FINANCIAL CONTROL AND TRANSFER PRICING

Savita A. Sahay
Department of Accounting and Information Systems
Rutgers Business School
Rutgers University
Janice Levin Building, Piscataay, !J "##$%
&'mail( savita)sahay*+usiness)rutgers)edu
,el( #%# %%$ -$%"
.a/(
Abstract
,his paper intends to e/plore transfer pricing and some popular transfer
pricing methods) Since transfer prices are used to assess the incomes of the
firm0s divisions, choice of a transfer pricing policy can influence many
important operational and strategic decisions, such as capital and resource
allocation, volume and efficiency of production, performance evaluation as
ell as ta/ planning)
1e use a descriptive method to study and compare the most popular transfer
pricing policies used in American industry and find that many transfer
pricing policies may lead to su+'optimal decisions and conflicts ithin the
company +ecause of the incentives they create for managers)
.or the purpose of optimal decision ma2ing in a multi divisional form,
Actual cost'+ased transfer pricing ith an additive mar2up has +een shon
to dominate an entire class of alternative policies) In multinational
corporations, there is an incentive to reduce the overall income ta/ +urden
+y charging higher prices to units located in countries ith high ta/ rates)
,his paper also e/plores the economic incentives for the use of a particular
transfer pricing policy +y multinational companies)
Keywords: ,ransfer pricing, divisional performance evaluation,
comparison, optimal, popular methods, ta/ planning)
Contents
FINANCIAL CONTROL AND TRANSFER PRICING .......................................................... 1
SAVITA A. SAHAY.............................................................................................................................1
ABSTRACT......................................................................................................................................... 2
1. INTRODUCTION .................................................................................................................... 4
2. DESIGNING RESPONSIBILITY CENTERS ........................................................................ 5
2.1 COST CENTERS....................................................................................................................6
2.2 REVENUE CENTERS ..........................................................................................................7
2.3 PROFIT CENTERS ..............................................................................................................7
2.4 INVESTMENT CENTERS .................................................................................................8
3. TRANSFER PRICING ........................................................................................................... 10
3.1 TRANSFER PRICING METHODS...................................................................................11
4. SOME THEORETICAL MODELS OF TRANSFER PRICING ........................................ 1
5. OPTIMAL TRANSFER PRICE ............................................................................................ 20
6. INTERNATIONAL TRANSFER PRICING ....................................................................... 23
7. LIMITATIONS OF FINANCIAL CONTROL SYSTEMS ................................................. 25
8. CONCLUSION ....................................................................................................................... 27
3
1. Introduction
In decentrali4ed firms, a transfer price is usually assessed for internal
transactions in hich one division of the firm provides an intermediate
product or service to another) ,he transfer price appears in the income
statement of the selling division as part of its revenue, and in that of the
+uying division as part of its cost) Since managers are typically evaluated
and compensated +ased on the reported income of their divisions, the
method used for setting transfer prices directly influences the decisions
delegated to them) ,his ma2es transfer pricing policy 5henceforth ,P6 an
important tool in the hands of upper management for coordinating
autonomous su+ordinate divisions) Additionally, the choice of ,P policy is
an important one for high'level management since ,P is related to many
other operational and strategic processes ithin the firm
3
)
1hile the choice of a transfer pricing policy is important and contentious, it
is a fascinating and curious phenomenon) Activities ithin an organi4ation
are clearly non'mar2et in nature' products and services are not +ought and
sold as they are in mar2et transactions) 7et, esta+lishing prices for transfers
among su+units of an organi4ation has a distinct mar2et flavor) ,he rationale
for transfer prices is that su+unit managers, hen evaluating decisions, need
only focus on ho their actions ill affect su+unit performance ithout
orrying a+out their impact on companyide performance) In a ell
functioning transfer pricing system, optimi4ing su+unit performance leads to
optimi4ing the performance of the organi4ation as a hole)
,he ,ransfer Pricing 5,P6 pro+lem +ecomes even more comple/ hen a
company has multiple divisions or su+sidiaries operating in different
countries that have different ta/ rates, tariff and import duties, currency and
foreign e/change restrictions) In multinational corporations, there is an
incentive to reduce the overall income ta/ +urden +y minimi4ing profits in
the higher ta/ countries and ma/imi4ing profits here the ta/ rates are
loer)
3
,hese include ta/ planning, capital and other resource allocation, costing, decentrali4ed co'ordination
and control as ell as performance evaluation, and formulation of integration and diversification policy)
Since large multi divisional firms delegate many decisions to the divisional
managers, designing a financial control systems that ould
coordinate the decisions throughout an organi4ation and ill guide the
+ehavior of its employees is an important tas2) ,o +e effective, financial
control systems should reflect an organi4ation0s strategies and goals) Since
an organi4ation0s ma8or goal is to earn a satisfactory profit, the control
systems put in place must ensure that the goals of the organi4ation are
consistent ith the goals of its individual mem+ers 5the goal congruence
o+8ective6) 9anagers and other employees of the company are individuals
ho might have personal goals, often in contrast ith organi4ational goal)
.or e/ample, a company ould prefer an employee to e/ert ma/imum effort
toards achieving a goal, hile the employee might prefer to or2 as little
as necessary to 2eep his 8o+) 9anagement control systems must motivate
managers and other employees to e/ert ma/imum effort through a variety of
monetary 5cash, company shares, vacations6 and nonmonetary 5promotion,
pride in or2ing for a successful company6 reards)
In this chapter, e ill try to understand ho a corporation0s senior
e/ecutives design and implement the financial control systems that are used
to plan and control the firm0s performance) Although there are many aspects
