Market-Based Transfer Prices and Intracompany Discounts

Firms frequently value internal transactions at external market prices subject to an intracompany discount. These discounts are generally explained by cost differences between internal and external sales. In a model where the supplying division has monopoly power in the external market, we find that cost differences are neither necessary nor sufficient for intracompany discounts to be desirable. The imposition of discounts always increases the divisional profits of the buying division, but may also lower the divisional profits of the selling division. We derive conditions for discounts to enhance firm-wide profit. We also study the sensitivity of the optimal discount to cost differences between internal and external transactions. Under certain conditions, market-based transfer prices subject to optimally chosen discounts perform well. If the buying division sells its final product in a competitive market and if demand and cost parameters are positively correlated, then market-based transfer pricing induces the divisions to engage in transactions which are nearly efficient from the corporate perspective