Models of transfer pricing

In most decentralized organizations, goods and services are transferred between divisions. These transfers are commonly recorded in the accounting books of affected divisions; the term transfer price refers to the dollar amount of the interdivisional exchange. Several methods of determining transfer prices have been developed; these methods are discussed in Chapter 1. An overview of current transfer-pricing theory is also included in Chapter 1.;In Chapter 2, this optimal benchmark level is computed. A model of cost-based transfer pricing is then developed. Transfer prices are computed based on the reported cost of the producing division. The results indicate that a compensation system utilizing this form of transfer pricing allows the firm to attain the optimal level of profits.;Next, a setting is considered where divisional managers are not able to communicate their private information to the firm's top management because of complexity of divisional environments. In this situation, a managerial-compensation system employing cost-based transfer pricing allows the firm to earn higher expected profits than if all decisions are made by the top management.;Chapter 3 analyzes negotiated transfer pricing. In this pricing method, managers are free to negotiate whether the intrafirm exchange takes place, the quantity to be transferred, and the transfer price. A multi-period model of managerial bargaining over transfer prices is developed. Results indicate that, by judicious choice of compensation schemes, the firm guarantees that all equilibria of the negotiations are desirable. When managers are able to communicate their information, the negotiated transfer-pricing system allows the firm to earn the optimal level of profits. When communication ability is limited, the firm earns a higher level of profits when negotiated transfer pricing is employed than when all decisions are made by the top management.;This dissertation analyzes two common methods of transfer pricing. A firm with two divisions is considered; divisional managers are better informed about the relevant local information than is the firm's top management. It is well known that, when certain assumptions are satisfied, the firm can attain an optimal level of profits by inducing divisional managers to report their private information to the firm's top managers; all relevant decisions are made by the top managers.