Strategic Transfer Pricing

Michael Alles * Srikant Datar

CBA 4M-202, University of Texas at Austin, Austin, Texas 78712
Harvard Business School, Accounting and Control Area, Soldier's Field, Boston, Massachusetts 02163

M\ , ost research into cost systems has focused on their motivational implications. This paper
takes a different approach, by developing a model where two oligopolistic firms strate-
gically select their cost-based transfer prices. Duopoly models frequently assume that firms game
on their choice of prices. Product prices, however, are ultimately based on the firms' transfer
prices that communicate manufacturing costs to marketing departments. It is for this reason that
transfer prices will have a strategic component to them. We derive implications for cost system
choice and transfer pricing, including showing that firms may cross subsidize their products-a
result consistent with the empirical evidence.
(Transfer Pricing; Full Cost Allocation; Incentives; Costing)

1. Introduction sentially the same as variable costs. Many economists,

Our objective in this paper is to develop a model of the therefore, advocate variable cost pricing. They further
firm that reconciles economic theory with the evidence state that managers should disregard fixed costs, allocated

that firms make pricing decisions on the basis of cost- costs, and ful costs (which are the sum of variable and
plus transfer prices rather than marginal costs. allocated costs). These cost constructions are said to be

Tang (1992) provides empirical evidence of the transfer irrelevant in arriving at selling prices." While economic

pricing methods used by firms. He reports that of the theory states that marginal revenue will equal marginal
transfer price methods used by 143 Fortune 500 firms, 46.2 costs, not that marginal costs equal prices, it is the case
percent are cost based. Of these, only 7.7 percent use vari- that the input into the pricing decision is marginal costs-
able costs of production, 53.8 percent use full production which cost-plus transfer prices are not equal to.

costs, and 38.5 percent use fuHl production cost plus a We believe one reason that much of the economic lit-
mark up or subsidy. In his survey of the pricing decisions erature omits an explicit role for cost accounting is that

of the largest 3,500 British companies, Mills (1988) statesthe problem is assumed away by taking as the firm's
objective function, revenue minus actual marginal costs
that: "Cost-based methods, usually reliant on full / absorp-
(assuming that the interests of "the firm" and its owners
tion costing principles, were the principal basis for deter-
mining prices under normal conditions. These cost-based coincide). However, in decentralized firms what is typ-
prices were usually modified by non-cost considerations ically maximized by the firm's marketing department is
of which reference to competitors' prices was the most im- revenue less the transfer price, or the costs reported by
portant of a number used" (p. 38, emphasis added). the internal costing system. This equals actual profits
Despite this large body of evidence that firms don't use only if transfer prices equal marginal costs. Since these
marginal cost pricing, accounting models of cost-plus pric- internal costs are chosen by firms, we address the ques-
ing have not been developed. As Govindarajan and An- tion of whether firms have an incentive to set transfer
thony (1983, p. 30) state, "Most of the academic literatureprices equal to marginal costs.' In particular, we show
on pricing is derived from the 'profit maximization'
model. It assumes that a firm attempts to maximize profits1 If production is carried out by another division of the firm, it is ap-
by setting prices such that marginal revenue equals mar- propriate to use the term transfer price for the means by which product
ginal cost. Marginal costs, as used in this model, are es- costs are communicated to marketing. If products are purchased from

0025-1909 /98/4404/ 0451$05.00

Copyright C) 1998, Institute for Operations Research
and the Management Sciences MANAGEMENT SCIENCE/Vol. 44, No. 4, April 1998 451

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 ALLES AND DATAR
Strategic Transfer Pricing

that the amount by which firms mark up their transfer The structure of the paper is as follows: We begin in
prices over marginal costs is directly a function of their ?2 by placing our model in context with the prior liter-
market power. Consequently, the magnitude of over- ature on transfer pricing. Section 3 describes the ele-
head allocations is also a function of the firm's market ments of the model, the product markets, the strategic
power, rather than of the size of its fixed costs. environment, and the nature of the actual and reported
In this paper, we formalize the link between the de- cost systems. The model is solved in ?4 and the strategic
termination of marginal product costs and the ultimate distortion is interpreted in relation to the familiar cost-
use of that information for pricing. The point is often ing concepts of drivers and indirect cost rates. We show
made that using appropriate cost drivers to compute that cost-plus transfer pricing is optimal in strategic
more accurate marginal costs is desirable from a prod- equilibrium when pricing products, and also that stra-
uct pricing standpoint and yields a competitive advan- tegic transfer pricing is consistent with empirical evi-
tage.2 We take the view that the firm's choice of a cost dence that cost systems are characterized by cross-
system is an endogenous and strategic variable. This subsidization of products. Section 5 offers some con-
perspective implies that we not assume that the use of cluding comments.
more accurate marginal costs for pricing purposes is
better, but rather that we examine whether using accu-
rate marginal costs is an equilibrium outcome. 2. Related Literature
An alternative way of stating this idea is that, from a Many standard accounting texts, such as Horngren,
pricing standpoint, there is a strategic component to trans-
Foster, and Datar (1994) or Kaplan and Atkinson (1989),
fer pricing. The objective is to explicitly place the firm'sexplicitly speculate that strategic factors may influence
choice of cost-based transfer prices within the context the choice of costs on which product prices are based.
of its overall competitive environment. The implication Consider the following from the latter text: "Some cor-
of our results is that in oligopolistic contexts, firms will porations deliberately allocate all corporate overhead
prefer to know their marginal costs as accurately as pos- expenses to operating departments with allocation ba-
sible, but that strategic considerations will dictate using ses that have little to do with the consumption or causes
marginal cost-plus transfer pricing when pricing prod- of the overhead costs. Senior managers apparently want
ucts. By using a multiproduct model, we also show that operating managers to be aware of centrally determined
firms may cross-subsidize their products in order to and controlled costs. Perhaps the fully allocated costs are
maximize their ability to raise prices in the strategic en- meant to encourage more aggressive pricing decisions by the
vironment. decentralized managers" (p. 247, emphasis added). "Cost-
plus pricing policies also provide stability to pricing de-

