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Dynamic
Dynamic transfer pricing under transfer
conditions of uncertainty – the pricing

use of real options

Jan M. Smolarski 535
Department of Accounting and Finance, Rowan University, Glassboro,
New Jersey, USA Received 25 August 2018
Revised 7 July 2019
14 September 2019
Neil Wilner Accepted 16 September 2019
Department of Accounting, University of North Texas, Denton, Texas, USA, and
Jose G. Vega
Department of Accounting, Stephen F. Austin University,
Nacogdoches, Texas, USA

Abstract
Purpose – This paper aims to examine the applicability of real options methodology with respect to
developing internal transfer pricing mechanisms. A pervasive theme in existing models is their inability to
handle the dynamic and volatile nature of today’s business environment, as well as their lack of objective
managerial flexibility. The authors address these and other issues and develop a transfer pricing mechanism
based on Black–Scholes and the binomial options pricing methodology, which is better suited in today’s
dynamic business environment.
Design/methodology/approach – The authors use a conceptual approach in developing theoretical
justifications and show, practically, how a transfer price can be developed using two different real options
pricing models.
Findings – The authors find that real options transfer price mechanism (real options framework [ROF]) can
effectively deal with many of the issues that permeate a modern organization with complex multi-dimensional
operations. The authors argue that uncertainty and behavioral issues commonly associated with setting
transfer prices are better handled using a transfer pricing mechanism that preserves flexibility at the business
unit level, the managerial level and the firm level. The approach allows for different managerial styles in both
centralized and decentralized sub-units within the same organization. The authors argue that an open multi-
dimensional framework using real options is suitable under conditions of uncertainty and managerial
opportunism.
Practical implications – ROF-based transfer pricing may be significant in that firms can use it as a tool
to manage an organization by setting the prices centrally and at the same time allowing managers to select the
transfer price that best suits their specific situation and operating conditions. This may result in a more
efficient and more profitable organization.
Originality/value – The contribution of the paper is the melding of the ROF from the finance literature
with the accounting problem of setting a transfer price for items lacking a competitive market price. The
authors also contribute to existing research by explicitly developing a framework that values managerial
flexibility, takes into account uncertainty and considers the behavioral aspects of the transfer pricing process.

The authors owe a debt of gratitude to the anonymous reviewers, from this journal, who gave them
many excellent comments on prior drafts. Journal of Accounting &
The authors are also grateful for the comments provided by Jacob Birnberg, Joseph M. Katz Organizational Change
Vol. 15 No. 4, 2019
Graduate School of Business, University of Pittsburgh and Anders Grönlund (retired), Stockholm pp. 535-556
Business School, who gave them an embryonic idea to this paper when they discussed spare capacity © Emerald Publishing Limited
1832-5912
with one of the co-authors. DOI 10.1108/JAOC-08-2018-0083
JAOC The authors establish the conditions under which a generic real options model is a feasible alternative in
determining a transfer price.
15,4
Keywords Decentralization, Flexibility, Real options, Organizational integration, Transfer pricing,
Managerial flexibility
Paper type Conceptual paper

536
1. Introduction
This paper demonstrates that a real options transfer price mechanism (real options
framework [ROF]), which uses both a Black–Scholes and binomial ROF, can effectively deal
with many of the issues that permeate a complex multi-dimensional organization with
respect to transfer pricing. Our purpose is to add an alternative approach to setting a
transfer price to the many methods found in the literature. Our study is important because
existing transfer pricing models are more appropriate in static business environments while
today’s environments are more dynamic. We add to the existing transfer pricing models,
which arbitrarily allocate profit between the parties and use optimal flexible pricing and
quantity strategies required under conditions of market uncertainty, ambiguity and
volatility (Cheng et al., 2017). We specifically identify a solution that addresses frictions,
which are caused by existing transfer pricing mechanisms and the conflicts of interest
encountered between upstream and downstream divisions as outlined by Arya and
Mittendorf (2007, 2010). We argue that uncertainty and behavioral issues commonly
associated with setting transfer prices are better handled using a transfer pricing
mechanism that preserves flexibility at the business unit level, the managerial level and the
firm level. Our arguments are in harmony with Lawrence and Lorsch (1967), Li and Kouvelis
(1999), Kanodia et al. (2004), Drew and Kendrick (2005), Hassan (2005), Arya and Mittendorf
(2007, 2010), Widener (2007), Doff et al. (2009), Shor and Chen (2009), Borkowski (2010),
Velten (2011), Erickson (2012), Ray and Goldmanis (2012), Cecchini et al. (2013), Rossing et al.
(2016) and Yongling et al. (2018).
Transfer pricing has been studied extensively with no definitive closure in sight. The
only conclusion that can be asserted is that different approaches are presented depending
on a host of circumstances. One approach may work in a given situation and be totally
inadequate in another set of circumstances. The only situation where there is agreement
that a “solution” exists is the trivial case when the transferred good or service or
acceptable substitutes, have a competitive market price. Because this only works in such
a restricted case, alternative approaches to determine the price must be used in the more
realistic situations where there are no exact competitive markets. Existing alternatives to
market price are cost-based and negotiated solutions. We discuss the alternatives later in
this paper.
We add to the extant literature by presenting an alternative pricing mechanism using a
ROF. This framework is highly applicable in today’s business environment. The
contribution of the paper is the melding of the ROF from the finance literature with the
accounting problem of setting a transfer price for items lacking a competitive market price.
Traditional models tend to be based on a deterministic managerial strategy as if they were
fixed rather than the dynamic processes that exist in a modern business environment. We
also contribute to existing research by explicitly developing a framework that values
managerial flexibility, takes into account uncertainty and considers the behavioral aspects
of the transfer pricing process. We establish the conditions under which a generic real
options model is a feasible alternative in determining a transfer price.
 Transfer pricing has been studied extensively. The continuing stream of research Dynamic
dealing with many issues involved indicates that transfer pricing policies continue to be an transfer
important area of research. Recent research has focused on how to set transfer prices
(Baldenius and Reichelstein, 2006; Kachelmeier and Towry, 2002; Smith, 2002; Gosh, 2000;
pricing
Anctil and Dutta, 1999; Edlin and Reichelstein, 1995; Ronen and Balachandran, 1988). Some
studies have focused on how business practices affect transfer pricing policies and schemes
(Dikolli and Vaysman, 2006) while others have focused on cost and organizational issues
(Göx, 2000; Gosh, 2000) or strategic issues (Alles and Datar, 1998). Researchers have also
537
focused on risks associated with formulating transfer pricing policies (Ghosh and Boldt,
2004; Göx and Schöndube, 2004; Sahay, 2003; Anctil and Dutta, 1999). Extant research has
tended to refine existing models to deal with important issues, which remain unresolved in
the prior studies. This is an incremental approach to the transfer pricing issue, which has
yielded significant insights but no definitive solution. We use a fresh approach to deal with a
number of issues that continually permeate the transfer pricing literature. We do not offer a
definitive solution but are confident that we are pushing along the body of knowledge with
an ROF perspective[1].
Basic real options research is of recent origin and most studies have been published
within the past 20 years (Anderson, 2000; Bowe et al., 2005; Smith, 2007). Early studies dealt
with the mechanics of real options and how to differentiate real options from financial
options. This was followed by explicitly incorporating flexibility, i.e. the value of flexibility
from a generic point of view (Trigeorgis and Reuer, 2017), for the strategic and managerial
decision-making aspects of real options (Trigeorgis, 2005 for an overview of the practical
aspects of real options and Trigeorgis, 2000, for mathematical aspects of real options).
Recent studies (Jafarizadeh and Bratvold, 2015; McGrath and Nerkar, 2004) have focused on
specific industries and specific functional issues such as the type of real option or
addressing specific industries or functional areas such as research and development, as well
as oil, gas and mining operations.
Real options studies have begun to appear in the accounting literature dealing with
managerial performance (Baldenius et al., 2016) and managerial flexibility (Hu et al., 2013).
Behavioral aspects and cost of optimal capacity relating to real options are covered by
Rockenbach (2004) and Kallapur and Eldenburg (2005). Dhavale (2005) and Rese and
Roemer (2004) studied, respectively, optimal capacity in relation to real options and
managing flexibility. In general, real options can be a powerful tool for quantifying the value
of strategic and operational flexibility (Chen and Chen, 2011). Some of the most important
overall findings from existing real options research are:

