A model of cost-based transfer pricing

In most decentralized organizations, goods and services are transferred between divisions. These transfers are frequently recorded in the accounting books of the divisions; the term transfer price refers to the dollar amount of the interdivisional exchange. This study considers two main issues: (i) the costs and the benefits of delegating decisions through a system of transfer pricing and divisional performance evaluation, and (ii) the performance of one common method of pricing intrafirm transactions: cost-based transfer pricing.The study analyzes a firm in which each divisional manager has better information about the divisional environment than what is known by the firm's top management. The first half of the paper demonstrates that the firm can attain the optimal level of profits with a compensation system utilizing (i) reports by divisional managers describing in complete detail each manager's private information, and (ii) divisional performance evaluation with cost-based transfer pricing. Next, a situation is considered in which divisional managers are not able to communicate their private information to the firm's top management because of complexity of divisional environments or managers' specialized expertise. In this bounded-rationality setting, a managerial-compensation system employing cost-based transfer pricing allows the firm to earn strictly higher expected profits than if all decisions are made by the firm's top management relying on divisional managers' reports.Financial support from the Unisys Corporation is gratefully acknowledged.     

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.     

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.     

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.     

Search Costs,Behavioral Biases,and Information Intermediary Effects

In many markets, buyers, sellers, and their agents have differential information about the quality of heterogeneous assets. We study negotiated transaction prices in the commercial real estate market, which is characterized by heterogeneous assets, illiquidity, and highly segmented local markets, all of which increase the importance of asymmetric information in negotiated pricing outcomes. Using 114,588 industrial, multi-family and office sale transactions that occurred during 1997–2011, we document that distant commercial real estate buyers pay, on average, premiums of 4 % to 15 % relative to local buyers, controlling for individual property characteristics as well as time fixed-effects. We also examine the extent to which the sources of these observed premiums are a product of higher search costs/information asymmetry problems associated with distance (search cost channel) or a result of reference-dependence preference/anchoring based on the price levels in the investors’ local market (behavioral biases channel). Our results suggest the observed price premiums are explained by distant investors who face higher search costs and are at an information disadvantage compared to investors located in closer proximity to the property. In contrast, anchoring plays a more muted role in explaining observed premiums. The use of an intermediary (broker) increases, on average, the acquisition prices of buyers and decreases the disposition prices of sellers by 3 % to 8 %. This result is consistent with the incentive real estate agents have to convince sellers to dispose of their properties too quickly and to convince buyers to search less and therefore pay higher prices.     

Managing price, gaining profit

The fastest and most effective way for a company to realize maximum profit is to get its pricing right. The right price can boost profit faster than increasing volume will; the wrong price can shrink it just as quickly. Yet many otherwise tough-minded managers miss out on significant profits because they shy away from pricing decisions for fear that they will alienate their customers. Worse, if management isn't controlling its pricing policies, there's a good chance that the company's clients are manipulating them to their own advantage. McKinsey & Company's Michael Marn and Robert Rosiello show managers how to gain control of the pricing puzzle and capture untapped profit potential by using two basic concepts: the pocket price waterfall and the pocket price band. The pocket price waterfall reveals how price erodes between a company's invoice figure and the actual amount paid by the customer--the transaction price. It tracks the volume purchase discounts, early payment bonuses, and frequent customer incentives that squeeze a company's profits. The pocket price band plots the range of pocket prices over which any given unit volume of a single product sells. Wide price bands are commonplace: some manufacturers' transaction prices for a given product range 60%; one fastener supplier's price band ranged up to 500%. Managers who study their pocket price waterfalls and bands can identify unnecessary discounting at the transaction level, low-performance accounts, and misplaced marketing efforts. The problems, once identified, are typically easy and inexpensive to remedy.     

Pricing and Indirect Cost Allocation — A Note

Companies that use cost-based pricing usually allocate indirect costs to their products. An inherent problem with this is that, while product prices are a function of the total cost, indirect cost allocation methods based on revenues depend on the product prices. This paper shows how to simultaneously determine unique product prices (with unequal markup rates) and cost allocations using the relative revenue method.     

Structuring International Cooperative Ventures

We examine the effect of bargaining power and informationalasymmetry on the design of international cooperative venturesin the presence of restrictions on equity participation andinvestment. When the bargaining advantage rests with the multinational,equity participation restrictions can increase the profits todomestic firms and encourage suboptimal investment policies.Overinvestment occurs when the multinational's bargaining advantageis reinforced by an informational advantage, while underinvestmentoccurs when the domestic firm possesses the informational advantage.In contrast, when the bargaining advantage rests with the domesticfirm, equity participation restrictions do not affect investmentlevels.     

Information dissemination by insiders in equilibrium

This paper generates an equilibrium explanation for partial disclosure of information by an insider to privileged associates. In our model, prices are set by competitive market makers in anticipation of trading volume, but not affected by the actual number of trades. Liquidity demand is not perfectly inelastic, but rather liquidity traders are sensitive to trading costs through a reservation price. Because profits from liquidity traders are bounded, the feasibility of an equilibrium depends on the balance between the number of associates, the precision of information and the number of liquidity traders. Partially, rather than fully, disclosing information alters this balance by limiting the informational advantage of individual associates. If the number of associates is exogenous, partial disclosure prevents market failure. If the insider chooses the number of associates, partial disclosure allows him to serve more associates but still increase total associate profits.     