external sources, then there is no transfer price, and a costing system

tells marketing how much more it costs the firm to make the product
available for sale. We shall use the terms transfer prices and reported
costs interchangeably, since our results apply to either setting.
2 (See Cooper 1989 and Shank and Govindarajan 1988). In most real- An NAA study of cost allocation (Fremgen and Liao
istic circumstances, perfectly accurate costs are unobservable to the
firm. In this paper, when we use phrases such as accurate or actual
product costs, we mean marginal costs as known to the firm, as ac-
curately as its information-gathering technology allows, rather than
some ideal measurement error-free number. This actual marginal cost
is contrasted to the cost number which is reported, either directly
through a product costing system or through a transfer pricing system,
to the marketing division for making pricing decisions. The question
analyzed in this paper is whether the transfer price will equal the
actual marginal cost, which is distinct from the question of whether
the firm has obtained the most accurate possible cost information in
the first place.
cisions.. . . Such stability may well be desired by man-
agers, especially in oligopolistic industries that might
otherwise be susceptible to short-term price cutting that
reduces prices below long-run marginal cost" (p. 187).
1981, p. 19) also explicitly considers the role of strategic
factors in the calculation of product costs when pricing.
In decentralized firms (comprising production and
marketing divisions), costs are reported to the market-
ing division through the use of transfer prices from pro-
duction. The transfer pricing literature (see Ronen and
Mckinney 1970, Harris, Kriebel, and Raviv 1982, Eccles
1985, Ronen and Balachandran 1988, Christensen and
Demski 1990, Holmstrom and Tirole 1991, Mookherjee
and Reichelstein 1991, Edlin and Reichelstein 1995, and

452 MANAGEMENT SCIENCE/ Vol. 44, No. 4, April 1998

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 ALLES AND DATAR
Strategic Transfer Pricing
Vaysman 1996) argues that asymmetric information
and divergence of preferences results in transfer prices
being set that differ from marginal costs.
Harris, Kriebel, and Raviv (1982), however, show that
transfer prices will be below marginal cost, a result that
is also possible in the model of Ronen and Balachandran
(1988). This is inconsistent with the empirical evidence
of Tang (1992). Moreover, these analytic models do not
address the implications of transfer prices for the pric-
ing function of the marketing department. Indeed, in
Ronen and Balachandran (1988), the owner markets the
product, and revenue is a function of output. The trans-
fer price that the owner pays the agents responsible for
production has no impact on the subsequent pricing de-
cision. Their model does not address the empirical evi-
dence.
By contrast, our model of transfer pricing explicitly
deals with the effects on the pricing decision of setting
a transfer price above marginal cost. Our results pro-
vide theoretical support for the empirical practices doc-
umented by Tang (1992). In our model, transfer prices
exceed marginal costs to promote strategic price inter-
actions among firms competing in oligopolistic markets.
In contrast, much of the transfer pricing literature fo-
cuses on internal performance evaluation, motivation,
control, and generally, the aligning of interests within
the decentralized firm.
Our paper focuses on the extemal role of cost and
transfer pricing systems. We recognize that the firm's
choice of transfer prices is an important element in its
price-setting mechanism. Further, prices are not chosen
in isolation, but in a strategic setting that explicitly con-
siders the firm's competitors.
3. The Model
There are two multiproduct firms that compete across
two independent markets. In each firm, product pricing
decisions for both products are delegated to a separate
marketing division. Decentralization is necessitated by
forces outside this model, such as costly communica-
tion, limited span of control, and the need to use local
knowledge to respond quickly to market shocks or the
actions of competitors. A decision has to be made in
each firm on how to cost products when they are trans-
firm,
ferred from the producing to the marketing division,
MANAGEMENT SCIENCE/Vol. 44, No. 4, April 1998 453
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and the marketing division has to decide on the price
to be charged for each of the goods the firm manufac-
tures.
Each firm is run by a CEO who is assumed to maxi-
mize the actual profits of the firm on behalf of the share-
holders. The CEO implements a cost system to deter-
mine actual costs as a function of the production pro-
cess, and then on the basis of these actual costs he
chooses the transfer prices to be used when transferring
products to the marketing department. We assume that
the CEO also puts in place benchmarking programs to
determine the actual costs of the firm's competitors,
since this information is critical in imperfectly compet-
itive markets.3 After determining the actual costs of the
firm and its competitors, the cost system defines the
transfer price for the transfer of products from manu-
facturing to marketing.
The cost-based transfer pricing system is the means
of communication within the decentralized organiza-
tion. The marketing manager is assumed to maximize
profits reported by the marketing division, those profits
computed on the basis of the transfer prices. Given that
marketing managers are rewarded on the basis of trans-
fer price-based profits, they have no reason to concern
themselves with whether the actual costs of production
equal their transfer prices. The question we analyze is
whether it is optimal for the transfer prices chosen to be
something other than the marginal costs of manufac-
turing.
The timeline of the game is as follows. In the first
stage of the game, the two firms' CEOs simultaneously
select the transfer prices for their marketing personnel
to use. The optimal transfer prices arise endogenously
as equilibrium outcomes.4 In the second stage, the
3Homgren, Foster, and Datar (1994, p. 428) describe the importance
of cost information when deciding on pricing and product emphasis:
"A business with knowledge of its rivals' technology, plant size, and
operating policies is better able to estimate its rivals' costs, which is
valuable information in setting competitive prices." Caterpillar, Gen-
eral Motors, Hewlett Packard, and Xerox are cited for their use of
techniques such as competitive benchmarking to estimate the costs of
their competitors.
4 Note that this model contrasts with those studied in the industrial
organization literature on the demand for the decentralization of the
such as Fershtman and Judd (1987), where the agents' contracts
serve as commitment devices. They demonstrate that oligopolists can
 ALLES AND DATAR
Strategic Transfer Pricing

