How can transfer pricing influence the incentives of separate business units?

How can transfer pricing influence the incentives of separate business units?

• A. It has no impact on incentives and is purely an accounting exercise.
• B. It affects reported profits and investment decisions; high transfer prices boost the transferor unit but reduce the transferee's profits, etc.
• C. It only affects external tax outcomes, not internal decisions.
• D. It always benefits the transferee unit.

Answer: (B)

Transfer pricing inside a corporate group sets the price for goods or services traded between units, so it becomes part of each unit’s revenue and cost. That directly changes how profitable each unit appears, which in turn influences performance assessments, capital budgeting, and resource allocation. When the transfer price is high, the transferor unit reports higher profits and the transferee reports lower profits, which can push management to favor projects and decisions that boost the transferor’s reported performance and discourage the transferee from investing or purchasing internally. Lower transfer prices would have the opposite effect. Because these internal profit signals drive incentives and investment choices, transfer pricing can steer how each unit behaves, beyond any tax considerations or purely accounting effects.

Transfer pricing inside a corporate group sets the price for goods or services traded between units, so it becomes part of each unit’s revenue and cost. That directly changes how profitable each unit appears, which in turn influences performance assessments, capital budgeting, and resource allocation. When the transfer price is high, the transferor unit reports higher profits and the transferee reports lower profits, which can push management to favor projects and decisions that boost the transferor’s reported performance and discourage the transferee from investing or purchasing internally. Lower transfer prices would have the opposite effect. Because these internal profit signals drive incentives and investment choices, transfer pricing can steer how each unit behaves, beyond any tax considerations or purely accounting effects.