Directory UMM :Data Elmu:jurnal:A:Accounting, Organizations and Society:Vol25.Issue7.Oct2000:

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Complementary arrangements of organizational factors and

outcomes of negotiated transfer price

Dipankar Ghosh

University of Oklahoma, Room 200, 397 W Brooks, Norman, OK, USA

Abstract

Since internal transfers of intermediate products between divisions of ®rms take place under a wide range of orga-nizational 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 eciency. 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 cen-ter relations, and it should be eectively managed to prevent the advantages of a multiple pro®t center form of organization from being over-whelmed by the problems of inter-pro®t center relations. The interdependence from sourcing,1_or

the extent to which products move from one divi-sion 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 dicult to manage (Eccles, 1985) because divisional out-comes, often the basis for evaluating and com-pensating the manager, is aected by sourcing (Spicer, 1988; Vancil, 1978). Hence, this research

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1 _{The term ``sourcing decision'' normally pertains to the}

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examines whether mutual arrangements or com-plementarity 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 eec-tively involves a consideration of organizational setting in which the transfers take place (Holm-strom & Tirole, 1991; Spicer; Wagenhofer, 1994).

Negotiation is a very common method to set transfer prices in US ®rms (Tang, 1992). Organi-zational settings are particularly important under the circumstances since they aect 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 alter-native 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 organiza-tional factors to examine the transfer pricing pro-blem it was done so without considering how or whether these factors are complementary.

To get dierent organizational settings in this study, complementarity of the independent vari-ables ± sourcing and compensation structure ± was manipulated between-subjects (i.e. a 22 research

design). Research on the behavioral outcomes of transfer pricing emphasizes the importance of fairness of the transfer pricing policy and inter-divisional 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 aect 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 consider-able amount of time in arriving at a transfer price (Eccles, 1985).

The results indicate that negotiation of transfer price bene®ts from the complementary arrange-ments of sourcing and compensation structure. Speci®cally, complementarity increased the per-ception 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; Ruben-stein, 1982). Separately, prior research has shown that faster (and more stable) negotiated agree-ments 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) beha-vior. However, as discussed later, these behaviors occur as a consequence of sourcing and compen-sation structure arrangements. Overall, the results of this study con®rm the importance of inter-dependence from sourcing and compensation structure as co-variates and that both of these organizational factors are necessary and their complementarities are sucient to understand the outcomes of negotiated transfer prices.

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1. Hypothesis Development

1.1. Background ± complementarity

Complementary factors are part of a system of mutually enhancing elements such that doing more of any of these factors increases the attrac-tiveness of doing more of the other factors in the system (Milgrom & Roberts, 1990). Thus, such factors are always jointly necessary for a compre-hensive description and analysis (Bohr, 1958). The concept of complementarity has widespread applications. For example, it is pervasive in engi-neering and economics because it is synonymous with the notion of system equilibrium; to illus-trate, the balance of supply and demand is central to all economic systems (Ferris & Pang, 1997). Complementarity is also a central component of the interpersonal theory of personality and refers to the extent to which the behavior of one partici-pant elicits speci®c behavior from the other parti-cipant (Carson, 1969); thus, friendly behavior elicits friendly behavior (Tracey, 1994). Research on the economics of modern management ®nds that investments in information and production technologies cannot stimulate productivity and growth without a number of complementary developments (Topkis, 1995), such as the intro-duction of more ¯exible workplaces, the delegation of more responsibility to labor, and skills enhance-ment among both managers and their employees (Harrison, 1996; Helper, 1998). And ®nally, researchers have shown that complementarity in organizational design leads to optimization of ®rms' pro®t function (Athey & Stern, 1998).

Complementaries arise naturally in diverse models of optimal decision-making in a ®rm (Topkis, 1995). The key to the use and notion of complementarity is identifying the policies or factors as complementary precisely when doing more of any of them increases the attractiveness of doing more of the others. Milgrom and Roberts (1990) argue that there are extensive complementarities between the various functions in ®rms which can reduce their net transaction costs of internal governance and bargaining, but only the more pro®t-making ®rms exploit these complementarities (see Milgrom, Qian & Roberts, 1991).

