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Chapter 22: Problem 11

What is one potential limitation of full-cost-based transfer prices?

Short Answer

Expert verified
One potential limitation of full-cost-based transfer pricing is inefficient decision-making within the organization. This occurs because full-cost-based pricing may not accurately reflect the true incremental cost of producing additional units, leading to decisions that are not cost-effective or efficient for the overall company, such as choosing external suppliers over internal divisions with excess capacity. This misalignment of costs and pricing could result in wasteful spending and reduced competitiveness.

Step by step solution

01

Overview of Transfer Pricing

Transfer pricing refers to the practice of setting the cost of goods and services sold between divisions of a company. Companies use various methods to determine the transfer price between divisions, like market-based pricing, negotiated pricing, and cost-based pricing. One such cost-based pricing method is full-cost-based transfer pricing.
02

Full-cost-based Transfer Pricing

Full-cost-based transfer pricing is when one division of an organization charges another division for the full cost of a product or service it provides. It typically includes variable costs (costs that change with the production volume) as well as fixed costs (costs that remain constant regardless of production). In some cases, a profit markup is also added to cover any profit that the producing division wants to make.
03

Limitation of Full-cost-based Transfer Prices

One potential limitation of full-cost-based transfer pricing is the possibility of inefficient decision-making within the organization. Since full-cost-based pricing includes both variable and fixed costs, it might not accurately reflect the true incremental cost of producing additional units. If a division is charged based on full cost, it might make decisions鈥攕uch as whether to buy a product or service internally or externally鈥攖hat are not the most cost-effective or efficient for the overall company. This could lead to wasteful spending and a less competitive organization. For example, if a division could buy a product from an external supplier at a lower cost than the full cost charged by a sister division, it might opt to buy externally, even if the internal division has excess capacity and could have produced the product at a lower incremental cost than the external supplier. This misalignment of costs and pricing could lead to suboptimal decisions and overall inefficiency.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Transfer Pricing
Transfer pricing is a vital component within multi-divisional organizations, governing transactions between different segments of the same company. It involves setting prices for the transfer of goods, services, or intellectual property between these segments. The main goal of transfer pricing is to allocate revenue and expenses fairly among divisions, which contributes to an accurate reflection of each division's profitability.

An optimized transfer pricing strategy ensures compliance with tax laws, as various jurisdictions may have different regulations and tax rates. This process helps prevent profit shifting to lower-tax locations, which can be viewed unfavorably by tax authorities. Furthermore, transfer pricing affects internal decision-making and may impact where within the company resources are allocated, thus influencing overall corporate strategy.
Cost Accounting
Cost accounting is a branch of accounting that focuses on capturing a company's total cost of production by assessing the variable costs of each step of production, as well as fixed costs, such as overheads. It is crucial for budget planning and control, aiding managers in understanding the cost structure of their operations to make informed financial decisions.

Through techniques like job order costing, process costing, and activity-based costing, cost accounting provides detailed cost information that is instrumental in setting selling prices, reducing costs, and managing budgets. It helps in identifying the least profitable segments and products, which allows businesses to streamline their operations and improve profit margins.
Decision-Making in Cost Accounting
Decision-making in cost accounting involves using cost information to choose amongst alternatives that will affect the future of an organization. Managers use cost accounting to identify and analyze costs, and then decide on the best course of action based on the data.

Key decisions related to production levels, pricing strategies, capital investments, or product mix all depend on insights from cost accounting. Issues arise when costs are misallocated, potentially leading to incorrect decisions. For instance, under full-cost-based transfer pricing, the inclusion of both fixed and variable costs may not reflect the true cost of production, leading to suboptimal decisions, like sourcing from an external supplier when internal production would be more cost-effective if only variable costs were considered.
Cost-Effectiveness
Cost-effectiveness is an evaluation metric that examines whether a project or decision will provide value or benefit relative to its cost. It involves analyzing various options to determine which provides the best results while utilizing the least resources. Achieving cost-effectiveness is an ongoing challenge in business operations, as it requires balancing quality, efficiency, and expense.

For companies, especially in competitive markets, maintaining cost-effectiveness is essential for survival and growth. This entails not just minimizing expenses but also optimizing operations and maximizing resource utilization. When transfer pricing is not aligned with actual cost structures, it can deter cost-effectiveness, leading to excess costs and hampered competitiveness.

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Most popular questions from this chapter

Give two reasons why the dual-pricing system of transfer pricing is not widely used.

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Ballantine Corp. produces and sells lead crystal glassware. The firm consists of two divisions, Commercial and Specialty. The Commercial division manufactures 300,000 glasses per year. It incurs variable manufacturing costs of 8 dollar per unit and annual fixed manufacturing costs of 900,000 dollar. The Commercial division sells 100,000 units externally at a price of 12 dollar each, mostly to department stores. It transfers the remaining 200,000 units internally to the Specialty division, which modifies the units, adds an etched design, and sells them directly to consumers online. Ballantine Corp. has adopted a market-based transfer-pricing policy. For each glass it receives from the Commercial division, the Specialty division pays the weighted-average external price the Commercial division charges its customers outside the company. The current transfer price is accordingly set at 12 dollar. Eileen McCarthy, the manager of the Commercial division, receives an offer from Home D茅cor, a chain of upscale home furnishings stores. Home D茅cor offers to buy 20,000 glasses at a price of 9 dollar each, knowing that the entire lead crystal industry (including Ballantine Corp.) has excess capacity at this time. The variable manufacturing cost to the Commercial division for the units Home D茅cor is requesting is 8 dollar, and there are no additional costs associated with this offer. Accepting Home D茅cor's offer would not affect the current price of 12 dollar charged to existing external customers. 1\. Calculate the Commercial division's current annual level of profit (without the new order). 2\. Compute the change in the Commercial division's profit if it accepts Home D茅cor's offer. Will Eileen McCarthy accept this offer if her aim is to maximize the Commercial division's profit? 3\. Would the top management of Ballantine Corp. want the Commercial division to accept the offer? Compute the change in firm-wide profit associated with Home D茅cor's offer.

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