the applicability of real options across numerous disciplines, different managerial
functions and decision-making situations;

that it explicitly incorporates risk and uncertainty; and

when managers have operating flexibility, it affects firm values positively
(Grullon et al., 2012).

We argue, based on existing research, that ROF has become an established decision aid,
which can deal with issues outside the traditional domain of financial options. We argue that
one such issue is the development of transfer prices. Thus, our paper does not refine ROF
model(s) but seeks to extend them to the setting of a transfer price.
The paper is organized as follows. First, we use existing research to build the theoretical
arguments in Section 2. Second, we provide an overview of the transfer pricing literature in
Section 3. This is followed by Section 4 covering real options. We include an analysis and
JAOC discussion of how a real option framework may be applied to transfer pricing. Where
15,4 applicable, we include a discussion dealing with implementation issues. We finish with a
discussion and concluding remarks in Section 5.

2. Theoretical development
We base our theoretical underpinnings on Lawrence and Lorsch (1967), Hatten et al. (1978),
538 Bourgeois (1985), Rossing, Pearson and Nesimi (2016) and Spekle et al. (2017). Lawrence and
Lorsch (1967) suggest, from a general perspective, that firm effectiveness depends on
structuring administrative arrangements appropriate to the nature of an organization’s
external environment. Industrial organization economics theory maintains that various
industrial and firm factors constrain firm conduct, which determines economic performance
(Hatten et al., 1978). Creativity and control are important drivers of organizational success
(Spekle et al., 2017). They are both necessary for organizational success (Gilson et al., 2005).
Adler and Chen (2011) argue that both creativity and control can co-exist. Recent research
studies (Spekle et al., 2017; Grabner, 2014; Hall, 2008) suggest that control enables desirable
action choices and therefore affects performance.
A central principle in management is that a match between environmental conditions
and organizational capabilities and resources is critical to firm performance (Bourgeois,
1985). Combining these arguments, the greater the match between the true environmental
volatility and managers’ perceived environmental uncertainty, the higher the economic
performance of a firm. Bourgeois (1985) also maintains that goal diversity within a firm
leads to better performance. Both diversity of environmental perceptions and diversity in
goals within firms are related to performance. These relationships depend on diversity of
both kinds and are highly related to congruence between perceived and actual
environmental uncertainty. Arya and Mittendorf (2007) argue for a standard decentralized
arrangement wherein each division focuses on its own profit. They also suggest that firms
may benefit by refining pricing and compensation structures and alter the approach to
transfer pricing to better exploit decentralization. In essence, flexible management styles
and decentralized structures benefit turbulent uncertain environments.
Cecchini et al. (2013) suggest that setting transfer prices is a complex problem, which
includes many factors and has many consequences. Rossing et al. (2016) argue that the need
for transfer pricing arises mainly from various risks, which is usually referred to as
downside variation in costs or margins that approximates economic reality. There are many
factors that contribute to transfer pricing risk, e.g. market risk (Doff et al., 2009), regulatory
risk (Borkowski, 2010), functional risk (Erickson, 2012), technical risk (Velten, 2011) and
internal risk (Drew and Kendrick, 2005; Widener, 2007). Market and internal risk are the
most relevant risks for us, since the main purpose of our paper is to develop a transfer
pricing mechanism from the organizational and operating perspective. Therefore, we are not
concerned with taxation or regulatory aspects in our paper. Taxation and regulatory issues
may be closely related but incorporate Organization for Economic Development and
Cooperation transfer pricing guidelines and individual countries’ tax regulations. While
there is some overlap, different departments and functional areas face different risks, e.g. the
risk for a marketing department is different from that of production and transportation.
Market risk in this paper refers to variance in performance associated with operating in
different market environments, by a single firm. Internal risk refers to the possibility that
various parts of a firm cannot operate efficiently. Widener (2007) finds that firms use control
systems to mitigate risk factors and that such systems have a positive effect on firm
performance. In many multinationals, the diagnostic/boundary control system for transfer
pricing relates strictly to calculating variance based pre-set acceptable earnings margins for
a specific subsidiary (Rossing et al., 2016). When the variance is out of range, adjustments Dynamic
are made after the fact, which may bring earnings within the pre-specified target range. The transfer
main weakness of this approach is that it does not take into account the reasons for the
variance, e.g. quality, opportunism, product/geographical parameters and uncertainties
pricing
related to both external and internal circumstances and issues, as well as problems facing
managers. Bedford and Malmi (2015) argue that firms use a combination of control systems
to deal with the uncertainties they face. These include results-oriented systems that are
539
flexible where administrative control processes help ascertain that managers stay within
pre-established boundaries.
We now turn to a discussion of the transfer pricing literature to discuss the extant
methods to setting the price. We then show how our proposed methodology adds to that
body in an incremental manner.