of financial control, such as strategic planning, +udgeting, performance
measurement, responsi+ility center allocation and transfer pricing, e ill
restrict our attention to the to most important aspects of financial control(
3) Design of responsi+ility centers
:) Selection of an appropriate transfer pricing methodology)
2. Designing Responsibility Centers
A desira+le feature of financial control systems is that they should +e
designed to reflect the decision'ma2ing responsi+ility of individual
managers) ,his necessitates assigning financial responsi+ility 5in terms of
costs, revenues, profits and assets6 to organi4ation su+units) ,hese su+units
are called Responsibility Centers 5R;6. A responsi+ility center is an
organi4ation su+unit that is headed +y a manager ho is responsi+le for its
activities) Since the managers< compensation is often dependent on the
financial performance of the division, managers are automatically motivated
to ma/imi4e the difference +eteen its inputs and outputs) Since a company
is a collection of responsi+ility centers, if each center earns a satisfactory
profit, the company as a hole ill earn satisfactory profit, a ma8or
o+8ective of any profit' oriented organi4ation) In this sense, .inancial
;ontrol measures ho ell a company or a R; or any department controls
its cost and ma/imi4es its profits)
,he core operation of any R; involves receiving inputs in the form of
material, la+or and services, and transforming them into outputs, either
tangi+le 5i)e) goods6 or intangi+le 5i)e) services6) ,he products produced +y a
R; may +e transferred either to another R;, here they are inputs, or to the
outside mar2etplace, here they are outputs of the organi4ation, and earn a
revenue) ,o measure their performance, the company may use one of the
four types of R;s(
2.1 COST CENTERS
A division is esta+lished as a cost center henever central management can
measure the output, 2nos the cost function and can set the appropriate
=uantity of output) ;ost center managers are given the authority to determine
the mi/ of inputs 5La+or, materials and outside services6 and they are
evaluated +ased on their efficiency in applying inputs to produce outputs)
Since they do not sell their product or services themselves, they are not
evaluated on profits or revenues)
;ost centers are typically manufacturing departments hich are as2ed to
produce a =uantity level determined +y top management and are either
responsi+le for minimi4ing cost for a given output or to ma/imi4e output for
a given +udget)
Since the cost center manager is typically evaluated +ased on minimi4ing
costs, he has the incentive to loer the costs +y loering =uality of inputs
resulting in a possi+le reduction in the =uality of the final part or output)
,herefore the =uality of products manufactured in a cost center must +e
carefully monitored)
In cases here cost center managers are alloed to choose the level of
output, they have the incentive to choose the output level at hich the
center0s average costs are minimi4ed, hich may not +e the optimal
production level 5Usually the level at hich marginal costs are minimi4ed6
for the company0s profits) 9oreover, cost center managers have an incentive
to over'report costs so that they can either poc2et the slac2 or e/ert minimal
effort in reducing costs)
,hus, cost centers are ideal for situations here the central management
determines the output level, has a good idea of the division0s cost function,
can o+serve the =uality of the output and can set the appropriate reards)
2.2 REVENUE CENTERS
In a revenue center, output is measured in monetary terms +ut the e/penses
are typically not matched ith revenue) Revenue centers are usually
mar2eting divisions that do not have the authority to set selling prices and
are evaluated against target revenues or +udgets) A center that is responsi+le
for +oth e/penses and revenues is called a profit center)
2.3 PROFIT CENTERS
Profit centers are divisions responsi+le for +oth the revenues and the costs
and are typically evaluated +ased on their efficiency in applying inputs to
produce outputs) Profit centers are set up hen the 2noledge re=uired to
ma2e the product is firm specific, the internal decisions regarding =uantity,
=uality and pricing of the output are proprietary information, costly to
transfer outside the division)
Since profit center managers are responsi+le for ma/imi4ing the division0s
profits, rearding them ith a portion of their divisional income seems
straightforard) >oever, there are a large num+er of profit centers that
produce an intermediate product, to +e transferred ithin the company) As
e ill see later, companies often use a ,ransfer Price to evaluate these
transactions) ,he choice of an inappropriate transfer pricing method can lead
to su+optimal =uantity, =uality or input mi/ decisions +y the profit center
manager)
A second pro+lem arises hen company0s overhead costs are to +e allocated
to these +usiness units) ,he allocation of corporate overhead costs is often
ar+itrary and is under constant de+ate +ecause it reduces the total profit of
the center)
As a result, profit ma/imi4ation +y an individual profit center may not
ma/imi4e profits for the firm as a hole due to inter dependencies among
different centers) .or e/ample, a profit center using resources to advertise its
product might hurt the sales of another product +y the same company,
leading to overall lesser profit for the firm as a hole)
,o help managers internali4e the effect of their decisions on the company as
a hole and other profit centers, profit center managers are often
compensated +ased on their on as ell as firm ide profits)
2.4 INVESTMENT CENTERS
Investment centers are similar to profit centers e/cept that they have
additional authority to ta2e capital investment decisions) ,hey are typically
evaluated on measures such as return on investment or residual income)
Investment centers are esta+lished hen the manager has specific 2noledge
a+out investment opportunities and possesses information specific to the
operating decisions) An investment center may have many profit centers and
cost centers inside it)
.!." Ret#rn on In$est%ent &ROI'
Return on Investment 5R?I6 is used +y a large ma8ority of US firms as a
method of compensating investment center managers) It is the ratio of
operating net income divided +y the total investment made in the center) ,he
method has intuitive appeal +ecause it compares the center0s performance
automatically ith other centers and ith other industry +enchmar2s)
>oever, R?I creates incentives for su+'optimal decision'ma2ing +y the
center manager, hurting the company0s overall profit or =uality or reputation
or long term prosperity) .or e/ample, the manager may try to increase
operating income +y decreasing depreciation, research and development and
other discretionary e/penses) >e may try to artificially increase the revenue
5>ence inflate the income, the numerator in the e=uation6 +y a practice
2non as ;hannel Stuffing, in hich managers ill supply the product
around the year'end to customers, even though they neither ordered nor need
