Transfer prices and incentive contracts in vertically-integrated divisionalized companies

Abstract

This paper studies a divisionalized firm with sequential transfers in which central management wants to motivate two division managers who receive predecision information. Central management can only contract on the observables price, cost and quantity. Starting with the optimal compensation schemes as a benchmark, the paper considers the question whether using transfer prices to substitute for price and cost, respectively, can replicate the optimal solution or not. This is to say, whether using an aggregate measure comes at a loss. The results are dependent on the design constraints (i) single or ‘dual’ transfer prices and (ii) simultaneous design of the reward functions or exogenously given reward functions. Basically, only in the case that central management is restricted to given reward functions, and wants to use the same single transfer price for both divisions, there is a loss relative to the benchmark solution. In the other cases, generally, there is enough latitude to design the available functions to mimic the benchmark. The paper goes on to discuss special cases. First, it finds conditions when purely cost-based transfer prices are optimal, and second, it derives explicit solutions for given linear compensation schemes over divisional book profits.