A model of cost-based transfer pricing

Abstract

In most decentralized organizations, goods and services are transferred between divisions. These transfers are frequently recorded in the accounting books of the divisions; the term transfer price refers to the dollar amount of the interdivisional exchange. This study considers two main issues: (i) the costs and the benefits of delegating decisions through a system of transfer pricing and divisional performance evaluation, and (ii) the performance of one common method of pricing intrafirm transactions: cost-based transfer pricing. The study analyzes a firm in which each divisional manager has better information about the divisional environment than what is known by the firm's top management. The first half of the paper demonstrates that the firm can attain the optimal level of profits with a compensation system utilizing (i) reports by divisional managers describing in complete detail each manager's private information, and (ii) divisional performance evaluation with cost-based transfer pricing. Next, a situation is considered in which divisional managers are not able to communicate their private information to the firm's top management because of complexity of divisional environments or managers' specialized expertise. In this bounded-rationality setting, a managerial-compensation system employing cost-based transfer pricing allows the firm to earn strictly higher expected profits than if all decisions are made by the firm's top management relying on divisional managers' reports.