Transfer Pricing: What Is the Minimum Price the Selling Division Will Accept?
Use both divisions' perspectives and identify whether internal transfer sacrifices an outside opportunity.
Selling division minimum
A common framework is variable cost plus opportunity cost.
Idle capacity
If the selling division has idle capacity and no external sale is sacrificed, opportunity cost may be zero under the simplified model.
Full capacity
If supplying the internal buyer means giving up an outside sale, the lost contribution margin becomes an opportunity cost.
Buying division maximum
The buying division generally does not want to pay more than the relevant cost of obtaining the item externally, adjusted for meaningful differences.
Goal congruence
A good transfer-pricing system encourages division managers to make decisions aligned with the organization overall.
The takeaway
Selling division protects contribution margin. Buying division compares outside alternatives.
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FAQ
What happens with idle capacity?
Opportunity cost can be zero under the simplified model.
What creates opportunity cost?
Giving up profitable external sales.
Is market price always the transfer price?
No.