Types of Costs Used in Transfer Pricing Derivations

When creating a transfer price based on any type of cost, one should carefully consider the types of cost that are used to develop the price. An incorrectly considered cost can have a large and deleterious impact on the pricing structure that is developed. In this post, I cover the use of “actual costs“, “standard costs“, and “fixed costs“ in the creation of transfer prices.

Is Using Actual Cost For Transfer Pricing a Good Idea?

When actual costs are used as the foundation for transfer prices, a company will know that its prices reflect the most up-to-date costs, which allows it to avoid any uncertainty regarding sudden changes in costs that are not quickly reflected in prices. If such changes are significant, a company can find itself selling its products internally at price points that do not result in optimum levels of profitability. But, is this a good idea? Read on…

Nonetheless, the following problems keep most organizations from using actual costs to derive their transfer prices:

• Volume-based cost changes. Actual costs may vary to such an extent that transfer prices must be altered constantly, which throws the buying divisions into confusion, because they never know what prices to expect. This is a particular problem when costs vary significantly with changes in volume. For example, if a buying division purchases in quantities of 10,000, the price it is charged will reflect that volume. However, if it places an order for a much smaller quantity, the fixed costs associated with the production of those units, such as machine setup costs that are spread over a much smaller quantity of shipped items, will drastically increase the cost, and therefore the price charged.
• Transfer of inefficiencies. By using actual cost as the basis for its transfer pricing, a selling division no longer has any incentive to improve its operating efficiencies, because it can allow its costs to increase and then shift the costs to the buying division. This is less of a problem when the bulk of all sales are external, because the division will find that only a small proportion of its sales can be loaded with these extra costs. However, a situation where most sales are internal will allow a division to shift nearly all of its inefficiencies elsewhere.
• Shifting of costs. When actual costs are used, the selling division will quickly realize that it can load the costs it is charging to the buying division, thereby making its remaining costs look lower, which improves the division manager’s performance rating. By shifting these costs, the buying division’s costs will look worse than they really are. Although this problem can be resolved by constant monitoring of costs by the relatively impartial headquarters staff, the monitoring process is a labor-intensive one. Also, there will be constant arguments between the divisions regarding what cost increases are justified.

In short, the use of actual costing as the basis for transfer prices is generally not a good idea, primarily because its use allows selling divisions to shift additional costs to buying divisions, which reduces their incentive to improve internal efficiencies.

A better approach is to use standard costing as the basis for a transfer price. This is done by having all parties agree at the beginning of the year to the standard costs that will be used for transfer pricing, with changes allowed during the year only for significant and permanent cost changes, the justification of which should be closely audited to ensure that the changes are valid.

By using this approach, the buying divisions can easily plan the cost of incoming components from the selling divisions without having any concerns about unusual pricing variances arising. Meanwhile, the selling divisions no longer have an incentive to transfer costs to the buying divisions, as was the case with actual costing, and instead can now fully concentrate their attention on reducing their costs through improved efficiencies. If they can drop their costs below the standard cost levels at which transfer prices are set for the year, then they can report improved financial results that reflect well not only on the division manager’s performance, but also on the performance of the company as a whole.

Furthermore, there is no need for constant monitoring of costs by the corporate headquarters staff, because standard costs are fixed for the entire year. Instead, the headquarters staff can concentrate its attention on the annual setting of standard costs; this is the one time during the year when costs can be manipulated to favor the selling divisions, which requires in-depth cost reviews to avoid. As long as standard costs are set at reasonable levels, this approach is much superior to the use of transfer prices that are based on actual costs.

Yet another issue is the addition of fixed costs to variable costs when setting transfer prices. When these costs are combined, it is called “full costing”. When a selling division uses full costing, the buying division only knows that it cannot sell the purchased item for less than the price it paid. However, this may not be the correct selling strategy for the company as a whole.

A series of divisions sell their products to a marketing division, which sells all products externally on behalf of the other divisions. The marketing division buys the products from the selling divisions at full cost. It does not know what proportions of the price it pays are based on fixed costs and which on variable costs. It can only assume that, from the marketing division’s perspective, its variable cost is 100% of the amount it has paid for the products, and that it cannot sell for less than the amount it paid.

The best way to ensure that the division making external sales is aware of both the fixed and variable costs that are included in a transfer price is to itemize them as such. When the selling division has full knowledge of the cumulate variable cost of any products it has bought internally, it can then make better pricing decisions. This separation of a transfer price into its component parts is not difficult and can be made on a cumulative basis for all products that have been transferred through multiple divisions.

Another way to handle the pricing of fixed costs is to charge a budgeted amount of fixed cost to the buying division in each reporting period. By doing so, there is no need to run a calculation in each period to determine the amount of fixed cost to charge at different volume levels. Also, the budgeted charge reflects the cost of the selling division’s capacity that the buying division is using, and so is a reasonable way for the buying division to justify its priority in product sales by the selling division over other potential sales—it has paid for the capacity, so it has first rights to production.

Another school of thought is that no fixed costs should be charged to the buying division at all. One reason is that the final price charged to an external customer is based on market rates, not internal costs, so there is no reason to account for the cost if it has no impact on the final price. Another reason is that the fixed cost typically charged to the buying division rarely includes all fixed costs, such as general and administrative expenses, so if the fixed cost cannot be accurately determined, why charge it at all?

Also, the fixed costs of a division are not closely tied to the volume of units produced [otherwise, they would be variable costs], so it is not possible to accurately assign a fixed cost to each unit of production sold. In short, this viewpoint questions the reason for assigning any fixed cost to a product, because of the difficulty of measurement and its irrelevance to the ultimate price set for external sale.

Not including any fixed cost in the transfer price will reduce the price that the buying division pays, and makes its profits look abnormally high, because these costs will be absorbed by those upstream divisions that supplied the product. However, the profits of the division that sells the product externally can be allocated back to upstream divisions, in proportion to their costs included in the product, so there is a way to give these divisions a profit.

The arguments in favor of standard costing make it the clear choice over the use of actual costs in the derivation of transfer prices. However, the preceding arguments both in favor of and against the use of fixed costs are much less clear. A company can avoid the entire issue by simply basing intercompany transfers on market prices for each item transferred, but there is no outside market for many products, so managers cannot use this method to avoid the fixed-cost issue. I do preferred approach is to assign a standard lump-sum fixed cost to the buying division in each period; this approach avoids the issue of how to determine the fixed cost per unit and also gives the buying division the right to reserve the production capacity of the selling division that is related to the fixed cost being paid by the buying division.