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. Transfer pricing occurs where an organizational structure itself into separate independent divisions. When separate divisions within the organization buy and sell to and from one another, then transfer pricing occurs
The existence of transfer pricing can distort the performance appraisal within a divisionalised organization structure:
- When 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 fair to both divisions. The alternatives are:
- 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.
- 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.
- 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.
- Set a transfer price based on negotiation between the managers of the buying and selling divisions.
The option often has behavioural benefits, as managers develop an understanding of each other’s problems. Transfer pricing is important as the transfer price affects both the buying and selling division profits. It unrealistic transfer pricing exists within an organization, it can result in divisional consequences.