3. Transfer pricing
We discuss, in this section, issues associated with transfer pricing from a traditional
accounting perspective. We end this section with a discussion of how ROF can contribute to
this literature. Transfer pricing has a significant impact on the performance of decentralized
organizations (Kachelmeier and Towry, 2002; Gavious, 1999). It is often a controversial issue
since it has the potential to transfer wealth among business managers and business units
(Baldenius and Reichelstein, 2006). Setting internal prices in decentralized firms routinely
reveals frictions throughout the organization (Arya and Mittendorf, 2010). Conflicts of
interest between upstream supplying divisions and downstream procuring divisions have
firms struggling to determine effective transfer prices (Arya and Mittendorf, 2007).
Divisions, business units and subsidiaries often supply goods and services to other
units within the same company. Performance evaluation metrics include measures based
on profit or return criteria such as operating margin or return on investment. Internal
transfers between units within the same company must use a transfer price to measure
profit in a traditional accounting sense. A well-functioning transfer pricing system
should allow for a fair assessment of divisional performance and encourage
improvements in organizational performance. The overall objective in setting transfer
prices is to motivate managers to act in the best interests of the company, not the best
interests of their own units. Sub-optimization and goal incongruence may result if this
objective is not achieved. Inappropriate transfer pricing mechanisms may result in
losses (Gavious, 1999) and make firms less competitive in the long run. Upstream
divisions excessively charge downstream divisions, which respond by taking suboptimal
actions in the procurement of inputs (Arya and Mittendorf, 2010). Sellers have an
economic incentive, at a managerial level, to charge as high of a price as possible, while
buyers have an incentive to pay as low of a price as possible.
In a well-functioning external market, where independent buyers and sellers are active, a
fair price is determined by the market (Kachelmeier and Towry, 2002)[2]. The situation is
different when the buyer and seller are from different units of the same company. An
external market for the transferred item may or may not exist. The lack of a competitive
external market leads to the need for alternative pricing mechanisms to market based. If the
performance of a division is determined by profits or return on investment, managers will
take an intense interest in how the transfer price is set. The price at which goods and
services are transferred can have a large impact on division profitability and therefore
managerial compensation, e.g. allowing upstream divisions to set profit-maximizing prices
for their input goods inflates the effective cost for downstream divisions, resulting in higher
JAOC prices and potentially a lower profit (Shor and Chen, 2009). We will now discuss common
15,4 transfer pricing mechanisms.

