Transfer pricing for multinational enterprises. An integrated approach

Diploma Thesis, 2003
52 Pages, Grade: 2,0 (B)



1 Introduction

2 Transfer Pricing and Management Accounting
2.1 Functions of Transfer Prices in Management Accounting
2.1.1 Coordination
2.1.2 Performance Evaluation
2.2 Types of Transfer Prices
2.2.1 Market-based Transfer Prices
2.2.2 Cost-based Transfer Prices
2.2.3 Negotiated Transfer Prices

3 Transfer Pricing and Strategy
3.1 Divisional Strategy Implementation with Transfer Pricing
3.1.1 Encouraging Divisional Competitive Position
3.1.2 The Enforcement of Retrenchment
3.2 Strategic Transfer Pricing
3.2.1 The Model of Strategic Transfer Pricing
3.2.2 Strategic Transfer Pricing and Observable Transfer Prices
3.2.3 Strategic Transfer Pricing and Unobservable Transfer Prices
3.2.4 Practical and Theoretical Implications

4 Transfer Pricing, Multinational Enterprises, and External Constraints
4.1 Transfer Pricing for Tax Accounting – The Primary Objective
4.1.1 The Organization for Economic Cooperation and Development
4.1.2 The Determination of Tax Transfer Prices
4.1.3 Thin Capitalization
4.2 Transfer Pricing and Secondary External Constraints
4.2.1 Import Duties
4.2.2 Economic Restrictions
4.2.3 Currency Fluctuations
4.2.4 Withholding Taxes
4.2.5 Outside Shareholders of Specific Divisions
4.2.6 Paying Taxes and Public Relations
4.3 Transfer Pricing and Governmental Considerations
4.3.1 Globalization and Tax Competition
4.3.2 Political Structures and Regulations
4.4 Integrated Multinational Transfer Pricing – Management Accounting, Strategy, and External Constraints
4.4.1 The Application of Several Books
4.4.2 Taking Advantage of Ranges for Tax Transfer Prices for Other Aspects
4.4.3 Mathematical Programming Approaches

5 Concluding Remarks


Ehrenwörtliche Erklärung

1 Introduction

Globalization of business has replaced the concept of national exchanges with global transactions. Consequently, the changes due to globalization play a big role in the strategy of multinational enterprises[1] (MNEs). Certainly, the volume of intrafirm trade[2] is huge and expanding rapidly as MNEs globalize their investment and trade.[3] Today, a considerable proportion of world trade takes place inside MNEs.[4] This indicates the importance of transfer pricing[5] conspicuously.

This paper is an attempt to integrate all aspects MNEs have to deal with in transfer pricing. In the main, this means aspects of:

- management accounting,
- strategy, and
- external constraints.

While management accounting as well as strategic aspects are also relevant for enterprises, which are not multinational, external aspects are only crucial for MNEs.[6] For this reason, this paper focuses on external aspects, especially profit taxes[7], more intensely.

There is already a considerable literature on transfer pricing. The intention of this paper is to describe the problem of transfer pricing as a whole and to exhibit some options for MNEs determining transfer prices. It is merely a short approach to that difficult problem, emphasizing some issues of, from the author’s point of view, particular importance. No claim on completeness is laid.

2 Transfer Pricing and Management Accounting

Enterprises of any noticeable size face the task of determining transfer prices, because they find it necessary to transfer goods and services internally.[8] The problem of transfer pricing between divisions of a vertically integrated enterprise is formally analogous to the traditional problem of economics – the efficiency of the price mechanism.[9]

Coase (1937)[10] raised the question why is observed so much economic activity inside formal organizations, although markets are such efficient mechanisms. His answer was in terms of the costs of transacting in a world of information asymmetry[11]. If the transaction costs of market exchanges are high, it might be less costly to coordinate production through a formal organization than through a market. More specifically, Coase argued that vertical integration arises when the costs of organizing transactions via a command hierarchy are less than the costs of using a price system.