marketing managers compete in Bertrand fashion on above the perfectly competitive level. We model the
the product markets, making pricing decisions to max- tastes of consumers as lying uniformly on the unit in-
imize the marketing division's profits. In practice, costs terval [0, 1] with each firm at either end, and those con-
are only one input into the pricing process. Demand sumers preferring a firm's product located near that
conditions, the requirements of specific customers, and firm. Thus a consumer one third the way along the unit
other such factors all play a role. This model is consis- interval prefers the product of the firm on the left more
tent with this more complex environment, since costs than a consumer who is two thirds the way along (but
are one of the more important of these inputs. The spe- less than a consumer one quarter away from firm one).
cific pricing model used here leaves out these other fac- Each consumer demands exactly one unit of each prod-
tors only in order to focus sharply on the role of costs. uct. In this model, the firm has market power to the
The major assumptions in our model are that (i) there extent that these preferences mean that the consumer is
is an absence of incentive issues, (ii) lack of uncertainty willing to pay a higher price to purchase a product that
about the costs of either firm, or of demand, and (iii) more closely fits her preferences-in other words, the
common knowledge that marketing managers maxi- product from the firm closer to her in product space.
mize transfer price-based divisional profits. This third The disutility to the consumer of not getting exactly
assumption flows from the assumed decentralized firm what she wants is measured by the distance to a firm
structure and the consequent need to communicate cost times t-the cost of being one unit away in preference
information to the marketing manager. Each firm need space from the product that exactly fits the consumer's
not observe its competitor's choice of transfer prices, needs. Whenever t > 0 the firm enjoys brand loyalty
and consequently, there is no necessity for each firm to and market power, since each consumer closer to the
commit to its transfer price. Rather, given the common firm in product space will patronize that firm even if its
knowledge that some transfer prices must be chosen, prices are slightly higher than the other firm, as long as
that price difference does not exceed t times the differ-
each firm will react to its prediction of what that transfer
price will be. Hence, the transfer prices chosen will be ence in preference locations between the two firms. If t
equilibrium outcomes. = 0, then consumers are not willing to pay a higher
The marketing managers of each firm have two prod- price for their preferred product and so pure price com-
5
ucts to price and sell. We assume that the firms are mul- petition results.5
tiproduct since costing is trivial in a single product set- In the appendix we show that this model leads to the
ting. To link the costing practices of the firm to its mar-demand function
ket power, we use a variant of a Hotelling model of
spatial competition, which is a special case of the ge- Dij = tPij + 2t Pkj,
neric demand function Di1 = Ao - A,Pii + A2Pkj for ar-
bitrary constants Ai > 0, where Di1 is the demand forand unlike the generic demand function given above,
the role of market power in leading to differentiated
the product j of firm i at its price Pij and its competitor's
price Pkj (see Tirole 1988 for a discussion of these demand is explicit. The market power of each firm to

models). charge differential prices, measured by t, is assumed to

In this model of oligopolistic competition, the de- be known with certainty to all parties and, for the sake

mand for a firm's product is a function of both its price

and its quality or brand identity. These nonprice factors 5 In other words, if the firm on the left of the unit interval offers a
allow a firm to differentiate its products to some extent product at price P1 while the firm on the right charges P2, then a con-

from the product of its competitor and so raise prices
increase firm profits by hiring a manager who is given an incentive
contract that may place unequal weights on revenues and costs. How-
ever, this literature provides no insight into transfer pricing.
sumer one quarter the way along the unit interval is willing to buy
from the left firm as long as P1 + 4t P2 + 4t. But a consumer one
third the way on the unit interval values the left firm's products rel-
atively less and so is less tolerant of the left firm's higher price. He
will pay P1 only as long as P1 + 3t P2 + 2 t. Clearly, when t -O 0, the
firm's ability to charge differential prices declines. We discuss later
how the firm can influence the size of its market power t.