them
:
) ,his action may record additional revenue at the year end for the
investment center, +ut it ill lead to returned goods costing money and
reputation)
:
See @ Blind Am+itionA in Business 1ee2, ?ct) :-, 3BB$, pp) C#'B:) According to Business 1ee2 article on Bausch
and Lom+ AUnder pressure to +eat sales target in 3BB-, contact lens managers shipped products that doctors never
ordered hile assuring them that they ouldn0t have to pay until they sold the lensesA)
Additionally, total value of investments used in the denominator of the R?I
calculation is also su+8ect to gaming +ehavior +y the center managers) Since
Accounting rules dictate that companies anticipate all losses +ut cannot
record any gain in mar2et value, the mar2et value of the asset value in the
denominator is not really a correct measure of the center0s investment) In
fact, managers have +een 2non to sell company0s fleet of cars and other
assets in the last =uarter to 2eep the denominator as small as possi+le)
.inally, use of R?I as the sole method for performance evaluation can lead
to other dysfunctional decisions +y the center managers) .or e/ample,
Investment center managers have incentives to re8ect profita+le pro8ects
hose R?I are +elo the current average R?I for the division +ecause
accepting any such pro8ect ould loer the overall R?I of the division) If
the firm is in an industry here the initial pro8ects earns a really high R?I,
then managers ill continue to search for such high'return pro8ectsD re8ecting
everything meanhile)
Another disincentive created +y R?I is the managers0 reluctance to ta2e
high'ris2 pro8ects) Since high'ris2 pro8ects have a higher cost of capital and
also a higher pro+a+ility of failing, managers ould not li2e any additional
ris2 imposed on them) Also, a manager ith a short'term hori4on may pic2
pro8ects that +oost R?I in the short run even though they incur huge long'
term costs)
.!. Resid#(l in)o%e &RI'
,o address some of the concerns related to R?I, some companies use
residual income to evaluate performance) Resid#(l in)o%e 5RI6 measures
the @a+normal returnsA earned +y the division) ,herefore a normal rate of
return, measured either +y the cost of capital or a re=uired rate of return for
the center) Is su+tracted from division0s profits) Under the residual income
approach, manager has incentive to select the pro8ect as long as the residual
income is positive, hich simply means that the divisional profit rates are
higher than the re=uired rate of return)
>oever, RI has some pro+lems of its on) ;omparing RIs across divisions
is difficult since larger divisions are more li2ely to have higher RI than
smaller divisions, since RI is an a+solute num+er)
9oreover, re=uired rate of return is li2ely to +e different for each division,
depending on the ris2iness and comple/ity of the pro8ect, ma2ing it to +e a
popular source of conflict in firms) .inally, RI suffers from the same
pro+lems as R?I, hen it comes to the managers ith short term hori4on'
,hey may try to increase short term RI +y cutting on e/penses li2e
maintenance, 8eopardi4ing future firm value and cash flos)
3. Transfer Pricing
,ransfer price is a price paid +y one division of a firm to another division for
some goods and services they may e/change) ,he transfer price appears as
revenue in the +oo2s of the supplying division and as cost in the +oo2s of
the +uying division) Since divisional managers care a+out their divisional
income, choice of a transfer pricing policy can +e an important tool in the
hands of the upper management to control and influence the decisions of the
managers) As a general rule, the transfer price policy should +e designed to
accomplish the folloing o+8ectives(
3) It should induce goal congruent decisions' that is, the system should
+e designed so that decisions that improve the division0s profits ill
also improve company profits)
:) It should help measure the economic performance of the division)
-) It should provide each division ith the information it needs to ta2e
+etter decisions)
%) It should +e simple to understand and easy to implement)
$) ,a/ considerations and other o+8ectives in International mar2ets)
,he variety of ,P policies in common use
-
in American industry suggests
that no single ,P policy can +e e/pected to +e optimal for all firms) ,he
structure of the firm and features of its environment are li2ely to determine if
one policy is +etter for it than others)
,he fundamental issue is that the transfer price should +e similar to the price
that ould +e charged if the product ere sold to outsiders or purchased
from outsiders, correcting for the savings in mar2eting and other transaction
costs) ,he rule is complicated to use in situations hen no outside mar2et
e/ists for the e/act same goods 5.or e/ample, an engine produced for a
sports car of a specific +rand6 or the product is hard to specify in the
+eginning 5.or e/ample, a large computer program6)
-
In ,ang0s 53BB:6 survey of .ortune $"" companies, there is evidence of companies using negotiated transfer pricing,
mar2et +ased transfer pricing as ell as several variations of cost +ased transfer pricing)
3.1 TRANSFER PRICING METHODS
,here are three methods commonly used to determine transfer prices) 1e
ill sho ho the choice of transfer pricing method can affect the
companyide operating income as ell as lead to su+optimal decision
ma2ing +y divisional managers'Su+optimal in the sense that they may
ma/imi4e the division0s income +ut may hurt the overall company profits)
,ransfer prices can vary from very simple to very comple/, depending on
the nature of the product) Let0s start ith the simplest first(
3.1.1 MARKT !A"D TRA#"$R PRIC"
Since mar2et +ased transfer price ill +est simulate a competitive
environment ithin the firm, a mar2et +ased transfer price is +est to use
hen there is a mar2et price availa+le reflecting the same =uantity, =uality
and other features as the product +eing transferred) ,he argument is that if
the firm cannot ma2e a profit at the mar2et price, then the company is +etter
off not producing it and purchasing it from outside) By using a mar2et price
in a competitive mar2et, a company can not only ta2e the correct ma2e or
+uy decisions, it can also achieve almost all the o+8ectives of a transfer
pricing policy( goal congruence, measurement of manager0s effort,
division0s autonomy, simplicity as ell as performance evaluation) It is also
li2ely to lead to minimum conflicts since most parties ill consider mar2et'
+ased price to +e fair)
A mar2et price for a similar product is often used in the a+sence of an
identical product) ;onflict is li2ely to set in hen the ad8ustment to the
e/ternal price is made to reflect the true opportunity cost of the product to
the firm) ,here are several reasons for this conflict) .irstly, internal
transactions are usually cheaper than outsourcing due to synergies or
interdependencies among products, reduced transportation costs, reduced
mar2eting and administrative costs and reduced costs of +ad de+ts) 9a2ing
an ad8ustment to the mar2et price to reflect all these savings is li2ely to +e
