APPENDIX TO CHAPTER 6Transfer Pricing
In the body of this chapter, we have focused on the production and sale of a
firm’s products to outside buyers. Although this is the most common case,
products are also sold among divisions within large firms. For example, major
automobile companies consist of many divisions. The division that produces
parts will transfer its output to separate assembly divisions responsible for auto-
mobiles, trucks, and vans. In turn, assembled vehicles are transferred to dif-
ferent sales divisions and finally to dealers. In the same way, within a major
chemical manufacturer, one division may produce a basic chemical that is used
as an input in the production of specialty chemicals and plastics, each housed
in separate divisions.
The price the selling division charges to the buying division within the
company is called the transfer price.The firm’s objective is to set the transfer
price such that the buying and selling divisions take actions that maximize the
firm’s total profit. Accomplishing this task requires an accurate cost assessment.
To illustrate the issues at stake, consider a large firm that sells a variety of office
electronics products, such as telephones, printers, desktop computers, and
copiers. One division specializes in the production of microchips that serve as
the “electronic brains” for many of the firm’s final products, including copiers,
laser printers, and facsimile machines. For the time being, we assume there is
no outside market for the firm’s specialty chips; they are produced only for use274
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