In a Transfer Pricing context, scheme in which the cost base can be either variable cost or full cost. It is easy to understand and convenient to use, but there are some disadvantages: (1) Inefficiencies of the selling divisions are passed on to the buying divisions with little incentive to control costs. The use of standard costs is recommended in such a case. (2) The cost-based method treats the divisions as Cost Centers rather than Profit or Investment Centers. Therefore, measures such as Return on Investment (ROI) and Residual Income cannot be used for evaluation purposes.
The variable cost-based transfer price has an advantage over the full cost method because in the short run it may tend to ensure the best utilization of the company's overall resources. The reason is that, in the short run, fixed costs do not change. Any use of otherwise idle facilities, without incurrence of additional fixed costs, will increase the company's overall profits.
