Negotiated Transfer Pricing and Divisional vs. Firm-Wide Performance Evaluation Tian Li
In multidivisional firms, the interest of divisions often conflict with the goal of firm-wide profit maximization. This conflict is characterized as an investment "hold-up" problem. This paper seeks a way to solve this problem. Transfer pricing and managerial performance evaluation appear to be the two key instruments for the firm to manage the conflict.
Theory and Hypothesis/Research question:
The theory is that proper transfer pricing and managerial performance evaluation can provide division managers incentives to balance the interest of their own divisions and the interest of the firm. In particular, the paper examined how managerial compensation contracts use divisional and firm-wide performance measures together with negotiated transfer pricing to influence the behavior of the risk-averse division managers. The assumption is that managerial compensation contracts are linear functions of divisional profit and firm-wide profit.
This research used a model of a decentralized firm with two divisions. Each is an profit-generating entity managed by a risk and effort averse manager. In addition to their independent external operations, the divisions can trade an intermediate product with each other. Mathematical functions are used to express the cost and revenue of transfering intermediate products between the two divisions, and the relationship between wage payment and performance measures. Following the sequence of contracting, the paper evaluated a couple problems that could happen, which are central management's contracting problem and profit maximization problem. Then the paper analysed how different investment options and different performance measures influence the compensation contract of both managers. An observation is made based on the analysis that the choice between negotiated transfer...