A TRANSFER PRICING SYSTEM BASED ON OPPORTUNITY COST AND GAME THEORY

Three general objectives for a desirable transfer pricing system have been identified. They are goal congruence, divisional autonomy, and divisional performance evaluation. Six steps have been proposed for a better transfer pricing system with respect to these three objectives which are not found in other systems in the current literature. In the first step, each divisional manager identifies independent opportunities other than the opportunity of trading internally with other divisions. In the second step, each division estimates the performance measures (revenues or profits) of each opportunity and selects the best opportunity. In the third step, top management in the central office estimates joint performance measures to be earned from the grand coalition of all divisions, and it determines the optimal output levels of the intermediate products. In the fourth step, joint performance measures are compared with the total of each division's independent performance measures. If the former amount is less than or equal to the latter amount, there will be no transfer pricing problems since no transfers take place. Otherwise, the intermediate products should be transferred among divisions for the corporation as a whole, and for each division as well. In the fifth step, joint performance measures are allocated to each participating division. Four game theoretic allocation schemes have been suggested, such as Shapley's value, Moriarity's allocation scheme, the Equal share scheme, and the Marginal contribution scheme. Top management in the central office, through consultation with each divisional manager, will select one of these allocation schemes, depending on the situation. In the last step, transfer prices are determined by using the information of optimal output levels and the allocated performance measures obtained from the selected allocation scheme.