1.2. Background Ð transfer pricing

Despite the abundance of the literature, transfer pricing remains a contentious problem. The tradi-tional approach to transfer pricing, based on the unitary view of the ®rm and rooted in neo-classi-cal economics, considers pro®t maximization as the sole objective of the ®rm. But it was noted long ago that neo-classical models had little to oer for addressing the transfer pricing problem and that a multi-disciplinary organizational approach Ð behavioral, economic and other approaches Ð was the course to follow to resolve the problem (Whinston, 1964). An organization is a coalition of participants with diverse and often mutually exclusive interests and objectives both ®nancial and non-®nancial: thus, the emphasis should be on pro®t satis®cing (Cyert & March, 1963). In this context, transfer prices are the outcome of a long-run but not endless negotiation process; hence, con¯ict and notion of fairness necessarily exists and how can they be mitigated should be of con-cern of the transfer pricing policy (Emmanuel & Messaoud, 1994).

Watson and Baumler (1975) was an early attempt to address the transfer pricing problem in an organizational context. They suggested that negotiated transfer price is an appropriate aid to integrate pro®t centers to achieve higher ®rm pro®ts and resolve interdivisional con¯ict. How-ever, they neglected two organizational co-variates which impact outcomes of negotiated transfer pri-ces ± divisional managers' compensation and interdependence between the trading divisions (Ackelsburg & Yukl; 1979; Grabski, 1985).

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price and the concerns they have about how long it takes them to reach an agreement.

In general, a large hierarchical organization is described as a set of systems of simultaneous competition and cooperation which involve man-agers with diverse preferences. On the one hand, managers must cooperate in pursuit of common organizational goals, yet they have to compete for limited resources, status and career advancement. Thus, transfer pricing policies should recognize the inherent mixed-motive nature of organizations (Kochan & Verma, 1983). However, although the organizational approach to negotiated transfer pricing has identi®ed some of the factors which aect the outcome of the price (Borkowski, 1990; Chalos & Haka, 1990; Luft & Libby, 1997), the literature provides little insight on how to align these factors in a composite fashion in mixed-motive organizations. To partly alleviate this problem, this research investigates whether the concept of complementarity can provide a framework to help align these factors and assess an organization's transfer pricing policy. Sourcing and the compen-sation structure are the two more important factors aecting transfer pricing outcomes. Thus, their complementarity on negotiation outcomes is initially examined since the basic argument of com-plementarity when restricted to just two of the relevant variables provides a useful introduction to the concept (Milgrom & Roberts, 1995).

Sourcing can be either primarily internal or pri-marily external. Internal sourcing often vertically combines technologically distinct production, sell-ing and other economic processes within the ®rm (Porter, 1980; Spicer, 1988). Thus, it often entails relatively higher dependency between the trading divisions. In contrast, external sourcing suggests each division act autonomously with a strategy that is independent of other divisions' strategies. Thus, it often results in relatively lower depen-dency between trading divisions and each division enjoys an autonomous status in the organization (Eccles & White, 1988).

A ®rm's compensation plan signi®cantly in¯uences the motivation of organizational members (Schwab, 1973) and also stimulates behavior between nego-tiating divisions by in¯uencing the aspiration levels of bargainers (Pruitt & Lewis, 1975). A

compensation plan can be structured many ways (see Milkovich & Wigdor, 1991). One structure is a combination of base salary and a bonus based on division pro®t, or ®rm pro®t, or sometimes both (Gerhart & Milkovich, 1992; Vancil, 1978). Bonuses are eective motivators because there is a salient link between performance and ®nancial rewards (Basu, Lal, Srinivasan & Staelin, 1985).

In general, the compensation structure within a multidivisional ®rm must complement other orga-nizational factors (e.g. sourcing) in order to realize the bene®ts associated with that factor (Day, 1984; Hill & Hoskisson, 1987). Further, compensation structure entails a con®guration of the basis of evaluation and decision rights (Jensen & Meck-ling, 1976; Simons, 1994), the latter in this research determined by the extent of sourcing. Prior research cautions that the pricing policy must ensure that the eects of compensation structure and sourcing are consistent (Eccles, 1985).2_{Hence, one needs to understand the}

impli-cations of their complementarity on perceptions and behavior of negotiators determining transfer prices.

1.3. Hypotheses

1.3.1. Fairness of the transfer pricing policy

Research on the behavioral eects of transfer pricing policies always emphasized the importance of fairness. Shillinglaw and McGahran (1993), for example, identi®ed the problem of fairness as one of the most important criteria in the design of a transfer pricing system (also see Luft & Libby, 1997). Eccles (1985) states that the problem of fairness is at the core of managing the transfer pricing problem.

