What it means
An internal sale is still recorded as a sale by the selling division and a cost by the buying division, even though no outside party is involved. When the group accounts are consolidated, these amounts cancel out completely, which is why the transfer price is invisible at group level but very visible at divisional level.
That divisional visibility is the first reason transfer prices matter. Divisional managers are usually measured, and paid, on the profit their unit reports, so a price set too high or too low can make a well-run unit look weak or a weak unit look strong.
The second reason is tax. When the two divisions sit in different countries with different tax rates, shifting the price shifts taxable profit across a border, so tax authorities apply the arm's length principle: the price must approximate what independent parties would have charged.
Groups are expected to keep written documentation supporting the price, and penalties for getting it wrong can be substantial. Several accepted methods exist for setting the price.
The comparable uncontrolled price method looks at what the same item sells for on the open market; the cost plus method adds a defensible mark-up to the supplier's cost; the resale price method works backwards from the final selling price; and profit-based methods split the combined profit according to what each side contributes. A common nuance is that the price which is right for tax may be wrong for motivating managers.
Some groups therefore run dual pricing, using a market-based figure for statutory and tax reporting and a marginal cost figure internally so that divisions still make sensible decisions about accepting extra volume.
In practice
Real-world examples.
Example
A software group holds its intellectual property in one company and licenses it to national sales companies for a royalty of 8% of local revenue. Each country's tax authority reviews whether 8% is what an unrelated licensee would have paid for comparable rights.
Example
A group's central services team costs $2,400,000 a year and supports 800 staff, so it charges divisions $2,400,000 / 800 = $3,000 per head. A division with 120 employees is charged $3,000 x 120 = $360,000, which its manager challenges because the division rarely uses the service.
Example
A drinks manufacturer bottles in one country and distributes in another. When the distributing country raises its corporate tax rate, the group is tempted to raise the transfer price so more profit stays with the bottler, and its tax advisers insist on fresh benchmarking before any change.
Formula
Calculation
Cost plus method: Transfer price per unit = fully loaded unit cost x (1 + mark-up %).
A group's manufacturing arm makes a component at a fully loaded cost of $80 per unit and applies a 25% mark-up, giving a transfer price of $80 x 1.25 = $100 per unit. It transfers 50,000 units to the group's distribution arm, so it records revenue of 50,000 x $100 = $5,000,000 and profit of 50,000 x ($100 - $80) = $1,000,000.
The distribution arm sells those units to customers at $150 each, giving revenue of 50,000 x $150 = $7,500,000 and gross profit of $7,500,000 - $5,000,000 = $2,500,000.
At group level the internal $5,000,000 cancels out, leaving revenue of $7,500,000 and combined profit of $1,000,000 + $2,500,000 = $3,500,000.Case study
Seen in the real world.
Kestrel Instruments is a fictional illustration of a two-division measurement equipment group. Its factory division transferred 50,000 units a year to its sales division at $100 each against a cost of $80, so the factory earned $2,000,000 less than it wanted and the sales division, selling at $150, earned $2,500,000 of gross profit.
Under pressure to improve factory returns, the board raised the transfer price to $120. Factory profit rose to 50,000 x ($120 - $80) = $2,000,000 while sales division profit fell to 50,000 x ($150 - $120) = $1,500,000. Group profit was unchanged at $3,500,000, but the sales team missed its bonus threshold and two senior account managers resigned.
The illustrative lesson is that a transfer price change moved no cash and created no value, yet it reallocated reported performance and damaged the group's selling capability. Kestrel eventually kept the higher price for statutory reporting and measured the sales division on contribution above marginal cost instead.
Watch out
Common mistakes.
- Believing a transfer price change improves group profit, when it only moves reported profit between divisions.
- Setting the price purely to minimise tax without documentation, which invites adjustments, interest and penalties on review.
- Using full cost with no mark-up for cross-border transfers, which usually fails the arm's length test because no independent supplier would work for nothing.
Questions
People also ask.
Who decides the transfer price?
Normally group finance sets the policy with tax advice, though divisional managers often negotiate the detail within that policy.
Does transfer pricing apply to services as well as goods?
Yes, and management charges, shared IT, guarantees and intra-group loans are among the most frequently challenged items.
What happens if a tax authority disagrees with the price?
It can restate the taxable profit of the entity in its jurisdiction, which may leave the same profit taxed twice unless the two countries agree a corresponding adjustment.
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