Which approach is used when an external market exists for setting transfer pricing?

The market based approach is appropriate when there is an external market for the goods or services being transferred between divisions or departments within an organization. This approach aligns the transfer price with the prevailing market price, which ensures that the selling division receives an amount that reflects what they could earn in a competitive market.

By using the market based approach, the organization can ensure that the transfer prices are fair and reflective of external conditions, which can motivate divisions to operate more competitively. It also helps avoid disputes between divisions, as both parties will agree on the price based on external benchmarks.

In contrast, the cost based approach primarily focuses on the costs incurred by the selling division, which may not always reflect the market conditions or value. The internal pricing method typically refers to more arbitrary or internal negotiation processes that are not influenced by external market prices. A hybrid pricing strategy, while it may combine elements of various approaches, is less straightforward than a pure market based approach when an external market is readily available.