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Capacity Rights and Full-Cost Transfer Pricing
Abstract
This paper examines the theoretical properties of full-cost transfer prices in multidivisional firms. In our model, divisional managers are responsible for the initial acquisition of productive capacity and the utilization of that capacity in subsequent periods, once operational uncertainty has been resolved. We examine alternative variants of full-cost transfer pricing with the property that the discounted sum of transfer payments is equal to the initial capacity acquisition cost and the present value of all subsequent variable costs of output supplied to a division. Our analysis identifies environments where particular variants of full-cost transfer pricing induce efficiency in both the initial investments and the subsequent output levels. Our findings highlight the need for a proper integration of intracompany pricing rules and divisional control rights over capacity assets.
This paper was accepted by Suraj Srinivasan, accounting.
... It is well known that the online direct channel is greatly appreciated for selling products from the manufacturer to consumers without the middleman being involved. Under the decentralized structure, we assume that the e-commerce division aims at maximizing all the revenue from the online channel using cost-based transfer pricing, which is the most prevalent method used in firms (Dutta & Reichelstein, 2021). According to Tang (1992), over half of the respondents with the cost-based method use full production cost as their internal transfer price. ...
Traditionally, manufacturer encroachment is investigated under an integrated organizational structure where the online business decisions are made at the whole firm level. However, with the establishment of a specific e‐commerce division, the manufacturer has the flexibility to delegate the decision‐making of the online business to its e‐commerce division to maximize the online revenue under a decentralized structure. We study manufacturer encroachment in a supply chain, where a manufacturer sells through a bricks‐and‐mortar retailer and plans to deploy its e‐commerce division to launch the online direct‐to‐consumer business. Different from prior research, we endogenize the manufacturer's choice between the integrated and the decentralized structures in its encroachment pursuit. Our results suggest that the decentralized structure could enlarge the manufacturer's feasible range to encroach, but it would also intensify the competition between the e‐commerce division and the retailer. Therefore, choosing the decentralized structure does not necessarily yield a higher profit for the manufacturer because the loss in the retail channel may be hard to offset due to the intensified competition. Instead, choosing the integrated structure could lead to a win‐win‐win outcome for the manufacturer, retailer, and e‐commerce division when the direct selling cost is sufficiently low. Although the manufacturer may benefit from encroachment under both internal structures, it should not encroach when the direct selling cost is between low and moderate. Notably, the bright side of manufacturer encroachment's impact on the retailer still exists under the decentralized structure. We also study some alternative settings, including consumers’ offline hassle cost, market‐based transfer price, and quantity competition, to obtain additional insights. This article is protected by copyright. All rights reserved
... Fahimnia, Tang, Davarzani, & Sarkis, 2015 ), transfer pricing (cf. Dutta & Reichelstein, 2018 ), and regulation (cf. Nezlobin, Rajan, & Reichelstein, 2012 ). ...
In a parsimonious model, we analyze how to obtain consistent incentives when both principal and agent are risk-averse and when a setting prevails in which the agent may have a shorter time horizon than the principal. Intertemporal dependencies in risky cash flows are taken into account.
Building on the fundamental results produced by Rogerson (Journal of Political Economy 105(4):770--795, 1997) and Reichelstein (Review of Accounting Studies 2(2):157--180, 1997), we establish a new risk allocation scheme, which enables consistent incentives to be achieved. Thereby, we demonstrate that the resulting performance measures correspond to an affine transformation of previous and current residual incomes or, alternatively, cash flows in such a way that information asymmetry between principal and agent is still possible. The risk allocation technique developed may prove useful in other contexts.
Abstract Recent years have seen an increasing,emphasis,on developing,more precise accounting measures of market- and customer-level profitability. These efforts are aimed at helping prune unprofitable constituencies and targeting resources to more profitable segments. This paper demonstrates that even if perfected, such refined segment profitability measures may unwittingly neglect a latent cross-subsidization effect linked with firm participation in multiple markets. In particular, when a firm relies on a privately informed supplier for inputs used across markets, the wholesale price it pays depends on the average profitability of its markets. Thus, if a firm were not to serve its less profitable markets, it may face a steeper wholesale price. Taking such interaction between upstream pricing and the firm's downstream reach into account, the paper shows that: (i) segment profit calculations can understate or overstate the value added by the segment depending on the segment's relative contribution margin, and (ii) the firm sometimes benefits from devoting resources to less profitable segments and perhaps even from serving unprofitable markets and/or customers.