Transfer prices are important in enterprises with decentralized organizational structure (see figure 1). They determine the decisions inside the divisions.

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Advantages and Disadvantages of Decentralization
Source: Adapted from Benke/Edwards (1980), 16.

Subdividing the enterprise into responsibility centers is an opportunity to decentralize decisions. Central management constitutes the rules of transfer pricing and the divisional managers are more or less responsible for the performance of their divisions.[12] Decentralization is at least a necessary condition for the existence of transfer pricing.[13] As long as decentralization exists the transfer pricing problem will remain.

2.1 Functions of Transfer Prices in Management Accounting

There are two primary objectives of transfer pricing in management accounting.[14]

- Firstly, transfer prices serve to guide divisional managers in making local decisions optimal for the entire enterprise (coordination).
- Secondly, transfer prices are used to determine divisional profits (performance evaluation).

However, these functions compete with each other. A transfer price, which complies with the objective of coordination, might be inappropriate or even counterproductive in complying with performance evaluation, and vice versa.[15]

From the perspective of the agency theory, transfer pricing for management accounting might be viewed as a mechanism that establishes incentives for the agent (divisional manager) and induces an optimal decision on the quantity of production (coordination). The principal (central management) delegates decisions to an agent to induce optimal decisions through proper compensation (performance evaluation).[16]

2.1.1 Coordination

In decentralized enterprises a lack of coordination between the divisions and central management may occur. A transfer pricing system should encourage divisional managers to maximize the entire enterprise’s profit. However, at the same time a divisional manager is usually responsible for the performance of his own division.[17] If there is a conflict between maximizing the enterprise’s profit and maximizing the division’s performance figure, the divisional manager concentrates inevitably on the success of its own division.[18]

Central management can achieve coordination between the objectives of the divisions and the objectives of the entire enterprise by affecting divisional cost information with transfer pricing. Accordingly, transfer prices, which are the basis for decisions of divisional managers, inter alia, should induce incentives to maximize the entire enterprise’s profit and circumvent suboptimization errors ex ante.[19]

2.1.2 Performance Evaluation

In addition to promoting congruence of objectives in the course of profit maximization, transfer pricing must enhance performance evaluation. Consequently, it is an objective of transfer pricing to allocate the profit of the enterprise onto the divisions ex post.[20]

Divisional profits are used to evaluate (and incite) divisional managers to allocate scarce resources and to consider whether or not activities should be outsourced, inter alia. If there are benefits from internal trade, the allocation of them is arbitrary, because these benefits would not arise, if the divisions would not trade with each other.[21]

2.2 Types of Transfer Prices

Generally, there are three different types of transfer prices:[22]

- market-based transfer prices,
- cost-based transfer prices, and
- negotiated transfer prices.

Empirical results illustrate that about 30 per cent of the enterprises use market-based transfer prices, between 40 and 50 per cent cost-based transfer prices, and about 20 per cent negotiated transfer prices.[23]

Each type complies with coordination and performance evaluation in a different extent.[24] Which transfer prices should be used depends on the specific objectives of the enterprise and on environmental conditions.[25]

2.2.1 Market-based Transfer Prices

One possible way to determine transfer prices is to use market prices. To this, the following conditions ideally have to be fulfilled.

- Firstly, there must exist a market for the intermediate product[26] or a substitute. In practice, this condition is mostly not completely fulfilled. In the majority of the cases, there are several comparable goods with different prices available.
- Secondly, transactions of the enterprise’s divisions may not exert an impact on the market price.
- Eventually, the market price may not be distorted by impacts that are myopically induced or depending on the quantity of supply or demand (e.g. distortions due to temporary rebates).

