Transfer pricing

There is unlimited demand for product X and Y. These can be sold directly outside the group by Division A. There is a labour constraint.

Ignoring division B, A will make most contribution by just selling product X as it earns $4 per labour hour whereas only $3 per labour hour is earned by selling Y. So, Division A will only make Product X.

Now introduce Division B. We don’t know what it makes, but it needs Product Y as a component. To get this component, Division A will have to be persuaded to switch production from X to Y. This will mean it loses contribution of $4 per labour hour or, to make a unit of Y, 4 X 10 = $40.

So the minimum transfer cost that would make it worthwhile for Division A to make and transfer a unit of Y is the variable cost plus the lost contribution: 70 + 40 = 110.