Abstract
AbstractThis paper analyzes the potential of one-step transfer prices based on either variable or full costs for coordinating decentralized production and quality-improving investment decisions. Transfer prices based on variable costs fail to induce investments on the upstream stage. In contrast, transfer prices based on full costs provide strong investment incentives for the upstream divisions. However, they fail to coordinate the investment decisions. We show that negotiations prevent such coordination failure. In particular, we find that the firm benefits from a higher degree of decentralization so that total profit increases in the number of parameters being subject to negotiations.
Highlights
In the literature, different transfer-pricing schemes are recommended depending on the purpose they are intended for
This paper focuses on the performance of simple cost-based transfer-pricing schemes, which are prevailing in business practice as to the coordination of investment and production decisions in a decentralized setting of team production for inducing qualityimproving investments
Transfer prices based on variable costs are able to induce coordination, but the upstream divisions have no incentive to invest and the downstream division maximizes total profit given the underinvestment of the upstream divisions
Summary
Different transfer-pricing schemes are recommended depending on the purpose they are intended for. One-step costbased transfer pricing prevails in business practice (see Section 2). It is well known from the literature that cost-based types of transfer prices exhibit significant disadvantages with respect to investment incentives in decentralized settings. The goal of our paper is to analyze the investment incentives generated by one-step cost-based transfer prices. The major innovation of our paper is that we do account for interstage and for intrastage dependencies of the divisions’ investment decisions This means that we analyze interdependencies across the stages -- as it is commonly done in the literature -- as well as goal conflicts between. Additional explanations concerning the negotiations under transfer pricing based on full costs are provided in Appendix C
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