A company that transfers goods between multiple divisions needs to establish a transfer price so that each division can track its own efficiency. Since there isn't a real market between a company's divisions, there is no way of knowing the actual correct price to charge.
How to Find the Minimum Transfer Price
There are different ways to find the minimum acceptable transfer price. Some companies simply set the minimum as equal to variable costs. Others add variable costs with a calculated opportunity cost. The general economic transfer price rule is that the minimum must be greater than or equal to the marginal cost of the selling division.
In economics and business management, a marginal cost is equal to the total new expense incurred from the creation of one additional unit.
For example, suppose a hammer manufacturing company has two divisions: a handle division and a hammer head division. The hammer head division only begins work after receiving handles from the handle division. This means the handle division is the selling division and the hammer head division is the buyer.
If it costs the handle division $7 to fashion its next handle (its marginal cost of production) and ship it off, it doesn't make sense for the transfer price to be $5 (or any other number less than $7) – otherwise, the division would lose money at the expense of money gained by the hammer head division.
Factoring in Opportunity Costs
Suppose that the hammer company also sells replacement handles for its products. In this scenario, it sells some handles through retail rather than sending them to the hammer head division. Suppose again that the handle division can realize a $3 profit margin on its sold handles.
Now the cost of sending a handle isn't just the $7 marginal cost of production, but also the $3 in lost profit (opportunity cost) from not selling the handle directly to consumers. This means the new minimum transfer price must be $10 ($3 + $7).