ar+itrary) Secondly, even if the monetary costs are the same, firms are more
li2ely to prefer to produce internally due to greater =uality control, timely
supply or greater control of proprietary information) 1hen all these factors
are included in the ad8ustment to the e/ternal price, the resulting transfer
price may not seem fair to all)

,herefore, the ideal situation to implement a mar2et +ased transfer price
ould +e one here the managers are free to +uy and sell in the outside
mar2et if it is in their +est interest) If +uyers cannot get a satisfactory price
from the inside source, they are free to +uy from outside) Similarly, if the
seller can get a +etter price +y selling it outside, it should +e alloed to do
so) In these circumstances, transfer price ill represent e/actly the
opportunity cost to the seller of selling the product inside and lead to goal
congruent decisions)
3.1.2 C%"T !A"D TRA#"$R PRIC"
If there is no e/ternal mar2et for the intermediate good, then a transfer price
+ased on some measure of cost may +e considered)
3.1.3 &ARIA!' C%"T TRA#"$R PRIC"
Since the goal is to set a transfer price that reflects the true opportunity cost
to the firm, varia+le production cost may +e the most effective transfer price)
Earia+le costs also receive support from economists since they are
considered to +e closest to marginal costs, the method of choice for
&conomists) ,he case for marginal cost is that that if the transfer price is
higher than the marginal cost, the supplying division ould li2e to sell more
than the optimal =uantity and the +uying division ould li2e to +uy less than
the optimal =uantity, leading to su+optimal production decisions)
>oever, transfer pricing at marginal cost has +een critici4ed +y some
e/perts) &ccles 53B#$, ::6 notes that transfer pricing ithout regard to fi/ed
costs, overhead and profit for the selling division leads to an unfair measure
of its contri+ution to the company) ,his criticism addresses the fact that the
manufacturing division does not recover its fi/ed costs) ,hus, the division
ould appear to +e losing money)
A related pro+lem ith varia+le cost transfer pricing is that it creates
incentives for the manufacturing division to distort varia+le cost upard,
perhaps +y misstating some fi/ed costs as varia+le costs) Since cost
classifications for many costs are to some e/tent ar+itrary, serious conflicts
ithin the firm can arise)
Lastly, manufacturing division has the incentive to try to convert some of its
fi/ed costs into varia+le costs, simply to get reim+ursement, even though
this conversion may +e costly to the firm as a hole) .or e/ample, the
division might choose to hire a costly consultant instead of hiring an
employee or lease an asset instead of +uying it to 2eep varia+le costs high
and fi/ed costs lo, since it gets reim+ursed for the varia+le costs +ut not for
the fi/ed costs)
,here are several variations of varia+le costs to consider as transfer prices(
3.1.( "TA#DARD &ARIA!' C%"T TRA#"$R PRIC"
A standard cost is a carefully determined cost of a unit of output) It may also
represent the future cost of a product, process or su+component) Standard
costs usually arise from the +udgeting process of the company and represent
the e/pected cost that ill +e used as a +enchmar2 to compare ith actual
operating costs for performance evaluation purposes)
Standard costs are useful for +oth decision'ma2ing and control) Since,
standard costs are 2non to all ell +efore the actual varia+le costs +ecome
2non, division managers have incentives to 2eep actual costs don, ithin
the standards prescri+ed or their performance ill suffer) Also using
standard costs as +enchmar2 allos top management to use deviations
+eteen actual costs and standard cost 5Eariance analysis6 effectively for
cost control and improvement in future performance) Lastly, since actual
costs may vary from one +atch to another, using standard costs are easier on
the accounting system)
>oever, standard costs have +een critici4ed for many reasons) .irst,
depending on the philosophy of top management, standard costs may mean
something that is currently achieva+le or something that can +e achieved
ith a+normal effort or luc2) ,oo tight a standard might discourage the
supplying division, hile too loose a standard might not encourage
ma/imum possi+le effort)
Second, most firms are reluctant to change standards during the year and
often thereafter, unless a large, une/pected change occurs in a standard)
Fnoing the relative rigidity of the standards encourages su+optimal
strategic +ehavior from the divisional manager) .or e/ample, manufacturing
division managers, ho are often involved in setting of standards, may
overstate costs and 2eep a @slac2A hich they can consume, in form of loer
effort, throughout the year) ?n the other hand, if standards are revised
fre=uently during the year, divisional managers have less incentive to
control costs) ,herefore the decision to revise standards often involves the
trade'off +eteen loose standards and tight standards) &ach of them can +e a
source of conflict +eteen trading parties)
3.1.) ACT*A' &ARIA!' C%"T TRA#"$R PRIC"
A common method for arriving at the transfer price is to use the actual cost
of production of the transferred product) A transfer pricing policy +ased on
actual cost is usually easy to implement) It is also attractive from an internal
accounting perspective since it generates an income statement that
eliminates intra'company profits)
It is usually said that transfer prices +ased on actual costs provide no
incentive to the supplying division to control costs, since the supplier is
reim+ursed for his costs) Also, since actual costs may vary from one +atch to
another, 2eeping trac2 of +atch costs and inventory may +e hard for the
accounting system) Another pro+lem ith actual cost +ased approach can
arise in firms here operations are capacity constrained) 1hen a firm is
operating at capacity, production decision should optimi4e the use of the
capacity rather than individual product0s profit margin) In such cases, actual
cost +ase transfer price ill lead to a su+optimal =uantity decision) In firms
operating at full capacity, transfer price should instead +e the sum of
marginal costs and the opportunity cost of capacity, hich ould +e the
profit of the +est alternative use of the capacity)
Because of the incentive and information pro+lems descri+ed a+ove, a
commonly used variation of varia+le cost transfer pricing is to price all
transfers at a )ost pl#s %(r*+#p) ,he mar2'up may +e in the form of a fi/ed
fee to cover manufacturing division0s fi/ed cost) Some firms choose a fi/ed
fee to cover fi/ed cost plus a return on e=uity)
,he most ell 2non e/ample of a mar2up is the multiplicative mar2up, in
hich the unit transfer price is determined +y multiplying a cost measure +y
a fi/ed factor) .or e/ample, it might +e set e=ual to 3:" percent of the cost)
9any accounting te/t+oo2s use the multiplicative method to illustrate the
character of cost'plus transfer pricing)
An alternative to the multiplicative method is the additive markup, in hich
