Transfer Pricing and the Control of Internal Corporate Transactions

One potential weakness of all divisional profitability schemes is their inability to capture synergies among business units. One way of managing this problem is to design a transfer pricing scheme that attempts to assign common costs and benefits to different business units. What makes transfer pricing both so interesting, and such a challenge, is that the solution involves finding a way to encourage divisional managers whose pay is likely to depend on such transfer prices to reveal their private or unbiased information about the firm’s costs in a way that serves the interest of the rest of the firm.

With that end in view, the authors provide a general analytical framework for setting transfer prices and go on to discuss the costs and benefits of each of the most common transfer-pricing methods: (1) market pricing; (2) marginal cost pricing; (3) full-cost pricing; and (4) negotiated prices.