Transfer Pricing in a Multi-Product Environment

This paper develops a simple model of a decentralized multi-product firm in which transfer pricing is used to co-ordinate the activities of its constituent divisions. Two goods are produced in a single facility and the accounting system provides the full cost for each based on a rule in which overhead costs are allocated in proportion to direct labor costs. The study compares the performance of some commonly used transfer pricing (TP) policies with respect to level as well as efficiency of production. The policies studied are Actual Cost-Based TP (ACTP), Standard Cost-Based TP (SCTP), and a hybrid TP policy based on both standard and actual costs. It is shown that under ACTP managers may have incentives to “pad†as well as misallocate costs deliberately to maximize their divisional incomes, while under SCTP there is over-reporting of costs leading to under-production. In general, neither policy achieves the first-best level of production or profit. ACTP yields higher profits to the firm than SCTP if the internally transferred good is the primary good produced by the firm. The hybrid policy eliminates some of the production inefficiencies associated with ACTP as well as the over-reporting problems associated with SCTP, resulting in a higher profit to the firm than can be achieved using either policy alone.