This paper studies the acquisition and subsequent utilization of production capacity in a multidivisional firm. In a setting
where an upstream division provides capacity services for itself and a downstream division, our analysis explores whether
the divisions should be structured as investment or profit centers. The choice of responsibility centers is naturally linked
to the internal pricing rules for capacity services. As a benchmark, we establish the efficiency of an arrangement in which
the upstream division is organized as an investment center, and capacity services to the downstream division are priced at
full historical cost. Such responsibility center arrangements may, however, be vulnerable to dynamic hold-up problems whenever
the divisional capacity assignments are fungible in the short-run, and therefore, it is essential to let divisional managers
negotiate over their actual capacity assignments. The dynamic hold-up problem can be alleviated with more symmetric choice
of responsibility centers. The firm can centralize ownership of capacity assets with the provision that both divisions rent
capacity on a periodic basis from a central unit. An alternative and more decentralized solution is obtained by a system of
bilateral capacity ownership in which both divisions become investment centers.
KeywordsPerformance management-Managerial incentives-Accrual accounting
JEL ClassificationM40-M41-D82
We present examples of a parameterized optimization problem, with a continuous objective function differentiable with respect to the parameter, that admits a unique optimal solution, but whose optimal value function is not differentiable. We also show independence of Danskin's and Milgrom and Segal's envelope theorems.
en A basic tenet of microeconomics is that for a competitive industry in equilibrium the market price of a product will be equal to its marginal cost. This paper develops a model framework and a corresponding empirical inference procedure for estimating long‐run marginal cost in industries where production costs decline over time. In the context of the solar photovoltaic (PV) module industry, we rely primarily on firm‐level financial accounting data to estimate the long‐run marginal cost of PV modules for the years 2008–2013. During those years, the industry experienced both unprecedented price declines and significant expansions of manufacturing capacity. We compare the trajectory of average sales prices with the estimated long‐run marginal costs in order to quantify the extent to which actual price declines were attributable to reductions in production costs. The trajectory of estimated product costs is then extrapolated to forecast an equilibrium trend line for future PV module prices.
Lier les prix des produits au coût marginal à long terme : le cas des modules photovoltaïques solaires
fr Selon un principe de base de la microéconomique, dans un secteur d'activité concurrentiel en situation d'équilibre, le prix du marché d'un produit sera égal à son coût marginal. Les auteurs élaborent un cadre modèle et une procédure d'inférence empirique correspondante servant à l'estimation du coût marginal à long terme dans les secteurs où les coûts de production déclinent avec le temps. Dans le contexte du secteur des modules photovoltaïques (PV) solaires, les auteurs s'appuient principalement sur les données comptables générales de l'entreprise pour estimer le coût marginal à long terme des modules PV pour les années 2008 à 2013. Durant ces années, des baisses de prix sans précédent ainsi que d'importantes expansions de la capacité de production ont marqué ce secteur d'activité. Les auteurs comparent l'évolution des prix de vente moyens aux estimations des coûts marginaux à long terme afin de quantifier la mesure dans laquelle les baisses de prix réelles étaient attribuables à la diminution des coûts de production. L'évolution des coûts estimatifs des produits est ensuite extrapolée, ce qui permet d'obtenir une courbe de tendance à l'équilibre des prix futurs des modules PV.
Despite the clear prescription from economic theory that a firm should set price based only on variable costs, firms routinely factor fixed costs into pricing decisions. We show that full-cost pricing (FCP) can achieve the optimal price. FCP marks up variable cost with the contribution margin per unit, which, in equilibrium, includes the fixed cost. FCP converges to the optimal price when the firm can estimate its equilibrium income. We compare FCP to alternative pricing algorithms that require less information, but converge to optimal price under more narrow conditions than FCP.
: In a dynamic setting with demand following a random process, we ask how investment and operating decisions can be delegated to a manager with unknown time preferences. Only the manager observes the demand realization in each period and, therefore, has private information when choosing whether to acquire the productive asset and, subsequently, how to utilize it. We derive accrual accounting-based performance measures under which the manager will make the efficient decisions provided the investment date is exogenously given. We show that in an environment where demand follows a martingale process, the corresponding accounting rules are more decelerated if the firm has the option to idle capacity in case of negative demand shocks. We then describe the limitations of accounting-based performance measures in a scenario where the investment date is endogenously determined, i.e., the firm has an option to wait.
We examine a life-cycle cost concept that applies to both manufacturing and service industries in which upfront capacity investments are essential. Borrowing from the energy literature, we refer to this cost measure as the levelized product cost (LC). Per unit of output, the levelized cost aggregates a share of the initial capacity investment with periodic fixed and variable operating costs. We relate this cost measure to the notion of full cost, as commonly calculated in managerial accounting texts. Our analysis identifies conditions under which the LC can be interpreted as the long-run marginal product cost. In particular, the LC is the relevant unit cost that firms should impute for investments in productive capacity.