3.1 Existing transfer pricing methods

There are several transfer pricing methods available, broadly classified as market-based,
cost-based and negotiated. Many firms rely on market-based transfer prices. Baldenius and
540 Reichelstein (2006) maintain there is almost universal agreement that market-based transfer
pricing is superior in well-functioning markets. It is also appropriate when products and
services are standardized with low levels of customization. The main problem with market-
based transfer prices is the requirement that divisions are able to observe and subsequently
use market prices. In addition, using market price means that firm specific issues may not be
dealt with sufficiently, since market prices may be based on averages or aggregation.
Averages incorporate information that may not be relevant for all subsidiaries and may also
be driven by outliers from an internal firm perspective. While it may be straight forward to
observe a market price for certain goods at the market level, it is considerably more difficult
at the customer, customer group and other levels. Also, observed prices may or may not
reflect quantity and other discounts, and unless the degree of customization is low, using a
market price may result in non-desirable distortions. Extant research suggests that firms
use inter-company discounts extensively to mitigate some of the inherent difficulties in
using market-based transfer prices (Baldenius and Reichelstein, 2006). Questions also arise
when accounting information is combined with market information. This is common in
dynamic environments, especially when combining discounts with market prices, and
results in inefficiencies (Christensen, 2010). A gap exists in the literature because, as we just
discussed, market-based pricing is not always feasible. We now turn our attention toward
the pricing methods proposed when market-based is not feasible.
The second group of transfer pricing methods are cost-based methods where internal
products and services are transferred at cost. This may be appropriate when the degree of
customization is high, when products and services are complex and when business customs
accept that cost is the basis for setting internal prices (Baldenius and Reichelstein, 2006).
There are several cost bases that may be used to set prices. These include variable cost,
absorption cost and absorption cost plus normal profit margin. The literature suggests that
standard costing be used in any cost-based scenario to prevent the selling division from
passing inefficiencies on to the buyer. Sahay (2003) suggests that cost-based methods are
simple to implement and use and may be appropriate when market prices are unobservable.
One obvious criticism of the cost method approach is the potential information asymmetry
in observing relevant costs. This asymmetry potentially puts the buying division at a
disadvantage. Another issue is the reality gap between theory and practice in management
accounting where the cost method is especially vulnerable (Lucas, 2003). There are potential
behavioral issues as well, which are caused by shifting profits between divisions. As you go
from variable cost to absorption cost to absorption cost plus a normal profit margin, the
profitability shifts in a decentralized environment, which may cause friction and increased
information costs. In most cases, variable costs are more observable compared to allocated
fixed costs. The allocation process is based on arbitrary values even in the rare case where
complete information about fixed costs is spread across all parts of the firm. Managers may,
however, be able to observe market prices with respect to variable costs. The cost methods
are also an attempt at re-allocating business risks. Transfer prices based on cost plus profit
result in some business units absorbing less risk. Assuming a minimal risk re-allocation, one
of the main issues to contend with in using the cost-plus method is the size of the premium
added to the cost since it may be determined arbitrarily. Finally, within the cost-based
methods, the issue of idle capacity, investments in yet-to-productive plant and equipment Dynamic
and demand forecasts become important. Conventional economic theory suggests that the transfer
long-term optimal transfer price is either variable cost or market value depending on
whether the supplier has idle capacity (Shih, 1996). The purchaser still has an incentive to
pricing
overstate demand at the planning stage, in these circumstances, if he or she knows that the
seller has idle capacity. This is especially true in industries with high-fixed costs because it
potentially lowers per unit costs at the subunit level. Overstating demand, in turn, promotes
the acquisition of excess capacity. The opposite holds if the seller is using a full cost 541
approach where the buyer has a disincentive to overstate demand. The result in this
situation is that the buyer will pay absorption cost plus a margin. Neither approach is
appropriate in volatile markets when prices are unstable across time. Note that activity-
based costing traditionally assumes, either explicitly or implicitly, the use of full cost in
setting a price (Kaplan, 1988). Anecdotal evidence suggests that business environments are
becoming more dynamic and therefore subject to significantly increased uncertainties in
determining the risk premium, capacity and demand. We argue that while cost methods are
simple, they are susceptible to inefficiencies and manipulation, as outlined above. Our
argument supports the notion that when linear cost allocation mechanisms are used
(including the two-stage ABC model), sub-units may profit from misallocations (Collier and
Collin, 2015) and that errors in common allocation practices render the various cost methods
less effective (Christensen, 2010).
The potential presence of coercive powers within the firm is another key difference
between internally set transfer prices and externally set prices. Coercion is usually not
present in arms-length transactions between two or more independent parties. A negotiated
transfer price is the product of negotiation between the buyer and the seller, where at least
the firm has coercive powers, either outright or through indirect methods such as cost
allocations. Either the buyer or seller may have specific coercive powers, depending on
circumstances. The method of negotiated transfer price is suitable when the level of
decentralization is high, where competition is significant and where business unit autonomy
is high (Göx, 2000; Gavious, 1999; Baldenius, 2008). This alternative increases transparency
since managers have a low informational threshold. The literature suggests that risk
preference and negotiation situation also affect negotiated transfer prices (Ghosh and Boldt,
2004). Göx and Schöndube (2004) suggest that risk-averse managers set higher transfer
prices compared to risk neutral managers. Additionally, the literature generally suggests
that a negotiated transfer price is preferable to a cost-based price.
To summarize, existing transfer pricing methods are not well suited to handle many
situations for various reasons. First, they do not handle volatile (uncertain) markets well.
Second, the coercive powers often present in intra-firm pricing arrangements are not
explicitly taken into account[3]. Third, the degree of customization, uniqueness and
complexity has implications for developing an effective transfer pricing mechanism. Fourth,
cost, negotiated and in some cases, market-based transfer pricing methods promote
managerial opportunism in a decentralized organization in that they allow for significant
demand manipulation, which may result in acquisition of excess capacity. Rules for transfer
pricing must be set centrally, but decisions based on the rules must be made in a
decentralized fashion at the local level, to achieve the desired level of transparency. Fifth, the
traditional transfer pricing methods do not take into account managerial flexibility to a large
extent. It is normally an arbitrary decision when they do. Finally, traditional pricing
mechanisms tend to be based on a deterministic managerial strategy and do not necessarily
take into account organizational structure, managerial behavior and the modern business
environment.
JAOC The ROF model we present is based on a set of rules, which are determined centrally and
15,4 address many of the issues we articulated in the prior paragraph. Decisions to act on these
rules are made in a decentralized environment. Thus, we emphasize individual
responsibility and accountability to achieve centralized goals and objectives. Division of
responsibilities for deciding upon the rules and making decisions based on these rules helps
ensure transparency. An important benefit of the real option framework is that it allows for
542 a cafeteria approach, i.e. setting different prices simultaneously in advance, taking into
account different scenarios that cater to the various stakeholders. This would result in
setting transfer prices where each manager may select a price that best suits his or her
operating environment. This is highly beneficial as most managers within the same firm
face different business scenarios, situations and environments. We now discuss how a real
options transfer pricing framework helps alleviate many of the issues managers face when
using traditional transfer pricing approaches.
Ray and Goldmanis (2012) demonstrate that the main feature of any efficient cost or
pricing structure must reflect the firm’s and the operating units’ underlying costs. While this
point may seem obvious, the linear rules used in cost allocations represent a blunt
instrument to control managerial behavior because they do not account for the firm’s
underlying costs and the shape of the firm’s cost function. Even though linear rules are, in
general, inefficient, they are widely used in practice. Charging each subsidiary for a common
resource (whether an actual average cost or a budgeted per-unit overhead rate) ignores the
fact that the actual marginal cost of each unit of resource used may depend on the total
amount of resources used and will depend on several other factors such as managerial
behavior and the market in which the subsidiary operates. Resources are historically
thought of as physical, which ignores intangibles resources such as flexibility, management
style and market specificity. Consequently, when using a linear rule, the price that a division
pays for an additional unit of resource (i.e. the private intra-company cost to the division)
differs from the actual marginal cost to the firm. This causes inefficient resource
consumption decisions in firm subsidiaries. The larger the firm, in terms of divisions and
subsidiaries, the less capable a linear allocation rule becomes and the firm will experience an
aggravated free rider problem (Ray and Goldmanis, 2012). Homburg et al. (2018) confirm
Ray and Goldmanis’ (2012) argument by showing that cost allocations in practice are based
on heuristics and limited information, and that decisions based on such cost systems
necessarily contain errors. Biases in cost estimates also hinder optimal decision-making
(Collier and Collin, 2015). Standard and common costs are imprecise and “provide, at best, a
noisy representation of a firm’s operation and underlying events” (Kanodia et al., 2004). We
argue that using a real option framework in developing transfer prices increases efficiencies
in that it allows managers to take into account private information of their own specific
operations. Practically, this means that prices are set and selected based on public (known to
all managers) and private information (known to a specific manager).
Li and Kouvelis (1999) show how flexibility and risk sharing can effectively reduce
product cost, and increase overall firm profits, in environments of price uncertainty. When
faced with ambiguity and uncertainty (volatility), intra-company buyers and sellers are
unsure about their future prospects, which creates doubt about the probabilities of future
events and their subsequent realizations. Most managers in this situation display
ambiguity, aversion and pessimism. This is especially true where commitments are
irreversible and transactional arrangements are uncertain. Interacting parties do not
necessarily have private information about their counterparties’ uncertainty, as expressed
through quantities, prices and other variables. In addition, revenues and costs are difficult to
predict in normal situations because they follow lognormal diffusions with ambiguous drifts
(Li and Kouvelis, 1999). Volatilities are normally ambiguous, which means that the actual Dynamic
rate of volatility is unknown in advance. Agency costs present in the normal transfer pricing transfer
process increase with volatility and risk aversion by as much as 55 per cent in a theoretical
setting (Hugonnier and Morellec, 2006). Managerial risk aversion has a significant impact on
pricing
overall cost outcomes. Idiosyncratic risk is also an important factor in managerial decision-
making. Real options help assist managers in formulating robust buying/selling strategies
under uncertainty (Yongling et al., 2018). Choi et al. (2018) show that firms tend to perform
better financially when they have flexibility in certain aspects of managerial decision- 543
making.
Despite the ambiguity and uncertainty faced by managers, they have some confidence in
their judgments. A transfer pricing mechanism that uses real option methodology allows the
transacting parties to choose a price that best reflects confidence in their judgments, their
individual attitudes toward ambiguity and their sentiment (ambiguity aversion or
pessimism) regarding the future fluctuations of their respective variables, i.e. revenues for
the buyer and costs for the seller, respectively (Yongling et al., 2018). These effects are likely
amplified in decentralized settings, where there are possible information asymmetries. Some
managers are better informed than others about projected cash flows and agency issues
such as unobserved managerial effort, costs and local market conditions. It is nearly
impossible to provide precise incentives to both parties to handle supply and demand
volatility, given that the exchange of public and private market information tends to be
inefficient within a decentralized organization (Cheng et al., 2017)[4]. While agency conflicts
and coercive powers are minimized in the standard real options paradigm, the hidden
information problem is that the value contains a component that is only privately observed
by the subsidiary manager. Managers could have an incentive to lie about the true quality of
the project and divert value for their private interests, absent any mechanism that induces
the manager to reveal private information voluntarily. However, once the subsidiary
manager selects a price, it is possible (but not certain) that this information indirectly reveals
private information to the non-subsidiary managers. A real option transfer pricing approach
includes the optimal contract price that induces the subsidiary manager to deliver to the
corporate manager the true value of the privately observed pricing component, and thus no
actual value diversion takes place in theory (Harris et al., 1982). Minimization of asymmetric
information is achieved in firms that offer managers a menu of allocation/transfer price
combinations, (Harris et al., 1982). Antle and Eppen (1985) provide a model which is similar
to Harris et al., 1982. Copeland and Antikarov (2005), among others, argue that real options
have the greatest value when there is uncertainty about the future, which increases the
likelihood that new information will be received over time. Managerial flexibility allows
managers to respond appropriately to new information, which increases the value of the
option to wait and the likelihood of reducing or postponing current decisions (Xie, 2009),
thus potentially increasing firm value. Kim (2011) also supports the argument that flexibility
is beneficial in ambiguous and uncertain business environments. Finally, using a real
options approach, firms can downplay product customization, uniqueness and complexity
as this can be handled by the cafeteria approach, which provides multiple transfer prices.
We will now discuss the real options literature with the intent of motivating the conditions
under which an ROF solution to the transfer-pricing problem may be feasible

