Not all companies operate a single entity. Some companies have several entities to manage. The reason a lot of those companies operate multiple companies is that each companies may contribute to the production of a products or a service. Consequently, having to transfer components to one entity to another to complete products or services. When companies sell components to one to another, this is called transfer pricing. The objective of transfer pricing is to figure what will be the selling price between companies that are linked together.
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To figure out what price to set the components of a sub or final product, we have to look at the economic situation of the related companies. What we are looking for is the availability of this component or subcomponent and the impact of the transfer pricing on each entities. If we are at max capacity and we don't have enough components to sell internally and externally, the selling company should always sell it's components internally at full cost (variable + fix costs) to cover the entire cost of production. If the entity is not at max capacity, meaning it has enough components to supply the internal and external demand, therefore the the selling price should be the variable cost of production.
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The following what we are looking for when setting a transfer pricing.
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1) Is the company selling the components at max capacity, meaning is there enough components to supply the demand internally and externally?
2) If the supply of components is enough to supply the demand, is it more profitable to sell infernally or externally?
3) For the entity buying the components, is it more advantageous to by internally or to buy externally?
4) Is there is enough components on the market from external suppliers to supply the demands of the buying company if we chose to go with external suppliers?
5) If we chose to go with external suppliers, will the quality, the durability, the strength and so on to meet the buying company standards?
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As an example, let's say Company A makes batteries for drones and Company B needs those batteries to complete the drones. The variable cost of the batterie, meaning only the raw material and the direct labor and variable overhead is $25 and the full cost including fixed cost is $55. Company A, can sell it's batteries on the market at $75 a batterie, therefore generating a gross profit of $20. Company B can buy the batteries from an external supplier at $27 a batterie. Just a side note, the quality and traits of the batteries of the internal and external supplier are the same.
Situation A: Company A doesn't have enough capacity to supply the internal and external demand. Because the supply of battery is not enough, Company A has to make a strategic decision to sell it's batterie internally or externally. Because company B can still procure it's components from an external supplier, Company A should sell it's battery externally as it would sell it's batteries to Company B at $55 a battery where as Company B can buy its batteries from the external supplier at $27 a batterie. Because it's cheaper to by externally, Company B should buy it's batteries from the external supplier.
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Situation B: Company A has enough capacity to supply the internal and external demand. Because the supply of battery is enough, Company A has to make a strategic decision to sell it's batterie internally or externally. Since Company A has enough batteries to supply both infernally and externally, Company A should sell it's batteries to Company B at its variable cost, $25 a battery. Consequently, Company B should buy it's batteries from Company A as the external source sells it's batteries at $27 a batterie.
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The reason for all of this is to not only maximize profit, but also to retain talent. When discussing transfer pricing you have to consider the people in charge of the business units as well. If you force a manager to sell its components internally when there isn't enough components to supply the demand, and the business unit manager is compensated on the gross margins for example, the manager will not be compensated for his efforts and therefore loose his motivation or quit as he has no control over the decision to sell internally or externally. As a result, you not only have to focus on the bottom line but also focus on the people who run the business.