Transfer pricing methods and behaviours - Dysfunctional deci...

Learning Outcomes

After reading this article, you will understand the main transfer pricing methods used in divisionalised organisations and the behavioural consequences these can produce. You will be able to explain how poorly designed transfer pricing systems can lead to dysfunctional decisions and conflict between organisational and divisional objectives. You will also learn to evaluate the trade-offs between divisional autonomy, goal congruence, and performance measurement, and apply these principles to assessment scenarios.

ACCA Advanced Performance Management (APM) Syllabus

For ACCA Advanced Performance Management (APM), you are required to understand not only how transfer pricing methods operate in practice, but also how they affect manager behaviour and overall organisational performance. In particular, you should be comfortable with:

• The purpose and criteria of effective transfer pricing systems
• Methods of setting transfer prices, including market-based and cost-based approaches
• How transfer pricing impacts divisional autonomy, performance assessment, and motivation
• The potential for dysfunctional decisions and performance trade-offs
• Recognising and recommending improvements to misaligned transfer pricing systems

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which transfer pricing method is most likely to create goal congruence when a perfectly competitive external market exists for the transferred good?
   1. Cost-based transfer pricing
   2. Negotiated price
   3. Market-based transfer pricing
   4. Dual pricing
2. A buying division chooses to source externally, even though the selling division has spare capacity to produce at a lower cost. What does this indicate?
   1. Effective transfer pricing policy
   2. Dysfunctional decision caused by transfer pricing
   3. Appropriate divisional autonomy
   4. Maximised group profit

3. True or false? A transfer pricing system that ignores opportunity cost may encourage sub-optimal decisions for the group as a whole.

4. Briefly explain how linking manager bonuses solely to divisional profit can create conflicts with group objectives.

5. List two risks of excessive divisional autonomy in a transfer pricing context.

Introduction

Transfer pricing is critical for performance management in decentralised organisations. It determines the prices at which goods or services are exchanged between divisions, directly shaping divisional profits, manager rewards, and inter-divisional relations.

The chosen transfer pricing method affects not only reported financial results, but also divisional autonomy, internal motivation, and the extent to which decisions are aligned with overall organisational objectives. When the transfer pricing system is poorly designed, it can encourage managers to act in ways that harm group performance—a situation known as dysfunctional behaviour. This article explains the main methods of transfer pricing, explores the root causes and symptoms of dysfunctional decisions, and considers the trade-offs involved in balancing divisional freedom and organisational goals.

Key Term: transfer pricing
The process of setting the price at which goods, services, or intangible assets are transferred between divisions within the same organisation for performance management or tax purposes.

Transfer Pricing Methods Overview

Organisations commonly use one or more of the following methods to set transfer prices between divisions:

Market-Based Transfer Pricing

If an external market exists, transfer prices are often set at the current market price.

• Promotes goal congruence and fair performance measurement, as decisions align with external realities.
• Most effective when the product is identical in quality and delivery terms to the open market offering.

Key Term: goal congruence
The situation where the objectives, decisions, and rewards of divisional managers align with overall organisational objectives.

Cost-Based Transfer Pricing

Transfers are priced at the division's cost of production. This can be:

• Actual full cost (variable plus fixed)
• Standard cost
• Variable cost only
• Variable or full cost plus a mark-up for profit

Cost-based methods may be necessary when no external market exists, but often fail to signal opportunity costs, leading to suboptimal group decisions.

Negotiated Transfer Pricing

Divisions negotiate a transfer price within boundaries set by their own cost structures and available external alternatives.

• Maintains divisional autonomy but can lead to time-consuming disputes and is highly dependent on managers’ negotiating skills.
• Can result in arbitrary prices that do not reflect economic reality.

Dual Pricing

Each division records transfers at a different price:

• The selling division records a higher (e.g., cost plus) price.
• The buying division records a lower (e.g., variable cost) price.
• The difference is adjusted centrally.

This can support divisional motivation but complicates group accounting.

