While an item's standard cost can be used to determine its transfer price, the two values are inherently different. An item's transfer price is the sales price charged for a good or service in a transaction between two entities under common ownership. Its standard cost, on the other hand, is simply the anticipated cost of all of the item's component parts.
When one entity purchases goods from another entity under the same ownership, a sales price is charged, just as it would be to an outside customer. This price is called the transfer price; the sale is made to another entity as part of the production process rather than to the end user.
Assume companies A and B are part of corporation X, which sells laptop computers. Company A manufactures microchips and assembles the laptops, while company B is the corporation's public brand and is responsible for sales. To avoid operating at a loss, company A must charge company B a transfer price for each laptop it purchases to sell to the public. The optimal transfer price is based on a number of factors, including the cost of the item and which entity receives the benefit of profits.
If management believes it benefits the corporation as a whole for company A to realize 100% of the profits, the transfer price is set using the market price of the product.
For example, if a laptop costs $100 to produce but can sell for $700 on the open market, then company A charges company B $700 per laptop. Company B then sells the finished product to the consumer at or above this same price. Company A absorbs all the costs and profits associated with the production of the item, while company B essentially breaks even. Depending on the actual sales price, company B may realize a small profit or loss. While corporation X's total profits do not change, it does not encourage company B to push sales of laptops; there is little to no financial benefit to that entity.
If company B receives the profit generated by the sale of goods, then the transfer price is set using the cost of manufacturing the product, rather than its market value.
Because the actual cost of manufacturing an individual item can vary due to operational inefficiencies, temporary shortages or human error, the simplest way to set a cost-based transfer price is by establishing the item's standard cost. The standard cost is the average, or anticipated, cost of producing an item under optimal circumstances. The standard cost can be adjusted over time to account for variances between the anticipated and actual costs of production.
Using the standard cost method in the above example, company B would pay company A $100 per laptop to cover the cost of manufacturing. Company B then sells the laptops at their market value. In this way, company A does not lose money on production, and company B receives 100% of the sales profits. However, as with market-based transfer pricing, the allocation of profits to one entity can discourage other entities from full participation.