Why is transfer pricing an important issue? Many large firms move parts, components, assemblies, and finished products among plants and divisions continuously. They also use plant and division profit and loss statements as local performance measurements, and encourage each plant or division to make procurement and sales decisions at the local level. Recently some companies have given all plants and divisions the authority to purchase and sell outside their company if a better price exists, even though several of these same companies are their-own biggest customers. This is a major problem with farreaching implications that impact the very existence of the company. What is the real result of these decisions?
This article examines one aspect of management accounting referred to as transfer pricing. Transfer prices are a cost accounting mechanism used within a firm to transfer assets from one plant or division to another. According to Edwards, Hermanson, and Salmonson, a transfer is an "artificial price used when goods or services are transferred from one segment to another within the same company." Transfer prices can be determined using the market price, product cost, or a negotiated price for the asset.
Mention of the transfer pricing issue can be found as far back as 1883. By the 1920s transfer pricing had become a major issue in accounting and management, and the central issue of global performance versus local performance was well defined. The issue was typically framed in terms of whether transfer prices should be set at cost or market price, with numerous arguments for and against each approach. Although raised during the 1920s, the concerns expressed were surprisingly similar to those faced by managers today.
The neoclassical economics view-The transfer pricing problem from the economics point of view was solved by Hirshleifer, who showed that, except in the case of a good traded in a perfectly competitive market, the transfer price should be the marginal cost of the selling division in order to maximize the firm's profit as a whole.
The solution assumes conditions of technological independence-the operating costs of each division are independent of the level of operations at the other division; and demand independence-an additional external sale by either division does not reduce the external demand for the products of the other.
The optimal solution for the firm would also require that one division provide the other with its demand or supply schedule as a function of the transfer price, and that the second division then determine its output level based on that transfer price. This solution also ignores the potential negative impact of requiring a division to sell at marginal cost on plant level performance measures.
While Hirshleifer's analysis was extended in the past 20 years to additional situations and to show the impact on decisions concerning the sale or closing of a division, the approach still has serious problems, including the significant amount of hard-to-obtain information required from each division, and the temptation of division general managers to misreport their demand and supply curves in order to optimize their local profits. In addition, neoclassical economics itself has been criticized for its focus on static analysis and equilibrium, stylized conceptions of markets, assumption of "hyperrational" decision makers, and unrealistic assumptions about cost behavior.
The strategic management view-The strategic management literature is almost silent on the issue of transfer pricing. Michael Porter addresses transfer pricing briefly, stating that if transfer prices differ from market prices, one unit will be subsidizing the other, leading management to make decisions that will "reduce the effciency and harm the competitive position of their units." He again touches on the issue when he states that basing transfer prices on market prices "negates the logic underlying interrelationships, no matter how administratively appealing it may be. …