Scenario 1: If there is perfectively competitive market for the product/service transferred

The ideal transfer price = Market Price.

A perfectly competitive market means:

 Many buyers and sellers.

 Identical products.

 No single buyer or seller can control the price.

 The price is determined purely by demand and supply in the market.

So, everyone buys and sells at the same market price.

Example:
Suppose Tata Motors has two divisions —

 Engine Division (makes engines)

 Car Division (assembles cars)

Why should the transfer price = market price in this case?

If there is a perfectly competitive external market for the product, the market price is the fairest
and most realistic measure of value.

 If the Engine Division can sell the same engine to outside buyers for ₹2,00,000,
then selling it to the Car Division for ₹2,00,000** keeps things fair** — neither division gains
or loses unfairly.

 The Engine Division gets the same return it would from selling outside.

 The Car Division pays what it would pay if it bought from the market.

This way, both divisions are motivated to perform efficiently, just like independent companies.

Scenario 2: If the selling division has surplus capacity or has no Alternative use

Suppose the Engine Division of Tata Motors can make 1,000 engines, but currently it only sells 700
engines to outside customers. So, it has 300 extra engines worth of capacity — this is surplus
capacity.

Why is the minimum acceptable transfer price = marginal cost for the “Selling Division”?

When the selling division has spare capacity, selling extra units internally doesn’t reduce its external
sales or profits.
So, any price above the marginal cost adds extra profit for the division.

 If it sells at marginal cost, it covers all extra costs (so no loss).

 If it sells below marginal cost, it would lose money on each unit.

 If it sells above marginal cost, it earns some profit.

Let’s continue with the Engine Division example:

Item Amount (₹)

Selling price in market 2,00,000

Marginal cost per engine 1,50,000

Fixed cost (per engine) 30,000 (already paid)

Now, suppose the Car Division asks to buy 100 extra engines.

Since the Engine Division already has spare capacity, it doesn’t lose any outside sales.

If it sells to Car Division at ₹1,50,000 (marginal cost) →It covers all variable costs → no loss.

If it sells at ₹1,60,000 →It earns ₹10,000 profit per engine.

If it sells below ₹1,50,000 →It loses money on each engine.

So, the minimum price acceptable = marginal cost (₹1,50,000)

Why the minimum price the “Buying Division” will accept is lower of External purchase price of the
transferred products or Net marginal Revenue?

The buying division will compare two things:

1️⃣External Purchase Price – the price it would pay if it bought the component from the market.
2️⃣ Net Marginal Revenue (NMR) – how much extra money it earns from using that component in
making and selling the final product.

Understanding Net Marginal Revenue (NMR):

Net Marginal Revenue = Selling Price of Final Product – Marginal Cost (excluding the transferred
item)

In simple words:
👉 It’s the maximum amount the buying division can afford to pay for the transferred component
without losing profit.

If it pays more than that, the final product becomes unprofitable.

The buying division will not pay more than what is rational:

 If the external market offers the component cheaper → it will prefer to buy outside.

 If the component’s contribution to profit (NMR) is less → it cannot pay more than that, or
else it would sell the final product at a loss.

Hence, the maximum acceptable transfer price for the buying division is the lower of:
👉 External Purchase Price
👉 Net Marginal Revenue
Let’s take a company with two divisions:

Item Amount (₹)

External market price of engine 2,00,000

Selling price of final car 5,00,000

Marginal cost of car production (excluding engine) 3,20,000

Now, let’s calculate Net Marginal Revenue (NMR):

NMR =Selling Price of Car −Marginal Cost of Car (excluding engine)

But in the market, the engine costs ₹2,00,000.

Therefore:

 External purchase price = ₹2,00,000

 NMR = ₹1,80,000
👉 Buying division will accept the lower of these two = ₹1,80,000

That means, the buying division will buy internally only if the transfer price ≤ ₹1,80,000.

Scenario: 3 The Selling Divion does not have any surplus capacity or has Alternative use

👉 The selling division has no surplus capacity — that means it is already using all its resources to
sell products to external customers.

So, if it has to sell to the buying division internally, it must stop selling some units to external
customers.