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 ALLES AND DATAR
Strategic Transfer Pricing

of simplicity and with little loss of generality, we as-
sume that t is the same for both firms and both products.
The customers' valuation of the product is also assumed
to be high enough that all consumers are willing to pur-
chase the good at equilibrium prices.
The cost measurement system identifies production
costs consisting of direct variable costs and fixed and
variable overhead costs. The costs of the marketing de-
partment are reported directly to the marketing man-
ager. Before the marketing manager can select the prices
for the firm's two products, however, he needs to know
what production costs he will be charged for the prod-
ucts transferred to his division. This is necessary infor-
mation for the marketing manager because it enables
him to calculate the profit he has to maximize by his
choice of the product prices. This information is con-
veyed to him through the transfer price. We shall refer
to the manufacturing costs of the firm's production de-
partment as its actual production costs and the transfer
prices reported to the marketing division as its reported
production costs. Hence, we define TC* to be the total
actual cost function of the production department of
firm i = 1, 2. We further assume constant marginal costs:
and production of Good 1 uses 3 machine hours, while
Good 2 uses only 1 hour, then a* = 0.75. Using the
fractional form of the cost drivers allows us to deter-
mine easily whether or not the cost system is cross-
subsidizing across products.
The actual variable manufacturing overhead incurred
in the production of one unit of each of the two products
is given by $fi. Continuing our example, if the indirect
cost rate is $5.50 per machine hour, then f= ($5.50)(3
+ 1) = $22.00. Thus, the indirect cost rate is $5.50 and
Product 1 requires 3 machine hours. The actual variable
manufacturing overhead applied to Product 1 is then,
$16.50 = (3)($5.50) = (3 ($5.50)(3 + 1) = ac4f.
Hence, the actual marginal manufacturing cost of prod-
uct j for firm i, given by C* above, can be rewritten as:
Ci = c + c4fa , C2 = + (1 - a)f*
C2i = CP + 2 C = CP + (1 - a)f
?41 a2 E [0, 1],
f*,f2 ?0.
flif -.

Now the firm has to choose transfer prices that will

TCi*(xi1, xi2) = G* + C*xjj + Cx2. be used to report production costs to the marketing de-
G 0 is the total fixed manufacturing costs of firm i. partment. Corresponding to the actual cost driver and
C* is firm i's actual marginal costs to manufacture prod-overhead rate a* and f defined above, the firm has to
uct j; xij is the quantity of product j produced by firm i.select cost drivers and allocation rates for its cost re-
The actual marginal manufacturing cost C* equals the porting system. These choice variables are denoted by
direct manufacturing labor and material costs of pro- ai and fi in contrast to the technologically determined
duction, cp, and variable manufacturing overhead.6 rates
We ac and f *.7 This allows us to write the transfer
assume that the variable manufacturing overhead is a
function of some cost driver that determines the pro- 7While the choice of the cost driver will affect the values of both com-
portion of the variable costs generated by the produc- ponents of the cost system, for a given cost driver, the choice of fi is
tion of each of the two products. The unit level cost independent of ai since the indirect cost rate is unrestricted. Of course,

driver is assumed to be such activities as direct manu-
facturing labor hours or machine hours. The production
of one unit of Good 1 requires the consumption of the
fraction a* of the actual cost driver. The production ofindirect
one unit of Good 2 consumes 1 - a* of the actual cost
the indirect cost rate, being on a per unit basis, requires an estimate of
the total quantities of products that are to be manufactured. For this
reason, thefi are only determined in equilibrium, along with total de-
mand. By contrast, the f *s introduced earlier, representing the actual
cost rates of the products, do not include an application of
overhead, and consequently are independent of volume. The fraction

driver. For example, if machine hours is the cost driver, of each cost driver incurred by each product ai and a* is a function of
the chosen and actual cost drivers, respectively, and is always inde-
pendent of volume. For example, the actual cost driver may be ma-
6 the sake of expositional clarity, we assume that the direct man- chine hours, while the costs are allocated using labor hours. How
ufacturing and marketing costs are constant across firms and products. much of each driver is used by each product is a function of the pro-
Relaxing this assumption would not change any of our results. duction technology.

MANAGEMENT SCIENCE/Vol. 44, No. 4, April 1998 455

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 ALLES AND DATAR
Strategic Transfer Pricing

LEMMA. Given the transfer prices, TPij, the unique prod-

price TPij, which is the reported per unit manufacturing
cost of product j of firm i, analogous to the uct
actual
pricesmar-
chosen by the marketing manager in equilibrium
ginal costs of production. to maximize the marketing department's profits in the pricing
subgame are:
TPll = cp + a1lfi TP12 = Cp + (1- al)f-
Pi, = t + cp + cm + 2aifi + ajf
TP21 = Cp + a2f2, TP22 = Cp + (1 - a2)f2, p ~~~3
a1, a2 E [0, 1],
Pi2 = t + cp + Cm + 2(1- ai)fi + (1- aj
3
fl,f2 : 0.

