Transfer Pricing, Incentive Compensation and Tax Avoidance in a Multi-Division Firm

This article examines the relation between transfer pricing and production incentives using a model of a vertically integrated firm with divisions located in different tax jurisdictions. We show that if divisional profits are taxed at the same marginal rate, the transfer price should be set to minimize the compensation risk faced by the manager of the buying division. For the case where divisional profits are taxed at different marginal rates, we are able to characterize the trade-off between the tax savings from setting transfer prices to reduce profitability in the high tax jurisdication and the loss of effort attributable to the impact of tax avoidance on the incentive compensation system. Further, we show that if it is feasible to compensate the division managers using multiple performance measures, the transfer price should be used to minimize the firm's overall tax liability. Finally, we show that when authority to determine the transfer price must be delegated to one of the division managers, it is optimal to assign responsibility for setting the transfer price to the manager of the division with the most production uncertainty.     

Information technology,organizational design,and transfer pricing

We show how information technology affects transfer pricing. With coarse information technology, negotiated transfer pricing has an informational advantage: managers agree to prices that approximate the firm's cost of internal trade more precisely than cost-based transfer prices. With sufficiently rapid offers, this advantage outweighs opportunity costs of managers’ bargaining time, and negotiated transfer pricing generates higher profits than the cost-based method. However, as information technology improves, the informational advantage diminishes; the opportunity costs of managers’ bargaining eventually dominate, and cost-based methods generate higher profits. Our results explain why firms generally prefer cost-based methods, and when negotiated methods are preferable.     

EVA AND DIVISIONAL PERFORMANCE MEASUREMENT: CAPTURING SYNERGIES AND OTHER ISSUES

This article makes three basic points about divisional performance measurement that managers should keep in mind when attempting to choose between EVA and more conventional, accounting-based measures. First, no divisional performance measure, whether it be EVA, divisional net income, or ROA, is capable of capturing synergies among divisions—those shared benefits or costs that make the sum of the parts worth more than the whole. And EVA is neither more nor less effective than more conventional financial measures in deterring divisional managers from taking actions that increase divisional profits at the expense of corporate value. Thus, there is a fundamental contradiction in the very attempt to evaluate the divisions of a multi—divisional firm as if they were independent companies. If there are synergies, divisional performance measures—even those employing transfer prices—are likely to prove inadequate in some respects (and this article recommends some methods for encouraging synergies that might be used to supplement if not replace divisional measures). But if there are no synergies, then top managers should re-examine their business strategy and consider selling or spinning off divisions. Second, a given performance measure's degree of correlation with stock returns should not be management's sole, or even its most important, criterion in choosing to adopt a given performance measure. A better method for evaluating performance measures is to weigh the behavioral or incentive benefits of a given measure against all direct and indirect costs associated with its implementation. In making such a costbenefit analysis, the incentive benefits from the tighter linkage of rewards to share prices provided by more market-based measures should be traded off against the greater market risk and exposure to other uncontrollables imposed by such measures as well as the costs involved in changing the firm's internal accounting and reporting systems. Third, the EVA practice of “decoupling” performance measures from GAAP accounting, while having have potentially significant incentive benefits, also has potential costs in the form of increased auditing requirements and the possibility of litigation.     

ENVIRONMENTAL VARIABLES OF MULTINATIONAL TRANSFER PRICING: A U.K. PERSPECTIVE

This paper reports the findings from an empirical study of multinational transfer pricing based on the information provided by 47 British multinational companies. The results indicate that company profit after tax was the key consideration for those companies in formulating their international transfer pricing policies. In addition, they also considered other important variables including the competitive position of their foreign subsidiaries, divisional performance evaluation, and foreign restrictions on repatriation of profits. Six dimensions of environment variables of multinational transfer pricing were also extracted using factor analysis technique.     

Goliath Corporation: An instructional case in transfer pricing policy

This case illustrates some of the issues associated with setting firms’ transfer pricing policies. The simulation requires students to assume the roles of top management and divisional management for Goliath Corporation in negotiating transfer prices. The student playing the role of top management first selects a transfer pricing policy from four possible mechanisms: market-based, cost-based, negotiated, and dual-pricing. Given the top manager’s policy choice, divisional managers are then constrained to use that policy as they decide whether to purchase internally or externally based on their respective negotiations. In each negotiation, there is an ex ante best decision for Goliath as a whole. The case is thus useful in demonstrating how managers’ transfer price policy choices can lead to bad sourcing decisions.     

