Making sense of cost-plus transfer prices where there are imperfect intermediate good markets by a ‘pragmatic-analytical’ perspective

Abstract

Full-cost transfer prices are widely stated in academic literature to be inconsistent with a theoretically appropriate solution in the sense that they must lead to sub-optimal levels of output in the short run. Nevertheless, it is equally widely recognized that many, if not most companies do use cost-plus transfer prices and, moreover, there is a wide variety of approaches to determining what that cost-plus figure should be. To date no rigorous approach to explain this discrepancy has been offered, although Kaplan and Atkinson suggest that practitioners may use cost-plus prices as an approximation to the long-run cost of committing the company to this product, although this still leaves the problem of short-run optimization unsolved. This paper offers an interpretation of practice which suggests that however companies calculate their cost-plus transfer prices and, within limits, whatever cost-plus figure is actually used, companies may not, after all, be departing far from short-run optimality. In addition, the paper offers a way of developing transfer prices which may be equally acceptable for taxation and management purposes. The methodology of the paper is to develop a variation of fundamental neo-classical micro-economic analysis. This analysis shows how a ‘pragmatic-analytical’ perspective, that is to say a combination of rigorous analysis with the behavioural benefits of negotiated outcomes, can improve our understanding of transfer pricing practices. The general ‘pragmatic-analytical’ stance may also offer new insights into other problems of financial analysis. It also contributes to current debates about the desirability of absorption costing.