4. Real options
Options research has traditionally focused on the financial markets for good reason. Option
valuation models (Binomial and Black–Scholes) were initially developed to deal with the
price of options on underlying financial assets. It became apparent that options were
JAOC available on many assets and non-assets alike, as financial option theory and models
15,4 developed.
A real option is present if a right, but not an obligation, exists in an uncertain
environment to make a decision at one or more future points, thus providing flexibility. A
key difference between a financial option and a real option is that a decision about a real
option may affect the value of an organization from an operational stand-point. A financial
544 option is always created around an underlying asset (often a financial asset or a commodity),
which affects the value of the option. A real option affects the value of the underlying asset.
Real options are omnipresent. An auditor who decides to investigate an irregularity is
exercising a managerial option. A manager who decides not to take a cash discount is
exercising his/her option not to do so. The same manager may face a decision to increase or
decrease variable costs. At a basic level, and from an accounting perspective, variable costs
are by their very nature similar to options. These costs vary with production volume but
remain constant on a per unit basis within the relevant range. In making a decision not to
produce, a firm has exercised the right to avoid variable costs. The firm has the right, but
not necessarily the obligation, to incur variable costs. It can avoid variable costs by electing
not to produce, defer production to a later date or in some cases, through asset disposals.
Firms can also break decisions down into several stages, resulting in compound options. A
compound option is a string of options or decision points that are inter-dependent. Firms can
make an investment in a productive asset on a small scale, wait to see if sales develop as
expected, and then make a further investment in fixed assets. Making the additional
investment would only happen if the market develops according to expectations. For
example, an oil company drilling an exploratory well will incur additional costs if it is
productive. On the other hand, if the first drilling results in a dry hole, no additional asset
acquisitions will be made.
Managers, from a behavioral perspective, may decide to absorb or transfer certain costs
between divisions, business units or products. They may also decide to embed options in
tactical and strategic choices that allow or force subordinates to make their own decisions.
An example of the latter would be a manager who provides a list of preferred suppliers but
allows subordinates to make a final decision among the preferred suppliers. Relevant to this
paper, we define a real option as a choice made available to managers for the purpose of
completing internal transaction opportunities. The transfer price is the price at which
divisions of a company transact with each other. Transactions include the trade of supplies,
components, products or labor between departments or divisions. Therefore, transfer
pricing is a real option because it represents a choice regarding transaction opportunities.
We are putting it in a context of transferring goods between two divisions of the same
company. We now turn our attention to an example.

