Final answer:
Setting transfer prices at either the variable cost or full cost incurred by the selling division has several disadvantages. It can lead to inaccurate cost allocation, undermine divisional autonomy, and distort performance evaluation.
Step-by-step explanation:
The cons of setting transfer prices at either the variable cost or full (absorption) cost incurred by the selling division are:
- Inaccurate Cost Allocation: Setting transfer prices based on variable or absorption costs may not accurately reflect the actual costs incurred by the selling division. This can result in incorrect profit and cost measurements for both the selling and buying divisions, leading to suboptimal decision-making.
- Undermines Divisional Autonomy: Using variable or absorption costs as transfer prices can undermine the autonomy of individual divisions within a company. It may discourage efficiency improvements and cost-saving efforts within the selling division, as it is not incentivized to reduce costs below the transfer price set by the company.
- Distorts Performance Evaluation: Transfer prices based on variable or absorption costs can distort the performance evaluation of both the selling and buying divisions. If the transfer price is set below the selling division's full cost, it may artificially inflate its performance, while the buying division may show lower profitability due to higher costs.