That means it loses external sales and the profit (contribution) it would have earned on those sales

When the selling division gives up external sales to make internal transfers, it loses the contribution
margin (i.e., Selling Price – Variable Cost) it could have earned from the external market.

That lost contribution is called the opportunity cost — the profit forgone due to choosing the
internal transfer.

So, the minimum transfer price should include:

👉 Marginal Cost (the cost to make one extra unit)

Selling Division: Engine Division

External selling price per 2,00,000

Marginal cost per engine 1,50,000

So, contribution per engine = 2,00,000 − 1,50,000 = ₹50,000

Now the Engine Division is already selling all 1,000 engines it can make. That means — no spare
capacity.

Buying Division: Car Division

Wants to buy 100 engines internally.

If the Engine Division agrees to this, it must cut 100 units of external sales — losing that
contribution.

Calculate the minimum transfer price

For each engine transferred internally:

Component Amount (₹)

Marginal Cost 1,50,000

Lost contribution (opportunity cost) 50,000

Minimum transfer price 2,00,000

Explanation:

If the Engine Division sells to the Car Division at ₹2,00,000:

 It earns the same total contribution as it would have by selling outside.

 So, it’s indifferent between internal and external sales.

If it sells for less than ₹2,00,000:

 It loses profit it could have earned from the external market.

Hence, the minimum acceptable transfer price = Marginal Cost + Lost Contribution.

The Maximum Price the “Buying Division” will pay is same as Scenario 2
Dual Pricing & Two-Part Tariff Systems:

Dual Pricing means the selling division and the buying division record two different prices for the
same internal transfer — one price from the seller’s point of view, and another from the buyer’s
point of view.

Dual pricing allows both divisions to feel they are treated fairly — the selling division gets credit for a
fair price (usually market price), and the buying division gets charged a reasonable cost(usually
variable cost).

Why do we use Dual Pricing?

Sometimes a single transfer price creates conflict:

 The selling division wants a high price (to earn more profit).

 The buying division wants a low price (to reduce its cost).

If both belong to the same company, using two different internal prices helps keep both divisions
motivated and fairly evaluated.

Let’s take an example 👇

Company: ABC Ltd.

Two divisions:

 Division A (Selling Division): makes components.

 Division B (Buying Division): uses them to make the final product.

Item Amount (₹)

External market price of 1,000

Marginal cost of component 600

Transfer price under dual pricing For Division A: ₹1,000 (market price)

For Division B: ₹600 (marginal cost)

What happens:

 Division A records sales at ₹1,000 → gets full credit like selling outside.

 Division B records purchases at ₹600 → incurs only the variable cost.

The difference (₹400) is adjusted by the head office (corporate accounts) as an internal accounting
entry — it’s not real cash but keeps performance evaluations fair.
Two-Part Tariff System means the transfer price between two divisions has two components:

So instead of one single price per unit,

 A fixed lump sum (like a membership or access fee), plus

 A per-unit charge (usually equal to marginal cost or variable cost).

It’s like paying a monthly subscription (fixed fee) plus a usage fee for each unit you buy.

This system tries to balance the interests of both divisions:

 The selling division recovers its fixed costs (through the fixed fee).

 The buying division pays only the marginal cost for each additional unit (keeping production
decisions efficient).

So both divisions are satisfied and efficient — no one feels underpaid or overcharged.

Let’s take a company: ABC Ltd.

Two divisions:

 Division A (Selling Division): Makes motors.

 Division B (Buying Division): Uses motors to make machines.

Cost and price data:

Item Amount (₹)

Marginal cost per motor 5,000

Total fixed cost of Division A 1,00,000

Units transferred to Division B 500

Calculate the two parts

 Variable charge per unit: ₹5,000 (marginal cost)

 Fixed charge (lump sum): to recover fixed cost = ₹1,00,000

So, the transfer price structure is:

Transfer price = ₹1,00,000 (fixed) + ₹5,000 per motor

How it works

 Division A (seller) recovers its total cost:

o ₹1,00,000 fixed + (₹5,000 × 500) = ₹26,00,000 total revenue

 Division B (buyer) pays ₹5,000 per motor (variable) + ₹1,00,000 fixed access fee.