Problem Description
In a large organization, a central management cannot monitor and control all
the operation parameters of every subunit. For this reason, large organizations
are usually separated into divisions. Each division is an autonomous unit
and its manager has the freedom to take all necessary action. But a
decentralized organization has difficulty evaluating the performance of the
division managers. Furthermore, the central management of the organization
needs to coordinate the actions of the divisions to maximize the organization's
total profit. In order to evaluate the performance of each division, a method
is needed for measuring the contribution of each division to the total profit
of the organization. A common solution to this problemis to set prices for
intermediate goods which are transferred from one division to another. These
prices are known as transfer prices. Transfer prices are mainly used
In the classical Transfer Pricing (TP) problem, we usually think of two
divisions in a decentralized organization. Division 1 produces an intermediate
good and Division 2 transforms it into a final good and sells it in the market.
Division 1 ``sells'' a quantity of the intermediate good to Division 2 at a
certain price. This price (the transfer price) is used to place a value on the
transaction between the two divisions. The total transaction value is considered
as income by the selling division and as expense by the buying division. This
allows the net profits of the two divisions to be determined. The division
managers are evaluated by the profits that their divisions generate, but the
organization's objective is to maximize its total profit. The objectives of the
organization and those of the division managers are often incompatible. There
fore, the problem of the organization is to determine a pricing rule that serves
its own goals, taking into account the objectives of the divisions. This is
easy in a world of perfect information, where central management can calculate
the optimal transfer prices. The problem is more difficult when there is
asymmetry of information (i.e., some information is private). Division managers
may wish to conceal some information, in order to manipulate the outcome in
their own favor.
In practice the problem is still more complicated. In addition to the asymmetry
of information, divisions may have multiple products or may face capacity
constraints, the product may have to be manufactured by a chain of more than
two divisions, some of the intermediate goods may also be sold in the market,
etc. Let us briefly discuss the transfer pricing methods in common use today.
We list here only some of the more common methods that appear in the accountancy
literature.
Cost methods: The transfer price is a certain function of the production cost
of the selling division. It may or may not include a fixed cost
component. There are several variations of this approach such
as cost plus fixed fee, cost plus a fixed percentage of the
cost, full cost plus markup, variable cost, marginal cost.
Market price methods: If there is a market for the intermediate good, then
the market price is used as the transfer price. Often the
transfer price is the market price minus the selling expenses.
Dual price methods: The price that the selling division receives is not equal
to the price that the buying division pays - and is usually
higher. This mechanism generates a deficit, which is set off
by central management. Because central management sets the
optimal transfer price, and hence sets the transaction volume
to be optimal, this mechanism yields higher performance than
other methods. However, it is not commonly used because it
requires central management to be involved in the complex
process of price-setting. The Ronen-McKinney mechanism and the
Groves-Loeb mechanism are the motivation behind this method.
Negotiated transfer prices: The transfer price is reached by negotiation
between the relevant division managers. The advantage of this
method is that it preserves the divisions' autonomy. Its
problem is the sensitivity of the outcome to the managers'
negotiation skills.
Each method in this list can be applied in various ways. For example, the
markup in the cost-plus method can be determined as a percentage of the cost,
which equals a certain return on investment of either the division or the
organization. The transfer pricing mechanism that an organization applies
may have a critical impact on the organization's performance. Although the
transfer pricing problem has been studied for many years it is still consider
ed an open problem.
Keywords: Transfer Pricing, Mechanism Design, Decentralization,
Capacity.
Classification: C69, C79, D81, D82, L22, M11.
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