Transfer pricing explained

June 2022

Nick Craggs explains a concept that is being introduced to the AAT syllabus for the first time
AAT’s Qualification 2022 is one of the biggest changes to the qualification in all the years that I have been teaching.

It has been refreshed and revised and brought bang up-to-date. One of the new additions is transfer pricing, a subject that has never been assessed in AAT, and appears in the new level 4 Applied Management Accounting unit.

If a company has more than one department, where goods transfer from one department to the other, they may want to assess the performance of the departments by allocating profit to each department. An example of this might be a company that makes up-market hampers.
They may have a production department which makes the sandwiches and cakes etc, and then finally a packaging department which takes the sandwiches and cakes, and the puts them into a hamper with a ribbon and sells it to customers. To assess the performance of each department, the business may allow the production department to ‘sell’ their goods to the hamper packaging department.

Obviously, the price that one department sells to the other department will affect how well they are deemed to be performing. This is known as the transfer price. There are a couple of ways that the company can decide on the transfer price.

The company could use the market price of the cakes and sandwiches based on the price they would get if they sold the sandwiches and cakes externally to an unrelated third party. You might adjust the market price as there would probably be some selling costs incurred if they had sold to a third party, such as shipping or admin.

However, the product you are selling might not have an external market that you can set the price on, so you may want to base the transfer price on what the product cost to produce.
But there are lots of different costs that we could use. Do we use the actual cost incurred, or the standard cost? If the cake department just passed their cakes on at the actual cost they incurred, there is no incentive for them to control the costs, and any wastage is just passed onto the packaging department. So, it is better to use standard cost here.

Then we need to decide if we use the full cost of producing the sandwiches and cakes or just the marginal cost. If the sandwich and cake department charge the full cost, they will ensure that all their costs are covered. However, the packaging department might be unfairly penalised if the cake and sandwich departments were charging more than what the packaging department could get cakes and sandwiches for if they went to an external supplier. But then conversely if the packaging department did buy from an external supplier, the cost may be more than what the marginal cost would be if the whole company were to produce the cakes and sandwiches themselves. The company would have to pay the fixed costs of the sandwich and cake department anyway.

Then to further complicate matters, there are two ways we can apply these prices. We can use dual pricing which tries to avoid some of the problems I have mentioned. If we have a market price, we can credit the cake and sandwich department with the market price, so they can make a profit. However, we then debit the packaging department with just the marginal cost. This does create a bit of a complication for management as the two costs won’t net off to zero. The other way is to use a two-part tariff where we set the transfer price at the marginal cost and then transfer a fixed amount over to the cake and sandwich departments as a contribution towards their fixed costs.

This is a lot to take in, so let’s see that in action. The sandwich department has the following costs per box of sandwiches:

Direct materials of £1
Direct labour of £1.5
Fixed overheads £2

Let’s look at the transfer price per unit if the packaging department needed 100 boxes of sandwiches under the following transfer price policies:

A. Full cost plus 20%

B. Full cost plus 20% with an external market price of £5.2

C. Two part tariff with fixed fee of £180

D. Dual pricing system based on marginal costing and market price of £5.2


A. The full cost plus 20% is £4.5 x 1.2 gives us £5.4

B. In this case the packaging department would want to buy the sandwiches externally as the market price of £5.2 is less than the full cost plus 20%. Therefore, the company would pay £5.2 for something they could make £2.5 (The marginal cost).

C. The transfer price would be set at the marginal cost of £2.5. The fixed fee doesn’t affect the transfer price.

D. The production department would be credited with the market price of £5.2, and the packaging department would be debited with the marginal cost of £2.5.

• Nick Craggs is a tutor at First Intuition