This paper analyzes a simple transfer‐pricing policy based on the actual cost of production. I show that the performance of actual cost‐based transfer pricing can be improved by using an additive markup above the unit production cost. I also show that this additive policy dominates an entire class of alternative markup policies, including the more common multiplicative policy, in which the transfer price is set at the actual cost plus a percentage markup. The optimal additive markup is shown to increase with increasing prices for the firm's product, and decrease with the cost of the supplying division's investment.
Surveys show that many firms use full cost to set prices. However, principles of relevant costing imply that product prices should be independent of how a firm allocates fixed manufacturing cost to products. Recent research tries to resolve this conflict between theory and practice by expanding the scope of the problem; pricing is only one part of the larger problem of determining which products to keep and which products to drop, how much capacity to install, and how to allocate available capacity among the products. An emerging view is that we must jointly consider the capacity‐planning and product‐pricing problems to clarify the role of full costing in these decisions. In this article we provide a critical overview of the results from this research, highlight how a combination of analytic and numerical methods have contributed to our understanding, and suggest directions for future research.
In the older treatments of depreciation the cost, or “theoretical selling price” of the product of a machine, was conceived of as determined causally by the addition of a number of items of which depreciation is one. In other words, depreciation was first computed by some rather arbitrary formula not involving the theoretical selling price, which was then found by the addition of depreciation to operating costs and division by quantity of output. It will be shown in this paper that depreciation and theoretical selling price must be computed simultaneously from a pair of equations which are frequently a bit complicated. The differences in the results obtained from the arbitrary and mathematical formulae are often very large.
This survey advocates the use of dynamic models to examine the incentive properties of commonly used accounting performance metrics. Drawing from recent work in this emerging field, the survey illustrates how one can use tractable multiperiod models to shed light on questions of fundamental interest to accountants. The author first examines the choice of goal congruent performance measures and then explains how the insights obtained from the goal congruent framework can be adapted to second-best contracting in formal agency models. Next, the author builds an analytically tractable multiperiod moral hazard model with a risk averse manager to examine the issue of aggregating accounting and nonaccounting information in constructing optimal performance measures.
This monograph focuses on the use of incomplete contracting models to study transfer pricing. Intrafirm pricing mechanisms affect division managers' incentives to trade intermediate products and to undertake relationship-specific investments so as to increase the gains from trade. Letting managers negotiate over the transaction is known to cause holdup (underinvestment) problems. Yet, in the absence of external markets, negotiations frequently outperform cost-based mechanisms, because negotiations aggregate cost and revenue information more efficiently into prices. This result is established in a symmetric information setting and confirmed, with some qualification, for bargaining under incomplete information. In the latter case, trading and investment efficiency can be improved by adding non-financial performance measures to a divisional performance measurement system. When the intermediate product can also be sold in an imperfectly competitive external market, internal discounts on external market prices are shown often to improve the efficiency of intrafirm trade and of upfront investments.
This paper investigatesinvestment decisions in a divisionalized firm, in which an upstreamdivision supplies an intermediate product to a downstream division.The upstream division''s investment includes two simultaneousdecisions. First, the division determines its capacity level,and second, it invests in a firm specific production technologythat lowers the marginal cost of production. Both the capacityand the specificity decision must be made before the actual demandfor the intermediate product is observable. Since the terms ofinternal trade are negotiated between the divisions, the upstreamdivision faces the well-known holdup problem and thus has incentivesto underinvest. It turns out that a simple contract stipulatinga minimum quantity and a transfer price for excessive quantitiesis sufficient to induce the efficient capacity and specificitydecisions.
In most decentralized organizations, goods and services are transferred between divisions. These transfers are frequently recorded in the accounting books of the divisions; the term transfer price refers to the dollar amount of the interdivisional exchange. This study considers two main issues: (i) the costs and the benefits of delegating decisions through a system of transfer pricing and divisional performance evaluation, and (ii) the performance of one common method of pricing intrafirm transactions: cost-based transfer pricing.
The study analyzes a firm in which each divisional manager has better information about the divisional environment than what is known by the firm's top management. The first half of the paper demonstrates that the firm can attain the optimal level of profits with a compensation system utilizing (i) reports by divisional managers describing in complete detail each manager's private information, and (ii) divisional performance evaluation with cost-based transfer pricing. Next, a situation is considered in which divisional managers are not able to communicate their private information to the firm's top management because of complexity of divisional environments or managers' specialized expertise. In this bounded-rationality setting, a managerial-compensation system employing cost-based transfer pricing allows the firm to earn strictly higher expected profits than if all decisions are made by the firm's top management relying on divisional managers' reports.
