Skip to main content
SpringerLink
Log in

Financial Control and Transfer Pricing

  • Reference work entry
  • First Online:
Encyclopedia of Finance

Abstract

This paper intends to explore transfer pricing and some popular transfer pricing methods. Since transfer prices are used to assess the incomes of the firm’s divisions, choice of a transfer pricing policy can influence many important operational and strategic decisions, such as capital and resource allocation, volume and efficiency of production, performance evaluation as well as tax planning.

We use a descriptive method to study and compare the most popular transfer pricing policies used in American industry and find that many transfer pricing policies may lead to sub-optimal decisions and conflicts within the company because of the incentives they create for managers.

For the purpose of optimal decision making in a multi divisional form, Actual cost-based transfer pricing with an additive markup has been shown to dominate an entire class of alternative policies. In multinational corporations, there is an incentive to reduce the overall income tax burden by charging higher prices to units located in countries with high tax rates. This paper also explores the economic incentives for the use of a particular transfer pricing policy by multinational companies.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 679.00
Price excludes VAT (USA)
  • Available as EPUB and PDF
  • Read on any device
  • Instant download
  • Own it forever
Hardcover Book
USD 849.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

Notes

  1. 1.

    According to Merchant (1989, about 95 % of the US managers’ compensation is based on their divisional income.

  2. 2.

    These include tax planning, capital and other resource allocation, costing, decentralized co-ordination and control as well as performance evaluation, and formulation of integration and diversification policy.

  3. 3.

    See “Blind Ambition” in Business Week, Oct. 23, 1995, pp. 78–92. According to Business Week article on Bausch and Lomb “Under pressure to beat sales target in 1993, contact lens managers shipped products that doctors never ordered while assuring them that they wouldn’t have to pay until they sold the lenses”.

  4. 4.

    For a detailed literature review of transfer pricing as a coordinating mechanism, see Adams and Drtina (2008)

  5. 5.

    In Tang’s (1992) survey of Fortune 500 companies, there is evidence of companies using negotiated transfer pricing, market based transfer pricing as well as several variations of cost based transfer pricing.

  6. 6.

    See for example, Kaplan (1982) for one of the firt detailed discussion of various TP methods.

  7. 7.

    For a theoretical model of Variable Cost based Transfer Pricing, see Vaysman (1996)

  8. 8.

    Hirshleifer (1956) established conditions under which pricing internal transfers at marginal cost maximizes firm profit.

  9. 9.

    For example, Garrison and Noreen (2012)

  10. 10.

    See Sahay (1997) and Sahay (2003).

  11. 11.

    See Sahay (2003).

  12. 12.

    Chung (1991) derives a similar efficiency result, also using a prior contract.

  13. 13.

    See also the Executive Summary of the Price Waterhouse (1984) survey which reports: “Most companies (72%) state that they do not use formal contracts to document internal buy/sell agreements” (p. ii.).

  14. 14.

    See Holmstrom and Tirole (1991) for an elaborate discussion of this point and for a model that endogenizes the need for transfer pricing in a more general study of possible decentralized forms. In this paper, however, we take transfer pricing as a control mechanism already in place in the firm.

  15. 15.

    The literature classifies TP policies as administered (where most rules are laid down by headquarters) or negotiated (where participating divisions formulate their own rules.) Administered TP is either cost-based or market-based while negotiated TP often uses cost or market price as a starting point for negotiations. See the surveys of Eccles and White (1988) and Price Waterhouse (1984) for more details.

  16. 16.

    For a comparison of actual cost based with NTP, see Sahay, S. (2008)

  17. 17.

    Jack Hirschleifer, “On the economics of Transfer Pricing,” Journal of Business, July 1956, pp. 172–84.

  18. 18.

    See general guidelines regarding Transfer Prices in Horngren et al. (2011)

  19. 19.

    Another example of tactics used by manager is found in Bausch and Lomb where unusually long credit terms were extended to customers in exchange for big orders. See “ Blind Ambition” in Business Week, Oct. 23, 1995, pp. 78–92.

  20. 20.

    According to Business Week article on Bausch and Lomb “Under pressure to beat sales target in 1993, contact lens managers shipped products that doctors never ordered while assuring them that they wouldn’t have to pay until they sold the lenses”.

References

  • Adams, L. and R. Drtina. 2008. “Transfer pricing for aligning divisional and corporate decisions.” Business Horizons 51–5, 411–17.

