Definition: The Transfer Pricing is a price charged for the goods and services supplied by one division to the other division of the same company. In other words, the price at which two or more divisions of the same enterprise transact with each other is called as Transfer Pricing.
Often, the larger sized firms divide their production activities into different product divisions or subsidiaries. Likewise, the growing firms add more divisions and departments to the existing ones. Thus, the goods and services produced by the new divisions or subsidiaries are bought by the parent organization. The price charged for the sale and purchase of goods and services is called as Transfer Pricing.
At what price the intra-firm trading shall be done, is a difficult task as each division has a separate function to maximize their profits. Thus, a profit maximization rule is applied to determine the price at which the intermediate goods are made available for the production of the finished goods. The price at which MC = MR, i.e. Marginal Cost (a cost incurred in producing an additional unit of a product) is equal to the Marginal Revenue (an additional revenue generated from the sale of an additional unit of a product), the profit is said to be the maximum.
Thus, every division of the enterprise tries to maximize their function of profitability and price the output in such a way that the profit maximization rule i.e. MC=MR is justified.