The next two examples describe additional “exogenous” factors affecting the choice of a transfer pricing scheme.

Example: Tax implication of transfers across countries

A and B are divisions of the ABC company. The A division is located in Silicon where the marginal tax rate is 50%. The B division is located in Sand where the marginal tax rate is 30%. The A division produces an intermediate product at a cost of $100 per unit and then transfers this product to the B division where it is finished at an additional cost of $100 and sold for $500. Assume 1,000 units are transferred annually and that the minimum transfer price allowed by the Siliconi IRS is the variable cost.

• What transfer price should be charged in order to minimize taxes?

Example: Transferring funds out of a foreign country

Continue the previous example. The Sandi government does not allow corporations investing there to transfer earnings out of the country. Suppose the parent company wants to use some of its consolidated earnings (including the earnings of the B division) to either pay dividends or invest in a new project outside of Sand. One option for removing capital from Sand is through the use of a high transfer price. In this case the B division would actually pay the A division the amount of the transfer price, which would result in earnings of the consolidated entity appearing as the income of the A division rather than the B division. This may be desirable since the parent company controls earnings of the A division but not of the B division. The Sandi IRS restricts the transfer price to being no less than the variable cost.

• What transfer price should division A charge to exercise control over all profits?
• What is the cost associated with this transfer pricing scheme choice?

The essence of decentralization lies in the freedom of managers to make decisions. The decentralization of an matter of degree.

Observations

In most organizations:

• Obtaining specialized (or local) information is costly.
• Communication of information is costly.
• There exist interdependencies between the decisions agers in terms of the outcome to the firm as a whole.

• The amount of information to be managed is extremely large.

• Transfer pricing is often complicated by imperfect, ill-structured, or nonexistent intermediate markets.
• Imperfect competition occurs when a single buyer or seller can influence the market price.
• If imperfect competition exists in the intermediate market, additional volume can be obtained if selling prices are lowered, thus causing transfer-price analyses to be exceedingly complex.

• In such a case, an “optimal” transfer pricing scheme may be volume dependent.

• An economic analysis might dictate that variable cost be used as the transfer price, but
• this would seldom be appropriate for dealing with other aspects of the managerial problems that present themselves simultaneously:
  • achieving goal congruence,
  • motivating managerial effort, and
  • making good use of local information in a decentralized organization.
• Therefore, different kinds of transfer prices (for example, market prices and cost-based transfer prices) may be assigned.
• A primary reason for decentralizing the decision making in an organi- zation is the existence of information asymmetry.
• Textbook examples often imply that there is some individual in the organization with all of the nec- essary information (incremental costs, opportunity costs, revenues, etc.) for all of the organization’s divisions.
• Yet, if this were the case we would not have needed a decentralized organization in the first place.
• If a perfectly competitive market existed for the intermediate good trans- ferred between two divisions, then from an economic perspective, nothing would be lost by severing the firm at that point.