Certainly, these conditions are only irreproachably fulfilled in perfectly competitive markets.[27]

The better these conditions are fulfilled, the better the market price is adapted for the transfer price. By using market-based transfer prices in perfectly competitive markets, both performance evaluation and coordination are optimally achieved. Admittedly, in practice, markets are mostly imperfectly competitive.[28]

Basically, in imperfectly competitive markets there is a range for the transfer prices. This range depends on the market price and the benefits from internal trade. Both of the divisions involved have incentives to trade internally inside this range.[29]

2.2.2 Cost-based Transfer Prices

For many products and services market prices are unavailable, inappropriate, or too costly to obtain. In these cases, enterprises can determine transfer prices on costs of the producing division.[30]

Cost-based transfer prices can base on variable costs, variable costs plus markup, full costs, or full costs plus markup, either at standard or actual basis. The possible markup can be established in different ways, such as a fixed percentage of full costs or a percentage calculated to yield a predetermined return on investment.[31]

Cost-based transfer prices are a possible way in imperfectly competitive markets, where the objective performance evaluation is difficult to achieve. The objective coordination can be achieved, but only by assuming central management to have complete information about divisional cost functions, as shown in the models below.

The Model of Hirshleifer

Hirshleifer (1956, 1957)[32] developed a model with the following assumptions.

- There is an enterprise with a producing and a buying division, both organized as profit centers[33],
- The enterprise is acting in an imperfectly competitive market for the final product[34].
- There is no external market for the intermediate product.
- Furthermore, no cost and demand interdependencies between the producing and the buying division exist.

He found the optimal solution to achieve coordination in this case in making use of transfer prices equal to marginal costs. “If a single joint level is to be determined (because no market for the intermediate commodity exists, or for any other reason), this output should be such that the sum of the divisional marginal costs equals the marginal revenue in the final market. To achieve this result by internal pricing, the transfer price must equal the marginal costs of the seller division.”[35] An implication of this solution is that decentralization results in the same output levels for the divisions as would occur with centralization.

In opposition, in Hirshleifer’s model decentralization is obsolete, central management makes decisions by itself (having complete information) and the divisions are pretended to decide autonomously.[36] Furthermore, the objective of performance evaluation is not achieved.[37] Nevertheless, Hirshleifer’s result is widely accepted from a theoretical point of view.

Dual Transfer Pricing

Dual pricing involves two different transfer prices for the producing and the buying division. Ronen and McKinney (1970)[38] introduced that this can be a transfer pricing mechanism fulfilling the objective of coordination. The price that the producing division receives (e.g. variable costs plus markup or a market-based price) is usually higher than the price that the buying division pays (e.g. variable costs). This mechanism generates a deficit that is set off by central management.

Hence, this means that the sum of the divisions’ profits is not equal to the profit of the entire enterprise. Consequently, the objective of performance evaluation cannot be achieved by using dual transfer prices.[39] Central management, requiring complete information, sets the optimal transfer prices to achieve coordination.[40] The objective of coordination is apparently achieved, but only for situations without information asymmetry where decentralization is not needed, just like in Hirshleifer’s model.

2.2.3 Negotiated Transfer Prices

In some cases, the divisions of an enterprise are free to negotiate the transfer prices and to decide whether to buy and sell internally or to deal with outside parties. However, it is necessary here that there is an outside market for the intermediate product and divisional managers are free to trade externally. If they cannot refuse internal trade, there is no basis for negotiations.[41]

The negotiated transfer prices will take place between the marginal costs of the producing division and the marginal benefits of the buying division. However, inside this range the result of the bargaining process depends only on the negotiating skills of the divisional managers and the external trade alternatives for the intermediate product (market price).[42]


[1] The term “multinational enterprise” is adopted in this paper as a vertically integrated enterprise with units in at least two different countries. The units involved can be departments, divisions, or related enterprises and will be called in this paper as “divisions.” The vertical integration is the combination of technologically distinct production, distribution, selling, or other economic processes inside a single enterprise. Cf. Porter (1980), 300. Contrary to distinctions made by some authors or institutions, the adjectives “multinational,” “international,” “global,” “world-wide,” “supranational,” and “transnational” are considered interchangeably in this paper. The only adjective used in this context is “multinational.”

[2] The term “intrafirm trade” is adopted in this paper as transfers between divisions of a single enterprise in one or more countries. The single transfers are “intrafirm transactions.”