4.1 Example
The idea behind our example is to show that an ROF specific transfer price may be
generated to replace a price determined by traditional methods. The next section of the
paper calculates the price that two divisions will use for the transferred good. We use a
binomial model for the calculations. The section following that uses the Black–Scholes
option-pricing model to calculate the option price used in the transfer. We select the
Black–Scholes option pricing model due to its ease of computation (Dai and Lyuu, 2010),
flexibility in implementation (Arnold et al., 2003) and, as previously discussed, to show
its relevance. Using Black–Scholes results in an option premium, rather than a product
price. This model is better suited in environments where the firm is a price taker or in the
situation where standardized product differentiation is largely based on price.
Importantly, the Black–Scholes model depends on the preference parameters (Câmara Dynamic
and Wang, 2011), which is highly relevant in our case. In addition, the model allows for a transfer
subjective estimate of the probability that a specific event may take place, e.g. a large
non-recurring order (Liang et al., 2012). We thus show how real options may be used in an
pricing
uncertain environment with respect to transfer pricing. We acknowledge that the
volatility parameter is the most difficult to elicit via empirical data or subjective educated
guess (Cobb and Charnes, 2004) and that the volatility estimation process and result may
be different in various divisions of a company. The logarithmic cash flow method, stock 545
proxy method, logarithmic present value returns method, the internal rate of return
method and management estimates are common approaches to estimating real option
volatility (Lewis et al., 2008). Other articles discussing real option volatility include Davis
(1998), Cobb and Charnes (2004) and Godinho and Costa (2007). Dotsis et al. (2012)
provide a framework for examining the impact of uncertain volatilities on option prices.
Many firms face challenges resulting from volatile input costs, including raw materials.
This is especially true when cost movements are hard to predict, and the company has to
deal with oscillating customer demand curves. Assume that the seller (division A)
manufactures widgets and that the current observable market price is $100 per widget.
Currently, the buyer (division B) purchases the widgets from the seller at the market price.
The market price of widgets fluctuates due to market conditions. These fluctuations cause
planning problems for both divisions and monitoring market prices is costly.
The buyer does not like the uncertainty resulting from the fluctuating price of the
widgets. This uncertainty is compounded if the buyer has fixed price supply contracts with
external customers. Similarly, the seller dislikes the uncertainty of not knowing the number
of widgets the buyer will purchase within a specified time period. We reason that producing
divisions (like the seller) prefer manufacturing efficiencies that come from as few set ups as
possible and smooth production runs over extended time periods, i.e. producing the same
product in predictable quantities over an extended time period. If this does not hold,
the seller must maintain production flexibility or use on-demand outsourcing facilities.
Spare capacity is another costly option. In this case, both divisions would like to reduce
uncertainty as much as possible. The value of entering into an options contract, from the
seller’s perspective, is based on the present value of the cash flows provided by the
opportunity, which can take many forms (Cobb and Charnes, 2004). The value proposition,
from the buyer’s perspective, is related to the potential gains from entering the options
contract, which comes from two sources:
(1) The reduced loss related to price or other fluctuations assuming the option is
exercised.
(2) If the option is not exercised, cost savings may accrue (Liang et al., 2012).

Currently, the buyer has a budgeted need for 100,000 widgets in the upcoming month.
The two division managers believe that the market value of widgets may fluctuate as
much as 25 per cent as measured by the current standard deviation of the price of
widgets. The manager of the seller decides to offer the buyer an opportunity to purchase
an option for $3.88 per widget. (calculations in the Stage Two section below). The option
would guarantee a price per widget of $98.20 (see calculations in the Stage One section
below). The $98.20 is the expected price given the assumptions, which we specify below.
We argued, in footnote 2, that while price movements show a tendency of predictability,
e.g. decreasing in this case, they may increase or remain stable, as well. The agreed upon
price of $98.20 reduces uncertainty for both divisions. Accepting $98.20 will eliminate the
risk of the buyer having to pay a higher price, assuming the purchase of at least 100,000
JAOC widgets. The cost for eliminating the risk of a higher price is charged to the buying
15,4 division at $3.88, i.e. the option premium. The buyer’s commitment to purchase 100,000
widgets would reduce the overall cost for the seller. The seller now knows how much
material it needs to purchase during the allotted time frame. If the buyer decides it needs
more than 100,000 widgets, it would have to pay the spot price for the additional units
needed. This should force the buyer to develop more accurate forecasts, which also
546 benefits the seller. The $98.20 price is the maximum price that the buyer will pay for a
pre-specified time-period and volume if purchasing the $3.88 option. Profits are thus
efficiently preserved by both the buyer, the seller, and at the corporate level. The reasons
why the buyer would enter into such an agreement are two-fold. First, it removes price
uncertainty within the specified time-period. Second, the transfer price is customized
because it allows the buyer to remove as much or as little uncertainty as desired based on
their specific operating conditions. This means that in a multi-divisional setting, each
division would accept a transfer priced based on their own set of circumstances. Using
the above information and assuming a European option (as required by the Black–
Scholes model) and a one-month time horizon (in our example), the transfer price is
$102.08 per widget ($98.20 plus $3.88). We show the calculations below, in two stages,
beginning with the binomial model. The binomial model calculates both the expected
price and the range of prices for a widget. The Black–Scholes model calculates the option
premium given the input parameters. The parameters are the same for both models.
Stage One – Calculating the Range of Transfer Prices Using the Binomial Model
We now calculate both the expected transfer price and the range of transfer prices facing
divisions A and B using a binomial option-pricing model. The rigidity of the Black–Scholes
model causes us to use the binomial model for this task. Costabile et al. (2009) argue that the
binomial model is computationally simplistic, which makes it suitable for non-financial
situations. The binomial option-pricing model is better suited to calculate the lowest, highest
and expected widget price using the same input parameters as the Black–Scholes model. It
is also more flexible in its application (Dai and Lyuu, 2010). The parameters for both models
are now given:

