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.
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