum acceptable transfer price at the selling division's variable cost per unit plus any contribution margin it forgoes by selling internally instead of externally.

A good transfer pricing policy promotes goal congruence: division managers acting in their own division's interest should also act in the company's overall interest. A poorly chosen price can push a manager to buy outside the company even when internal sourcing is cheaper for the firm as a whole. For multinational companies, transfer prices also shift taxable income between jurisdictions, which is why tax authorities require them to reflect arm's-length terms.

The CMA Part 1 exam tests transfer pricing within responsibility accounting and performance management. Be ready to compute minimum transfer prices, compare market-based, cost-based, and negotiated methods, and explain how each affects divisional performance evaluation and goal congruence.