Finance Management 03. Enjoy it.

Full cost transfer price

When external market price does not reflect the correct price or viewed as an unfair price, a firm can use cost based transfer price. When using cost basis the actual cost of production cannot be captured to a single unit price easily. Thus a standard cost will be used as the transfer price. Also it should be noted that the cost captured as price will be correct at one output level only. Thus when the division produce varied amount of goods it will not cover the actual cost of production.

But when cost based transfer price is used it is likely to be treated as an input variable cost by the receiving department and if selling prices are based on costs the selling prices may not produce the best results for the firm as a whole as it’ll be low priced in the market. With a full cost based transfer price divisional performance appraisal become meaningless as it will result in a breakeven point or even a loss. So transacting just at a cost will make the employees demotivated. (Sharman, Paul, 2003)Use of cost basis will turn the strategic business unit to a cost center. In situations where actual costs include inefficiencies of the division, the transfer price set on the basis of such inefficiencies may lead to incorrect management decisions on pricing and using full cost as price will not encourage management to control such inefficiencies.

Cost-plus a mark-up transfer price

The word cost is a wage definition. It may be marginal cost, standard cost, absorption costor even opportunity cost. Whatever it be management should make sure that the added mark up is sufficient to cover all costs and to cover up any variations in estimations so that it will allow the selling division to earn a reasonable profit, allowing employees to be motivated on appraisal results. This price will often be an approximate market price.(Kaplan, Atkinson, 2000)But conflicts may arise between the two sets of managers in terms of setting a price with a fair mark up. At some operation levels where each divisionis trying to be profitable, the company may not achieve its best. Thus the mark up should be selected carefully so that it assures goal congruence.(Simons, Robert, 1990)