Abstract
Cost-based transfer pricing is used by many firms. However, there exist many cost-based methods that may be centralized or decentralized. If centralized, the firm's central office has discretion how accurately to measure the divisions' costs. In order to measure cost reliably, the firm must incur considerable setup costs for an information system. This paper analyzes the tradeoff between the fixed costs of such information gathering and the incentives that arise under several cost-based methods. Our central result is that transfer prices should be based on centralized standard costs if the returns on investments are high and/or if cost uncertainty is low. Decentralization should occur if there is intermediate uncertainty. Finally, transfer pricing should be centralized and based on actual costs if uncertainty is high.
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