Generally speaking, cost-based transfer pricing is top management chooses a transfer price based on the costs of producing the intermediate product. For instance, variable production costs, variable and fixed production costs, full costs (including life-cycling costs) as well as some markup. It is useful when market prices are unavailable or too costly to obtain. When a large organisation transfers product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues (Horngren, Datar, Foster, Rajan, Lttner, 2009).

When transfer prices are based on full cost plus a markup, it may probaly lead to sub-optimal decisions. Since it causes the buying division to regard the fixed costs and the markup of the selling division as a variable cost. Indeed, the buying division may then purchase products from an external supplier expecting savings in costs that will not exist (Horngren, et al, 2009).

In a large company, the transfer price is a major factor between manufacturing and distribution divisions. In order to achieve company profit maximization when decentralized segments of a company interact, a transfer pricing system should be established that treats supplying segments as variable cost recovery centers and setup costs are treated as a variable function of run size. This induces optimal run sizing decisions by the producing and purchasing divisions.

Let take a typical example of the real world, it is common practice for large companies to treat setup costs as a constant per unit and to include fixed costs and profit margins in transfer prices. However, this treatment leads to sub-optimization for the company. On the other hand, managers make decisions pricing, purchasing, production, etc. based on transfer prices. Therefore, the transfer