Negotiated versus Cost-Based Transfer Pricing

This paper studies an incomplete contracting model to compare the effectiveness of alternative transfer pricing mechanisms. Transfer pricing serves the dual purpose of guiding intracompany transfers and providing incentives for upfront investments at the divisional level. When transfer prices are determined through negotiation, divisional managers will have insufficient investment incentives due to hold-up problems. While cost-based transfer pricing can avoid such hold-ups, it does suffer from distortions in intracompany transfers. Our analysis shows that negotiation frequently performs better than a cost-based pricing system, though we identify circumstances under which cost-based transfer pricing emerges as the superior alternative.     

Transfer Pricing and the Control of Internal Corporate Transactions

One potential weakness of all divisional profitability schemes is their inability to capture synergies among business units. One way of managing this problem is to design a transfer pricing scheme that attempts to assign common costs and benefits to different business units. What makes transfer pricing both so interesting, and such a challenge, is that the solution involves finding a way to encourage divisional managers whose pay is likely to depend on such transfer prices to reveal their private or unbiased information about the firm's costs in a way that serves the interest of the rest of the firm. With that end in view, the authors provide a general analytical framework for setting transfer prices and go on to discuss the costs and benefits of each of the most common transfer‐pricing methods: (1) market pricing; (2) marginal cost pricing; (3) full‐cost pricing; and (4) negotiated prices.     

Intrafirm Trade,Bargaining Power,and Specific Investments

This paper compares the performance of standard-cost with negotiated transfer pricing under asymmetric information. Negotiated transfer pricing generally achieves higher expected contribution margins, as this method tends to be more efficient in aggregating private information into a single transfer price. Standard-cost transfer pricing confers more bargaining power to the supplier and therefore generates better incentives for this division to undertake specific investments. The opposite holds for buyer investments. If a corporate controller has disaggregated information about divisional costs and revenues, then the firm can improve upon the performance of standard-cost transfer pricing by setting a centralized transfer price equal to expected cost plus a suitably chosen mark-up.     

Collusion Proof Transfer Payment Schemes with Multiple Agents

Most of the current studies on transfer pricing under asymmetric information focus on a single principal and a single agent. Under a separating management and ownership assumption, transfer pricing is at minimum a three-person problem involving one principal and two agents. This paper considers a transfer pricing problem with two agents who possess private information and seek to maximize their net cash flows, instead of divisional accounting profits. The objectives of this paper are: (1) to derive a direct-revelation mechanism that induces truth telling and efficient allocation; (2) to study the agents' collusion behaviors under the direct-revelation mechanism. The findings indicate that when agents have the option to quit after contracting, it is optimal for the center to produce less than the first-best output level unless the costs for both divisions are at their lowest levels. The optimal amount of underproduction varies according to the demand condition. In addition, two sets of transfer functions, named as identical and nonidentical functions, are derived to induce truth-telling and yield optimal equilibrium output. The two sets of transfer functions are subject to collusion. However, the functions induce different collusion behaviors among agents, that is, the collusion sets for both functions are not common sets. This property enables us to eliminate any collusion between agents, particularly prior to their observation of private information.     

THE VIABLE EVA CENTER (OR, HOW TO SLICE A COMPANY SO IT DOESN'T BLEED)

How a company is sliced, or broken up into divisions of various sorts, has a huge effect on the accountability and hence the behavior of its managers. Senior management faces a tradeoff between delegating authority to subordinates who have the best information for specific decisions, and maintaining authority to avoid parochial behavior that might hurt the organization as a whole. Divisions exist within companies to provide a framework for such delegation. A divisional structure allows decision-making authority to be pushed down along with accountability for results. Thus, how divisions are established is critical to decision-making, motivation, and accountability.
The ultimate test of a well-formed division is a high degree of correspondence between division financial results and financial results for the company as a whole. When an increase in divisional EVA can contribute to a decline in company-wide EVA, this is evidence of a poorly formed division, or what the author calls a "non-viable" EVA center. This article provides a framework for defining a "viable EVA center" as well as three ways of making existing divisions more viable: (1) use of transfer pricing and intrafirm charges; (2) reorganization; and (3) aggregation of divisional results.     