Price: S0 = $100 where S0 is equal to the current market price.

Interest rate: r = 0.83 per cent where r is the market observed time appropriate risk
free interest rate.

Time to expiration: T = 0.0833333 (in this case one month out) where T is equal to a
pre-specified time period of the agreement, one month. Note that the time period can
be up to 12 months, which conveniently corresponds to many budget cycles and also
the annual reporting period.

Standard deviation: s = 25 per cent where s is the standard deviation the risk that
the price will increase or decrease over a specific time interval. The estimation of
volatility should be based on facts and circumstances of a specific firm’s operations.
Common examples of possible volatility measures may include a commodity that
represents a major component used in production or the volatility estimate may be
based on a basket of component prices, fluctuations in labor costs, multiple
commodities or market prices of raw materials that are not commodity based to
name a few possibilities.

The model assumes that the price can increase or decrease. In addition, we assume that both
parties have access to the same information and form the same opinion about future market
conditions. In the likely event that the subsidiaries and managers form different views of
future market conditions, the model may result in better managerial outcomes because each Dynamic
party will be able to interpret the result from his or her perspective[5]. The parties may be transfer
able to maximize overall outcomes, by doing so. This is a more realistic situation, even if the
pricing
process and information sharing is transparent, since the parties may possess local and
global information that is not shared for a variety of reasons. It is also a normal situation
since it is very difficult to form a real and objective probability that a specific event will or
will not occur. The binomial model variables are: 547
Su is the widget price in one month given a price increase and Sd is the widget price in one
month given a price decrease.
Su = Price increase (u): es Ht = e.25x.H0.0833 = $107.4836.
Sd = Price decrease (d): 1/u = 0.930374 = $93.0374.
Probability of a price increase, Pr(u): (ert – d)/(u – d) = 49.3512 per cent.
Probability of a price decrease, Pr(d): 1 – Pr(u) = 50.6488 per cent.
Expected (most likely) Transfer Price: ({$107.4836*0.493512} þ {$93.0374*0.506488)}/
(1 þ 0.02) = $98.2027, which we round to $98.20.
We have calculated the likelihood of a price increase (49.3512 per cent) and price
decrease (50.6488 per cent) using the binomial model. We also determined, that if a price
increase (decrease) occurs, the new price will be $107.4836 ($93.0374) one month later.
Therefore, using the stipulated risk-free interest rate, the best price estimate is $98.20
one month out. The Binomial model has thus been used to calculate a range of transfer
prices. These are theoretical transfer prices that the parties can agree on if the views of
supply, demand and other conditions are known to both parties. The worst-case
scenario for the buyer is, given a price increase, $107.4836 and the worst-case scenario
for the seller, given a price decrease, is $93.0374. The buyer is motivated by avoiding
the possibility of having to pay $107.4836. The seller is motivated to agree to avoid
having to sell to the subsidiary for $93.0374. The agreement functions as protection
against further price increases or decreases. The spread between the transfer prices, in
our example, is driven, to a large extent, by the volatility of 25 per cent. The binomial
option pricing model allows for multiple transfer prices, which may mitigate
coerciveness and allow subsidiaries to make decisions concerning which transfer price
to accept given their specific circumstances. We now turn to calculating the option price
using the Black–Scholes Model.
Stage Two – Calculating the Option Premium Using the Black–Scholes Model
C0 is the call option value or option premium today and N(d1) and N(d2) are risk adjusted
probabilities.
Thus, the Black–Scholes pricing formula for the call option is equal to:

C0 ¼ S0 N ðd1 Þ  Xert N ðd2 Þ


lnðS0 =X Þ þ r þ s 2 =2 T
d1 ¼ pffiffiffiffi
s T
pffiffiffiffi
d2 ¼ d1  s T

First, we calculate d1:

    
JAOC ln 100
98:20 þ 0:0083 þ 0:25 2
2
0:08333
15,4 d1 ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ¼ 0:2974
0:25 0:08333

Then, we compute d2:

pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
548 d2 ¼ 0:3109  0:25 0:08333 ¼ 0:2252

Next, we find the probability that a random draw from a standard normal distribution will
be less than d:

