Strategic Cost Management · Transfer Pricing (Cost Management)

Behavioural Issues and Divisional Performance in Transfer Pricing

Updated 11 October 2026 · Fact-checked

Transfer prices shift profit between divisions, so they change divisional profit, ROI and manager rewards. Managers may then act for their own division and hurt company profit. This is suboptimisation. To answer, compare divisional and company profit, find the conflict, and recommend a price or rule that restores goal congruence.

Understand Behavioural Issues and Divisional Performance

A transfer price is the price at which one division sells goods or services to another division of the same company. On consolidation it cancels out. The company's total profit does not change because of the price itself. But each division's reported profit does change.

This is where behaviour starts. A selling division wants a high transfer price, because it raises its revenue and profit. A buying division wants a low one, because it lowers its cost. If managers are judged and paid on divisional profit or ROI, each will push for the price that suits their own division.

Suboptimisation happens when a division takes a decision that is good for itself but bad for the company. A common case: the buying division refuses to buy internally because the transfer price is above the outside price, even though the selling division has spare capacity and its variable cost is lower than the outside price. The company loses the contribution. Another case: the selling division sells outside and refuses an internal order that would have earned the company more.

Goal congruence means divisional managers' goals line up with company goals. A good transfer pricing system should give goal congruence, be fair for performance evaluation, keep divisional autonomy, and be simple to use. These aims often conflict. Full autonomy may produce suboptimal decisions. Head-office control may fix the decision but demotivate managers.

Performance evaluation needs care. A division's profit is only meaningful if the transfer price is reasonable. If head office imposes a price, managers can fairly say the result is not in their control. Good practice is to judge managers on controllable items, to separate manager performance from divisional (economic) performance, and to allow negotiation or arbitration where divisions disagree.

Key rules to remember

Minimum transfer price (selling division): Minimum = Marginal (variable) cost per unit + Opportunity cost per unit to the company; With spare capacity, opportunity cost is nil, so the minimum is variable cost. With full capacity, it includes the contribution lost on outside sales.
Maximum transfer price (buying division): Maximum = Lower of (net marginal revenue from the final product) and (outside purchase price for an equivalent input); The buyer will not pay more than it can recover or can buy elsewhere. Net marginal revenue = final-product selling price per unit less the buyer's own further processing costs per unit.
Company-level gain from internal transfer: Gain per unit = Outside price avoided − Variable cost of internal supply (spare capacity case); If positive, the company should transfer internally whatever the divisions' reported profit shows.
Divisional ROI: ROI = Divisional profit ÷ Capital employed × 100; Transfer prices change the profit numerator, so ROI rankings can change without any change in real efficiency.
Residual Income: RI = Divisional profit − (Capital employed × Required rate of return); Used alongside ROI to reduce the tendency to reject projects that earn above the cost of capital but below current ROI.

How to solve Behavioural Issues and Divisional Performance questions

Use this method for any question on conflicts, suboptimisation or evaluation under transfer pricing.

1Read the facts: capacity position of the selling division, outside prices, variable costs, and how managers are evaluated.
2Work out the company's best decision first, using relevant costs: variable cost, opportunity cost and the outside price.
3Compute each division's profit or ROI under the proposed transfer price.
4Check whether each manager's best choice matches the company's best choice. If not, name the conflict as suboptimisation or lack of goal congruence.
5Quantify the loss to the company from the divisional decision.
6Recommend a fix: a price in the range between the seller's minimum and the buyer's maximum, negotiated or dual pricing, or a change in the evaluation measure.
7State the behavioural effect of your fix on autonomy, motivation and fairness, and give a one-line conclusion.

Quickest way: Range test for transfer decisions

When to use it: Use it when a numerical case asks whether a transfer should happen and whether divisions will agree.

Write the seller's minimum price (variable cost plus opportunity cost).
Write the buyer's maximum price (lower of outside price or net marginal revenue).
If minimum is below maximum, the company gains by transferring. Gain per unit = maximum − minimum.
Any price between the two makes both divisions better off. A price outside the range makes one refuse, which is suboptimisation.
Write the recommendation in one line with the total gain.

Common mistakes in Behavioural Issues and Divisional Performance

Saying the transfer price changes total company profit.
Students see divisional profit move and assume the whole company moves.
Fix: State that the price only shifts profit between divisions. Company profit changes only through the quantity and source decisions it triggers (and tax or duty effects, if any).
Using full cost as the minimum price when the seller has spare capacity.
Habit from cost-plus pricing.
Fix: Use variable cost when capacity is spare. Fixed cost is not relevant to the company's decision.
Ignoring opportunity cost when the seller is at full capacity.
Students stop at variable cost.
Fix: Add the contribution lost on outside sales per unit transferred.
Writing only theory points on conflict without numbers.
The topic looks descriptive.
Fix: Quantify the company loss or gain from the divisional decision, then explain the behaviour behind it.
Judging managers on profit affected by an imposed transfer price.
Students forget controllability.
Fix: Say that evaluation must use controllable results, and that imposed prices weaken accountability and motivation.
Recommending head-office control without noting its cost.
It solves the numeric problem quickly.
Fix: Add that forced decisions reduce divisional autonomy and may demotivate managers. Prefer negotiation within the range where possible.

