Question

What is the difference between external and internal pricing? What factors must be considered when setting internal transfer pricing between divisions of a company? What are the different methods of setting internal transfer pricing? Which is the most effective? Why?

Answer 1

External pricing is the pricing of those goods and services that will be sold outside company. It considers all the external factors in external environment to fix or determine pricing. External factors include demographics

Internal pricing is the pricing done to sell goods to another division or department inside the company. It considers all internal factors for pricing. Internal factors may involve marketing or company’s objective, marketing mix strategy that a firm follows.

Transfer pricing is used to fix the internal price of goods that are to be sold to another department or division inside the company. Factors that must be considered in internal transfer pricing are:

-Impact on operations of the company: Excess inventory could be put into productive use. Another department can use the remaining unsold inventory of one department.

-Design of pricing: If pricing is not well designed then it leads to unrealistic pricing of products and services to market.

-Must be transparent: It must be clear to everyone which method the company is using, all the procedures must be transparent in order to ensure clarity.

-internal environment: internal technological and social environment must be considered.

-External environment: External environment must always be considered by the company. Change in technologies, updation of machinery, social and demographics all must be considers. As it also impacts internal transfer pricing

Methods of internal transfer pricing are:

-Negotiated transfer pricing: In this goods are sold at actual cost plus another amount that is opportunity cost of not selling the goods or services outside in the market.

-market based transfer pricing: This price lies between market price and company’s marginal cost.

-cost –based transfer pricing: It takes actual costs and add margins to simulate the market price.

Conceptwise Negotiated transfer pricing is considered as best of all methods.

Companies generally use other 2 methods as they are much practical than the above one.

Company uses that method which ensures its effectiveness and allocates fair amounts. This is an important task to do , one wrong method or inaccurately done can lead to high competition and high prices that can take away customers. Therefore it must be done right to avoid such kind of problems.