If competitive external prices are not available and transfer prices are established on the basis of cost plus profit, outline the salient features of this method, explaining what problems may be anticipated and what possible solutions may be applied. (7 marks) Solution Two main problems exist here: how to determine cost and how to determine profit. The cost basis The usual basis for costing is that of standard cost. If actual cost is used the manufacturing efficiencies would be passed on to the buyer. In the event that prices and to be negotiated between profit centres, the establishment of a standard cost may be difficult. In the event of arbitration managers may argue that they are no longer in control of profits. The profit basis The simplest method of achieving this is to establish profit as a percentage of costs. A better base is the invested capital, but this can be very difficult to calculate. The amount of profit should be permitted is a difficult question to answer, as the managers be measured and motivated by the amount of profit produced. A target profit is that profit that would be made by a similar external company. We note the following: Transfer prices should not encourage the failure to maintain standards of quality, investment or other parameters that the manufacturing centre would do if it were an independent company selling to an external market. The performance factors should be segregated by responsibility, ie. inefficiencies in production should not be passed on to the next profit centre