Transfer price based on opportunity cost

Division A transfers to Division B

Div A has own costs of 10
Div B has own costs of 12 and can sell the finished product for 30.

The group therefore makes a profit of 30 – 10 – 12 = 8 for every item made and sold.

Now assume that Div A could sell its intermediate product for 15. Division B therefore has two sources of revenue: the intermediate market at 15 or through the group at whatever the transfer price is. Div A will sell the product where it gets some income.

If the intermediate market has unlimited demand but Div A has limited production capacity, it earns that Div A could sell everything outside and sell nothing to B, but that would harm the group because:

Div A selling outside earns the group 15 – 10 = 5

Div A selling to B then selling the finished product gives a contribution of 8

The group wants A to sell to B so the transfer price must be enough to cover the manufacturing cost in A (10) and to compensate A for the profit it won’t make by not selling outside at 15. That profit foregone is the opportunity cost, so the minimum transfer price that will get Diva A to sell to B is 10 (MC) + 5 (OC) = 15.

A simpler way of think about it is that if the groups wants Div A to sell to B the transfer price must successfully complete with what A could get from selling outside. So, the transfer price must be at least 15.