Transfer Pricing and Cost Management
What this domain tests
Transfer pricing sets the internal price between divisions; it must motivate both divisions while preserving overall group profit. The exam tests the general rule, the alternative methods, and how transfer prices behave with a perfect intermediate market, spare capacity or a binding constraint.
Core rules
- General rule: minimum transfer price = incremental cost of the transferring division + opportunity cost of the transfer. The maximum for the buying division is the external market price.
- With spare capacity, opportunity cost is zero, so transfer at incremental cost is optimal. At full capacity, the transfer price must equal market price (incremental cost plus lost contribution).
- Methods: market-based (best where a perfect intermediate market exists), cost-based (cost plus mark-up; simple but passes inefficiency downstream), negotiated (preserves autonomy but reflects bargaining power), dual pricing (different prices in each division's books; needs a group adjustment and can hide inefficiency).
- Multinational transfer pricing is constrained by the arm's-length principle and tax authorities.
- Cost management: target costing, kaizen costing (continuous reduction on existing products), value engineering, life-cycle costing and value chain analysis.
Worked example
Division A makes a component with variable cost Rs. 200 and can sell all output externally at Rs. 260. Division B wants 5,000 units and A is at full capacity. Minimum transfer price = 200 + (260 − 200) = Rs. 260. Any price below Rs. 260 makes the group worse off because A sacrifices Rs. 60 contribution per unit. If A had spare capacity, the minimum would be Rs. 200 and any price between Rs. 200 and Rs. 260 would be acceptable, with negotiation determining the split.
Traps
Forgetting opportunity cost when the seller is at full capacity; using full absorption cost as the transfer price floor; ignoring that cost-plus prices encourage the buyer to source externally; confusing kaizen costing (existing products) with target costing (new products).