[3] Cf. e.g. Eccles (1985), 2-3; Kant (1989), 233; Lozano/Boni (2002), 169; Martinson/Englebrecht/Mitchell (1999), 93; Plasschaert (1979), 17; Sansing (1999), 119; Tang (1997), 1.

[4] Cf. e.g. Kopits (1976), 624; Martinson/Englebrecht/Mitchell (1999), 92; Martinson/McKee (2001), 40; Neighbour (2002), 30.

[5] The term “transfer price” is adopted in this paper as the per-unit valuation of goods and services being shifted between divisions of a single enterprise. The term “transfer pricing” means occupying with transfer prices.

[6] Cf. Itagaki (1979), 447.

[7] The taxes treated in this paper are mostly profit taxes. Withholding taxes are only considered in chapter 4.2.4. Other tax types are neglected.

[8] Cf. Benke/Edwards (1980), 1; Lozano/Boni (2002), 169-170.

[9] Cf. Albach (1974), 216-242; Gould (1964), 61; Schmalenbach (1908/1909), 166-168.

[10] Cf. Coase (1937), 386-405.

[11] Information asymmetry exists in situations where all parties in an enterprise do not have identical information, e.g. information about costs, prices, efforts, skills, preferences, and so on. Basically, information asymmetry between divisional managers and central management induces the need of a coordination mechanism like transfer pricing in the context of management accounting. Cf. e.g. Amershi/Cheng (1990), 62; Antle/Eppen (1985), 163; Eccles (1991), 135; Ewert/Wagenhofer (2003), 593-603; Hass (1968), 310; Hayek (1945), 519-520; Hofmann (2002), 530-531; Holmstrom/Tirole (1991), 201; Schiller (1999), 655; Wagenhofer (1994), 71; Williamson (1971), 119-120; Williamson (1973), 317-318.

[12] Cf. e.g. Amershi/Cheng (1990), 62; Baldenius/Reichelstein (1998), 236; Coenenberg (1973), 373-374; Cook (1955), 87; Dahlheim/Günther/Schill (2001), 243; Eccles (1985), 2; Frese (1995), 942-943; Göx (1998), 260; Göx (2000), 328; Hirshleifer (1956), 172; Melumad/Mookherjee/Reichelstein (1992), 445-446; Menge (1961), 216-217; Merville/Petty (1978), 935; Ronen/Balachandran (1988), 301; Schmalenbach (1908/1909), 167; Wagenhofer (1994), 71; Wagenhofer (1998), 23; Watson/Baumler (1975), 466; Weilenmann (1989), 934-936.

[13] Cf. Grabski (1985), 33.

[14] Cf. e.g. Anctil/Dutta (1999), 87-88; Coenenberg (1973), 374; Darrough/Melumad (1995), 65-66; Edlin/Reichelstein (1995), 276; Ewert/Wagenhofer (2003), 593-603; Martinson/McKee (2001), 40; Meer-Kooistra (1994), 123-126; Schmalenbach (1908/1909), 170; Vaysman (1996), 73; Wagenhofer (1995), 269-270.

[15] Cf. Coenenberg (1973), 377-380; Grabski (1985), 34; Wagenhofer (1995), 272; Wagenhofer (1998), 26; Yunker (1983) 51.

[16] Cf. Ronen/Balachandran (1988), 300.

[17] Divisional managers are not necessarily responsible for their divisions’ profit, they can also be evaluated on various other items, such as costs and investments.

[18] Cf. Abdel-khalik/Lusk (1974), 8-9; Anctil/Dutta (1999), 87; Benke/Edwards (1980), 20; Cook (1955), 87; Dahlheim/Günther/Schill (2001), 244; Wagenhofer (1998), 25-26; Weber (1994), 101-102; Werner (1994), 409-410.

[19] Cf. Baldenius/Reichelstein (1998), 236; Hirshleifer (1956), 182; Schiller (1999), 655-656; Swieringa/Waterhouse (1982), 149; Wagenhofer (1995), 269; Wagenhofer (1998), 26.