Judgment of fairness is in¯uenced by the sur-rounding environment (Leventhal, 1980), such as policies, and their outcomes (Miceli, 1993; Miceli & Lane, 1991). Thus, if managers believe that the transfer pricing policy results in performance mea-sures, compensation and outcomes that are unfair, then they will perceive the policy to be unfair

2 _{Jensen and Meckling (1976) argue that organizational}

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(Eccles, 1983; Grabski, 1985). In organizations, fairness is closely bound to power, position (i.e., autonomy or independence) and its compensation system, and organizational design must attempt to complement them (James, 1993). For example, the compensation system should be®t the level of inde-pendence of the organizational member to ensure perceptions of fairness of treatment from the orga-nization (James). Complementary orgaorga-nizational designs not only in¯uence perceptions of fairness, but absence thereof actually has a direct negative

impact on perceived job fairness (Walker, Gilbert & Ford, 1977).

Trading divisions with primarily internal sour-cing suggest cooperative behavior should occur among organizational members (Lawrence & Lorsch, 1967; Ouchi, 1979). Meanwhile, a com-pensation structure based on the division man-agers' contributions to ®rm pro®t also encourages cooperative behavior (Welbourne & Gomez-Mejia, 1991). The nature of both the factors re¯ects a state of dependency between the trading division. So, the complement for a division with primarily internal sourcing is the division man-ager's compensation based on ®rm performance. This is fairness based on ``shared fate'' since a manager's compensation depends on how well the other managers in the ®rm have fared. In contrast, trading divisions with primarily external sourcing usually has an autonomous relation between them (Spicer, 1988). At the same time, a compensation structure based on division pro®t induces compe-titive behavior (Welbourne & Gomez-Mejia). Now since both factors point to a state of greater inde-pendencies for the trading divisions, the comple-ment of divisions with primarily external sourcing should be to compensate the managers on their divisions' performance. This is deemed fair when the performance of the other division or the com-pany as a whole does not aect their compensa-tion when their own division's objectives have been achieved (Eccles, 1985). Fairness here is similar to the impartial spectator of the market-place in Adam's Smith's economic theory, whereby individuals are compensated based on the extent to which they achieve their own self-inter-est. The ®rst hypothesis is now stated based on the above discussion:

H1:A negotiated transfer pricing policy should be perceived as more fair when the arrangements of sourcing and compensation structure are complementary (i.e. they are both dependent or independent in nature) compared to when the arrangements of sourcing and compensation are noncomplementary (i.e. one factor is depen-dent and the other is independepen-dent in nature).

1.3.2. Con¯ict

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while the complement of divisions with external sourcing is the divisional managers being com-pensated on the performance of their divisions (i.e. an independent or competitive behavior mode). Noncomplementarity sends one expectation through sourcing and another one through compensation structure. Inconsistent preference expectations result in anxiety and frustration, which leads to con¯ict (Pfeer & Salancik, 1978; Thomas, 1992). Thus, since internal (external) sourcing and com-pensation structure based on ®rm pro®t (division pro®t) complement each other since they are both dependent (independent) in nature, con¯ict between trading divisions negotiating the transfer price should be lesser for these organizational arrangements. The second hypothesis is:

H2:In negotiating transfer prices, a complementary arrangement of sourcing and compensation structure (i.e. they arebothdependent or inde-pendent in nature) should have lesser con¯ict compared to when there is a noncomple-mentary arrangement of sourcing and com-pensation structure (i.e. one factor is dependent and the other is independent in nature).

1.3.3. Firm pro®t

This is an important outcome variable of trans-fer pricing (Ghosh, 1994; Spicer, 1988). The ques-tion is what organizaques-tional type, competitive or cooperative, will derive optimal negotiator out-comes? Pruitt (1981) argues that self-interested behavior often motivates parties to seek integrative solutions, thereby creating additional value that might be overlooked in the absence of a struggle to claim value. Sebenius (1992) states that though ``many people seek common ground and believe that dierences divide us, it is often the dierences among negotiators that constitute the raw mate-rial for creating value'' (p. 29). In other words, the aggressive pursuit of con¯icting and independent goals by two parties lead to constructive outcomes because competitive bargaining, with the sole objective to claim value, may signal priorities and may dislodge bargainers from adopting a rigid pos-ture (Carnevale & Pruitt, 1992; Wilson, 1989). Thus, prior research seems to suggest that competitive behavior during negotiation leads to higher overall

outcomes. As discussed earlier, complementarity of internal sourcing and compensation based on ®rm pro®t should result in cooperative behavior since both the factors are dependent in nature. Similarly, complementarity of external sourcing and compensation based on division pro®t should result in competitive behavior since both the fac-tors have independent characteristics. However, in case of noncomple-mentarity between sourcing and compensation structure (i.e. one factor is dependent while the other is independent in nat-ure), managers may adopt a mixed-motive or col-laborative behavior which is a complex combination of both competitiveand cooperative behavior (Walton & McKersie, 1965). Accord-ingly, the following hypothesis is stated:

H3:Firm pro®t will be the most from competitive behavior, the least from cooperative behavior, with ®rm pro®t from collaborative behavior coming in between the two.

