Transfer pricing
In one sentenceThe price at which one department or branch sells goods or a service to another department within the same business; it affects each department's profitability without changing the business's profit.
Simply put
When one branch supplies another, the transfer price decides where the profit shows up. A high price flatters the seller's profit and weakens the buyer's.
It is usually based on market price, cost or negotiation. Between related companies in different countries there are special tax rules on transfer pricing.
Worked example
A manufacturing department sells a part to the assembly department in the same business; the variable cost is 40 SAR, the market price is 60 SAR, and they agreed on 55 SAR for 1,000 parts.
Manufacturing department's profit(55 − 40) × 1,000 = 15,000 SAR
Assembly department's saving compared with the market(60 − 55) × 1,000 = 5,000 SAR
Effect of the price on the whole business's profitZero (it moves between the two departments)
Agreed transfer price55 SAR per part