Pricing Decisions, Transfer Pricing and Life Cycle Costing
This chapter moves the cost-accounting toolkit built in earlier chapters into three decisions a manager actually makes: what price to charge an external customer, what price one division should charge another division of the same company, and how to think about cost across a product's entire life rather than one accounting period at a time.
1. Pricing decisions
Cost-plus pricing sets price by adding a target margin to a computed cost base — full (absorption) cost, marginal cost, or total cost including a share of selling and distribution overhead, depending on the specific cost-plus variant used:
The choice of cost base changes the answer materially: a mark-up on full cost already embeds fixed overhead recovery into the price, while a mark-up on marginal cost recovers fixed overhead only through the margin itself, meaning the margin percentage needed to break even is necessarily higher under marginal-cost-plus than under full-cost-plus pricing for the same target profit.
Market-based pricing, by contrast, starts from what the market will bear (competitor prices, customer's perceived value) and works backward to what cost structure is needed to be profitable at that price — a fundamentally different starting point from cost-plus, and increasingly the more commercially realistic approach in competitive markets where a firm cannot simply set its own price by adding a margin to its cost.
2. Transfer pricing between divisions
Where one division of a company supplies goods or services to another division of the same company, a transfer price must be set for that internal transaction, and unlike this chapter's other pricing decisions, the transfer price does not generate new profit for the company as a whole — it only decides how much of the company's total profit is credited to the selling division versus the buying division.
This single fact is what makes transfer pricing a genuinely different problem: a transfer price that is fair to both divisions individually can still, in some methods, drive the wrong decision for the company overall.
| Method | How it is set | Main weakness |
|---|---|---|
| Cost-based (variable or full cost) | Transfer at the selling division's cost, sometimes plus a small mark-up | Selling division has no profit incentive to control its own costs, since costs simply pass through |
| Market-price-based | Transfer at the external market price for an equivalent good or service | Requires a genuine, observable external market for the exact item transferred |
| Negotiated price | Divisions bargain a mutually agreed price, often anchored between cost and market price | Can consume significant management time and may reflect relative bargaining power rather than economic logic |
Goal congruence — the alignment of each division's own profit-maximising incentive with what is actually best for the company as a whole — is the central evaluative question for any transfer-pricing method.
A poorly chosen transfer price can lead a buying division to reject an internal transfer that would have been profitable for the company overall (because the internal price looks worse than an external alternative that is actually more expensive once the whole company's costs are considered), or lead a selling division to prioritise external sales over an internal transfer that would have been more valuable company-wide — both are goal-congruence failures the chosen method should be judged against.
3. The learning curve effect
The learning curve effect describes a well-documented, repeatedly observed pattern in labour-intensive, repetitive manufacturing: as cumulative output doubles, the average labour time (and therefore average labour cost) per unit falls by a constant percentage, because workers become progressively faster and more efficient at a repeated task. An "80% learning curve" means that each time cumulative output doubles, average time per unit falls to 80% of its previous level.
where is the cumulative average time per unit, is cumulative units produced, is the time for the first unit, and is the learning index (negative, since time falls as output rises).
In practice, most examination problems apply the learning rate directly by doubling — average time for 2 units = learning rate × average time for 1 unit, average time for 4 units = learning rate × average time for 2 units, and so on — rather than requiring the logarithmic formula to be solved from scratch, since the doubling relationship is usually all that is needed.
The learning curve matters for cost estimation and pricing directly: quoting a fixed per-unit labour cost for a large, repetitive order without allowing for the learning effect will overstate the true labour cost of later units in the order, potentially pricing the quote uncompetitively high, or conversely, understating expected profitability if the learning effect is ignored when the cost was already set low to win the order.
4. Life cycle costing
Traditional cost accounting reports cost period by period — this month's, this quarter's, this year's — but a product's true profitability can only be judged across its entire life, from initial research and development through introduction, growth, maturity and eventual decline and withdrawal, and life cycle costing is the discipline of tracking cost against this full span rather than any single period in isolation.
The single most important insight in life cycle costing is the gap between when a cost is committed and when it is incurred: a large majority of a product's total lifetime cost is effectively locked in by decisions made during the research, design and development stage — the chosen materials, the manufacturing process, the number of components — even though the cash is not actually spent (incurred) until much later, during manufacturing, marketing and after-sales support.