1.3.4. Negotiator's time

Time is a scarce, but valuable commodity for most types of entities, and this construct has been studied by scholars in number of dierent dis-ciplines. It is regarded as a major economic com-modity for managers (Hitt et al., 1990) and inappropriate usage of time can negatively aect an organization. For example, when managers spend too much time on acquisitions, mergers, spinos, etc., organization performance (i.e., pro®t) suers because there is not much time for other regular activities (Hill, Kelley, Agle, Hitt & Hoskisson, 1992). To some extent, transaction-cost analysis also recognizes the role of time (Wil-liamson, 1975). Thus, some researchers argue that time represents a ®nite duration available to man-agers to manage internal and external exchanges (Lusch, Brown & Brunswick, 1992).

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®rms and that managers are concerned with the magnitude of these durations and the factors that aect it. For example, one divisional general manager reported spending 50% of his time in his ®rst three months on issues related to transfer price negotiation (Eccles, 1985, p.167). Another manager, explaining a recent change in policy which had reduced the amount of time for hag-gling over transfer prices, said, ``People recognized that it was an absolute waste of time for the cor-poration when people argued about transfer pri-ces. We wanted to get on with running the business'' (p. 195).

When individuals operate as agents within an organization, their behavior and decision-making process are in¯uenced by organizational designs (Frederick, 1983). As discussed before, com-plementarity of sourcing and compensation struc-ture would result in consistent expectations whereas their noncomplementarities would result in incon-sistent expectations causing managers to adopt a mixed-motive bargaining behavior. This would extend the duration of the bargaining process and consume more of the managers' time to reach an agreement (cf. Stonich, 1988; Thomas, 1992). This suggests the last hypothesis:

H4:In negotiating transfer prices, a complementary arrangement of sourcing and compensation structure (i.e. they are both dependent or independent in nature) should result in lesser time to come to an agreement compared to when there is a noncomplementary arrange-ment of sourcing and compensation structure (i.e. one factor is dependent and the other is independent in nature).

2. Research method

2.1. Overview

Each negotiator in a dyad assumed the role of a division manager in a manufacturing ®rm, either selling (hereafter referred to as S) electric motors as a subcomponent (Manager Ð Motors Division) or buying motors (hereafter referred to as B) as a subcomponent (Manager Ð Fans Division). Each

division manager had private information which consisted of a pro®t schedule matrix (Table 1A for S; Table 1B for B). From all the possible combi-nations in a price-quantity matrix, S and B were required to negotiate a price/quantity agreement. In the tables, transfer prices are listed on the left side and quantities across the top; entries in each cell represent division pro®t arising only from internal transfer for all arrangements of sourcing and compensation structure. Also, the payos were symmetrical across both S and B.

2.2. Independent variables

2.2.1. Sourcing

Internal sourcing diers from external sourcing ``...primarily in terms of interdependence'' (Smith, Carroll & Ashford, 1995, p. 10). Thus, the sour-cing decision was operationalized in terms of interdependency between the buying and selling divisions (Spicer, 1988; Vancil, 1978). However, empirical evidence of the percent of internal transfer is sparse. Eccles' (1985) survey found that internal transfers ranged from 30 to 90% of a division's input or output. Vancil reports that the transferred amount varied up to 75% of cost of goods sold. In the current study, when divisions use internal sourcing, about 75% of either divi-sion's pro®t was impacted by internal transactions; the remaining 25%, the ®xed pro®t component, came from external transactions. Under external sourcing, the percentages were reversed; that is, only 25% of either division's pro®t was impacted by internal transactions, whereas 75% of the pro®t (®xed) came from external transactions.