the unit transfer price is set at a fi/ed dollar amount over cost 5e)g), the
varia+le cost plus G$)6 &vidence for the use of such methods appears in a
survey of .ortune $"" companies conducted +y Price 1aterhouse) ,he
survey revealed that a+out %$ percent of all companies use an approach that
@does not rely on percentage calculationsA 5Price 1aterhouse 3B#%,3-6)
Instead, @the cost and mar2up are maintained as to pieces of information
and intra'firm profit is determined +y adding up the mar2ups)
&fforts to compare different transfer pricing methods sho that additive
mar2up is optimal among the class of cost'plus methods
%
) ,he argument is
that additive mar2ups are not only convenient to 2eep separate trac2 of costs
and profits, they also motivate the manufacturing division to reduce the cost
so that it can ma/imi4e the num+er of units transferred 5>ence the amount of
mar2'up earned6) In contrast, under a multiplicative mar2'up, the
manufacturing division0s income 59ar2'up6 is proportional to the production
cost) >ence, the division is more interested in increasing the cost, and the
resulting mar2'up, than transferring the optimal =uantity)
3.1.+ $*'' C%"T TRA#"$R PRIC"
Since most transfer pricing methods discussed so far suffer from some
incentive pro+lem or accounting complication, one alternative is to use a
simple and o+8ective transfer'pricing rule that ill avoid asteful disputes
and ar+itration costs) Since full cost is the sum of fi/ed and varia+le cost, it
is easily availa+le in the accounting system and cannot +e changed +y
reclassifying a fi/ed cost as varia+le cost)
Another reason for the popularity of full cost transfer pricing is its a+ility to
deal ith the pro+lem of changes in capacity) As a plant +egins to reach
capacity, opportunity cost to produce one more unit is li2ely to rise higher
than varia+le costs) In such cases, full cost might +e a closer appro/imation
to opportunity cost than varia+le cost)
,he incentive pro+lem that most cost +ased systems suffer from is also
present here',hey provide no incentive to the manufacturing division to
control costs, since the costs can alays +e recovered via transfer price) In
%
See Sahay 5:""-, 3$6
fact, full cost method allos manufacturing division to transfer all of its
inefficiencies to the +uying division)
.rom optimality standpoint, the pro+lem ith full cost transfer pricing is that
the =uantity traded ill alays +e su+optimal) Since full cost overstates the
opportunity cost of producing and transferring one more unit internally,
manufacturing division ould li2e to produce and transfer more units hile
the +uying division ould li2e to +uy too fe a units)
Despite all of these pro+lems, full cost transfer pricing appears to +e very
common in practice) Perhaps the reason for its popularity is its simplicity
and lo cost of implementation) Scant theoretical research also suggests that
ith an appropriately chosen mar2up, the performance of actual cost +ased
transfer pricing can +e significantly improved, even though the mar2up leads
to su+optimal resource allocation decision ithin the firm
$
) ,his result is
consistent ith the conventional isdom of the accounting profession that
8udicious use of transfer pricing in a decentrali4ed firm must trade off
pricing efficiency ith effective incentives for divisional decision ma2ing
that ould further the long term interests of the firm) &mpirical evidence
also suggests that firms that use cost +ased transfer pricing are ell aare of
its incentive pro+lems, a vast ma8ority of them choosing to price transfers
a+ove incremental production costs) 5See Price 1aterhouse 53B#%6 survey
and ,ang 53BB:6 survey6
3.1., #-%TIATD TRA#"$R PRIC"
Several surveys of transfer pricing practices among large, decentrali4ed
firms document the use of negotiated transfer pricing policies) Such a policy
lets divisional managers negotiate all aspects of an intra'firm transaction,
including its price) Since divisional managers have superior local
information, minimum interference from upper management in the trading
decision enhances the Hfle/i+ility gain0 associated ith decentrali4ation) In
particular, if the divisions have symmetric information, negotiated transfer
pricing is li2ely to lead to efficient intra'firm trade( the divisions ill choose
to ma/imi4e the 8oint contri+ution margin, negotiations +eing limited to ho
this margin ill +e shared)
$
See Sahay 5:""-, 3$6
1hile negotiation is a fairly common method, it too has dra+ac2s) .irstly,
divisional performance +ecomes sensitive to the relative negotiating s2ills of
the to divisional managers) 9oreover, if the supplying division manages to
negotiate a price higher than the optimal price, implying that the receiving
division ill get loer than the optimal price, the =uantity traded ill +e less
than optimal, leading to loer firm'ide profits)
Secondly, negotiated transfer pricing can produce conflicts among divisions,
leading to time and resource consuming ar+itrations)
.inally, It is ell 2non that negotiated transfer pricing suffers from under'
investment due to the Hhold'up0 pro+lem) ,his pro+lem has received much
attention in the literature on incomplete contracts 5see, for e/ample,
1illiamson 53B#$66 and occurs hen the parties to a trade have the
opportunity to ma2e specific investments +efore the date on hich they
negotiate a price for the traded good) In such a setting, the investment costs
must +e considered Hsun20 hen negotiating the price since they ould have
to +e +orne even if negotiations ere to fail) ,hus, the parties ill +e
reluctant to incur any costs ex ante, and investments ill +e Hheld up)0
&dlin and Reichelstein 53BB$6 sho that the hold'up pro+lem associated
ith negotiated transfer pricing may +e eliminated if the parties are alloed
to sign a contract +efore the investments are chosen)
I
In essence, this prior
contract 5hich serves as the status quo, should su+se=uent negotiations fail6
provides protection for the costly investments) >oever, as argued +y
>olmstrom and ,irole 53BB36 inter'divisional transactions in a large firm are
governed +y incomplete contracts that are impossi+le to enforce, ma2ing the
hold'up pro+lem unavoida+le)
C
,he discussion a+ove suggests that no single ,P policy can +e e/pected to
+e optimal for all firms) ,he structure of the firm and features of its
environment are li2ely to determine if one policy is +etter for it than others)
It is somehat surprising, therefore, that there has +een little theoretical
research on the comparison of alternative ,P practices or on the setting up of
general guidelines +ased on economic principles that can help a firm in its
,P policy'ma2ing) Part of the reason for this state of affairs is that it is
e/tremely difficult to address the ,P pro+lem ithout touching upon a host
of other pro+lems to some degreeD a theory of ,P is really part of a deeper
I
;hung 53BB36 derives a similar efficiency result, also using a prior contract)
C
See also the &/ecutive Summary of the Price 1aterhouse 53B#%6 survey hich reports( @9ost companies 5C:
