Entry deterrence through credible commitment to transfer pricing at direct cost

Abstract

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.

Cost-based transfer pricing with the existence of a direct channel in an integrated supply chain

“…The outcome shows that the degree of fixed cost allocation, , has a significant impact on the choice of a transfer pricing method. However, prior research (e.g., Göx, 2000;Matsui, 2013) does not analyze a direct channel and the choice of transfer pricing method.…”

“…These studies mainly assume transfer pricing and cost allocation decisions to be vested in a single player, which has convenient implications for management practices. Some studies examine optimal transfer price decisions and cost allocation in integrated supply chains via a non-cooperative game theoretical approach, including competition with rival firms in a product market and conflicts between divisions (Alles and Datar, 1998;Hamamura, 2018Hamamura, , 2019Harris et al, 1982;Matsui, 2011Matsui, , 2012Matsui, , 2013Narayanan and Smith, 2000) [3]. In practice, many firms face product market competition, which affects internal decisions (e.g., transfer pricing, cost allocation).…”

“…Assuming product market competition, our model examines an optimal transfer pricing method such as Matsui (2012Matsui ( , 2013 and Göx (2000). As a transfer pricing method would maximize a vertically integrated supply chain's profit, as Tang (1992) proposes, choosing one is difficult.…”

Management Aspects of Production Cost Accounting in Horse Breeding

“…The purpose of this method is increasing the speed of decision-making on pricing and possibility of analyzing the relationship of the costs, volume of production (sales) of products and profit (CVP-analysis) as well as analysis of break-even point. The main principle of operational analysis is the classification of costs into variable and fixed ones (Ittner & Larcker, 2002;Matsui, 2013). Such analysis, as the main tool for operational planning, is the search for the optimal combination between the variable costs per unit of output, fixed costs, sales volume and price.…”

Forecasting the Development of Horse Breeding Enterprises

“…Management accounting is a historically established, scientifically based system, which arose as a result of changes in conditions of production and development of structural forms of organization, this being the determining factor in its value as a basic tool of decision-making (Ittner, & Larcker, 2002;Matsui, 2013;Quinn, 2014).…”