(63)---COST BASED APPROACHES TO TRANSFER PRICING.

Cost-based approaches to transfer pricing.

Cost-based approaches to transfer pricing are often used in practice, because in practice the following conditions are common.

• There is no external market for the product that is being transferred.
• Alternatively, although there is an external market it is an imperfect one because the market price I affected by such factors as the amount that the company setting the transfer price supplies to it, or because there is only a limited external demand.

In either case there will not be a suitable market price upon which to base the transfer price.
Actual costs vary with volume, seasonal and other factors, seasonal and other factors. Moreover, if actual costs are used as a basis for transfer price, any inefficiency in the producing department will be passed on the receiving department in the form of an increased transfer price. The use of standard costs is therefore recommended.

Transfer prices based on full cost.Under this approach, unsurprisingly, the full cost (including fixed overheads absorbed) that has been incurred by the supplying division in making the intermediate product is charged to the receiving division. If a full cost plus approach is used a profit margin in also included in this transfer price.

The transfer price fails on all there criteria j(divisional autonomy, performance measurement and corporate profit measurement) for judgment.

• Arguably, the transfer price does not give fair revenue or charge b a reasonable cost, and so their profit performance is distorted. It would certainly be unfair, for example, to compare A’s profit with B’s profit.
• Given this unfairness it is likely that the autonomy of each of the divisional managers is under threat. If they cannot agree on what is a fair spilt of the external profit a decision will have to be imposed form above.
• It would seem to give an incentive to sell more goods externally and transfer less to B. THIS MAY OR MAY NOT BE IN THE best interest of the company as a whole.

Transfer prices based on Variable cost.A variable cost approach entails charging the variable cost that has been incurred by the supplying division to the receiving division.