It is important to note that our model does not impose Di,= + t [ajfj - aifi],
any constraints on the firm's choice of reported costs or
transfer prices. The firm can choose any reported costs 11
Di2 = + 6[(1 -a)fj- (1-ai)fi],
that it wishes, including reporting actual marginal man-
ufacturing costs to its marketing department. All we as-
for any given cai, fi, aj, and fj chosen by the firm's
sume is that the transfer price is cost based. Note that
the direct costs of the production department cp are ac- PROOF. See the appendix. W
curately reported by the cost system, there being no am- In the costing stage of the game, given their knowl-
biguity with regard to these numbers. To complete the edge of both the second stage strategies and of total ac-
model, the marginal costs of the marketing department tual marginal costs, the firms' CEOs select the parame-
are assumed to be given by cm, and, before selecting ters of their cost systems, the ai andfi, to maximize each
firm's overall profits:
prices, would be added to the transfer price TPij by the
marketing manager to give the total cost of the product,
THEOREM 1. The unique pure strategy Nash equilibrium
Cij = TPij + Cm.
in the choice of cost systems is given by:

4f* + f2
4. Strategic Transfer Pricing fi = 2t + 1 +
In the pricing stage of the game the marketing managers
choose the prices for the two products to maximize the + 4f2
f2 = 2t +
marketing division's profits, which are calculated using 5

the transfer prices, TPij, chosen by the firm's CEO. Con-

4(1aff + at+2
sequently, the product prices also become a function of
those transfer prices. Since both firms are organized in
the same way, each CEO can predict what prices will
result from this stage of the game, and how those prices (1 - 2)f2 =t~alf2
+ 4(1 =- al)f
t ++ cf
(1 - cf
a*j)f2
5
are a function of his choice of transfer prices. Conse-
quently, in the costing stage of the game, the CEO will (xA -a!lf + 4a!2f2
choose those transfer prices to maximize the firm's ac- 5

tual profits, subject to the pricing decisions made by the

marketing managers. In other words, within each firm
the CEO acts as a Stackelberg leader with respect to his
marketing manager, strategically choosing transfer
prices to influence the product pricing decisions sub-
sequently made by the marketing manager. As a con-
sequence, the product prices are functions of ai and f
rather than the actual cost variables a 7 and fi.
(1ae2)f2 = t + (1 - al)f 1 + 4(1 - a2)f 2
PROOF. See the appendix. Cl
The transfer prices TP11, TP12, TP21, and TP22 are cal-
culated by adding cp to the last four expressions of The-
orem 1. It follows from Theorem 1 that the cost-based
transfer prices cp + aifi are, in general, not equal to cp

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 ALLES AND DATAR
Strategic Transfer Pricing

tablish
+ aifi, the actual marginal costs. It is in this a brand
sense thatidentity. By having market power t
costs for pricing purposes are chosen strategically. Note = t(G) as a function of fixed costs, an implication of
that the marketing department's manager would not Theorem 1 is that it is not fixed costs that differentiate
firms and make fixed cost recovery feasible, but rather
use the actual cost parameters a* and fS when pricing,
even if he knew them, since he is compensated on the their successful application to create market power, t.
basis of divisional profits calculated using the transfer Note that,
prices. We can make two other observations about the
~v 1 K CkJ -CiJ[ Cki -Ciilo
strategic transfer prices:
At 2t [ 3 3t ]
1. Given the values of fi and f2, we have:

for a firm not at a great cost disadvantage relative to its

fi-f= 2t+ - competitor. Hence, unless the firm is already in a hope-

5
less competitive position in a market, it pays for it to

This is always positive for the firm with the lower actual invest in the creation of market power to gain the lee-

indirect cost rate, and for both firms if t is large enough.
When the actual rates are the same across the two firms
the markup equals t, making the point that the amount
by which the firms mark up their transfer prices over
marginal costs is directly a function of their market
way to raise prices without fear of customer defections.
Our results suggest that the firm will increase fixed costs
Gi until (Flij / 8t)t'(Gi) = 1. To the extent that success
differs, we would expect firms to differ in the extent of
fixed costs they allocate when setting transfer prices.

power.8 Conversely, we would expect firms that apply a greater

2. Fixed costs Gi play no direct role in the determi- proportion of fixed overhead costs (including sales and

nation of either transfer prices or final product prices administrative overhead) when setting transfer prices

meaning that allocations are not "tidy." What Theorem to be also the firms that enjoy greater market power and
1 shows is that the magnitude of overhead allocations product differentiation.

is a function of the market power of the firm and not To further our intuition of these results, it is useful to

