Cost-based Approach - Assignment Example

Cost-based Transfer Pricing Cost-based transfer pricing is that particular kind of transfer pricing in which, the basis to charge the prices from onedivision to another division, is the production cost of the unit. The calculation of production cost can take either of the following forms.“Full Cost” that includes complete cost of the units in addition to cost of inefficiencies or full standard cost.“Cost-plus” that adds certain amount of mark-up as a profit on production cost.“Variable Cost plus Lump Sum Charge” is the cost that aims to provide benefits to the selling division by charging some of the fixed costs incurred by selling division.

“Variable Cost plus Opportunity Cost” is the cost which is useful for decision making in particular. Therefore, minimum transfer price which selling division should charge must be at least equal to the sum of production cost and the amount of contribution forgone by the selling division because of providing goods to the buying department which resulted in the loss of opportunity to sell outside customer. The formula to calculate minimum transfer price is given below:Minimum Transfer Price = Incremental Cost + Opportunity Cost.

Strengths of Cost-based Transfer PricingThe biggest advantage of this method of transfer pricing is that it actually includes all the direct costs incurred by the selling division. Other strengths include easy computation of costs, multiple sub-methods of cost basis etc.Weaknesses of Cost-based Transfer PricingThe weaknesses of this method of transfer pricing include the likelihood that the buying division may purchase it from outside supplier if lower prices are offered, loss of the opportunity of profits that could have been gained from outside customers by selling division etc.

ReferencesAlles, Michael. & Datar, Srikant. (1998). Strategic Transfer Pricing. Management science, 44(4), 451-461. Top of Form