Transfer pricing can contribute directly to the process of departmental performance measurement and indirectly to the measurement of product performance.
A transfer price is a value attached to the output of a department in order to measure the value of its trade with other departments inside the organization. The transfer price of the supplying division is charged to the receiving division. Transfers prices do not affect overall organizational profit results but do affect the profits reported by divisions. The following example illustrates this point. Different transfer prices allocate profit in different ways between divisions and it should be clear that:
1) Transfer pricing shares profits between divisions but does not, on its own, affect total profits;
2) Transfer pricing can motivate managers to take actions to improve profits for their divisions and for the organization as a whole. The transfer price should allow the opportunity for effort to be translated into a positive measurement of performance.