Full-Cost Transfer Prices
Full-cost transfer prices are a method of setting internal prices within an organization for transactions between different divisions. This approach calculates the transfer price based on the full cost incurred by the supplying division, but without adding a profit margin. While this method helps to cover all production costs, it can sometimes lead to suboptimal managerial decisions if cost information is inaccurate or misaligned.
Examples
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Manufacturing Firm: Suppose a manufacturing firm has two divisions – Divisions A and B. Division A supplies components to Division B. The full cost of producing the component in Division A is $50 per unit. Using the full-cost transfer pricing method, Division A transfers the component to Division B for $50 per unit, without including any profit margin.
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Software Company: In a software company, Division X develops software modules which are needed by Division Y for creating customer solutions. The total cost of developing one software module is $200. Division X transfers the module to Division Y at a transfer price of $200 per module.
Frequently Asked Questions (FAQs)
Q1: What are the advantages of full-cost transfer prices?
- Answer: Full-cost transfer prices ensure that the supplying division covers all costs incurred, promoting cost recovery. It also simplifies the internal pricing mechanism by focusing on actual costs incurred without needing to determine an additional profit margin.
Q2: What are the potential drawbacks of using full-cost transfer prices?
- Answer: One major drawback is that it can lead to poor decision-making if the cost information is inaccurate. Additionally, since no profit margin is included, the supplying division might lack incentives to control costs or increase efficiency.
Q3: How does full-cost transfer pricing affect inter-divisional relationships?
- Answer: Full-cost transfer pricing can lead to conflicts between divisions, especially if the receiving division feels the transfer price is too high or if it doubts the accuracy of the cost calculation. It can also reduce the supplying division’s motivation to make cost improvements.
Q4: Is full-cost transfer pricing suitable for all companies?
- Answer: It depends on the company’s structure and business model. While it may be suitable for companies looking to simplify internal processes and ensure cost recovery, it may not be ideal for those needing strong cost controls and efficiency incentives.
Q5: Can full-cost transfer prices be adjusted?
- Answer: Yes, companies can periodically review and adjust full-cost transfer prices based on changes in cost structures, market conditions, or strategic objectives.
Related Terms with Definitions
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Transfer Pricing: The setting of prices for transactions between related parties within an organization, such as divisions of a corporation or subsidiaries of a multinational corporation.
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Full Cost Pricing: A pricing strategy that includes all the costs of producing a product or service, including fixed and variable costs, but does not add any profit margin.
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Cost-Based Transfer Prices: Transfer pricing methods based on the cost of production, including full cost and variable cost transfer pricing.
Online References
- Investopedia - Transfer Pricing: Transfer Pricing
- Corporate Finance Institute - Transfer Pricing: Transfer Pricing Guide
Suggested Books for Further Studies
- “Transfer Pricing Handbook” by Robert Feinschreiber
- “International Transfer Pricing” by Ernst & Young LLP
- “The Taxation of Multinational Enterprises: Basic Principles and Practices” by Charles A. King
Accounting Basics: “Full-Cost Transfer Prices” Fundamentals Quiz
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