# Transfer Pricing Illustrated

### Reviewed by Subject Matter Experts

Updated on March 06, 2023

Suppose that a company has two divisions: Division A and Division B.

Division A sells to both Division B and other outside customers. However, Division B buys from only Division A.

The following unit costs were incurred by Division A for the coming year:

• Direct materials = \$10
• Direct labor = \$6
• Variable manufacturing overhead = \$3
• Variable selling costs = \$1
• Total = \$20

Suppose that for the year, Division A produced 40,000 units, 30,000 of which were sold to Division B for \$25 each. The outside sales were for \$30. Also, the fixed manufacturing costs for the year were \$80,000.

When Division B receives the units from Division A, it processes them further before selling them to customers.

The variable unit costs of Division B are \$5 and its fixed costs for the year are \$50,000. Division B sells all the units received from Division A at \$35 each.

* 10,000 units x \$30 = \$300,000 and 30,000 units x \$35 = \$1,050,000

** 30,000 units x \$25 = \$750,000

*** 40,000 units x \$20 = \$800,000 and 30,000 units x \$5 = \$150,000

**** Transferred-in costs are the same as internal sales

Exhibit 1 shows how transfer pricing affects each division's income statement and the company as a whole.

The 30,000 units transferred from Division A to Division B is shown as \$750,000 of internal sales for Division A and as \$750,000 of transferred-in cost to Division B.

Both amounts are not considered when preparing the overall company income statement.

This is done so as to provide the external users of financial statements with information relating to the economic activities of the company with outside parties and not internal transfers.

Now suppose that Division B is allowed to buy from outside suppliers.

An outside supplier has offered to supply the same type of units for \$22 to Division B. Division A does not agree to reduce its price even though it has no alternative use of its production capacity.

* 10,000 units x \$30 = \$300,000 and 30,000 units x \$35 = \$1,050,000

** 10,000 units x \$20 = \$200,000 and 30,000 units x \$5 = \$150,000

*** 30,000 units x \$22 = \$660,000

Exhibit 2 shows that Division B increased its net income by \$90,000 when it purchased from an external supplier.

However, the profit of Division A and the company as a whole declined when Division B purchased from an outside supplier.

* 10,000 units x \$30 = \$300,000 and 30,000 units x \$35 = \$1,050,000

** 30,000 units x \$22 = \$660,000

*** 40,000 units x \$20 = \$800,000 and 30,000 units x \$5 = \$150,000

**** Transferred-in costs are the same as internal sales

Finally, assume that Division A is willing to negotiate a transfer price with Division B for \$22. Exhibit 3 shows the income statement for each division and the company as a whole with the negotiated transfer price.

Comparing Exhibits 1 and 3, the overall income of the company remains the same when there are internal transfers and the transfer price is reduced from \$25 to \$22.

However, the profit of Division B increases, and that of Division A decreases. Division B is satisfied to have outside competition since its net profit increases under both the alternatives.

Hence, transfer prices influence the profitability of both the buying and selling divisions. Performance evaluation of the divisional managers can also be done in a realistic manner.

The company-wide impact of transfer prices should be carefully examined to fully assess the results of the decisions involved in transfer pricing.