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2.2.2. Compensation structure

This was de®ned here in terms of the basis of evaluation Ð division pro®t versus ®rm pro®t (Jensen & Meckling, 1976). For internal sourcing where 75% of divisional pro®t was from transfer pricing, the earnings percentage was three. When negotiators' compensation was based on division pro®t, actual earnings for each player in a dyad was 3% of their division's pro®t, but if it was based on ®rm pro®t (sum of the two divisional pro®ts), each player shared 3% of their dyadic or ®rm pro®t. On the other hand, for external sour-cing where 25% of divisional pro®t was from transfer pricing, the earnings percentage was one. If compensation was based ondivisionpro®t, each dyadic player received 1% of their division's pro®t as earnings, but if it was based on®rm pro®t, each player shared 1% of their dyadic or ®rm pro®t. The earnings percentage was adjusted so that, at

the optimum, the compensation paid to subjects in each of the four cells was identical. Appendix 1 includes part of the instructions to the subjects explaining their compensation structure.3

The 22 research design for the two

indepen-dent variables resulted in four cells: (1) internal sourcing-®rm pro®t; (2) internal sourcing-division pro®t; (3) external sourcing-®rm pro®t; and (4) external sourcing-division pro®t. As stated earlier, the arrangements of sourcing and compensation structure are complementary in cells #1 (both fac-tors aredependentin nature or `DD') and #4 (both factors areindependentin nature or `II'). In the other two cells, the arrangements are noncomplementary:

Table 1

Pro®t schedule for (A) Motors Division (seller) and (B) Fans Division (buyer) from internal transfera

Quantity

(A) 20 25 30 35 40 45 50 55 60

Selling price $

5.50 24.00 30.00 36.00 43.75 50.00 56.25 55.00 60.50 66.00 6.00 34.00 42.50 51.00 61.25 70.00 78.75 80.00 88.00 96.00 6.50 44.00 55.00 66.00 78.75 90.00 101.25 105.00 115.50 126.00 7.00 54.00 67.50 81.00 96.25 110.00 123.75 130.00 143.00 156.00 7.50 64.00 80.00 96.00 113.75 130.00 146.25 155.00 170.50 186.00 8.00 74.00 92.50 111.00 131.25 150.00 168.75 180.00 198.00 216.00 8.50 84.00 105.00 126.00 148.75 170.00 191.25 205.00 225.50 246.00 9.00 94.00 117.50 141.00 166.25 190.00 213.75 230.00 253.00 276.00 9.50 104.00 130.00 156.00 183.75 210.00 236.25 255.00 280.50 306.00

(B)

Buying price $

5.50 104.00 130.00 156.00 183.75 210.00 236.25 255.00 280.50 306.00 6.00 94.00 117.50 141.00 166.25 190.00 213.75 230.00 253.00 276.00 6.50 84.00 105.00 126.00 148.75 170.00 191.25 205.00 225.50 246.00 7.00 74.00 92.50 111.00 131.25 150.00 168.75 180.00 198.00 216.00 7.50 64.00 80.00 96.00 113.75 130.00 146.25 155.00 170.50 186.00 8.00 54.00 67.50 81.00 96.25 110.00 123.75 130.00 143.00 156.00 8.50 44.00 55.00 66.00 78.75 90.00 101.25 105.00 115.50 126.00 9.00 34.00 42.50 51.00 61.25 70.00 78.75 80.00 88.00 96.00 9.50 24.00 30.00 36.00 43.75 50.00 56.25 55.00 60.50 66.00

a _{Entries in each cell represent total divisional pro®t from internal transfer.}

3 _{For brevity sake, only instructions to subjects role-playing}

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sourcing is `dependent' and compensation structure is ìndependent' in cell #2 (or `DI'), while sourcing is ìndependent' and compensation structure is `dependent' in cell #3 (or ÌD').

2.3. Dependent variables

2.3.1. Fairness

In general, fairness is aected by both percep-tions about outcomes and perceppercep-tions about the process or policies which aect the outcomes (Miceli, 1993). These two aspects seem to parallel the notion of fairness about transfer pricing policy (Eccles, 1985; Vancil, 1978), namely, (i) the fair-ness of the transfer priceper se, and (ii) how that pricing policy impacts the divisional manager's compensation structure. Therefore, the following two questions were posed to the subjects:

1. Do you think that the agreed upon transfer prices and quantities are apt to bene®t only one division and not the other division in the ®rm?

2. To what extent did you feel that the basis for your performance evaluation, on which your monetary compensation was based, was fair to you?

Reverse coding of question one was appro-priately handled in the computation of the fairness score. The total score from the two questions was used as a measure of perceived fairness for each dyadic subject, with a higher score indicating greater perceived fairness.

