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This paper examines the choice between direct and absorption costing in a cost-based transfer pricing system for duopolistic firms competing with product market prices. Existing literature has shown that the adoption of an absorption costing system, which drives up the intrafirm transfer price, strategically dominates direct costing for the two firms, regardless of whether the transfer price is publicly observable, thereby constituting a subgame perfect Nash equilibrium (SPNE). However, we demonstrate that direct costing can strategically dominate absorption costing when one of the two firms is an incumbent, whereas the other is a potential entrant. Stated differently, the well-known result in the strategic cost allocation problem reverses if we consider entry threats. More specifically, we show that if the incumbent credibly commits to an observable transfer price, the upfront adoption of a direct costing system enables the incumbent to deter the entry of the potential rival in the SPNE. As a commitment device for the observable price, we consider the regulation of transfer prices that usually exists in oligopolistic network industries. We show that a regulator that pursues social welfare maximization approves direct costing but not absorption costing. Therefore, the firms and the regulator can share a mutual interest in the adoption of a direct costing system, a state thus sustained as the SPNE. This result yields managerial accounting implications for a divisionalized firm facing the threat of potential competitors entering the market in that the firm can use this accounting system to help monopolize the market.

The choice of a particular transfer pricing system in a divisionalized company operating within a variety of economic environments has commanded significant attention in the managerial accounting literature. In one of a series of surveys of Fortune 500 and Fortune 1000 firms (Tang, 1992, Tang, 1993 and Tang, 2002), Tang (2002) reports that 46.2% of the transfer pricing methods of 143 Fortune 500 firms are cost based, suggesting that this is the most prevalent transfer pricing method in practice. Of these same firms, 53.8% employ actual or standard full production costs, 38.5% full production costs plus a markup, and 7.7% variable costs of production, thus indicating that full cost rather than variable cost transfer prices are more common. Mills (1988) also asserts that cost-based methods are the principal basis for determining prices based on a survey of the largest 3500 British companies. In addition, Mills (1988) suggests that noncost considerations generally modify cost-based prices, of which the prices of competitors are the most important, implying that oligopolistic firms commonly make use of internal transfer prices as a strategic tool to compete with rivals. Transfer prices certainly work as a strategic device, as found by the significant number of studies following Hirshleifer (1956). However, firms in advanced economies are not completely free to set internal prices between divisions as they are frequently subject to regulation. For the most part, authorities in advanced countries tend to impose strict regulation, particularly on tax-motivated transfer pricing (Ernst and Young, 2012). When we consider incentives for transfer pricing other than tax evasion, the regulation of transfer prices also becomes important in oligopolistic industries where a divisionalized company potentially exerts significant market power. Accordingly, the regulation of internal transfer prices especially pertains to network industries, such as public utilities. This is because the price considerably affects social welfare if another firm purchases the network service at an access price, which is typically set to equal the transfer price.1 Consequently, the management of a firm operating in an industry where few firms operate should properly balance not only the strategic situation but also the regulatory regime surrounding the firm that to some extent dictates the transfer price. In light of the considerable debate on the most desirable accounting method and regulation for transfer pricing, this paper investigates the economic outcomes of two representative cost-based transfer-pricing methods for duopolistic firms facing product market competition; namely, direct costing and absorption costing. We first construct a model where firms act without any transfer pricing regulation to focus on their incentives for the choice of costing system. The extant literature has shown that the adoption of an absorption costing system, which drives up intrafirm transfer prices, can strategically dominate direct costing for both firms, regardless of whether the transfer price is publicly observable, thereby constituting a subgame perfect Nash equilibrium (SPNE). However, we demonstrate that the direct costing system can strategically dominate absorption costing when one of the two firms is an incumbent and the other is a potential entrant. Stated differently, the well-known result in the strategic cost allocation problem reverses if we consider the threat of entry. More specifically, if the incumbent credibly commits to an observable transfer price, we show that the upfront adoption of the direct costing system enables the incumbent to deter the entry of the potential rival and to monopolize the market in the SPNE. This result yields important managerial accounting implications for a divisionalized firm facing the threat of potential competitors entering the market in that the incumbent firm can use the accounting system to bind itself to more aggressive market behavior, creating a virtual barrier to entry. The rationale behind this result is as below. If one of the two firms installs the absorption costing system in advance as a Stackelberg leader, the other firm subsequently enters the market by introducing the absorption costing system because the latter may earn sufficient positive revenue to counterbalance any business entry costs. Consequently, the leader is obliged to share the market with the follower. Conversely, if the leader strategically adopts the direct