Three forms of cost-based transfer pricing will be considered: full cost, full cost plus markup, and variable cost plus fixed fee. In all three cases, to avoid passing on the inefficiencies of one division to another, standard costs should be used to determine the transfer price. For example, the Micro Products Division of Tandem Computers, Inc., uses a corporate materials overhead rate, rather than the division-specific rate, to facilitate cost-based transfers between divisions. A more important issue, however, is the propriety of cost-based transfer prices. Should they be used? If so, under what circumstances?
Full-Cost Transfer Pricing
Perhaps the least desirable type of transfer pricing approach is that of full cost. Its only real virtue is simplicity. Its disadvantages are considerable. Full-cost transfer pricing can provide perverse incentives and distort performance measures. As we have seen, the opportunity costs of both the buying and selling divisions are essential for determining the propriety of internal transfers. At the same time, they provide useful reference points for determining a mutually satisfactory transfer price. Only rarely will full cost provide accurate information about opportunity costs. A full-cost transfer price would have shut down the negotiated prices described earlier. In the first example, the manager would never have considered transferring internally if the price had to be full cost. Yet, by transferring at selling price less some distribution expenses, both divisions and the firm as a whole were better off. In the second example, the manager of the Pharmaceutical Division could never have accepted the special order with the West Coast chain. Both divisions and the company would have been worse off, both in the short run and in the long run.
Full Cost Plus Markup
Full cost plus markup suffers from virtually the same problems as full cost. It is somewhat less perverse, however, if the markup can be negotiated. For example, a full-cost-plus-markup formula could have been used to represent the negotiated transfer price of the first example. In some cases, a full-cost-plus-markup formula may be the outcome of negotiation; if so, it is simply another example of negotiated transfer pricing. In these cases, the use of this method is fully justified. Using full cost plus markup to represent all negotiated prices, however, is not possible (e.g., it could not be used to represent the negotiated price of the second example). The superior approach is negotiation, since more cases can be represented, and full consideration of opportunity costs is possible.
Variable Cost Plus Fixed Fee
Like full cost plus markup, variable cost plus fixed fee can be a useful transfer pricing approach provided that the fixed fee is negotiable. This method has one advantage over full cost plus markup: if the selling division is operating below capacity, variable cost is its opportunity cost. Assuming that the fixed fee is negotiable, the variable cost approach can be equivalent to negotiated transfer pricing. Negotiation with full consideration of opportunity costs is preferred.
Propriety of Use
Full-Cost Transfer Pricing
Perhaps the least desirable type of transfer pricing approach is that of full cost. Its only real virtue is simplicity. Its disadvantages are considerable. Full-cost transfer pricing can provide perverse incentives and distort performance measures. As we have seen, the opportunity costs of both the buying and selling divisions are essential for determining the propriety of internal transfers. At the same time, they provide useful reference points for determining a mutually satisfactory transfer price. Only rarely will full cost provide accurate information about opportunity costs. A full-cost transfer price would have shut down the negotiated prices described earlier. In the first example, the manager would never have considered transferring internally if the price had to be full cost. Yet, by transferring at selling price less some distribution expenses, both divisions and the firm as a whole were better off. In the second example, the manager of the Pharmaceutical Division could never have accepted the special order with the West Coast chain. Both divisions and the company would have been worse off, both in the short run and in the long run.
Full Cost Plus Markup
Full cost plus markup suffers from virtually the same problems as full cost. It is somewhat less perverse, however, if the markup can be negotiated. For example, a full-cost-plus-markup formula could have been used to represent the negotiated transfer price of the first example. In some cases, a full-cost-plus-markup formula may be the outcome of negotiation; if so, it is simply another example of negotiated transfer pricing. In these cases, the use of this method is fully justified. Using full cost plus markup to represent all negotiated prices, however, is not possible (e.g., it could not be used to represent the negotiated price of the second example). The superior approach is negotiation, since more cases can be represented, and full consideration of opportunity costs is possible.
Variable Cost Plus Fixed Fee
Like full cost plus markup, variable cost plus fixed fee can be a useful transfer pricing approach provided that the fixed fee is negotiable. This method has one advantage over full cost plus markup: if the selling division is operating below capacity, variable cost is its opportunity cost. Assuming that the fixed fee is negotiable, the variable cost approach can be equivalent to negotiated transfer pricing. Negotiation with full consideration of opportunity costs is preferred.
Propriety of Use
In spite of the disadvantages of cost-based transfer prices, many companies use these methods, especially full cost and full cost plus markup. There must be some compelling reasons for their use reasons that outweigh the benefits associated with negotiated transfer prices and the disadvantages of these methods. The methods do have the virtue of being simple and objective. These qualities, by themselves, cannot justify their use, however. Some possible explanations for the use of these methods can be given. In many cases, transfers between divisions have a small impact on the profitability of either division. For this situation, it may be cost beneficial to use an easy-to-identify, costbased formula rather than spending valuable time and resources on negotiation. In other cases, the use of full cost plus markup may simply be the formula agreed upon in negotiations. That is, the full-cost-plus-markup formula is the outcome of negotiation, but the transfer pricing method being used is reported as full cost plus markup. Once established, this formula could be used until the original conditions change to the point where renegotiation is necessary. In this way, the time and resources of negotiation can be minimized. For example, the goods transferred may be custom-made, and the managers may have little ability to identify an outside market price. In this case, reimbursement of full costs plus a reasonable rate of return may be a good surrogate for the transferring division’s opportunity costs.
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