How does capacity affect transfer pricing decisions?

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.

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.