Outline what you understand by the term ‘transfer pricing’ and explain how the existence of transfer pricing can distort performance appraisal within a divisionalised organisation structure

Transfer pricing occurs where an organisation structures itself into separate independent divisions. When separate divisions within the organisation buy and sell to and from one another, then transfer pricing occurs. The transfer price is the cost of buying the product in the buying division and is the sales revenue for the selling division. The level of the transfer price will affect the profitability of both divisions and thus has performance appraisal implications. For example, should the selling division set a high transfer price then its profits will increase, but the profits of the buying division will decrease. Thus some agreed price must be found that is fair to both divisions.

The alternatives are:

1. Set full cost price as the transfer price. This however is very harsh on the selling division and undermines its profitability and hence its performance appraisal.
2. Set cost plus a mark-up as the transfer price. This system would help ensure the selling division has some element of profit on the transaction.
3. Set market price as the transfer price. This is a feasible option where prices would be set, based on listed prices of identical products or services, or, on a price a competitor is quoting.
4. Set a transfer price based on negotiation between the managers of the buying and selling divisions. This option often has behavioural benefits, as managers develop an understanding of each others problems.

Transfer pricing is important as the transfer price affects both the buying and selling divisions profits. If unrealistic transfer pricing exists within an organisation, it can result in divisions reporting misleading profits, which can have negative motivational consequences.