Concept of Optimal Transfer Pricing
The economic theory of transfer pricing explains how a firm may determine an optimal transfer price to maximize its overall profits. In this theory, optimal transfer pricing means a pricing arrangement that produces the maximum total profit for the entire firm.
The theory is based on a simplified and theoretical economic environment. It assumes that there are no taxes, capital risks, development risks, externalities, or other market frictions. Therefore, the model does not fully represent actual business conditions.
In practice, multinational corporations consider several additional factors while determining transfer prices. These factors may include performance measurement, capabilities of accounting systems, import quotas, customs duties, Value Added Tax (VAT), taxes on profits, and the level of attention given to internal pricing decisions.
Marginal Cost and Marginal Revenue Principle
The basic economic principle used in determining the optimal level of output is the Marginal Cost–Marginal Revenue Principle.
According to marginal price determination theory, the optimum level of output is reached when:
Marginal Cost (MC) = Marginal Revenue (MR)
A firm should continue increasing its output as long as the marginal revenue earned from additional sales is greater than the marginal cost of producing those additional units.
When marginal cost becomes equal to marginal revenue, the firm reaches the profit-maximizing level of output. In the economic model, the intersection of the marginal cost and marginal revenue curves represents the optimum output level.
Transfer Pricing with No External Market
When a company transfers a product only between its own divisions and there is no external market for the transferred product, the transfer pricing analysis becomes more complex.
However, the basic profit-maximization principle remains unchanged. The overall demand curve of the firm remains the same, and the optimum price and quantity for the entire firm also remain the same.
In such a situation, the marginal cost of the production division can be separated from the total marginal cost of the firm. Similarly, the marginal revenue associated with the production division can be separated from the total marginal revenue of the firm.
Net Marginal Revenue in Production
The marginal revenue relating specifically to the production division is referred to as Net Marginal Revenue in Production (NMR).
Net Marginal Revenue is calculated as:
Net Marginal Revenue (NMR) = Marginal Revenue of the Firm − Marginal Cost of Distribution
The concept of NMR helps determine the contribution of the production division to the overall profitability of the firm.
The optimal quantity for the entire firm is reached where the firm’s Marginal Cost curve intersects the Marginal Revenue curve. The same quantity is also obtained where the production division’s Marginal Cost curve intersects the Net Marginal Revenue from Production curve.
Therefore, the profit-maximizing output of the entire firm and the production division can be determined using the same basic marginal analysis.
Transfer Pricing with a Competitive External Market
A different situation arises when the production division can sell the transferred product both internally to another division and externally in a competitive market.
In a competitive market, the firm is a price taker. This means that the firm cannot independently determine the market price and must accept the price established by market forces.
The transfer price is therefore influenced by the competitive external market price. The marginal revenue from transferring the product and the demand for the transferred product are represented by the market-determined transfer price.
For profit maximization, both the production division and the firm must operate at the point where:
Marginal Cost = Marginal Revenue
If the external market price is relatively high, the production division may produce more than the quantity required internally. This creates an internal surplus or excess internal supply.
The excess production may then be associated with the external market because the production division has the ability to sell the transfer product outside the firm.
Thus, when a competitive external market exists, the market price plays an important role in determining the transfer price.
Transfer Pricing with an Imperfect External Market
When the firm can sell the transfer product in an imperfect external market, the firm is not necessarily a price taker.
In this situation, there may be two different markets with different prices. One price may relate to the firm’s final product market, while another price may relate to the market for the transferred product.
The aggregate market is determined by combining the two markets. The relevant net marginal revenue curve is formed by the horizontal summation of the marginal revenue positions of the two markets.
The firm’s total optimum quantity is the sum of the quantity supplied to the final market and the quantity supplied to the transfer market.
This relationship can be expressed as:
Total Optimum Quantity (Q) = Qf + Qt
Here, Qf represents the quantity relating to the firm’s final market and Qt represents the quantity relating to the transfer market.
Therefore, under an imperfect external market, the firm determines the total profit-maximizing output by considering the marginal revenue conditions of both markets.
Key Exam Points
The economic theory of transfer pricing aims to determine a transfer price that maximizes the overall profit of the firm.
The basic profit-maximization principle is Marginal Cost = Marginal Revenue.
A firm should increase output as long as Marginal Revenue is greater than Marginal Cost.
Where there is no external market, the production division’s marginal cost is compared with Net Marginal Revenue in Production (NMR).
NMR = Marginal Revenue of the Firm − Marginal Cost of Distribution
In a competitive external market, the firm is a price taker, and the market price influences the transfer price.
A high external market price may create an internal surplus or excess internal supply.
In an imperfect external market, the firm is not necessarily a price taker and different markets may have different prices.
The total optimum quantity under an imperfect external market is:
Q = Qf + Qt