the size of its fixed costs. ask why the firm's CEO does not set transfer prices
equal to marginal costs and how the firm benefits by
The difference fi - f > 0 can be achieved either by
not doing so. If he did and the marketing manager max-
adding a markup to the variable indirect manufacturing
imized actual profits, we can make the following obser-
cost rate, as in cost-plus transfer pricing, or by the ap-
vations about how the firm's product prices and de-
plication of some portion of fixed overhead. Survey ev-
idence by Govindarajan and Anthony (1983) shows that
mand will differ from those given in Theorem 19:
1. The difference in transfer prices across the two
while 83 percent of firms apply some fixed costs when
firms is smaller than the difference of the actual mar-
costing for pricing purposes, they vary in the amount,
ginal costs of the firms.
with 33 percent allocating only fixed production over-
head and another 41 percent allocating both fixed pro-
duction overhead and fixed selling, general, and admin-
9 To derive these observations, note that:
istrative expenses.
1. By direct computation, afif - a2f2 = 3 (a - f a2f2).
Firms incur fixed costs on, for example, research and
2. Let D! and Pij represent the demand and price, respectively,
development, advertising, and plant and equipment to when the firms report marginal cost transfer prices. Taking Firm 1 as
strategically differentiate their products from those of
an example, D*1 = + (1 / 6t)[a2f* - alf*], while D1i = -
their competitors. Our results suggest an interesting ex-+ (1/1Ot)[a2f* - alcf].
3. P*1 = t + c + ct, + 3[2ac4f* + a2*f ]; P1, = 2t + c + C71, + ?[3a*
tension of our model to an earlier technology choice stage
+ + 2a2*f]. Consequently, Pl* - P* = l[alcf - a24f] > 5[alf*
of the game, in which the firm incurs fixed costs to es-
- *4f2] = Pul - P21. Finally, P1l - P* = t - (1 / 15)[a4fl - ac2f 2]; P21
-P = t + (1/15)[acf* - a2*f] w -[Pll + P21] = ?[P* + P21] + t.
The firm with the higher actual marginal costs bears the greater
8We assume that t > I (fj - f*) / 10 1 in order to ensure nonnegative
costs and demand. increase in price and the corresponding decrease in demand. D

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 ALLES AND DATAR
Strategic Transfer Pricing

2. The market share of each firm in each product is costs, Gi. Choosing ai appropriately enables reported
more equal to the market share of the other firm than costs to appear to be closer to each other, across firms,
when marginal costs are used to set prices. than actual marginal costs are. Once cost differences are
3. In any given market, the difference in prices is mitigated, a mark up can be used to raise costs and con-
smaller than it would be under the regime with mar- sequently prices. The strategic choices of ai andfi make
ginal costing, but the average price level is higher. each firm's marketing division act as if their costs are
These results give insights into the nature of the stra- more similar and higher than they actually are. This di-
tegic interaction between the firms. To maximize profits, minishes the marketing managers' incentives to under-
each firm's marketing manager wants to raise prices for cut each other's prices, since they will only do so if they
his products to as much as the market will bear. There think their costs are significantly lower than the other
is a limit to this process, however. While both firms gain firms. Further, note that because of the cost to the con-
from an increase in prices, there is the countervailing sumer of changing retailers-represented by t-there is
incentive to gain market share by undercutting the other a limit to the increase in market share a firm can obtain
firm's price if it is too high. In our model, though, in by undercutting the other's price. This stops prices un-
addition to product prices, by choosing their cost sys- raveling to marginal costs.
tems strategically the firms' CEOs have another control The leveling and markup effects affect the relation
variable-the choice of transfer prices-that they can between costs across the two products within a given
use to dampen the marketing managers' incentive to firm, which leads to the following result:
undercut. Instead of being based on marginal costs,
COROLLARY 1. When no onefirm has an absolute advan-
prices can be based on transfer prices that are chosen to
tage in all markets, then each firm will find it in its interest
reduce cost differences across firms. Across firms, the
to cross-subsidize the product it has a comparative advantage
transfer prices are closer together than the actual mar-
in at the expense of its other product. Hence, if, for firms i
ginal costs. The differences in the resulting product
prices are also then smaller than they would be if they and j, C* > C1* and C* < C*2, then Cil < Cjl and CQ2
> Cj2.
were based on marginal costs and so there is less of an
incentive on the part of the marketing managers to un- PROOF. See the appendix. W
dercut each other and start a price war. With prices Many oligopolistic industries are characterized by
closer together, consumers become indifferent to the comparative rather than absolute advantage. Our re-
firm from which they purchase, and market shares tend sults show that when strategic interactions occur among
to come closer together. When the relative price differ- firms in these industries, cross-subsidization is an in-
ence across firms decreases, the average price level can evitable consequence of the need to reduce cost differ-
be raised without disrupting market shares. ences between the firms-cost differences being a cat-
It is the transfer prices that are committed to market- alyst for the marketing managers to undercut each other
ing that sets bounds on how much each marketing di- when pricing. The transfer prices for the relatively
vision is willing to undercut price in this oligopolistic lower cost product is increased while the transfer price
environment. The strategic equilibrium we describe for the product whose cost is higher than that of the
cannot be reached if transfer prices are not available as competitive firm is lowered. The lower cost product is
endogenous control variables. cross-subsidizing the higher cost product. Evidence that
It is easy to show that if the two firms are similar ormany cost systems do indeed cross-subsidize high cost
enjoy large market power, both firms will unambigu- products has been well documented in the literature
ously gain from strategically reporting costs to market- (see, for example, Cooper 1987, Wruck 1988).1o
ing. The intuition underlying this observation is that the
strategic distortion of transfer prices is marked by two
10 In recent years there has been increasing attention paid to obtaining
phenomena: a leveling effect, working through the
better product costs through the use of techniques such as Activity-
choice of a cost driver ai, and a mark up achieved byBased Costing (ABC). Wruck (1988) discusses the link between the
setting fi > fi that can be used to recover the fixed activity-based costing system in the Electric Motor Works production