N ð0:2974Þ ¼ 0:6169

N ð0:2252Þ ¼ 0:5891

C0 ¼ 98:20   0:6169  98:20e0:0083  0:08333  N ð0:5891Þ ¼ $3:88

The Black–Scholes model calculated option price of $3.88 plus the exercise price of $98.20
yields the ROF transfer price of $102.08.
The ROF framework can be used at the tactical or the strategic level in relation to
transfer pricing. We have discussed, in detail, and with an example how managers can
improve the process of setting transfer prices.
We now turn our attention to model specification issues. The estimation of volatility is
crucial. It is possible to use the volatility of an underlying commodity, in a simple situation,
if it is the major component used in production. In our case, volatility comes from the price of
the widget. The volatility estimate, in more complicated cases, may be based on a basket of
component prices and fluctuations in labor costs or fluctuations in multiple commodity
prices. Thus, it is possible to use a variety of volatility inputs, depending on the facts and
circumstances of firm-specific operations.
The time variable in the model can accommodate T = 1 month to T = 12 months and will
produce a different transfer price depending on the value of T. This is one of the strengths of
the framework, i.e. that it can accommodate multiple time frames, available to the managers
to choose from, depending on the operating environment. In practice, a different price would
be set for monthly, quarterly, semi-annual and annual periods. Prices are based, to a large
extent, on the likelihood of a price increase or decrease over a specific time-period using
probabilities (e.g. the state of a specific market at a specific point in time) and the effect the
internal price may have on firm operations. The result is a set of minimum and maximum
prices at specified time intervals. As time passes and market conditions change, information
is revealed resulting in more accurate information with respect to price for both Division A
and B. We now present a final section offering additional discussion and concluding remarks.

5. Discussion and concluding remarks

We have argued, in this paper, that existing transfer pricing methods are suboptimal in today’s
dynamic business environment. Our contribution rests on several principles and arguments as
outlined in this paper. The most important factor is the static and arbitrary nature of these
pricing models. Researchers have attempted to address some of the shortcomings of existing
models through various incremental improvements to handle specific situations. We specifically
identify a solution that addresses frictions caused by existing transfer pricing mechanisms, deals Dynamic
explicitly with the conflicts of interest encountered between upstream and downstream transfer
divisions, as outlined by Arya and Mittendorf (2007, 2010). Our solution is more suitable for a
dynamic business environment since the model takes into account operational and market
pricing
differences within a multi-national or multi-divisional firm. Our model does this by attempting to
match the true environmental volatility and managers’ perceived environmental uncertainty.
The success of the model is therefore related to the fit between perceived and actual
environmental uncertainty, i.e. that model inputs are well correlated to various firm operations
549
and the external operating environment. As we stated earlier, firms use the cost method due to
its simplicity, even though they are aware of its shortcomings. Our proposal is more complex
and would require firms to develop multiple transfer prices. The number of required transfer
prices would increase significantly, depending on the complexity of a firm’s operations, as
defined by how many operating segments and products the firm has. Another challenge in our
model is the volatility variable, which needs to be carefully developed. Developing a suitable
volatility measure may be relatively straightforward for products that consist of a single
commodity, as in our example. The same is the case for products consisting of low volatility
inputs. Combining operating environment and product input volatilities, on the other hand,
increases complexity. It may be possible to mainly focus on operating environment volatilities in
developing an overall volatility input measure, depending on firm goals. This focus would
depend very much on the firm’s environment. We argue, however, that many large firms can
access big data and develop appropriate mixes of input volatilities, which would then drive the
process of setting transfer prices. This approach helps in managing factors that contribute to
transfer pricing risk. In addition, since the actual transfer prices are set centrally but acted upon
in a decentralized fashion, firms should experience increased efficiencies since sub-unit
managers are often best equipped to decide what is best for their specific domain. The model
allows both parties to calculate the attractiveness of locking in the price based on their own
assumptions. The model also allows for the calculation of prices for different levels of managerial
and behavioral flexibility, i.e. to agree or not agree to a specific price. The result is multiple
transfer prices, which are set based on, for example, market conditions, environmental threats,
managerial styles, firm goals and objectives, and market or segment specific requirements. The
key is that managers may select specific transfer prices that fit their specific requirements.
This is an exploratory study with a goal of developing a transfer pricing mechanism using a
real options framework that is suitable when market or cost-based solutions are not available.
Our discussion has focused on a generic model. Our research suggests that a multi-dimensional
transfer pricing system using a real option framework is suitable to the conditions under which
many modern firms operate. This is the key factor of the framework: it can be adapted to
situations that firms actually face. Our research also suggests that an open, multi-dimensional
framework, using real options is suitable under conditions of uncertainty and managerial
opportunism. Our approach incorporates flexibility, uncertainty and managerial decision-
making and encourages transparency in transfer pricing decisions. Further research is of
course required. Possible future research areas include field studies or surveys, optimization
and corporate governance related issues, as well as how ROF developed transfer prices affect
firm effectiveness, efficiencies and profitability based on either simulated or actual situations.

Notes
1. Faiferlick et al. (2004) use an ROF to help set a transfer price in the specific case where uncertainties
may cause the IRS to apply the commensurate with income standard of Code section 482. We are
using the ROF framework with internal organizational situations, goals and objectives in mind.
JAOC While our aim is to develop a transfer pricing mechanism that reduces risk, we focus our attention
on management of the firm, from both an effectiveness and efficiency perspective.
15,4
2. We support the extant argument that many rates and prices will show a tendency toward
predictability (stable, increasing or decreasing) even though there may be fluctuations in
response to short-term uncertainties. This can be shown in a mean-reverting process, e.g. when
prices are too high managers tend to become more cautious when entering into agreements. The
opposite is also intuitive: when prices are low, firm managers will be less reluctant. In addition,
550 managers can make more accurate decisions as they incorporate new information gathered over
time. Using a Bayesian method, managers are able to capture real option changes from resolving
uncertainties (Herath and Park, 2001).
3. We argue that firms have coercive powers to varying degrees in most instances when dealing
with internal issues. Some firms also have significant coercive powers in dealing with external
parties. An example would be situations where switching costs are high.
4. In external markets, supply contracts are often a solution; however, a single contract will need to
combine multiple provisions to address a broad range of issues and risks, which enormously
complicates contract specification and analysis. In an internal situation such approach is not
feasible and other means must be used to assure supply and reduce uncertainty in cost and other
hazards (Cheng et al, 2017).
5. Liang et al. (2012) provide a mathematical discussion on the impact of subjective probabilities on
profits.

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Corresponding author
Jan M. Smolarski can be contacted at: jsmeu@hotmail.com

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