The Value of Negotiating Cost-Based Transfer Prices

Theory recommends various transfer pricing schemes depending on the purpose they are designed for. In contrast, empirical evidence shows the predominance of a single scheme, namely one-step cost-based prices. Our paper concentrates on cost-based transfer, especially focusing on the coordination of delegated investment and marketing decisions. We consider a team setting in which divisional investments' productivities depend on each other.The goal of our paper is to analyze how the performance of cost-based transfer prices can be improved by organizational arrangements so that they set proper investment incentives. In detail, we show that transfer prices based on variable costs are able to induce coordination among the divisions but fail to induce investments on the first production stage. Transfer prices based on full costs, however, provide strong investment incentives for the upstream divisions but typically are insufficient to induce coordination. The driving force of this result is the assumption of a convergent production structure, i.e., there are two divisions on the first production stage. We show that interdivisional negotiations prevent coordination failures. A major result is that the firm benefits from a higher degree of decentralization so that total profit increases in the number of parameters being subject to negotiations