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 ALLES AND DATAR
Strategic Transfer Pricing

If a firm has an absolute advantage in all markets,
then the cost of all its products has to be increased
through the use of transfer prices, and the overall costs
of its competitor decreased. However, while this pro-
cedure will allow higher market prices to be attained,
the greatest benefits will naturally accrue to the more
efficient firm.
We motivated the strategic choice of transfer prices
as resulting from the interaction of firms in an oligo-
polistic environment. If this is indeed the case, then we
would expect that when no strategic interactions exist,
as in the case of perfectly competitive industries or mo-
nopolies, transfer prices would be equal to marginal
costs rather than differing from them in order to try Our
and analysis provides an explanation for the "paradox-
gain a competitive advantage. This intuition can be for-
malized as follows, with only a simpler model with one
product and linear costs needed to obtain the result:
COROLLARY 2. Both a monopolist and a perfectly com-
petitive firm will choose transfer prices equal to marginal
costs.
marketing divisions. To choose prices to maximize prof-
its, the marketing division of each firm needs to obtain
product cost information from the firm's cost system.
As a result, the cost information that is reported by the
transfer prices to the marketing division for product
pricing purposes becomes a component of the strategic
interaction between the firms.
In this setting, we show that there is a "strategic com-
ponent" to the manufacturing costs reported to the mar-
keting division for pricing purposes. In a cost-based
transfer pricing context, this is equivalent to marking
up transfer prices over the marginal costs of the pro-
duction division.
ical" behavior of firms in basing their pricing decisions on
cost-plus transfer prices rather than marginal costs. Our
results, that transfer prices may exceed marginal manu-
facturing costs, are consistent with survey evidence on the
costing and transfer pricing practices of firms.11
Our results draw a clear distinction between the
knowledge a firm wants of its actual cost, and the use

PROOF. See the appendix. D that is made of this information, when determining

In either of these market settings, the firm's profits transfer prices. We emphasize that costing is only a

are only affected by its own actions, strategic interac- means toward the end of profit maximization, and not

tions with other firms being absent. Consequently, mo- the end in itself.12

nopolies and perfect competition induces firms to report 12 We thank two anonymous referees, George Foster, Mahendra
their correct marginal manufacturing costs to their mar-Gupta, Russell Lundholm, Nahum Melumad, Paul Newman, Eric No-

keting managers.
5. Concluding Comments
We began our analysis with the recognition that firms
are decentralized, with pricing decisions delegated to
division of Siemens AG and the transfer prices to the sales division.
Despite the ABC system, transfer prices include the absorption of fixed
overhead costs, which are then adjusted for the profitability of the
order and the expected profitability of the customer. As a result, the
transfer prices are "biased" relative to the "accurate" ABC costs and
there is considerable cross-subsidization across orders and customers.
Cooper (1987), in his well-known case on the German apparel fas-
tener maker Mueller Lehmkuhl GmbH, also documents an instance of
strategic product costing. In this instance, the net effect of cost-plus
pricing was to dampen the incentives for destructive competition in
the oligopolistic European fastener industry. This case is characterized
by both a cross-subsidization across products and a markup of all
products-a phenomenon predicted by our model.
reen, Stefan Reichelstein, Joshua Ronen, Reed Smith, Mark Wolfson,
Amir Ziv and seminar participants at Stanford University, Berkeley,
UBC, MIT, Wharton, UT Austin, Columbia, NYU, and Washington
University for their comments. All errors are our responsibility alone.
Appendix
A.1. Proof of the Lemma
Without loss of generality, let the first firm be located at the origin
the unit interval and let Pij be the price the ith firm charges for the jt
" Ferreira and Merchant (1985) in their study of the NuTone Housing
Group of Scovill, Inc., describe a costing system consistent with our
results. NuTone deliberately uses overstated labor time standards that
result in large year end labor efficiency variances and overstated prod-
uct prices. This policy has lasted for several decades with the full
knowledge and support of management. One executive defended the
practice in the following terms: "We make a lot of special quotes, and
sometimes the pressure to squeeze profit margins on these quotes are
too strong. That's where our inflated standards play an important role;
they give us a cushion to protect our margins when we are making price
decisions" (emphasis added).

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 ALLES AND DATAR
Strategic Transfer Pricing

librium
good, and Dij the corresponding demand. Then, given thatand
allthe fact that Firm 2 is also strategically selecting its transfer
custom-
ers are served at prevailing prices, consumers along the unit interval prices. With profit maximization the only rational belief regarding firm
will purchase good j from the first firm at price Plj, given the cost t behavior
of in the pricing stage of the game, a probability weight of 1
changing retailers, until the distance from the origin is great enough can be assigned to the price and demand functions derived in Theorem
that good j from the second firm at price P2j becomes equally attractive. 1. Hence, the CEO will determine his best response by solving the
These assumptions imply that demand is a function of the consumer's profit maximization problems of both firms,
distance in preference space from the firm. Hence, we have the follow-

ing relation, where demand, Dij, is reinterpreted as the distance from max Il(al, a2, fl, f2)
alcfi
the origin to the marginal consumer:

