Transfer at Cost to the Selling Division:

Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division.

Although the cost approach to setting transfer prices is relatively simple to apply, it has many defects. First, the use of cost–particularly full cost– as a transfer price can lead to bad decisions and thus sub-optimization.

Second, if cost is used as the transfer price, the selling division will never show a profit on any internal transfer. The only division that shows a profit is the division that makes the final sales to an outside party.

A third problem with cost based price is that they may not provide intensive to control costs. If the actual cost of one division is simply passed on to the next division, then there is little intensive for anyone to work to reduce any costs. This problem can be overcome by using standard cost rather than actual costs or transfer prices.

Despite these short comings, cost based transfer prices are commonly used in practice. Advocates argue they they are easily understood and convenient to use.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

1. Decentralization in organizations
2. Traceable and common fixed costs
3. Segment reporting and profitability analysis-segmented income statements
4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
5. Segmented Financial Information on External Reports
6. Return on Investment (ROI) for Measuring Managerial Performance
7. Controlling and Improving Rate of Return on Investment
8. Return on Investment (ROI) and Balanced Scorecard
9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
10. Residual Income-Another Method to Measure Managerial Performance
11. Limitations, Criticism or Disadvantage of Residual Income Method
12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
13. Set transfer prices at cost using variable or full (absorption) cost
14. Set transfer prices at the market price
15. Divisional Autonomy and Sub optimization
16. International Aspects of Transfer Pricing

Other Related Accounting Articles:

• Set Transfer Price at Market Price
• Limitations, Criticism or Disadvantage of Residual Income Method
• Criticism/Disadvantages or Limitations of Return on Investment (ROI) Method of Performance Evaluation
• Negotiated Transfer Pricing
• Segmented Financial Information on External Reports
• International Aspects of Transfer Pricing
• Return on Investment (ROI) and Balanced Scorecard
• Divisional Autonomy and Sub-optimization
• Traceable and Common Fixed Costs
• Residual Income-A Method to Measure Managerial Performance