Complementary arrangements of organizational factors and outcomes of negotiated transfer price

Since internal transfers of intermediate products between divisions of ®rms take place under a wide range of organizational factors and their arrangement, understanding transfer pricing involves a consideration of how these factors are arranged; that is, do they complement or ®t with each other or not. The current research experimentally investigates the impact of complementarity of sourcing (internal versus external) and compensation structure (based on division or ®rm pro®t) on transfer pricing in the case when such prices are negotiated between the trading divisions. The dependent variables were perceived fairness of the transfer pricing policy, inter-divisional con ̄ict, the economic outcome measure of ®rm pro®t, and the time taken by the managers to negotiate an agreement (since time is an important economic resource to the manager) and ®rm pro®t eciency. Overall, the results indicate that whether or not the arrangement of the organizational factors was complementary had a considerable in ̄uence on negotiated transfer prices. Speci®cally, complementary arrangements signi®cantly increased perception of fairness, and reduced both con ̄ict between the trading divisions and the time taken to reach an agreement. However, the economic outcome of ®rm pro®t was explained more by the negotiators' competitve behavior which occurs as a consequence of organizational factor arrangements. # 2000 Published by Elsevier Science Ltd. All rights reserved. Transfer price is at the heart of inter-pro®t center relations, and it should be e€ectively managed to prevent the advantages of a multiple pro®t center form of organization from being overwhelmed by the problems of inter-pro®t center relations. The interdependence from sourcing, or the extent to which products move from one division to another, necessitates a transfer price since pro®t center managers are responsible for both revenues and costs. Thus, sourcing is a critical factor to consider in internal transfers (Bower & Doz, 1979; Colbert & Spicer, 1995). Separately, researchers contend that the relation between transfer pricing, performance evaluation and compensation of the division managers is dicult to manage (Eccles, 1985) because divisional outcomes, often the basis for evaluating and compensating the manager, is a€ected by sourcing (Spicer, 1988; Vancil, 1978). Hence, this research 0361-3682/00/$ see front matter # 2000 Published by Elsevier Science Ltd. All rights reserved. PI I : S0361-3682(99 )00060-4 Accounting, Organizations and Society 25 (2000) 661±682 www.elsevier.com/locate/aos 1 The term ``sourcing decision'' normally pertains to the selection of a supplier by a buyer. Here it will also be used to refer to customer selection by the seller. Incidentally, the extent of sourcing should be re ̄ective of the degree of asset speci®ty associated with the transfer, a factor which has been found to in ̄uence transfer pricing outcomes (see, for example Spicer, 1988). examines whether mutual arrangements or complementarity of sourcing (internal versus external) and compensation structure (based on division or ®rm pro®t) can help manage the transfer pricing problem when the price is negotiated between the divisions. As suggested by many researchers, the results of this paper show that understanding the transfer pricing problem and managing it e€ectively involves a consideration of organizational setting in which the transfers take place (Holmstrom & Tirole, 1991; Spicer; Wagenhofer, 1994). Negotiation is a very common method to set transfer prices in US ®rms (Tang, 1992). Organizational settings are particularly important under the circumstances since they a€ect managers' behavior during negotiation (Lax & Sebenius, 1986; Putnam & Wilson,1982) and the subsequent outcomes (Graham, 1985). Most accounting text books discuss the transfer pricing problem without reference to the broader issues of organizational factors, and, instead focus on presenting alternative methods to set the price (see, e.g. Maher, 1997). Prior research has generally considered transfer pricing as an isolated contracting problem without reference to the organizational factors. Hence, their results are not insightful since they apply equally to trade between two ®rms as well as to trade between two units of the same ®rm (Holmstrom & Tirole, 1991). And, as discussed later, when prior research did include organizational factors to examine the transfer pricing problem it was done so without considering how or whether these factors are complementary. To get di€erent organizational settings in this study, complementarity of the independent variables ± sourcing and compensation structure ± was manipulated between-subjects (i.e. a 2 2 research design). Research on the behavioral outcomes of transfer pricing emphasizes the importance of fairness of the transfer pricing policy and interdivisional con ̄ict over transfer prices (Eccles, 1985; Grabski, 1985). Thus, fairness and con ̄ict are two of the dependent variables. Another important criterion for evaluating a company's transfer pricing policies is whether these policies positively a€ect the economic outcome measure of ®rm pro®t (Eccles, 1985); thus, it is a variable in this study as in many other transfer pricing studies (e.g. Chalos & Haka, 1990; Ghosh, 1994). The last variable examined here is the time taken by the negotiating managers to reach an agreement since managers' time is a major economic resource (Hitt, Hoskisson & Ireland, 1990) and empirical research ®nds that managers expend a considerable amount of time in arriving at a transfer price (Eccles, 1985). The results indicate that negotiation of transfer price bene®ts from the complementary arrangements of sourcing and compensation structure. Speci®cally, complementarity increased the perception that the negotiated transfer pricing policy is fair and reduced con ̄ict between the trading divisions. Complementarity also reduced the time taken by the negotiators to reach an agreement. This ®nding is consistent with prior research that noncomplementarity of organizational factors increases transaction ``cost'' (i.e. managers' time) of bargaining (Milgrom & Roberts, 1990; Rubenstein, 1982). Separately, prior research has shown that faster (and more stable) negotiated agreements occur in settings where the outcomes are considered to be fair by the two parties (Benton & Druckman, 1973; Pruitt & Syna, 1985). And, ®nally, regarding ®rm pro®t, it was better explained by the dyadic negotiators' competitive or cooperative behavior. Speci®cally, ®rm pro®t was the highest from more competitive behavior, the least from more cooperative behavior and in between the two from more collaborative (i.e. simultaneous competitive and cooperative) behavior. However, as discussed later, these behaviors occur as a consequence of sourcing and compensation structure arrangements. Overall, the results of this study con®rm the importance of interdependence from sourcing and compensation structure as co-variates and that both of these organizational factors are necessary and their complementarities are sucient to understand the outcomes of negotiated transfer prices. The remainder of the paper is organized as follows. The next section develops the research hypotheses. Section 3 discusses the research method. Data analysis is presented in Section 4. The last section summarizes the results and concludes with a discussion of the implication of the results and avenues for future research. 662 D. Ghosh /Accounting, Organizations and Society 25 (2000) 661±682