2.3.2. Con¯ict

This was measured in two ways: (i) The ®rst used the Rahim Organizational Con¯ict Inventory #1 (ROCI-1), designed to measure the self-report of con¯icts arising from dyadic interaction. The instrument has six questions framed to assess a

subject's perceptions of his or her relationship with the other subject in the dyad. The instrument uses a ®ve-point Likert scale to measure the level of con¯ict. The minimum score on a question is 1, and the maximum is 5; so the total score from the instrument can range from a minimum of 6 to a maximum of 30. A higher score represents a higher perception of individual con¯ict in a dyad (Rahim, 1983). In this experiment, the instru-ment's Cronbach is 0.79 compared to 0.81

reported by Rahim. Interdivisional con¯ict was measured by summing the responses to the six questions for each negotiator in a dyad. However, asking about perceived con¯ict may not be the same as observing outcome behavior of con¯ict. (ii) The second measure of con¯ict is a more direct measure, namely, the absolute values of the dif-ference between divisional pro®ts (Ghosh, 1994; Lax & Sebenius, 1986). Since negotiators have a general aversion to unequal outcomes (Luft & Libby, 1997; Thomas,1992), a 50/50 split of the total pro®t from intra-®rm negotiation indicates compromise and reconciliation of both parties' interests (Pruitt, 1983). Thus, it is logical to assume that a greater dierence in divisional pro®ts is associated with higher dyadic con¯ict.

2.3.3. Firm pro®t

This was the sum of the divisional pro®ts from

transfer pricing only for each of the three periods that the prices were negotiate.

2.3.4. Negotiator's time

This was the time taken in minutes to come to an agreement by the two negotiators in each of the three periods.

2.4. Experimental procedure

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periods.4 _{All relevant information was}

auto-matically recorded throughout the experiment. Subjects received continuous feedback on the time remaining during each period and the negotiation was terminated if the subjects were unable to come to an agreement within the allotted time of 10 minutes. To avoid opportunistic behavior in the last period, the subjects were not told the number of periods. In each period, the negotiation process consisted of oers and counter-oers that termi-nated either as an agreement if an oer was accepted or as a disagreement if no oer was accepted within 10 minutes. The opening oer in each period alternated between buyer and seller to avoid giving a ®rst-oer advantage. When a transaction took place, the computer informed each subject of their pro®t for that period and their compensation. At the end of each period, the computer also indicated the total cumulative compensation earned. A prompt then indicated the start of the next period.

The experiment had three stages and lasted about 2 hours. In the ®rst stage, the subjects read the instructions and then participated in a two-period practice game designed to verify their understanding of the trading procedures and the available information. However, the subjects did not receive any compensation. The second stage was the main experiment; it had three periods and the subjects received compensation. In the third stage, the subjects were administered a two-part debrie®ng questionnaire. In part one, the ROCI-1 instrument was administered to each dyadic sub-ject to measure con¯ict attitudes toward his or her dyadic negotiation partner. Also, the subjects were asked how they perceived certain aspects of the project. Part two collected information about each subject's background.

3. Results

3.1. Post-experiment questionnaire and descriptive statistics

The subjects were randomly assigned to one of the four cells arising from the treatment manipulation of sourcing and compensation structure, and within each cell, as either a buyer or a seller. Analyses of each subject's division pro®t, con¯ict (ROCI-1) and fairness scores indicated that they were not aected by any of the following non-theoretical variables: buyer and seller classi®cation, gender, graduating major, semester standing, work experience, computer knowledge, or transfer pri-cing knowledge. Hence, for hypotheses testing, the buyer and seller classi®cation was collapsed across subjects. Table 2 shows the descriptive statistics for all the dependent variables by treatment, sourcing and compensation structure. As dis-cussed earlier (Section 2.3.1), their arrangements resulted in two complementary cells (`DD' and `II') and two noncomplementary cells (`DI' and `ID').

Subjects' perceptions of competitive/cooperative behavior during negotiation were also evaluated via a rating scale in the debrie®ng questionnaire with higher scores indicating more competitive behavior. The subjects were asked (Note: scale reversed for half the subjects): Your partner's behavior was more cooperative or more competi-tive during the negotiation process?

The scale was scored as `1' for cooperative and `10' for competitive. Subjects in cell ``DD'' indi-cated a score of 3.27, while those in cell `ÌI'' had a score of 7.64. Subjects in cells ``DI'' and `ÌD'' had scores of 5.31 and 5.38, respectively. Schee's test shows that all the scores were signi®cantly dier-ent from each other (at P=0.0001) except those from cells ``DI'' and `ÌD.''