percent6 state that they do not use formal contracts to document internal +uyJsell agreementsA 5p) ii)6
theory of decentrali4ation)
#
Another reason is the very variety of corporate
,P practice hich ma2es the pro+lem important and interesting( it is
difficult to analy4e various methods of administered and negotiated ,P
B
in a
single theoretical model, in order to e/tract principles that can +e generally
applica+le)
A fe efforts in theoretical research have +een made to produce a systematic
study of the policies governing intra'firm transactions in a large, multi'
divisional firm) ,he purpose of this research is to produce a systematic study
of the policies governing intra'firm transactions in a large, multi'divisional
firm) ,he results point toards emergence of a theory that addresses
=uestions as to hich ,P policy is +est for a given firm) .indings suggest
that firms should +e cautious in putting a particular ,P policy in place, since
the choice of the policy could significantly affect firm0s profits, volume and
efficiency of production and managers0 incentives in ta2ing other decisions
important to the firm) In general, several economic factors have +een
identified that ma2e one ,P policy prefera+le to other) ,hese economic
factors include revenue and cost characteristics of the intermediate product
transferred, the num+er of products, the price elasticity and the level of
competitiveness of the e/ternal mar2et faced +y the firm)
In one of the first papers 5BRS BB6, a comparison of negotiated transfer
pricing 5!,P6 and standard cost'+ased transfer pricing 5S;,P6 reveals
general superiority of !,P) In a second paper 5Sahay "36 I sho that the
performance of actual cost'+ased transfer pricing ith an additive mar2up is
superior to any other cost'+ased policy in its class) Specifically, the actual
cost'+ased method is shon to outperform several cost'+ased transfer
pricing schemes, including S;,P) Sahay 5:""$, 1or2ing paper6 attempts to
complete the ran2ing, shoing the superiority of actual cost'+ased transfer
pricing over negotiated transfer pricing, as long as the +uying division0s
investment is sufficiently important)
#
See >olmstrom and ,irole 53BB36 for an ela+orate discussion of this point and for a model that endogeni4es the need
for transfer pricing in a more general study of possi+le decentrali4ed forms) In this paper, hoever, e ta2e transfer
pricing as a control mechanism already in place in the firm)
B
,he literature classifies ,P policies as administered 5here most rules are laid don +y head=uarters6 or negotiated
5here participating divisions formulate their on rules)6 Administered ,P is either cost'+ased or market'+ased
hile negotiated ,P often uses cost or mar2et price as a starting point for negotiations) See the surveys of &ccles
and 1hite 53B##6 and Price 1aterhouse 53B#%6 for more details)
(. "%M T.%RTICA' M%D'" %$ TRA#"$R
PRICI#-
,here is a considera+le +ody of research availa+le on theoretical transfer
pricing models) >oever, only a fe of these models are used in actual
+usiness situations) Although these models are not directly applica+le to the
real +usiness situations, they are useful in conceptuali4ing transfer pricing
systems) ,hese models may +roadly +e divided into three types(
3) 9odels +ased on economic theory,
:) 9odels +ased on linear programming, and
-) 9odels +ased on Shapley value)
(.1 C%#%MIC M%D'"
,he classic economic model as first descri+ed +y >irschleifer
3"
as a series
of marginal revenue, marginal cost and demand curves for the transfer of an
intermediate good from one division to another) >e used these curves to
esta+lish transfer prices that ould optimi4e the total profit of the to
+usiness units)
,he difficulty ith this model is that it can +e used only hen a specifies set
of conditions e/ists( It must +e possi+le to estimate the demand curve of the
product, there can +e no alternative use of facilities used to ma2e the
intermediate good and the selling unit ma2es only one product hich it
transfers to a single +uying unit) Such conditions are rarely met in the real
orld)
,his model 5and other economic models6 assumes that transfer prices ill +e
dictated +y central management) It, therefore, denies the importance and
+enefits of negotiation among trading units) As a result, using the model
may lead to delayed and dysfunctional decision ma2ing since negotiation
+eteen divisions leads to +etter decisions regarding price and =uantity)
(.2 'I#AR PR%-RMMI#- M%D'"
,he linear programming model is +ased on an opportunity cost approach)
,he model calculates an optimal production pattern for the firm and uses this
production pattern to calculate a set of values that impute the profit
contri+utions of each of the scarce resources) ,hese are called shadow
3"
Jac2 >irschleifer, @?n the economics of ,ransfer Pricing,A Journal of Business, July 3B$I, pp) 3C:'#%)
prices and one ay of calculating them is called @o+taining the dual
solutionA to the linear program) If the varia+le costs of the intermediate good
are added to their shado prices, a set of transfer prices results that should
motivate divisions to ta2e optimal production decision for the firm) ,his is
so +ecause, if these transfer prices are used, each +usiness unit ill optimi4e
its profits +y producing in accordance ith the patterns developed through
the linear program)
If relia+le shado prices could +e calculated, this model ould +e useful in
arriving at the transfer prices) >oever, many simplifying assumptions are
needed to ma2e the model or2) Some of these assumptions are that the
demand curve is 2non, that it is static, that the cost function is linear and
that the incremental profits from alternative use of factory can +e estimated
in advance) It is hard to meet these assumptions in the real orld)
(.3 ".AP'/ &A'*
Shapely value as developed in 3B$- +y L) S) Shapley as a method of
dividing the profits of a coalition of individuals in proportion to each
individual0s contri+ution) It is used commonly in the theory of games as the
most e=uita+le solution to this pro+lem)
1hether the same techni=ue can +e applied in transfer pricing is a de+ata+le
issue) Although the techni=ue has +een around for many years, fe practical
applications have +een reported) A possi+le reason for its lac2 of popularity
could +e the comple/ity of computation unless there are only a fe products
involved in the transfer) Another reason is the general +elief that the Shapley
method is not valid for solving the transfer'pricing pro+lem)
). %PTIMA' TRA#"$R PRIC
Although no general rule alays meets the goal of choosing the +est transfer
pricing policy, some guidelines and +oundaries can +e esta+lished(
,." -INI-.- TRANSFER PRICE
,he minimum transfer price accepta+le to the selling division is clearly the
varia+le unit cost of the product) Since, fi/ed costs are considered to +e sun2
costs, selling division ould +e interested in trading as long as its out of
poc2et costs are covered)
,his is true, hoever, if the selling division has sufficient capacity to
produce the entire order and ould not have to give up some of its regular
