Negotiated Transfer Pricing and Divisional Versus Firm-Wide Performance Evaluation

Posted: 23 Feb 1999

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Regina M. Anctil

University of Minnesota - Twin Cities - Carlson School of Management

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Abstract

A firm with two divisions, each run by a risk-averse manager, contracts with the two managers to operate their divisions and possibly engage in interdivisional trade. Each division can increase the total surplus generated through interdivisional trade by making costly relationship-specific investments. The terms of trade are determined through negotiations between the two managers. Managerial compensation contracts are linear functions of divisional profit and firm-wide profit. If managers are compensated solely on the basis of their divisional profits, they invest less than the first-best amounts. While compensation contracts based on firm-wide profits alone can induce first-best investments, they impose extra risk on risk-averse managers. Therefore, we find that optimal linear compensation contracts will contain both divisional and firm-wide components. Our analysis also identifies a feature of negotiated transfer pricing, namely interdivisional risk-sharing, and characterizes its impact on the design of optimal contracts.

JEL Classification: J33, D23, M40, M46

Suggested Citation

Dutta, Sunil and Anctil, Regina M., Negotiated Transfer Pricing and Divisional Versus Firm-Wide Performance Evaluation. Available at SSRN: https://ssrn.com/abstract=149772

Sunil Dutta (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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Regina M. Anctil

University of Minnesota - Twin Cities - Carlson School of Management ( email )

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United States
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