One simple approach to setting a transfer price is to use the item’s variable cost. After all, in a negotiation, this amount would have been the seller’s minimum price anyway.
Suppose that Ernie’s Western Dairy has two divisions: Milk and Ice Cream. The Milk division produces milk for a variable cost of $3 per gallon. The Ice Cream division processes milk into ice cream for an additional variable cost of $1 per gallon. Its ice cream sells for $6 per gallon.
Variable cost gives Ernie’s a transfer price of $3 per gallon. The figure shows how this price affects the two divisions’ contribution margins.
Setting the contribution margin at Milk’s variable cost of $3 shifts all the profits from the Milk division to the Ice Cream division, such that Milk earns no contribution margin per unit (left column), while Ice Cream earns $2 per unit (right column).
If Ernie’s evaluates the Milk division on its profitability, then the Milk division needs to find a better customer than the Ice Cream division — one that provides more contribution margin. Selling to an outside customer for a slightly higher price would improve Milk’s profitability.