sales) In cases here capacity constraints force the division to either transfer
an item internally or sell it e/ternally' that is, it cannot produce enough to do
+oth, then the selling division ould e/pect to +e compensated for the
contri+ution margin on those lost sales) In general, if the transfer has no
effect on fi/ed costs, then from the selling division0s standpoint, the transfer
price must cover +oth the varia+le cost of producing the transferred units and
any opportunity costs from lost sales)
.rom the firm0s standpoint, transfer is desira+le if 536 the total cost of
producing the good 5+y +oth divisions6 is less than the price it can receive
for the good in the outside mar2et and 5:6 it does not pay more to produce
the good internally than it ould have to pay to +uy it in the mar2etplace)
,he only transfer price that ould achieve +oth these o+8ectives for the firm
is the formula suggested +elo(
9inimum ,ransfer Price KSeller0s varia+le cost Lopportunity cost)
,. -A/I-.- TRANSFER PRICE
.rom the +uying division0s perspective, the trade is +eneficial only if its
profit increases) .or that, it must +e a+le to sell the final product for more
than the transfer price plus other costs incurred to finish and sell the product)
So the ma/imum transfer price that it can offer is the difference +eteen the
final price and additional varia+le costs incurred +y the +uying division) ,his
transfers the entire surplus from the transaction to the selling division) .or
e/ample, if a good can +e sold in the mar2et for G-" and the varia+le costs of
selling and +uying division are G3" and GI respectively, then the +uying
division can pay up to G:% 5G-" ' GI6) Anything more ould put him at a
loss)
In cases here the +uying division has an outside supplier availa+le, the
choice of ma/imum transfer price is simple) Buy from an inside supplier
only if the price is less than the price offered +y the outside supplier) ,his
may lead to su+optimal decision from the firm0s standpoint) .or e/ample, if
a good can +e sold in the mar2et for G-" and the varia+le costs of selling and
+uying division are G3" and GI respectively, then per unit profit for the
company is G3%) >oever, if the transfer price is set at G3: and an outside
supplier is illing to provide it for G33, the +uying division ould +uy it
from outside, even though the company could have spent only G3" in
producing it internally) So, the highest transfer price in this case is G33, the
alternative ma/imum price from an outside source)
,.0 IDLE CAPACIT1 AND TRANSFER PRICE
As mentioned +efore, idle capacity can significantly change the economics
and psychology of transfer pricing) If selling division has large unused
capacity, more than enough to satisfy the +uying division0s demand, then it
ould +e interested in the proposal as long as its varia+le cost is covered)
Since there ould +e no lost sales, there is no opportunity cost, minimum
transfer price ould +e e=ual to varia+le cost) 5G3" in the e/ample a+ove)6

9a/imum transfer price ould, once again, depend on the availa+ility of an
outside price) If the +uying division can +uy similar product from an outside
vendor for G3$, then it ould +e unilling to pay more than G3$ as the
transfer price)
,hus com+ining the re=uirements of +oth the selling and the +uying
division, the accepta+le range of transfer price ould +e +eteen G3" and
G3$)
,.! NO IDLE CAPACIT1 AND TRANSFER PRICE
Menerally, firms prefer internal transactions to e/ternal ones) After all, firms
are organi4ed as a collection of profit centers due to synergies and savings in
transaction, +argaining, mar2eting and other administrative costs and ould
prefer to produce a part internally than +uy it from outside) ?ther reasons for
firms to prefer an internal transaction may +e =uality control, timely delivery
and security of proprietary information) So if the selling division is selling
its entire capacity production to outside mar2et, it ould have to divert some
product aay from its regular customers to +e a+le to fill an order from the
+uying division)
In such cases, the minimum transfer price ould +e unit varia+le cost plus
the unit contri+ution margin from lost sales) ,o continue the e/ample a+ove,
suppose that the selling division is selling its entire capacity of 3""" units to
outside mar2et at G3$ per unit and receives an order of :"" units to +e
supplied to the internal division) So the minimum price, that the selling
division is illing to consider as transfer price, is its unit varia+le cost 5G3"6
plus the unit contri+ution margin on lost sales 5G$ K G3$ ' G3"6)
,he ma/imum transfer price, as +efore, ould +e e=ual to the cost of +uying
it from an outside supplier) ,hus, if the outside vendor is ready to supply the
good at G3# as in the e/ample a+ove, the transfer price ould +e set +eteen
a range of G3$ and G3#)
,., SO-E IDLE CAPACIT1 AND TRANSFER PRICE
If the selling division has only some idle capacity, +ut not enough to fill the
entire order +y the +uying division, then it ould have to divert only some
of the product from its regular customers, 2eeping the opportunity cost
portion of the minimum transfer price at a loer level) In our e/ample,
suppose the selling division is currently selling only B"" units hen its
capacity is 3""" units, it can supply only 3"" units internally ithout
diverting sales from its regular customers) >oever, the +uying division
needs :"" units) Let us also assume that the selling division ill have to
supply the entire order of :"" units, having to divert 3"" units from its
regular customers) ,hus the minimum transfer price ould +e varia+le cost
5G3" / :"" units K G:"""6 plus the unit contri+ution margin on lost sales 5G$
/ 3"" unitsKG$""6) Since the transfer =uantity is :"" units, unit transfer price
ould +e G3:)$" K 5G:""" L G$""6J :"" units)
+. I#TR#ATI%#A' TRA#"$R PRICI#-
In today<s glo+al mar2ets, companies may produce goods and services
domestically and sell them internationally or produce them outside the
country and sell them here) Since the profit is earned in the country of the
sale, differences in ta/ las can +e the leading determinant of transfer
pricing choices) ,a/ factors include, not only income ta/es +ut also payroll
ta/es, custom duties, tariffs, sales ta/es, environment related ta/es and other
government levies on organi4ations) La/ ta/ las in one country can
encourage a 9ulti'!ational ;orporation to deploy resources in that country)
;hoice of an appropriate transfer pricing policy can help in minimi4ing a
company<s ta/ +urden, foreign e/change ris2s and can lead to +etter
competitive position and governmental relations) Although domestic
o+8ectives such as divisional autonomy and managerial motivation are
alays important, they often +ecome secondary hen international transfers
are involved) ;ompanies ould typically focus on charging a transfer price
that ould reduce its ta/ +ill or that ill strengthen a foreign su+sidiary)

.or e/ample, a company may choose a lo transfer price for parts shipped
to a foreign su+sidiary to reduce custom duty payments or to help the
su+sidiary to compete in foreign mar2ets +y 2eeping the su+sidiary0s costs