= [P, - C - Cm]Dji + [P12 -C1- Cm]Dl2-G*

Pii + DiJt = Pkj + (1-Dij)t * Dij = kj 2 ijt
max H(a1, a2, fl, f2)
a2Jf2
In the pricing stage of the game, each marketing manager chooses the
prices for the firm's products in order to maximize the reported profits
= [P21 - C2 - Cm]D21 + [P22 -C2- cm]D22 - G*
of his division, which are calculated using the transfer prices chosen
by the CEO. Since a firm's transfer prices are not observable, each CEO
Taking the partial derivatives of nl with respect to a1 andf,
assumes that its rival's marketing manager will profit maximize on Firm l's reaction curves,
the basis of whatever transfer prices were chosen in the first stage.
An equilibrium is attained because each firm's CEO anticipates that
the other is rational, and so uses the other firm's reaction curve to V,l 8tgf2(2a2 - 1)-41(2a, - 1) + 3ff*l(2a* - 1)],
Oa, 18t
predict its strategy. Each CEO's expectations will be confirmed in equi-
librium. We take as given that the marketing manager will select prod-an* 1
uct prices in order to maximize reported profits. The reported profit -Of,
= - [3t + (1 + 2aja2 - a, - a2)f2
18t
in any product is given by:

+ 3(1 + 2a1aj - a, - ai)fi - 4(1 + 2al - 2a,)fi].

ni, = (Pij - Ci)Dij(Pi, Pkj).
The marketing manager takes into account the direct costs cm of the Using his knowledge of Firm 2's actual marginal costs to also obtain

marketing department (and perhaps any fixed costs), as well as the the reaction functions of his competitor, Firm l's CEO solves the re-

transfer price of the product, when maximizing the marketing de- sulting set of four (non-linear) equations to determine the optimal

partment's profit. Hence, the product costs are given by Cij = TPij choice of cost parameters:
+ cm. The two product markets can be considered independently at
this stage of the game. This implies that for profit maximization, the
- 2t + 4f* +f
price chosen by the marketing manager of firm i is determined by the
reaction function:

4(a1-2)fl + (at2-2)ft2
p Pkj + t + Cij
15f 2
1 2

It is easily seen then that the second stage Bertrand Nash equilibria,
The choice of these parameters determines the output choice of the
the unique sequentially rational outcome in the pricing game, for firm
marketing manager. Second order conditions can be shown to be sat-
i, where k * i, is given by:
isfied for these results, which can also be readily rewritten in the man-
ner shown in Theorem 2.
Pij(al, a2, fi, f2) = + 2Ct1 + Ckj follows from the concavity of the profit functions in
Uniqueness
3
each firm's own actual costs. This is the only Nash equilibrium. Actual
costing, where transfer prices equal the marginal manufacturing costs
Dij(al, a2, fi, f2) = + 6t [Ckj - Cij],
is not an equilibrium in this game, since each firm would have an
incentive to change the costs reported to its marketing department if
nij(al, a2, fi, f2) = t + C Ci1] the other firm used marginal cost transfer prices (as can be seen from
the fact that the first order conditions given above do not equal zero
Uniqueness follows from the concavity of the profit function (in its when both firms use actual costs). Ol
own cost). LI
A.3. Proof of Corollary 1
A.2. Proof of the Theorem From Theorem 1, the reported manufacturing costs for a product is
Taking Firm 1 as an example, the CEO's object is to select a1 andfiweighted
to average of both firms' actual marginal costs for that produc
maximize first stage profits, anticipating both the second stageplus
equi-
the markup t. Hence,

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 ALLES AND DATAR
Strategic Transfer Pricing
a,fi = t + 4a tf + la j*fj,
(1 - ai)fi = t + 4(1 -0 a)ft + 5(1 -0 a)fj.
Analogous expressions can be derived for Firm 2. Hence, when each
firm has a comparative advantage in a product (i.e., a*f > a**f
t (1 - at*)f* < (1 - a )f7, for firm i and firm j), then each firm will
cross subsidize the product it has a cost disadvantage in at the expense
of the product that it does have a comparative advantage in, meaning
that Cil < C* and Ci2 > C*, and the converse for firm j. L
A.4. Proof of Corollary 2
1. Consider a monopolist with linear costs, C*(x) = G* + C*x, and
facing linear demand, P(x) = A - Bx, where x is output. Now assume
that the firm's marketing manager maximizes his department's profits
on the basis of the transfer price, TP. It is easily shown that the optimal
response of the manager is to sell up to where marginal revenue equals
his reported marginal cost. Thus,
A - TP
x =
2B
Actual profits are then:
(A B[A 2B ] C)(A 2B) -
= 1 (A - C*)2 - ? (TP - C*)2 - G*.
4B 4B
We immediately have that the monopolist's CEO has no incentive to
choose transfer prices that differ from actual marginal costs. (TP = C*)
2. The case of a perfectly competitive firm is even simpler, since in
a given market actual profits are a function only of the difference be-
tween the price and actual marginal costs, I* = (P - C*)x. Firm profits
are independent of the choice of transfer prices since the marketing
manager's decision is to sell as much as the firm can produce, when-
ever TP + Cm < P. Over this range the firm then has no incentive to
distort transfer prices, given that its actual profits are independent of
its choice. LI
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