Question

How does capacity affect transfer pricing decisions?

Short answer

In case of operation at full capacity, the transfer price equals to market selling price, however in case of operation below capacity, than transfer price equals to variable cost per unit.

Step-by-step solution

Definition of Transfer Price

Transfer Price is defined as the transaction amount of one unit of goods when the transaction occurs between the different divisions of the same company, and the process is known as the transfer pricing.

 Effect of capacity on transfer pricing decisions

If any division is operating at capacity, it means the company is selling all the goods without expanding the facility and adding more employees. In this case, the company has to make a choice about whom to sell the product. So, the transfer price should be a market-based transfer price.

If any division is operating below capacity, it means the division should be willing to sell the product at an amount equal to or higher than the variable cost of the product. It is a cost-based transfer price. In this situation, the manager can negotiate a transfer price that is satisfactory to both divisions.