Worked examples

Example 1

Division A makes a component with variable cost ₹60 per unit. It has spare capacity, enough to supply B's requirement of 5,000 units without giving up any outside sales. B can buy the same component outside at ₹85. A proposes a transfer price of ₹90. B's manager is judged on divisional profit. What will B do, and what is the effect on the company?

Show the solution

Company's best decision: A has spare capacity, so the cost of internal supply is ₹60 per unit. Outside purchase costs ₹85. Internal supply saves ₹85 − ₹60 = ₹25 per unit.
B's view: at ₹90 internal price against ₹85 outside, B saves ₹5 per unit by buying outside, so B will refuse the internal supply.
Company effect: if B buys outside, the company pays ₹85 outside instead of incurring ₹60 of variable cost internally. Loss = ₹25 × 5,000 = ₹1,25,000.
Cause: the transfer price is above the buyer's maximum (₹85), so the divisional decision conflicts with the company's interest. This is suboptimisation.
Fix: set a price between ₹60 and ₹85, for example ₹72.50 (midpoint). Then A earns ₹12.50 per unit contribution and B saves ₹12.50 per unit.

Answer: B will buy outside at ₹85. The company loses ₹1,25,000. A transfer price between ₹60 and ₹85 (for example ₹72.50) makes both divisions better off and removes the suboptimisation.

Example 2

Division X has capital employed of ₹20,00,000 and earns profit of ₹3,60,000 using a transfer price that head office imposed. Division Y has capital employed of ₹10,00,000 and earns ₹2,20,000. The company's required return is 15%. Head office plans to lower the transfer price from X to Y by ₹50,000 a year in total. Compute ROI and residual income before the change, and ROI after. What does it show about evaluation?

Show the solution

Before: ROI of X = 3,60,000 ÷ 20,00,000 × 100 = 18%. ROI of Y = 2,20,000 ÷ 10,00,000 × 100 = 22%.
Residual income of X = 3,60,000 − (20,00,000 × 15%) = 3,60,000 − 3,00,000 = ₹60,000. Residual income of Y = 2,20,000 − 1,50,000 = ₹70,000.
After the change: X's profit falls to 3,10,000. Y's profit rises to 2,70,000.
ROI of X = 3,10,000 ÷ 20,00,000 × 100 = 15.5%. ROI of Y = 2,70,000 ÷ 10,00,000 × 100 = 27%.
Total profit is ₹5,80,000 before and after. Nothing real has changed.
Observation: Y looks better and X looks worse only because of the price. Rewards tied to ROI would shift from X's manager to Y's manager without any change in efficiency.

Answer: Before: X ROI 18%, RI ₹60,000; Y ROI 22%, RI ₹70,000. After: X ROI 15.5%, Y ROI 27%. Company profit stays at ₹5,80,000. Transfer prices distort divisional measures, so managers should be judged on controllable results and the price should be set on a fair, agreed basis.

Exam tips

In MCQs, remember that a transfer price does not change total company profit on consolidation. Options claiming otherwise are usually wrong.
In case answers, give the number first (company gain or loss), then the behavioural reason. Examiners reward the link between the two.
Use the words suboptimisation, goal congruence, autonomy and controllability in your answer where they fit.
Always state a clear recommendation, such as a negotiated price range or a change to the performance measure, and mention its behavioural side effect.

Practice questions from Transfer Pricing (Cost Management)

Behavioural Issues and Divisional Performance in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Behavioural Issues and Divisional Performance: frequently asked questions

What is suboptimisation in transfer pricing?

It is a situation where a division makes a decision that benefits itself but reduces the total profit of the company. For example, a buying division may buy outside at a lower price even though internal supply costs the company less.

How does transfer pricing affect divisional performance evaluation?

The transfer price decides how profit is split between the selling and buying divisions. This changes divisional profit, ROI and residual income without any real change in efficiency, so evaluation can be unfair if the price is imposed or arbitrary.

How can conflicts between divisions over transfer prices be reduced?

Use a price within the range between the seller's minimum and the buyer's maximum, allow negotiation with arbitration by head office, or use dual pricing. Also judge managers on controllable results.

What is goal congruence?

It means the goals of divisional managers match the goals of the company. A good transfer pricing system makes managers' best personal choice the same as the company's best choice.