Influence Costs and Capital Structure

This paper analyzes the role of capital structure in the presence of intrafirm influence activities. The hierarchical structure of large organizations inevitably generates attempts by members to influence the distributive consequences of organizational decisions. In corporations, for example, top management can reallocate or eliminate quasi rents earned by their employees, while at the same time, they must rely on these employees to provide them with information vital to their decision making. This creates the opportunity for lower level managers to influence top management's discretionary decisions. As a result, divisional managers may attempt to inflate the corporate perception of their relative contributions to the firm, or to take actions that make the elimination of their rents more costly for the firm. This incentive to influence is especially acute when managers fear losing their jobs, for example in the event of a divestiture. Since the firm's capital structure can affect future divestiture decisions, it can be chosen to reduce or increase the divisional managers' incentives to influence top management's decisions. The control of influence activities arises at the expense of restrictions on future divestiture decisions. Hence, there emerges an optimal capital structure that trades off the costs of influence activities against the costs of making poor divestiture decisions. The findings suggest that capital structure can also be chosen to control influence activities that arise under less extreme motivations. We identify several key factors that determine the optimal capital structure: the top management's prior assessment of the likelihood that it will be optimal to divest a specific division; the costs of influence activities to the firm and to the divisional managers; and the difference in the valuation of the division's assets in the current firm and under alternative uses.     

Cost-System Choice and Incentives—Traditional vs. Activity-Based Costing

We incorporate information and managerial incentives into the analysis of a common cost-management tool—activity-based costing (ABC). We study the choice of a costing system in a firm where the owners contract with a manager to use either a traditional or an ABC system and make production decisions. We show that, as commonly argued in managerial-accounting literature, in a first-best setting with no informational asymmetries the ABC system is always preferred to the traditional costing one. However, when the firm's manager has relevant private information, the owners' choice of a costing system is not as clear. We demonstrate that the firm earns higher expected profits under the ABC system when the uncertainty about the manager's private information is high. Conversely, the firm's expected profit is higher under the traditional costing system when the uncertainty surrounding the manager's private information is low because the gross benefits of better information provided by ABC are exceeded by the additional informational rents the owners must pay the manager under this system. Our results provide a formal explanation of the coexistence of traditional and ABC systems in practice.     

Cost-based transfer pricing

This paper compares the performance of alternative cost-based transfer pricing methods. We adopt an incomplete contracting framework with asymmetric information at the trading stage. Transfer pricing guides intra-company trade and provides incentives for value-enhancing specific investments. We compare actual-cost transfer prices that include a markup over marginal costs with standard-cost transfer prices that are determined either by the central office ex ante (centralized standard-cost transfer pricing) or by the supplying division at the trading stage (reported standard-cost transfer pricing). For the actual-cost methods, we show that markups based on the joint contribution margin (contribution-margin transfer pricing) dominate purely additive markups (cost-plus transfer pricing). We obtain the following results. (1) Centralized standard-cost transfer pricing dominates the other methods if the central office and the divisions ex ante face low cost uncertainty. (2) The actual-cost methods dominate the other methods if the central office and the divisions ex ante face high cost uncertainty and later, at the trading stage, the buying division receives sufficient cost information. (3) Reported standard-cost transfer pricing dominates the other methods if the central office and the divisions ex ante face high cost uncertainty, and the buyer has insufficient cost information at the trading stage.     

Decentralized capacity management and internal pricing

This paper studies the acquisition and subsequent utilization of production capacity in a multidivisional firm. In a setting where an upstream division provides capacity services for itself and a downstream division, our analysis explores whether the divisions should be structured as investment or profit centers. The choice of responsibility centers is naturally linked to the internal pricing rules for capacity services. As a benchmark, we establish the efficiency of an arrangement in which the upstream division is organized as an investment center, and capacity services to the downstream division are priced at full historical cost. Such responsibility center arrangements may, however, be vulnerable to dynamic hold-up problems whenever the divisional capacity assignments are fungible in the short-run, and therefore, it is essential to let divisional managers negotiate over their actual capacity assignments. The dynamic hold-up problem can be alleviated with more symmetric choice of responsibility centers. The firm can centralize ownership of capacity assets with the provision that both divisions rent capacity on a periodic basis from a central unit. An alternative and more decentralized solution is obtained by a system of bilateral capacity ownership in which both divisions become investment centers.     