Strategic transfer pricing,absorption costing,and observability

This paper analyses the use of transfer pricing as a strategic device in divisionalized firms facing duopolistic price competition. When transfer prices are observable, both firms’ headquarters will charge a transfer price above the marginal cost of the intermediate product to induce their marketing managers to behave as softer competitors in the final product market. When transfer prices are not observable, strategic transfer pricing is not an equilibrium and the optimal transfer price equals the marginal cost of the intermediate product. As a strategic alternative, however, the firms can signal the use of transfer prices above marginal cost to their competitors by a publicly observable commitment to an absorption costing system. The paper identifies conditions under which the choice of absorption costing is a dominant strategy equilibrium.     

Corporate environments and international transfer pricing: an empirical study of China in a developing economy framework

This paper investigates the international transfer pricing methods adopted by multinational corporations (MNCs) in China and how their choices are affected by their specific corporate attributes in the context of the business environment in China. Empirical test results based on structured interviews indicate that MNCs having a local (Chinese) partner in management tend to adopt market-based transfer pricing methods. The influence of local partners on the choice of transfer pricing methods is modified by the impact of the source of foreign investment, as the analysis reveals that US-sourced MNCs are more likely to use cost-based pricing methods for international transfers. The influences of these two variables on the choice of transfer pricing methods are significant both directly and interactively. There is also some evidence that export-oriented enterprises are more likely to adopt cost-based transfer pricing than those aiming at China's domestic market. By providing empirical evidence on the impact of key corporate attributes on transfer pricing which have not been studied by prior research in the context of a developing economy, this research contributes to a more comprehensive understanding of transfer pricing in developing countries.     

BORROWING RELATIONSHIPS,MONITORING, AND THE INFLUENCE ON LOAN RATES

While monitoring borrowers, a bank obtains private information about its customers, giving the bank an informational advantage in the production of subsequent services. Competing theories exist on the way banks use this advantage in the pricing of subsequent services to the customer. If moral hazard limits the transfer of private information, the borrowing relationship transforms into an informational monopoly and can be characterized as a “wasting asset.” Alternately, if the banks' competitive environment necessitates that cost economies are shared, the relationship has “value.” Ordering pairs of successive loans made to a particular borrower as prior loans and subsequent loans, and controlling for environmental, borrower, and loan characteristics, we show that the subsequent loan is priced significantly lower than the prior loan.     

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.     

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.     

Strategic default,workout, and commercial mortgage valuation

This paper extends existing equilibrium commercial mortgage pricing models by endogenizing negotiated workout into the usual noncooperative lending game. Workout is a feasible subgame strategy for the lender to play whenever foreclosure transaction costs exist for either party to a loan transaction. In particular, negotiated workout solutions Pareto dominate the foreclosure alternative when default occurs. To obtain our results, we embed a cooperative bargaining game within a noncooperative mortgage loan/default game. We also address the valuation wedge problem that occurs when foreclosure transaction costs are introduced. Through the notion of replacement game equilibrium, we find symmetric mortgage pricing solutions that eliminate the valuation wedge and thus suggest that lending will occur in commercial real estate mortgage markets even when foreclosure transaction costs exist.     

Divisional performance measurement and transfer pricing for intangible assets

This paper examines the effectiveness of three transfer pricing methodologies for an intangible asset that is developed through bilateral, sequential investment. In general, a royalty-based transfer price that can be renegotiated provides better investment incentives than either a non-negotiable royalty-based transfer price or a purely negotiated transfer price, and in some cases induces first-best investment. This result contrasts with previous research that finds that the inability to limit renegotiation of initial contracts reduces investment efficiency. Further, I examine how tax transfer pricing rules inform optimal internal transfer prices when the firm decouples internal and external transfer prices.     

Search and Wholesale Price Discrimination

Firms often choose not to post prices in wholesale markets, and buyers must incur costs to discover prices. Inspired by evidence of customized pricing (e.g., some customers pay up to 70% more than others) and search costs, I estimate a search model to study how personalized pricing impacts efficiency in a wholesale market. I find that price discrimination decreases total surplus by 11.6% and increases the sellers' profits by up to 52.1%. These effects are partially explained by price discrimination softening competition through a decrease in search incentives, illustrating how price discrimination may magnify the efficiency costs of search frictions.     

Information Pricing: The Evidence From Equity Mutual Funds

The theory of information pricing implies that the benefits from obtaining costly information should be offset by the costs. In the case of mutual funds, this theory suggests that trades by fund managers should take place at prices that compensate their clients for the managers' costs of becoming informed. This paper controls for risk, fund size, and age to assess the relationship of a fund's information costs to its performance. The findings show that stock funds charging the highest expenses generally earn returns insignificantly different from funds charging the lowest expenses. This lends support to the theory of information pricing. The findings are also indicative of an efficient market, given that information is costly.     

Learning, Cascades, and Transaction Costs

The paper analyzes the effect of transaction costs on sociallearning in an asset market with asymmetric information, sequentialtrading, and a competitive price mechanism. Both fixed and proportionaltransaction costs reduce the information content of tradingorders and lead to informational cascades. If transaction costsare very high, an informational cascade may occur not only whenbeliefs converge on a specific asset value but also when thereis extreme uncertainty about the asset's fundamental value.Finally, if the value in the bad state is sufficiently low,proportional transaction costs lead to an informational cascadeonly when prices are very high.