Definition of Transfer Pricing
Transfer pricing involves setting a price that will be used when one responsibility center of a company sells goods or services to another responsibility center of the same company. The responsibility centers are often profit centers of a decentralized corporation such as related subsidiary corporations, separate divisions of a corporation, or some other subunits.
Depending on the production capacity and the demand for each subunit's goods or services, a transfer price could be based on cost, market prices, variable costs plus an opportunity cost, or some other amount.
A concern with transfer pricing is whether the transfer price will cause a subunit's manager to take the action that is best for the company as a whole.
Example of Transfer Pricing
Assume that Giant Corporation has several subsidiary companies including Sub1 and Sub2. Sub1 manufactures electronic components that it sells to companies throughout the world. Sub2 manufactures a unique consumer gadget that uses a component that Sub1 manufactures. Sub1 sells the component for $20 to its many outside customers and its cost to manufacture the unit is $12.
The transfer price is the amount that Sub2 will pay Sub 1 for each component it needs. If Sub 1 has idle capacity, it can make an additional profit even with a transfer price of less than $20. However, Sub2 will be able to sell far more of its profitable consumer gadgets if its cost of the component from Sub 1 is $16. It may be in the best interest of Giant Corporation to arrange for both Sub1 and Sub2 to agree to a transfer price of $16.