[20] Cf. Benke/Edwards (1980), 21; Ewert/Wagenhofer (2003), 593-599; Wagenhofer (1998), 26.

[21] Cf. Ewert/Wagenhofer (2003), 593-599; Frese (1995), 946-948; Wagenhofer (1998), 25. Benefits from internal trade are e.g. saved costs for marketing and delivery, improved plant utilization, and concerted use of brand names and know how.

[22] Cf. e.g. Baldenius/Reichelstein/Sahay (1999), 67; Cook (1955), 88; Dahlheim/Günther/Schill (2001), 244; Eccles (1983), 152-153; Ewert/Wagenhofer (2003), 593-603; Farmer/Herbert (1982), 53; Shi/Kwak/Lee (1998), 99; Wagenhofer (1994), 71; Weilenmann (1989), 946.

[23] Cf. Eccles (1985), 40-49; Grabski (1985), 56; Tang (1992), 22-26.

[24] Cf. Dahlheim/Günther/Schill (2001), 244; Wagenhofer (1995), 272-275; Wagenhofer (1998), 26.

[25] Cf. Wagenhofer (1994), 92.

[26] The term “intermediate product” is adopted in this paper as the product or service internally exchanged between divisions of a single enterprise.

[27] Cf. Albach (1974), 239; Coenenberg (1973), 376-377; Cook (1955), 88-90; Ewert/Wagenhofer (2003), 604-611; Hirshleifer (1956), 172.

[28] Cf. Benke/Edwards/Wheelock (1982), 45; Coenenberg (1973), 376-377; Farmer/Herbert (1982), 53-54; Wagenhofer (1994), 71-73; Wagenhofer (1998), 25.

[29] Cf. e.g. Ewert/Wagenhofer (2003), 604-611.

[30] Cf. Shi/Kwak/Lee (1998), 99; Vaysman (1996), 74.

[31] Cf. Benke/Edwards (1980), 49-73; Cook (1955), 90-92; Eccles (1985), 40-41; Martinson/Englebrecht/Mitchell (1999), 99; Schiller (1999), 656-657.

[32] Cf. Hirshleifer (1956), 172-184; Hirshleifer (1957), 96-108.

[33] Profit centers are responsibility centers with divisional profit responsibility.

[34] The term “final product” is adopted in this paper as the product or service externally sold to an outside market by the buying division which has previously bought the intermediate product from the producing division.

[35] Hirshleifer (1956), 183.

[36] Cf. Baiman (1990), 341-371; Bond (1980), 191; Coenenberg (1973), 381; Drumm (1972), 254; Ewert/Wagenhofer (2003), 612-633; Ronen/Balachandran (1988), 301; Shi/Kwak/Lee (1998), 99.

[37] Cf. e.g. Ewert/Wagenhofer (2003), 612-633.

[38] Cf. Ronen/McKinney (1970), 99-112.

[39] Cf. Eccles (1985), 101-103; Ewert/Wagenhofer (2003), 630-633.

[40] The divisions are also pretended to decide autonomous, like in the model of Hirshleifer.

[41] Cf. e.g. Ewert/Wagenhofer (2003), 634-639.

[42] Cf. Benke/Edwards (1980), 36; Cook (1955), 93; Wagenhofer (1994), 84.

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Transfer pricing for multinational enterprises. An integrated approach
Schmalkalden University of Applied Sciences  (Economics)
Cost Pricing und Controlling
2,0 (B)
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ISBN (eBook)
ISBN (Book)
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518 KB
Enterprises must overcome many obstacles in introducing transfer pricing mechanisms. This paper analyzes the use of transfer pricing as a device for management accounting, strategy implementation, and dealing with external constraints in divisionalized, vertically integrated, multinational enterprises.
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Erik Wintzer (Author), 2003, Transfer pricing for multinational enterprises. An integrated approach, Munich, GRIN Verlag,


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