Other information also suggests that negotiators' behavior in the complementary and non-complementary cells were very dierent (see ``Mis-cellaneous,'' Table 2). For example, the dierence

4 _{Pilot studies indicated that 10 minutes was sucient}

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between possible pro®ts from the opening oer and the actual pro®ts from the ®nal agreement were much greater in cells ``DI'' ($14.71) and ``ID'' ($13.52) than in cells ``DD'' ($4.56) and ``II'' ($7.03); thus, in the noncomplementary cells the slope of convergence was steeper. Also, ¯uctua-tions in the oers and counteroers in the non-complementary cells were, more as evidenced by the higher standard deviations of possible pro®ts from oers and counteroers in these cells, and the cell negotiators took more rounds (note: a round is

an oer and the counteroer or agreement) to agree to a transfer price. Finally, ®rm pro®ts from transfer pricing for negotiation periods one and three were separately compared. In the ``DD'' (``II'') cell, ®rm pro®tincreasedfrom $305.08 ($333.17) in period one to $326.41 ($355.93) in period three, or an improvement of 6.99% (6.83%). In contrast, during the same period, cell ``DI'' ®rm pro®t increased only from $324.43 to $325.23 (i.e. by 0.2%) while cell ``ID'' ®rm pro®t decreased mar-ginally from $331.80 to $330.14 (i.e. by 0.5%).

Table 2

Descriptive statistics

Compensation structure

Sourcing Compensation based on ®rm pro®t Compensation based on division pro®t

Internal Cell#1 (13 dyads/26 subjects) or ``DD'' Cell#2 (13 dyads/26 subjects) or ``DI''

Dependent variables Mean S.D. Dependent variable Mean S.D.

Fairness 16.36 1.55 Fairness 13.46 1.44

Con¯ict Con¯ict

ROC-1 15.46 2.12 OC-1 18.73 2.24

Div.pro®t di. 6.18 4.94 Div. pro®t di. 10.95 5.92 Firm pro®t ($) 316.22 15.11 Firm pro®t ($) 324.03 8.14 Time (min) 8.04 0.27 Time (min) 9.24 0.08

Miscellaneous (averages) Miscellaneous (averages)

Possible pro®t-opening oer $162.67 Possible pro®t-opening oer $176.72 Individual negotiator pro®t 158.11 Individual negotiator pro®t 162.01

Dierence $4.56 Dierence $14.71

S.D. of pro®t from oers and counter-oers 5.56 S.D. of pro®t from oers and counter-oers 9.14 # of rounds for agreement 4.48 # of rounds for agreement 5.38

External Cell#3 (13 dyads/26 subjects) or ``ID'' Cell #4 (13 dyads/26 subjects) or ``II''

Dependent variables Mean S.D. Dependent variables Mean S.D.

Fairness 12.83 1.19 Fairness 16.17 1.43

Con¯ict Con¯ict

ROC-1 18.69 2.38 ROC-1 14.69 1.57

Div. pro®t di. 10.75 4.54 Div. pro®t di. 5.98 3.45 Firm pro®t ($) 330.73 5.58 Firm pro®t ($) 344.31 6.36 Time (min) 9.30 0.07 Time (min) 8.50 0.11

Miscellaneous (averages) Miscellaneous (averages)

Possible pro®t-opening oer $178.89 Possible pro®t-opening oer $179.19 Individual negotiator pro®t 165.37 Individual negotiator pro®t 172.16

Dierence $13.52 Dierence $7.03

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3.2. Test of hypotheses

3.2.1. Fairness of transfer pricing policy

Hypothesis H1 predicted that a negotiated transfer pricing policy should be perceived as more fair when there is a complementary arrange-ment of sourcing and compensation structure compared to when their arrangements are non-complementary. The dependent variable was the perceived fairness score collected from individual negotiators in a dyadwith higher scores indicating greater perceived fairness. An ANOVA procedure was used for the statistical analysis of H1. The arrangements of independent variables had two levels ± complementary and noncomplementary. The analysis indicates (refer to part A of Table 3) that the ANOVA model is signi®cant (F=126.71;

P=0.0001). To get an insight of this result, the means of perceived fairness under all the dierent arrangements of sourcing and compensation structure were compared. The results (refer to part B of Table 3) show that subjects perceived the

pricing policy to be signi®cantly more fair (at

P=0.01) in the case of complementary arrange-ments (i.e. cells `DD' and ÌI') than in the case of noncomplementary arrangements (i.e. `DI' and ÌD'). Further, perceived fairness from the com-plementary cells (i.e. cells`DD' and ÌI') was not signi®cantly dierent from each other. Similarly, the fairness scores from the noncomplementary cells (i.e. cells `DI' and ÌD') were also not sig-ni®cantly dierent from each other. In summary, the results support hypothesis H1.

