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. Management accounting textbooks and surveys discuss a variety of transfer pricing mechanisms used in practice. While the rules and procedures of these mechanisms have been described extensively in the literature, it seems to be less well understood when particular transfer pricing schemes perform relatively well. Under what circumstances would a firm prefer one particular transfer pricing scheme to another? In this paper, we conduct a performance comparison of two commonly used schemes: negotiated and cost-based transfer pricing. These two alternatives seem particularly prevalent in practice when there is no established external market for the intermediate good in question.1 Transfer pricing serves two major purposes in our model: to guide intrafirm transfers of an intermediate product and to create incentives for divisional managers to make relationshipspecific investments. Such investments can take different forms, e.g., research and development (R&D), machinery and equipment, or personnel training. In our one-period model, investments entail an upfront fixed cost and a subsequent reduction in the unit variable cost incurred by the supplying division. Alternatively, investments by the buying division may enhance net revenues obtained from internal transactions. The divisional incentive to invest will depend both on the transfer payments and the quantities that the divisions expect to trade. Earlier literature has shown that negotiated transfer pricing is prone to underinvestment.2 If the negotiated transfer price splits the total gains from trade available to the two divisions, each division receives only a share of the overall returns to its investments. But if divisions bear the full cost of their investments, a “hold-up” problem will arise such that the resulting investment decisions will be biased downward. The literature on incomplete contracts has 68 BALDENIUS, REICHELSTEIN, AND SAHAY shown that this hold-up problem can be mitigated by an initial contractual agreement.3 However, since formal contracts do not appear to be common in inter-divisional relations, we ignore the possibility of upfront contracts and effectively take the perspective that the intermediate good in question cannot be contractually specified in advance.4 In our model of cost-based transfer pricing, the supplying division issues a cost report, and the buying division decides how many units of the good it wants to purchase at that unit cost which then serves as the transfer price. Relying on standard rather than actual cost is necessary since actual unit (variable) cost becomes known only at a later stage, and even then this value will not be verifiable to a central office, e.g., a controller. A common complaint raised in connection with standard-cost transfer pricing is that the supplying division tends to exaggerate its production cost.5 In the first part of our analysis, we take this possibility to the extreme by assuming that standard cost is based on a cost calculation provided by the selling division, and that outside parties effectively cannot dispute this cost calculation. The selling division then acquires monopoly power: it sets a price and the buying division decides how many units to buy at that price. We find that negotiated transfer pricing frequently performs better than standard-cost transfer pricing. In settings where only the selling division invests, standard-cost transfer pricing avoids the hold-up problem but entails distortions in the quantities transferred due to the selling division’s monopolistic pricing. Generally, these quantity distortions outweigh the positive effect of avoiding the hold-up problem. Only when the buying division’s marginal revenue curve is sufficiently concave will the monopoly effect diminish sufficiently so as to give standard-cost transfer pricing an advantage. Our results are robust to the possibility that the selling division can exaggerate its true (expected) cost only to a limited extent. When the selling division has only limited leeway in inflating its true cost, the resulting quantity distortions become smaller, yet the selling division’s investment incentives diminish as well since it receives a smaller share of the overall contribution margin. We find that irrespective of how much leeway there is in issuing the cost report, negotiation will be preferable to cost-based pricing in settings where only the selling division invests. When only the buying division makes specific investments, cost-based transfer pricing entails a “hold-up” problem of its own: the supplying division will expropriate part of the buyer’s investment returns by adjusting its standard-cost report. This effect combined with the quantity distortions inherent in cost-based transfer pricing makes negotiation again the preferred regime when the seller has considerable leeway with its cost report. In contrast, if the selling division is not in a position to issue a standard cost which exaggerates its true expected cost by much, then standard-cost transfer pricing will shift most of the potential contribution margin to the buying division and thereby provide it with appropriate investment incentives. As a consequence, negotiated transfer pricing then becomes the inferior alternative. When both divisions make simultaneous investments, the resulting performance comparison follows the two unilateral investment settings since the investments constitute strategic complements. The present paper deviates in several respects from recent literature on transfer pricing. We confine our analysis to the relative efficiency of two transfer pricing mechanisms commonly observed in practice. In contrast, most of the recent work on transfer pricing has used the NEGOTIATED VERSUS COST-BASED TRANSFER PRICING 69 techniques of mechanism design to characterize optimal transfer pricing mechanisms.6 The mechanisms derived from this approach tend to be “centralized” in the sense that intrafirm transfers and payments are based on reports that divisions make to a central office. For the transfer pricing mechanisms considered in this paper, the central office only specifies generic rules regarding the rights and obligations of the divisions. This is also the approach taken in the earlier work of Baldenius and Reichelstein (1998) who consider a special case of the present model in which the buying division’s marginal revenue curve is linear.7 Following earlier work on incomplete contracting, we make the assumption that the divisions have imperfect but symmetric information about the relevant state variables. In contrast, informational asymmetries between the divisions have been central to many of the recent models on transfer pricing. Finally, we abstract from moral hazard and managerial compensation issues. Our analysis simply posits that division managers seek to maximize the expected income of their own divisions.8 The remainder of this paper is organized as follows. We present the basic model and the two candidate transfer pricing schemes in Section 1. Section 2 compares the performance of these two schemes for settings where, respectively, only the selling division invests, only the buying division invests, or both divisions invest. Section 3 reexamines our comparison results in a setting where the selling division faces constraints on its ability to exaggerate the true expected cost of the intermediate good. Section 4 considers extensions of the model such as two-part transfer pricing schemes. We conclude in Section 5.