The Economics of Full Cost Transfer Pricing

Abstract

Full-cost transfer pricing has been criticized for providing production units with too few incentives to economize on costs. Our empirical study based on panel data from a sample taken from a large producer of fast moving consumer goods shows that charging too high a transfer price for products has the potential to send a production unit into a death spiral. However, our results also suggest that transfer price increases subsequently to volume drops are much smaller than volume drops right after transfer prices increases occurred. These results would suggest that the focal units take measures that would prevent the death spiral to take full effect, rendering the production unit obsolete altogether. We find some evidence to suggest that managers take cost reduction measures and focus their cost reduction activities on products with the best sales prospects. These results suggest that in a context where managers must fear that their production unit will be adversely affected when they overcharge their products, full-cost transfer pricing can serve as a credible commitment device to motivate managers to reduce costs.