    Article  Google Scholar 

  • Baldenius, T, S. Reichelstein and Sahay, S. 1999. “Negotiated versus Cost based transfer pricing” Review of Accounting Studies 4, 67–91.

    Google Scholar 

  • Chung, T. 1991. “Incomplete Contracts, Specific Investments and Risk Sharing,” Review of Economic Studies, 58, 1031–1042.

    Article  Google Scholar 

  • Eccles, R. 1985. The Transfer Pricing Problem: A Theory for Practice, Lexington Books, Lexington.

    Google Scholar 

  • Eccles, R. and H. White. 1988. “Price and Authority in Inter-Profit Center Transactions” American Journal of Sociology, 94 Supplement, S17–S48.

    Google Scholar 

  • Edlin, A. and Reichelstein, S. 1995. “Specific Investment under Negotiated Transfer Pricing: An Efficiency Result,” The Accounting Review, 70–2.

    Google Scholar 

  • Eun, C. and Resnick, B, 2012. International Financial Management, 6th Ed., Mcgraw Hill.

    Google Scholar 

  • Garrison, R.H. and Noreen, E.W. 2012. “Managerial Accounting” 14th Ed. Mcgraw Hill.

    Google Scholar 

  • Hirshleifer, J. 1956, “On the Economics of Transfer Pricing” Journal of Business, July 1956.

    Google Scholar 

  • Holmstrom, B. and J. Tirole1991. “Transfer Pricing and Organizational Form,” Journal of Law, Economics and Organization, 7, 201–228.

    Article  Google Scholar 

  • Horngren, C, G. Foster and S. Datar, 2011. “Cost Accounting: A Managerial Emphasis”, 13th Ed., Prentice-Hall, Englewood Cliffs, NJ.

    Google Scholar 

  • Kaplan, R. 1982. “Advanced Management Accounting”, Prentice-Hall, Englewood Cliffs, NJ.

    Google Scholar 

  • Merchant, K. 1989. “Rewarding Results: Motivating Profit Center Managers”, Harvard Business School Press.

    Google Scholar 

  • Price Waterhouse 1984. “Transfer Pricing Practices of American Industry” New York.

    Google Scholar 

  • Sahay, S. A. 1997. “Studies in the theory of transfer pricing”, Dissertation, UC Berkeley.

    Google Scholar 

  • Sahay, S. A. 2003. “Transfer pricing based on actual cost”, Journal of Management Accounting Research 15. 177–192.

    Google Scholar 

  • Sahay, S. 2012. “Negotiated vs. Actual Transfer Pricing,” working paper, Rutgers University.

    Google Scholar 

  • “Transfer Pricing 2003 Global Survey.” International Tax Journal 30.3, 1–86.

    Google Scholar 

  • Tang, R. 1992. “Transfer Pricing in the 1990s,” Management Accounting, 73–8, 22–26.

    Google Scholar 

  • Vaysman, I. 1996. “A Model of Cost-based Transfer Pricing,” Review of Accounting Studies, 1, 73–108.

    Article  Google Scholar 

  • Williamson, O. 1985. The Economic Institutions of Capitalism, The Free Press, New York, NY.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Department of Accounting and Information Systems, Rutgers Business School, Rutgers University, Janice Levin Building, Piscataway, NJ, 08854, USA

    Savita A. Sahay

Authors
  1. Savita A. Sahay
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Savita A. Sahay .

Editor information

Editors and Affiliations

  1. Dept. Finance, Rutgers University, Rockafeller Road 94, New Brunswick, 08854-8054, New Jersey, USA

    Cheng-Few Lee

  2. College of Business, San Francisco State University, Holloway Ave. 1600, San Fransisco, 94132, California, USA

    Alice C. Lee

Rights and permissions

Reprints and permissions

Copyright information

© 2013 Springer Science+Business Media New York

About this entry

Cite this entry

Sahay, S.A. (2013). Financial Control and Transfer Pricing. In: Lee, CF., Lee, A. (eds) Encyclopedia of Finance. Springer, Boston, MA. https://doi.org/10.1007/978-1-4614-5360-4_67

Download citation

  • DOI: https://doi.org/10.1007/978-1-4614-5360-4_67

  • Published:

  • Publisher Name: Springer, Boston, MA

  • Print ISBN: 978-1-4614-5359-8

  • Online ISBN: 978-1-4614-5360-4

  • eBook Packages: Business and Economics

Publish with us

Policies and ethics

Search

Navigation