Cost-based transfer pricing under R&D risk aversion in an integrated supply chain

This paper examines the economic role of transfer pricing for a vertically integrated supply chain when a risk-averse production-division manager faces uncertainty on the outcomes from R&D investment. In particular, we compare two representative cost-based transfer pricing methods: full-cost and variable-cost pricing. We construct an economic model based on the assumption that R&D investment reduces the expected fixed costs of a production factor as well as the variable production costs. We show that a firm's profit under full-cost transfer pricing is greater than that under variable-cost transfer pricing under certainty. Contrary to this benchmark result, variable-cost pricing becomes more profitable than full-cost pricing when the risk-averse manager bears relatively high risk. (C) 2011 Elsevier B.V. All rights reserved.