Generally speaking, cost-based transfer pricing is top management chooses a transfer price based on the costs of producing the intermediate product. For instance, variable production costs, variable and fixed production costs, full costs (including life-cycling costs) as well as some markup. It is useful when market prices are unavailable or too costly to obtain. When a large organisation transfers product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues (Horngren, Datar, Foster, Rajan, Lttner, 2009).
When transfer prices are based on full cost plus a markup, it may probaly lead to sub-optimal decisions. Since it causes the buying division to regard the fixed costs and the markup of the selling division as a variable cost. Indeed, the buying division may then purchase products from an external supplier ...view middle of the document...
However, this treatment leads to sub-optimization for the company. On the other hand, managers make decisions pricing, purchasing, production, etc. based on transfer prices. Therefore, the transfer price has direct economic consequences for the company. The transfer price also is used to measure performance of managers and company segments. Transfer prices that are best for decision making are not always the best for measuring performance.
According to Zimmerman (1997), a dual transfer pricing scheme could be used to avoid this dilemma and allow management to achieve the objectives of operating a decentralized form of organization. A dual transfer pricing scheme would credit the manufacturing division at one price, presumably full cost plus a negotiated markup, and charge the purchasing segment at another price, usually the variable cost of production. The difference between the two prices is charged to a corporate clearing account.
However, dual transfer pricing schemes are seldom used in practice. One concern is that the manager of the supplying division does not have sufficient incentives to control costs. Another concern is that the dual transfer price does not give a clear signal to lower level managers about the level of decentralization desired by top management. In addition, the dual transfer price tends to insulate segment managers from the market. It is the lower level managers who are in the best position to have knowledge of the markets in which they operate. The dual transfer price reduces the incentive to obtain this knowledge (Horngren, et al, 2009).
To conclude, many companies will use the transfer price based on budgeted rates and practical capacity because it is able to overcome the problem of inefficiencies in actual costs and costs of unused capacity getting passed along to the buying segments.
Horngren, C. T., Datar, S. M., Foster, G., Rajan, M. & Ittner, C. (2009), Cost Accounting: A Management Emphasis, 13th edn, Pearson Prentice Hall, Inc., Upper Saddle River, NJ.
Zimmerman, J. L. (1997) Accounting for Decision Making and Control, Chicago, IL: McGraw-Hill.