Transfer Pricing

Alpha Corporation has two divisions. The chip division manufactures computer chips, while the assembly division uses those chips to assemble laptops.

When the assembly division needs chips, it receives them from the chip division. To measure the performance of each division, Alpha Corporation assigns a price to this internal exchange, known as the transfer price.

Suppose the chip division sells the same chips to external customers for one hundred fifty dollars per unit.

However, internally, Alpha Corporation charges the assembly division one hundred twenty dollars per unit.

Since the internal price is lower than the market price, the chip division reports lower profit than it would earn by selling chips to external customers.

To prevent such inaccurate profit reporting, regulatory authorities require companies to follow the arm’s-length principle.

This principle states that internal transfers should be priced the same as transactions between independent buyers and sellers in the open market.

Alpha Corporation should record the internal transfer at the one hundred fifty dollar market price for transparent financial reporting across both divisions.