高管宏观认知具有管理者“烙印”吗？——基于管理者风格效应的实证检验

本文利用“管理层讨论与分析”(MD&A)中的文本信息构造高管宏观认知指标(MMC),研究高管宏观认知是否具有管理者风格效应及其作用机理。研究发现,高管宏观认知具有明显的管理者个体“烙印”,会受到管理者个人风格的显著影响,表现为管理者风格效应。进一步研究发现,管理者个人背景特征对高管宏观认知的管理者风格效应具有显著影响,管理者风格效应主要受管理者后天因素的影响。管理者能力与高管宏观认知的管理者风格效应显著正相关。     

An empirical study of voluntary transfer pricing disclosures in China

This paper empirically investigates the factors that affect the management’s voluntary disclosures of the transfer pricing details of related-party transactions. Using Chinese data from 2004 and 2005, we hypothesize and find that firms that make voluntary disclosures of the pricing methods of related-party transactions are negatively associated with (i) a higher level of earnings management (as captured by abnormal related-party transactions) and (ii) its underlying incentives (as captured by the management’s performance-linked bonuses and the firm’s incentives to achieve earnings targets); further, they are positively associated with (i) a higher percentage of independent directors and (ii) a higher percentage of government ownership. Overall, our findings suggest that earnings management and its incentives, board composition, and ownership structure significantly influence the voluntary disclosure decisions of managers.     

The interplay between cost accounting knowledge and presentation formats in cost-based decision-making

Most studies on cost-based decision-making examine the profit impact of cost reports that rely on different methods to allocate costs. In practice, firms’ cost reports often employ the same cost allocation method with subtle variations in the way that the cost data are presented. This paper examines experimentally the profit impact of a cost report’s presentation format in relation to a decision maker’s level of cost accounting knowledge. Using a customer profitability report prepared using activity-based costing and presented in either a tabular or a graphical format, participants analyze a complex pricing and resource allocation task that affects firm profitability. The results suggest a strong relation between presentation format and cost accounting knowledge. Specifically, decision makers with a low level of cost accounting knowledge attain higher profits when they use a graphical format in comparison to a tabular format. More surprisingly, graphs (versus tables) have an adverse effect on profits for users with a high level of cost knowledge. This result has broad implications: in order to facilitate the decisions of a variety of users of accounting data (e.g. managers, external investors, etc.), firms may need to adapt the presentation format of their accounting data to the level of accounting sophistication of the users.     

Costly Communication and Delegation in Multiple-Division Firms

This paper examines the costs and benefits of delegated decision making in a multi-division firm. The delegation versus centralization decision hinges on the trade-off between: (1) the costs of communication between divisions of the firm and the firm's headquarters under centralized decision making; and (2) gains from closer controls under centralized control. The performance of the two organizational designs are examined in a stylized principal-agent model with the firm's central management represented by the principal and two divisions of the firm by two self-interested agents. In a centralized scheme the agents report private information to the center who then sets production quotas and co-ordinates the agents' production. Under delegation, the production and co-ordination decisions are left to the agents. Central management simply rewards the agents based on observed performance. The advantages of centralization over delegation are shown to diminish when the correlation between the agents' private information approaches the polar extremes of perfect correlation and statistical independence.     

“和而不群”还是“卓尔不群”?——基于基金网络信息使用的视角

如何识别出优秀的基金管理者,理解其信息决策机制,对于优化资源配置、提升市场效率具有重要意义。本文探究了基金经理对自身所处基金网络中的共享信息的使用程度与其管理能力之间的关系。具体而言,本文通过基金的重仓持股构建了基金网络,采用基金自身交易与其所处网络中其他基金平均交易的偏离程度作为该基金对基金网络中信息使用的衡量。研究发现:(1)对基金网络中信息使用程度较低的基金的业绩要显著好于对基金网络中信息使用程度较高的基金。(2)更高的超额收益主要来源于基金经理优异的选股能力,虽由此承担了更多的异质性风险,却并未增大总体风险水平。(3)基金经理更换数据表明基金对网络内信息的使用程度更多地与基金经理特征相关而非与基金特征相关。(4)网络内信息使用程度直接反映了基金私有信息含量,因此更可能与基金经理能力相关。     

The effect of obedience pressure and authoritarianism on managers' project evaluation decisions

This study examines the effects that obedience pressure and the personality trait of authoritarianism have on managers' project evaluation decisions. A laboratory experiment was conducted to test the various hypotheses formulated in this study. The results suggest that project managers have a higher inclination to escalate their commitment to a failing project in the presence of obedience pressure. The results further reveal that project managers' tendency to escalate is most prominent in a private information situation and in an obedience pressure condition. In addition, the results suggest that low authoritarian project managers exhibited a greater tendency to continue a failing project regardless of the extent of obedience pressure under private information conditions. Furthermore, high authoritarian project managers exhibited a greater tendency to continue a failing project only when obedience pressure was present under private information conditions.