Segments within companies often exchange products with each other. The Pontiac, Buick, and other divisions of General Motors buy and sell automobile parts from each other, for example. No market exchange takes place, so the company sets transfer prices that represent revenue to the selling division and costs to the buying division.

A transfer price is an artificial price used when goods or services are transferred from one segment to another segment within the same company. Accountants record the transfer price as a revenue of the producing segment and as a cost, or expense, of the receiving segment. Usually, no cash actually changes hands between the segments. Instead, the transfer price is an internal accounting transaction.

Segments are generally evaluated based on some measure of profitability. The transfer price is important because it affects the profitability of the buying and selling segments. The higher the transfer price, the better for the seller. The lower the transfer price, the better for the buyer.

Ideally, a transfer price provides incentives for segment managers to make decisions not only in their best interests but also in the interests of the entire company. In practice, companies mostly base transfer prices on (1) the market price of the product, (2) the cost of the product, or (3) some amount negotiated by the buying and selling segment managers.

For example:

The BWB Company makes bugles. Right now, the company buys the mouthpiece for $8 from several outside vendors. Other variable costs are $9, plus $10,000 in fixed costs. The bugles sell for $30 and the company is producing and selling 1,000 units per month. The contribution margin statement currently looks like this:

Concerned with supply issues, BWB Company management has purchased a small supplier of mouthpieces. That company, MP Co., sells 600 mouthpieces per month for $10 each and has $3 per unit in variable costs plus $2,500 in fixed costs. None of those 600 mouthpieces are sold to BWB, and the company has a capacity of 1,000 units per month. The current contribution margin income statement for MP Co. at 600 units per month looks like this:

BWB upper management has asked the managers of the bugle production to get together with the management of MP Co. to negotiate a transfer price.

Here are the normal constraints that the negotiators would consider:

1. The minimum price the selling division would reasonably consider would be equal to variable costs because that division would lose money if it accepted less.
   • If the segment (MP Co.) is operating at capacity, management of that segment could shift production/sales over to BWB, but would only do that at the current market price of $10. If the segment is operating below capacity, which is the case in this situation, then the management of MP Co. should be willing to take a lower price, all the way down to the variable cost of $3 per unit. In this case, since current sales of 600 units to outside parties is covering both variable and fixed costs, MP Co. could produce 400 more units, and since it is now a wholly-owned subsidiary, it could transfer those units at cost, just as if it was a department in the whole process.
2. The buying division would not reasonably consider a transfer price that was above what that division could buy the item for on the open market.
   • BWB is currently buying them from other suppliers at $8, so a transfer price of $10 wouldn’t make sense.

Therefore the negotiating range for our example would be $3 to $10 for MP Co., but BWB wouldn’t go above $8, so the combined negotiating range would be $3 – $8.

Here is a proforma contribution margin income statement for MP Co. based on a transfer price of $3 per mouthpiece for an additional 400 units (reaching the capacity of 1,000 total) transferred to BWB:

MP Co. is now operating at capacity and transferring 400 units per month to the bugle segment at cost.

And here is the bugle segment now purchasing 400 mouthpieces internally with an assigned price of $1,200 and the other 600 externally for $9 each ($4,800) for a total cost of $6,000.

Let’s throw one more twist into the scenario. After the segment managers have met, upper management overrides their decisions in order to shift company profits from BWB to MP Co., because MP Co. operates in a country with a lower tax rate.

Here is the consolidated income statement for the two combined companies with a transfer pricing of $3 per unit:

Upper management requests a revision to the transfer price to $8, which is the current market price for the bugle division. This will increase revenue to MP Co. in the lower tax rate country and away from BWB in the higher tax rate country. Transferring 400 units at $8 to BWB results in gross intercompany sales of $3,200 with no increase in cost, effectively shifting $2,000 of operating income to MP Co. from BWB.

Outside sales = 600 units at $10

Internal transfers = 400 units at $8

However, the total operating income on the consolidated statement is the same:

In this example, upper management requested the adjustment to the transfer price to reduce taxes. However, financial reporting of transfer pricing has strict guidelines and is closely watched by tax authorities. Extensive documentation is often required by auditors and regulators. If the transfer value is done incorrectly or inappropriately, the financial statements may need to be restated, and fees or penalties could be applied.

For instance, the U.S. tax code requires that transfer pricing should be the same for intercompany transactions as it would have been if the company had done the transaction with a party or customer outside the company. According to the IRS website, transfer pricing is defined as follows:

The regulations under section 482 generally provide that prices charged by one affiliate to another, in an intercompany transaction involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.

Here is a more in-depth analysis of transfer pricing with excess capacity:

You can view the transcript for “Transfer Pricing (with Excess Capacity)” here (opens in new window).

And without excess capacity:

You can view the transcript for “Transfer Pricing (No Excess Capacity)” here (opens in new window).

Now, check your understanding of transfer pricing.