1. Market-Based Transfer Pricing
If a perfectly competitive outside market exists for the component part, the ideal transfer price is the current Market Price.
- Logic: The selling division can sell all it wants to outside clients at market rates, and the buying division can purchase parts from outside vendors at the same price. This preserves autonomy and measures genuine competitiveness.
2. Cost-Based Transfer Pricing Models
When an outside market price is unavailable or highly volatile, companies rely on internal cost models:
Full Cost-Plus Pricing
The transfer price is set at the total production cost plus a fixed profit markup percentage.
- Flaw: This passes inefficiencies down the supply chain. If the selling division mismanages its factory floor and runs up high material waste, these excess costs are passed directly to the buying division as a higher transfer price, killing the supplier’s incentive to control costs.
Variable Cost Pricing
The transfer price is set at the selling division’s variable production cost.
- Utility: Excellent for maximizing total corporate profit because it encourages the buying division to expand sales. However, it is highly unfair to the selling division, forcing them to operate at a structural loss while the downstream division captures all corporate profits.
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