Definition of Cost-Based Transfer Pricing

Written by eric novinson
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Definition of Cost-Based Transfer Pricing
What are the costs? (factory image by Zbigniew Nowak from Fotolia.com)

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.

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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

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.

Tax Reduction

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.

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