This paper considers incentive provisions for a manager who makes investment decisions. The manager's performance measure can be based on current accounting information: cash flow, depreciation, book value, and current investment. We argue that Residual Income is the unique (linear) performance measure that achieves goal congruence, i.e., the manager accepts all positive NPV projects, and only those. If the manager has the same discount rate as the owner, the depreciation rules remain indeterminate. However, if the manager's discount rate assumes potentially a whole range of values, then a particular depreciation policy combined with Residual Income is the unique way to achieve goal congruence.
This paper studies an incomplete contracting model to compare the effectiveness of alternative transfer pricing mechanisms. Transfer pricing serves the dual purpose of guiding intracompany transfers and providing incentives for upfront investments at the divisional level. When transfer prices are determined through negotiation, divisional managers will have insufficient investment incentives due to hold-up problems. While cost-based transfer pricing can avoid such hold-ups, it does suffer from distortions in intracompany transfers. Our analysis shows that negotiation frequently performs better than a cost-based pricing system, though we identify circumstances under which cost-based transfer pricing emerges as the superior alternative.
This paper compares the performance of alternative cost-based transfer pricing methods. We adopt an incomplete contracting
framework with asymmetric information at the trading stage. Transfer pricing guides intra-company trade and provides incentives
for value-enhancing specific investments. We compare actual-cost transfer prices that include a markup over marginal costs
with standard-cost transfer prices that are determined either by the central office ex ante (centralized standard-cost transfer
pricing) or by the supplying division at the trading stage (reported standard-cost transfer pricing). For the actual-cost
methods, we show that markups based on the joint contribution margin (contribution-margin transfer pricing) dominate purely
additive markups (cost-plus transfer pricing). We obtain the following results. (1) Centralized standard-cost transfer pricing
dominates the other methods if the central office and the divisions ex ante face low cost uncertainty. (2) The actual-cost
methods dominate the other methods if the central office and the divisions ex ante face high cost uncertainty and later, at
the trading stage, the buying division receives sufficient cost information. (3) Reported standard-cost transfer pricing dominates
the other methods if the central office and the divisions ex ante face high cost uncertainty, and the buyer has insufficient
cost information at the trading stage.
KeywordsTransfer pricing–Specific investments–Actual costs–Standard costs
This paper examines the effects of imperfect competition in unregulated electricity markets from a general equilibrium perspective, and demonstrates that horizontal market power can explain both the large peak-period price spikes observed recently in California and elsewhere, and the marked reduction in addition to capacity that have also occurred during the transition to competitive markets.
Earlier literature has pointed to the effectiveness of residual income-type measures based on particular accrual accounting rules such as the relative benefit allocation rule. These performance metrics have been shown to generate desirable managerial incentives when investment decisions are delegated. This paper further attests to the robustness of these measures by extending the result to a sequential adverse selection model with an inherent real option (an option to abandon). In other words, as long as the residual income measures are judiciously constructed, neither private information nor the requirement to selectively exercise an option derails their use in this setting.
This paper provides a formal analysis of how managerial investment incentives are affected by alternative allocation rules when managerial compensation is based on accounting measures of income that include allocations for investment expenditures. The main result is that there exists a unique allocation rule that always induces the manager to choose the efficient investment level. The income measure created by this allocation rule is usually referred to as residual income or economic value added. Copyright 1997 by the University of Chicago.
This paper considers the profit-maximization problem of a firm that must make sunk investments in long-lived assets to produce output. It is shown that if per-period accounting income is calculated using a simple and natural allocation rule for investment, called the relative replacement cost (RRC) rule, under a broad range of plausible circumstances, the firm can choose the fully optimal sequence of investments over time simply by choosing a level of investment each period in order to maximize the next period's accounting income. Furthermore, in a model in which shareholders delegate the investment decision to a better-informed manager, it is shown that if accounting income based on the RRC allocation rule is used as a performance measure for the manager, robust incentives are created for the manager to choose the profit-maximizing sequence of investments, regardless of the manager's own personal discount rate or other aspects of the manager's personal preferences. (c) 2008 by The University of Chicago. All rights reserved..
Our model of network mechanisms studies individually addressed messages between any two members of an organization. For a given organizational objective function, we examine communication costs, as measured by the number of message variables that agents need to exchange at equilibrium in order to achieve the desired action choices. For the class of objective functions we consider, price mechanisms are shown to minimize communication costs. If one requires the network to be hierarchical, the organization may be forced to use more message variables. We identify the increase in communication costs associated with alternative hierarchies. Journal of Economic Literature classification numbers: D20, D21, D87, L22, P41. Copyright 1998 Academic Press.