This is why life cycle costing pushes cost-control effort earlier, into the design stage, rather than relying only on cost control during the manufacturing stage, by which point most of the cost structure is already effectively fixed by design decisions already made.
Worked Examples
Example 1. A product's marginal cost is ₹400 per unit. The firm wants a 25% margin on marginal cost. Compute the selling price under marginal-cost-plus pricing.
Price = ₹400 × 1.25 = ₹500.
Example 2. The same product has a full (absorption) cost of ₹550 per unit (including a share of fixed overhead). If the firm instead wants a 25% margin on full cost, compute the price, and explain why it differs from Example 1's answer even at the same mark-up percentage.
Price = ₹550 × 1.25 = ₹687.50. It differs because the full-cost base already includes fixed overhead recovery within the cost figure itself, so a mark-up of the same percentage on a larger cost base produces both a higher price and a different (in this case, larger) absolute margin.
Example 3. Division A produces a component at a variable cost of ₹200 and transfers it to Division B at cost, with no mark-up. Division B sells the finished product externally for ₹450, incurring ₹150 of its own additional costs. Under this cost-based transfer price, does Division A have any profit incentive from this internal transaction, and what problem does this illustrate?
No — Division A earns zero profit on the transfer (transferred at its own cost with no mark-up), even though the overall internal transaction contributes ₹100 to company profit (₹450 − ₹200 − ₹150). This illustrates the cost-based method's core weakness: the selling division has no profit incentive from internal sales, which over time can reduce its motivation to prioritise cost control or internal supply.
Example 4. A firm experiences an 80% learning curve. The first unit takes 100 labour hours. Find the cumulative average time per unit after 4 units are produced.
Average time for 2 units = 80% × 100 = 80 hours. Average time for 4 units = 80% × 80 = 64 hours.
Example 5. Using Example 4, find the total labour hours for all 4 units, and the time taken specifically for units 3 and 4 combined.
Total time for 4 units = 4 × 64 = 256 hours. Total time for 2 units = 2 × 80 = 160 hours. Time for units 3 and 4 combined = 256 − 160 = 96 hours.
Example 6. A company's design team is deciding between two component designs: Design X (cheaper to manufacture but requires costlier after-sales servicing over the product's life) and Design Y (costlier to manufacture but requires minimal servicing). Using life cycle costing, explain why comparing only the manufacturing cost of the two designs would be misleading.
Manufacturing cost alone captures only one stage of the product's life. Design X's servicing costs are incurred later but were effectively committed by the design decision made now, so a life cycle costing comparison must include the expected total after-sales servicing cost over the product's life for each design, not just the manufacturing-stage cost, before concluding which design is genuinely cheaper overall.
Example 7. Explain why life cycle costing argues for greater cost-control attention during the research and design stage, even though very little cash is actually spent at that stage compared to the manufacturing stage.
Although the cash outflow during design is small, the design decisions made at that stage — choice of materials, number of components, manufacturing process — effectively lock in (commit) the large majority of the product's total lifetime cost, even though that cost is not actually incurred (paid) until later stages such as manufacturing and servicing.
Because most of the cost is already effectively fixed by the time manufacturing begins, cost-control effort applied only at the manufacturing stage can influence only a small remaining share of total lifetime cost, which is why life cycle costing pushes cost-control focus earlier, into the design stage itself.
Summary
Cost-plus pricing sets price from a chosen cost base (marginal or full cost) plus a target margin, while market-based pricing works backward from what the market will bear — and the two can give materially different prices even at an identical margin percentage, since the cost base itself differs.
Transfer pricing between divisions of the same company does not create new company-wide profit, only redistributes it between divisions, and cost-based, market-price-based and negotiated methods each carry a different risk to goal congruence — the alignment between each division's own incentive and the company's overall best interest.
The learning curve captures a well-documented fall in average labour time as cumulative output doubles (an "80% learning curve" halves-then-multiplies average time by 0.8 at each doubling), directly affecting cost estimation for large repetitive orders.
Life cycle costing tracks cost across a product's full life rather than one period, built around the key insight that most lifetime cost is committed early (at the design stage) even though it is incurred much later, which is why cost-control effort is most effective when applied at the design stage rather than only during manufacturing.