lo) ?n the other hand, it may choose to charge a higher transfer price to
dra profits out of a country that has high income ta/ rates to a country that
has loer ta/ rates or out of a country that has stringent control on foreign
remittances)
,ransfer pricing is a ma8or concern for multinational companies as
highlighted +y the fact that appro/imately #"N of .ortune 3""" firms select
transfer pricing policies 2eeping financial, legal and other operational
considerations in mind) In addition, intra'firm trade accounts for a+out $$N
of the trade +eteen Japan and &U, and #"N of the trade +eteen US and
Japan)
,a/ authorities are aare of the incentives to set transfer prices to minimi4e
ta/es and import duties) ,herefore, U)S) Internal Revenue Service 5IRS6
pays close attention to ta/es paid +y multinational companies ithin their
+oundaries) At the heart of the issue are the transfer prices that companies
use to transfer products from one country to another) .or e/ample, in :""%,
the IRS fined U)F) +ased pharmaceutical manufacturer Mla/oSmithFline
G$)$ +illion in +ac2 ta/es and interest, stemming from a transfer pricing
dispute regarding profits from 3B#B through 3BBI)
It is not surprising, therefore, that most countries have restrictions on
alloa+le transfer prices) Section %#: of the U)S) Internal Revenue ;ode
governs ta/ation of multinational transfer pricing) ,his section re=uires that
transfer prices +eteen a company and its foreign su+sidiary, for +oth
tangi+le and intangi+le property, e=ual the price that ould +e charged +y an
unrelated third party in a compara+le transaction) In other ords, transfer
prices must reflect an arms length price) .or tangi+le goods, the +est
method is considered to +e a comparable controlled price +eteen unrelated
firms) 1hile this method is theoretically sound, it is difficult to use in
practice +ecause intra firm transactions are hard to compare ith open
mar2et transactions)
,he ne/t +est method is the resale price approach, hich is alloed if there
is no compara+le price availa+le) ,he method allos all costs and a
reasona+le profit to +e deducted from the resale value)
,he third method is the cost plus approach, here an appropriate mar2 up is
added to the manufacturing cost to determine the transfer price)
In summary, companies are alloed to use a mar2et +ased or a cost plus
method as long as the surplus represents margin on compara+le transactions)
In addition, international ta/ treaties regulate alloa+le transfer pricing
methods)
&un and Resnic2 5:"3:6 discuss a case study here the firm0s choice of a
transfer pricing policy ith lo mar2up on cost versus a transfer pricing
policy ith a high mar2up result in different incomes and ta/ +urdens for the
companies operating in countries ith different ta/ rates, e/change
restrictions, import duties and other regulations affecting transfer prices)
,. 'IMITATI%#" %$ $I#A#CIA' C%#TR%' "/"TM"
An important goal of a +usiness enterprise is to optimi4e shareholder returns)
>oever, optimi4ing short'term profita+ility does not necessarily ensure
optimum shareholder returns in the long run) At the same time, the need for
ongoing feed+ac2 and performance evaluation re=uires companies to
measure a division0s performance in the short term, usually at least once a
year) ?veremphasis on financial controls may +e dysfunctional for this as
ell as many other reasons(

.irstly, it may encourage short'term actions that are not in the company0s
long'term interests) .or e/ample, the manager may use inferior ra
materials to 2eep costs don, adversely affecting company0s goodill and
future sales)
Secondly, divisional managers may not underta2e useful long'term actions,
in order to ma/imi4e short'term profits) .or e/ample, managers may not
invest sufficiently in research and development0 since ROD investments
must +e e/pensed in the year in hich they are incurred +ut their +enefits
sho up only in the future)
,hirdly, using short'term profit ma/imi4ation as the sole criteria for
performance evaluation can lead to gaming +ehavior +y managers) .or
e/ample, divisions may set profit targets that can +e achieved very easily so
that they are never penali4ed for missing the target) ,his ould result in
su+optimal =uantity produced and sold) Leading to loer profit for the
firm)
33
Lastly, tight financial control may motivate managers to manipulate data to
meet current profit targets) .or e/ample, managers may ma2e inade=uate
provision for +ad de+ts and arranty claims) 9anagers may also +e tempted
to falsify data'that is, deli+erately provide inaccurate information)
3:
In short, relying on financial control measures alone is insufficient to ensure
long'term profit ma/imi4ation) ,he solution is to use a +lend of financial
5costs, revenue, profits6 and nonfinancial measures 5=uality, customer
satisfaction, innovation6 that ould achieve the long'term success of the
organi4ation)
33
Another e/ample of tactics used +y manager is found in Bausch and Lom+ here unusually long credit terms ere
e/tended to customers in e/change for +ig orders) See @ Blind Am+itionA in Business 1ee2 , ?ct) :-, 3BB$, pp) C#'
B:
3:
According to Business 1ee2 article on Bausch and Lom+ AUnder pressure to +eat sales target in 3BB-, contact lens
managers shipped products that doctors never ordered hile assuring them that they ouldn0t have to pay until they
sold the lensesA)
0. Conclusion
,his study analy4es the performance of various transfer pricing policies
used +y American industries and compares them ith regard to firm
profits and efficient decision ma2ing +y divisional managers)
Since most firms use transfer prices to assess internal transactions, choice
of a transfer pricing policy affects the reported income of the divisions)
Since managers are typically evaluated and compensated +ased on the
reported income of their divisions, the method used for setting transfer
prices directly influences the decisions delegated to them) ,his ma2es
transfer pricing policy an important tool in the hands of upper
management for motivating managers to ta2e decisions that are in the +est
interest of firm0s overall profits)
,he variety of ,P policies in common use suggests that no single ,P policy
can +e e/pected to +e optimal for all firms) ,his study compares the
performance of popular ,P policies in a large multi'divisional firm) 1e see2
to identify economic factors that ma2e one ,P policy prefera+le to other)
,hese economic factors may +e revenue and cost characteristics of the good
transferred, the num+er of products, the price elasticity and the level of
competitiveness of the e/ternal mar2et faced +y the firm)
,he findings of the study suggest that firms should +e cautious in putting a
particular ,P policy in place since the choice can +e crucial to firms0
performance) It seems that among the class of cost +ased ,P policies, an
additive mar2up over varia+le cost is most desira+le from the optimal
resource allocation standpoint +ecause it motivates the seller to reduce costs
and increase production)
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