costing system, the follower cannot earn sufficient revenue to cancel out any entry costs, irrespective of its choice of accounting system upon entering the market. Eventually, the follower surrenders entering the market. The key implication of this analysis is that an upfront direct costing system choice enables the leader to increase profits through monopoly in the SPNE. To derive this result, the observability of the transfer prices of competing firms is an essential assumption, even though internally chosen prices are generally unobservable outside the firm. To ensure the observability in our model, we next consider the regulation of transfer prices that usually exists in oligopolistic network industries, such as a public utility. Specifically, we propose a model extension where firms operating in a network industry make transfer-pricing decisions in the presence of a regulator that pursues social welfare maximization. Because access prices in network industries affect social welfare significantly, regulators monitor the prices for improving social welfare.2 Using this model, we show that the regulator approves the direct costing system but not the absorption costing system. Therefore, the firms and the regulator can share a mutual interest in the adoption of a direct costing system, a state thus sustained as the SPNE. The remainder of the paper is structured as follows. Section 2 provides a comprehensive review of the literature relating to transfer pricing from a managerial accounting viewpoint. Section 3 presents the basic settings that underpin our analytical transfer-pricing model. Section 4 presumes that firms are free from any regulation in order to highlight their equilibrium incentive for transfer pricing system choice. Section 4.1 first assumes that both firms are incumbents and thus competing on retail price immediately from the start of the game, identifying the subgame perfect dominant strategy equilibrium as the benchmark. Section 4.2 then develops the benchmark model by assuming that one of the two firms is an incumbent while the other is a potential entrant. We demonstrate that entry deterrence and the development of a monopoly position by the incumbent firm through the adoption of the direct costing system take place as the SPNE, contrary to the results of the benchmark model. In Section 5, we incorporate transfer-pricing regulation into each of the models constructed in Section 4, showing that firms and the regulator can agree on the benefit of adopting a direct costing system in the SPNE. Section 6 performs comparative statics of our results and theoretically reveals that the strategic situation and the regulatory environment together drive desirable managerial accounting design. Section 7 provides our concluding remarks.

7. Conclusion and discussion This paper investigates the cost-based transfer pricing method choice between direct costing and absorption costing for duopolistic firms in interfirm rivalry. The existing work has concluded that the dominant strategy involves a fixed cost allocation to the transfer price, regardless of whether the price is publicly observable (Alles and Datar, 1998, Shor and Chen, 2009 and Matsui, 2011) or unobservable (Göx, 2000, Narayanan and Smith, 2000, Göx and Schöndube, 2004 and Göx and Schiller, 2007). Unlike this conventional outcome, our analysis demonstrates that no fixed cost allocation to the subordinate division through the direct costing strategy can dominate the absorption costing if one of the two firms is the incumbent and the other is an entrant; namely, the familiar result arising from the earlier series of transfer pricing models reverses when we consider entry threats. More specifically, we show that if the incumbent credibly commits to an observable transfer price, a potential entrant does not enter the market, and the incumbent can thus monopolize the market through the direct costing system in the SPNE. Finally, while we have concentrated on competition through price throughout the present paper, it would be interesting to examine the potential impact of a change in the nature of competition from prices to quantities on the equilibrium outcomes of the entry game. Recall that the earlier literature has shown that if the transfer price is observable, the transfer price is below the marginal cost. That is, subsidization to the downstream division constitutes the Nash equilibrium when the strategic variable is quantity (e.g., Fershtman and Judd, 1987). However, this equilibrium is not mutually desirable, as the payoffs for both firms can improve if they both change to marginal cost transfer pricing. In this sense, the Nash equilibrium in quantity competition is an example of the so-called “prisoners’ dilemma”. This insight indicates that if we consider Cournot-type quantity competition, transfer pricing equal to direct cost can no longer work as a barrier to entry. If the potential entrant decides to enter the market, a transfer price below marginal cost is the dominant strategy for the entrant compared with transfer pricing equal to marginal cost. If the incumbent takes the strategy of transfer pricing at direct cost in this situation, the payoff for the entrant increases and the entrant then has a greater incentive to enter the market than under a transfer price below marginal cost for the incumbent. Hence, the incumbent never commits to direct costing in the entry game as well as in the game with two incumbents, a counter result to the model under price competition. Overall, an equilibrium transfer price below marginal cost is unrealistic, especially given that a number of studies by Tang, 1992, Tang, 1993 and Tang, 2002 find that it is seldom used in actual business practice. Indeed, given the transfer pricing practice, most previous game theory models deal only with price competition that drives up the equilibrium transfer price above marginal cost (e.g., Alles and Datar, 1998, Göx, 2000, Narayanan and Smith, 2000, Göx and Schöndube, 2004, Fjell and Foros, 2008, Dürr and Göx, 2011 and Matsui, 2011). In this respect, price competition is more appropriate than quantity competition to describe strategic transfer pricing.