Dada Adefolami:
“You don’t really need to learn any of the specific principles if you understand what it is trying to achieve: the trading of divisions with each other for the benefit of the company as a whole. If the scenario in a question was different, you may have to consider how transfer prices should be set to optimise the profits of the group overall.”

By Dada Adefolami.

Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods is the transfer price.

Pricing Strategy : Activities aimed at finding a product’s optimum price, typically including overall marketing objectives, consumer demand, product attributes, competitors’ pricing, and market and economic trends.
Transfer pricing is important, there are general principles that should be applied when setting a transfer price. Transfer prices will be negotiated between the two parties. Note that marketing strategy is the fundamental goal of increasing sales and achieving a sustainable competitive advantage. 

Why transfer pricing is important
It is essential to understand that transfer prices are only important in so far as they encourage divisions to trade in a way that maximises profits for the company as a whole. The fact is that the effects of inter-divisional trading are wiped out on consolidation anyway. Hence, all that really matters is the total value of external sales compared to the total costs of the company. So, while getting transfer prices right is important, the actual transfer price itself doesn’t matter since the selling division’s sales (a credit in the company accounts) will be cancelled out by the buying division’s purchases (a debit in the company accounts) and both figures will disappear altogether. All that will be left will be the profit, which is merely the external selling price less any cost incurred by both divisions in producing the goods, irrespective of which division they were incurred in.

As well as transfer prices needing to be set at a level that maximises company profits, they also need to be set in a way that is compliant with tax laws, allows for performance evaluation of both divisions and staff/managers, and is fair and therefore motivational. A little more detail will be given below:
· If your company is based in more than one country and it has divisions in different countries that are trading with each other, the price that one division charges the other will affect the profit that each of those divisions makes. In turn, given that tax is based on profits, a division will pay more or less tax depending on the transfer prices that have been set.

· From, this, you can see that the transfer price set affects the profit that a division makes. In turn, the profit that a division makes is often a key figure used when assessing the performance of a division. This will certainly be the case if return on investment (ROI) or residual income (RI) is used to measure performance. Consequently, a division may, for example, be told by head office that it has to buy components from another division, even though that division charges a higher price than an external company. This will lead to lower profits and make the buying division’s performance look poorer than it would otherwise be. The selling division, on the other hand, will appear to be performing better. This may lead to poor decisions being made by the company.

· If this is the case, the manager and staff of that division are going to become unhappy. Often, their pay will be linked to the performance of the division. If divisional performance is poor because of something that the manager and staff cannot control, and they are consequently paid a smaller bonus for example, they are going to become frustrated and lack the motivation required to do the job well. This will then have a knock-on effect to the real performance of the division. As well as being seen not to do well because of the impact of high transfer prices on ROI and RI, the division really will perform less well.
Let us now go on to consider the general principles that you should understand about transfer pricing.

General principles about transfer pricing

An external market for the product being transferred
Minimum transfer price
When we consider the minimum transfer price, we look at transfer pricing from the point of view of the selling division. The question we ask is: what is the minimum selling price that the selling division would be prepared to sell for? This will not necessarily be the same as the price that the selling division would be happy to sell for, although, as you will see, if it does not have spare capacity, it is the same.

The minimum transfer price that should ever be set if the selling division is to be happy is: marginal cost + opportunity cost.

Opportunity cost is defined as the ‘value of the best alternative that is foregone when a particular course of action is undertaken’. Given that there will only be an opportunity cost if the seller does not have any spare capacity, the first question to ask is therefore: does the seller have spare capacity?