Cost-based transfer pricing is a method of setting prices when goods are sold to divisions within the same company. Several factors affect the price, including production costs, managers' reviews, international taxation and competitors' pricing. There are different methods of selecting the cost-based transfer price.
Marginal Cost Definition
Marginal cost of producing the product is one method to set the transfer price. A division records all of the parts used to make, for example, a computer case, such as the sheets of metal and plastic used to build it. Variable overhead is added, including energy bills, wages of additional workers and rent of additional factory space.
Marginal Cost Considerations
One complication of using marginal cost is that central management may not have exact details on the actual costs of the divisions. This creates an incentive for division managers to mislead central managers. Without considering fixed costs, the purchasing division gets a discount compared with buying parts on the open market, and the manufacturing division appears inefficient, which affects each manager's review.
Full Production Costs
Most companies use full production costs or full production costs plus a markup. Full production costs add fixed overhead expenses to the cost of each item. Fixed overhead is defined as overhead expenses that stay the same when the company changes the number of components it makes. For example, fixed overhead includes the managers' wages, the rent for the current factory space and salaries of clerical and janitorial workers who don't directly produce components.
Cost plus is another term for full production costs plus a markup. Adding the fixed costs will still give a price much lower than selling the product on the open market. The market price includes wages of sales agents, truck drivers, storage at other warehouses, and other external factors. The manager of the computer case division might be able to sell the cases to a competitor for greater profits. Because this harms the firm's overall competitiveness, many firms have the managers of the divisions negotiate a price between the full production cost and the cost of buying in the market.
Cost based transfer pricing is used to reduce tax payments. If a firm owns a factory in a country with a low tax rate, and sells finished products in a country with a high tax rate, it pays less taxes overall by setting a high transfer price. The profits are earned by the manufacturer in the other country, which may make it difficult to repatriate them without paying additional taxes. The Guardian of Great Britain gives the example of the 18 pence freezer, as well as the surprising statistic that most world trade takes place inside multinationals, not between them.
- Photo Credit factory image by Zbigniew Nowak from Fotolia.com
Issues in Transfer Pricing
Transfer pricing is used to set the internal price of goods and services that move between the divisions or business units of...
What Is a Market-Based Pricing Strategy?
As a business owner, you have to choose the proper pricing for your products if you want to be successful. If you...
Method of Transfer Pricing
Transfer pricing refers to the price of good and services that a company provides to itself. Firms with multiple divisions or subsidiaries...
How to Calculate Transfer Prices in Management Accounting
Many companies find it mutually beneficial to transfer products to another department or a subsidiary. Instead of charging regular retail price for...
How to Calculate Full Cost Pricing
Full cost pricing takes into account every cost a business may have associated with a product. First, you need to look at...
How to Determine the Minimum Transfer Price
Companies that do business with their own subsidiaries may face some tough tax questions. A corporation that buys equipment from a foreign...
The Disadvantages of Cost Plus Pricing
Cost plus pricing is simple in its overall concept. A business calculates the cost to create products. From there, it determines what...
What Are the Purposes of a Transfer Pricing System?
Business organizations are made up of different units. Management holds these units accountable for their expenses and the profits they generate. The...
Retail Method of Inventory
Managing inventory is a crucial aspect of a successful retail business. Having the right product and the right amount of that product...