3. Cost-based transfer pricing methods and formulas

As the name implies, the cost-based transfer pricing method utilizes cost information to determine transfer prices. There are several variations of formulas under this method:

• On a lower end, only the variable costs of a selling division are used to set transfer prices. This approach can be used when there is extra (idle) production capacity at the selling division that would not be utilized anyway. So including fixed costs would not be adequate from the buying division’s standpoint.

• The next variation of the cost-based transfer pricing is when transfer prices include both the variable and fixed costs of the selling division. This approach is used when a company does not have data on its variable costs (i.e., accounting system reports costs by account, not behavior). Also, in the long run the selling division may want to get paid for its full manufacturing cost, not just the variable manufacturing cost.

• Finally, on a higher end, the transfer price will include variable costs, fixed costs, and a partial or full profit (or opportunity cost) of the selling division. This is sometimes referred to as cost-plus arrangements. This approach is important when internal exchange may impact the selling division’s normal sales to external customers. In the presence of the external market, the cost-plus approach is similar to the market-based approach because the opportunity cost is the lost margin on normal sales to the external market.

Cost-Based Transfer Pricing Examples

Under one scenario, Division D1’s transfer price to Division D3 can be based solely on the variable cost. In this case, the transfer price would be $70. The cost savings of $80 (= $150 external vendor price - $70 transfer price) will accrue to Division D3.

Under the next scenario, Division D1’s transfer price to Division D3 includes both variable and fixed costs for a total transfer price of $100 ($70 variable cost and $30 fixed cost per unit). The cost savings for the buying Division D3 is $50 (= $150 external vendor price (cost) - $100 transfer price (cost)). The contribution margin received by Division D1 is $30 (i.e., $100 transfer price (revenue) - $70 variable cost). The contribution margin covers the fixed cost of $30 per unit in the selling division (in the long run).

Finally, under the cost-plus arrangement, Division D1’s price to Division D3 includes the total cost plus a full or partial profit margin of Division D3. In this case, both divisions share any cost savings from the internal trade instead of having Division D3 buy widgets externally. Let’s assume that top management agreed to provide a partial profit of $10/widget to the selling Division D3. In this case, the transfer price is set to $110 (= $70 variable cost + $30 fixed cost + $10 allowed profit). The buying division’s cost savings are $40 (= $150 external vendor price (cost) - $110 transfer price (cost)). The selling division’s contribution margin is $40 (= $110 transfer price (revenue) - $70 variable cost)), which covers the fixed cost of $30 per unit and generates a profit margin of $10 per unit.

Considerations for Cost-Based Transfer Pricing

• Under this approach, any production inefficiencies of the selling division will be passed on to the buying division as cost data is used for transfer prices.

• Unless policies and procedures are clearly described and established, variations in the cost-based transfer pricing formulas may create confusion and disagreements between company divisions.

• There may be disagreements between divisions as to which division should benefit from the internal transfer price savings.

Not a member?

See why people join our
online accounting course: