Managerial Accounting For Dummies
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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.

About This Article

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About the book author:

Mark P. Holtzman, PhD, CPA, is Chair of the Department of Accounting and Taxation at Seton Hall University. He has taught accounting at the college level for 17 years and runs the Accountinator website at, which gives practical accounting advice to entrepreneurs.

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