Internal transfer prices

What it means

Internal transfer prices are the prices at which departments of one company charge each other for their output. For example, the workshop charges production for repairs, the IT department charges other units for services, or production hands products over to the sales department. It is an internal matter that does not leave the company.

They are used to measure the results of cost centres and profit centres. They show which unit is performing efficiently, what internal services cost and whether it would be cheaper to buy them externally.

Internal transfer prices have no effect on the company's total profit or income tax, because one unit's revenue is another's cost and they cancel out. This distinguishes them from transfer prices between separate companies in a group, which do affect the tax base.

How it works in practice

Internal prices can be set in various ways: at actual or budgeted cost, at cost plus a mark-up or at market prices for comparable services. The method chosen affects how profit is split between units and therefore managers' incentives.

A system of internal prices is part of management accounting and builds on classifying costs by function. In practice it is recorded in the chart of accounts through internal accounts or in a separate module of the accounting software.

Prices should be set before the period begins and recorded in an internal policy. If costs change significantly they need adjusting, otherwise centre results will be distorted. In product costing, internal prices are used to value internal deliveries.

What to watch out for

If internal prices are unrealistic, some units will report artificial profits and others losses. This can lead to wrong decisions, such as closing a seemingly loss-making unit that actually creates value for the whole company.

Disputes between units over internal prices can distract from real goals. The rules should be simple, transparent and approved by management so that the system supports management rather than creating needless administration.