Key Term: opportunity cost
The benefit lost when a resource is used for one purpose instead of its next-best alternative, central to setting transfer prices that optimise group profit.

Behavioural Issues: Dysfunctional Decisions

Dysfunctional behaviour occurs when managers act in their own division’s interest but, due to poor transfer pricing rules, harm overall group results. This typically arises in the following ways:

• A manager rejects transfers that would benefit the group, because the impact on their division’s measured profit is negative.
• A division sources externally even when internal supply would be cheaper for the group as a whole.
• Managers may manipulate results if rewards are based on divisional profit rather than group profit.

Worked Example 1.1

A manufacturing group has two divisions. The selling division can supply a component at a variable cost of $12 per unit and has surplus capacity. The external market price is $20. The buying division can source the part externally for $19.

Question:
If the transfer price is set at $19 (external price), what will the buying division choose? Is this in the group’s best interest?

Answer:
The buying division is indifferent between buying internally and externally at $19 and may buy outside for ease. However, the group's cost would be only $12 if supplied internally. If the transfer price were set at variable cost ($12), the buying division would always buy internally, benefiting the group, but the selling division's reported profit would suffer. This creates a conflict—illustrating dysfunctional decision making.

Worked Example 1.2

A division is evaluated by ROI. It can accept a project that will increase group profit but slightly decrease the division’s ROI. The manager refuses the project.

Question:
What behavioural issue is illustrated, and how should transfer pricing or performance measures be changed?

Answer:
The division’s manager makes a decision that benefits the division but not the group. This is a classic example of dysfunctional behaviour. Remedy: Use performance measures like residual income (RI) or economic value added (EVA) that encourage value creation above the cost of capital, or align rewards with group performance.

Key Term: dysfunctional behaviour
Actions by managers within divisions that improve their own measured performance but reduce the value or profit of the overall organisation.

Trade-Offs: Autonomy, Motivation, and Group Objectives

Strong transfer pricing systems must balance the following:

• Divisional autonomy: Encourages local initiative and quick responses, motivating managers.
• Goal congruence: Ensures decisions benefit the whole group, not just the division.
• Fair and reliable performance measures: Manager rewards should reflect factors they control, but also encourage cooperation.

Tension arises because increased autonomy can lead to short-term, self-interested actions, while rigid, centrally imposed transfer prices may demotivate managers and slow responses.

Key Term: divisional autonomy
The freedom granted to divisional managers to make decisions and control resources without central interference.

Key Term: residual income (RI)
A performance measure calculated as controllable profit less a capital charge based on the division's invested capital, rewarding managers only when returns exceed a required rate.

Exam Warning

Always assess whether a transfer pricing system is creating dysfunctional behaviour—especially if managers can manipulate divisional profit or ROI. Explain how better alignment with group interests can be achieved, or how performance measures can be adjusted to correct misaligned incentives.

International and Tax Considerations

While primarily an issue for multinational groups, differences in tax rates can lead to transfer pricing being manipulated to shift profits across borders, further complicating performance measurement and creating additional trade-offs between tax efficiency and operational fairness.

Summary

Transfer pricing is a core element of divisional performance management. Its design influences not only reported profits, but also divisional autonomy, management motivation, and the achievement of overall group objectives. Poorly designed systems create dysfunctional decisions and performance trade-offs that can harm the organisation’s results. A strong transfer pricing policy balances group and divisional needs using appropriate price-setting methods and performance measures.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the main transfer pricing methods and their effects
• Describe how goal congruence and divisional autonomy interact
• Identify causes of dysfunctional behaviour in transfer pricing systems
• Analyse worked examples of performance trade-offs from transfer pricing
• Recommend improvements to align divisional and group interests
• Recognise the importance of appropriate performance measures alongside transfer pricing

Key Terms and Concepts

• transfer pricing
• goal congruence
• opportunity cost
• dysfunctional behaviour
• divisional autonomy
• residual income (RI)