3.2.2. Con¯ict

Hypothesis H2 states that during negotiation of transfer prices, a complementary arrangement (of sourcing and compensation structure) should have lesser con¯ict compared to when there is a non-complementary arrangement. As stated earlier, con¯ict was measured in two dierent ways; thus, separate ANOVA analyses were done for the two con¯ict measures. The independent variables had two levels, as described earlier.

Table 3

Complementary arrangements of organizational factors aecting negotiated transfer prices and its impact on perceived fairness of the transfer pricing policy (for H1)

A. Analysis of variance (n=104 subjects)

Source df SS (111) Mean2 _F_value _P_value _R2

Model 1 253.906 253.906 126.71 0.0001 0.55

B. Comparisons of cell means Ð Schee's test (n=26 subjects per cell)

Cells compareda _{Means of cells compared}

Cell Mean Cell Mean Absolute dierence between means

DD and DI DD 16.36 DI 13.46 2.90*b

ID and II ID 12.83 II 16.17 3.34

DD and ID DD 16.36 ID 12.83 3.53

DI and II DI 13.46 II 16.17 2.71

DD and II DD 16.36 II 16.17 0.19

DI and ID DI 13.46 ID 12.83 0.63

a _{Variable de®nitions are as follows: DD=Complementary arrangement of sourcing and compensation when both factors are}

dependent on nature. DI=Noncomplementary arrangement of a dependent (sourcing) and an independent (compensation) factor. ID=Noncomplementary arrangement of a dependent (compensation) and an independent (sourcing) factor. II=Complementary arrangement of sourcing and compensation when both factors are independent in nature.

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3.2.2.1. ROCI-1. The dependent variable was the sum of the con¯ict scores foreach negotiator in a dyadwith higher scores indicating greater con¯ict. The analysis indicates (refer to part A of Table 4) that the ANOVA model is signi®cant (F=78.14;

P=0.0001). Comparisons of the cell means of con¯ict (refer to part B of Table 4) show that it was signi®cantly less in the case of complementary arrangements (i.e. cells `DD' and `II') compared to noncomplementary arrangements (i.e. cells `DI' and `ID'). Further, con¯ict scores in the two complementary cells were not signi®cantly dier-ent from each other, as were the con¯ict scores from the noncomplementary cells.

3.2.2.2. Divisional profit difference.A higher score on this dependent variable, measured for each dyad, would suggest higher con¯ict. The analysis was a repeated measures ANOVA where Period was used as a repeated-measures factor with three levels, one each for the periods the transfer price was negotiated. The results in Table 5 (Parts A and B) indicate that con¯ict between the trading divisions was lower from complementary organi-zational arrangements took. These results,

there-fore, parallel those from the con¯ict responses using ROCI-1. In conclusion, the above results provide evidence in support of hypothesis H2.

3.2.3. Firm pro®t

Hypothesis 3 predicted that ®rm pro®t will be the most from competitive behavior (or cell ÌI'), the least from cooperative behavior (or cell `DD'), with ®rm pro®t from collaborative behavior (or cells `DI' and ÌD'), coming in between the two. Analysis in the ``Post-experimental Ques-tionnaire'' section (p. 20) showed that negotiator behavior was more competitive in cell ÌI', more cooperative in cell `DD', and between competitive and cooperative in cells `DI' and ÌD'. Thus, the independent variable for this analysis was a ``cell'' with four levels. The dependent variable was the sum of the two divisions' pro®ts from negotiated transfer prices only (i.e. a dyadic measure). The analysis was a repeated-measures ANOVA with Period as the repeated-measures variable with three levels. The results (refer to part A of Table 6) indicate the ANOVA model is signi®cant (F=20.13;P=0.0001). Comparison of cell means (refer to part B of Table 6) show that ®rm pro®t

Table 4

Complementary arrangements of organizational factors aecting negotiated transfer prices and its impact on con¯ict measured using ROCI-1 (for H2)a

A. Analysis of variance (n=104 subjects)

Source df SS(111) Mean2 _F_value _P_value _R2

Model 3 343.471 343.471 78.14 0.0001 0.43

B. Comparisons of cell means Ð Schee's test (n=26 subjects in each cell)

Cells compared Means of cells compared

DD and DI DD 15.46 DI 18.73 3.27*b

ID and II ID 18.69 II 14.70 3.99

DD and ID DD 15.46 ID 18.69 3.23

DI and II DI 18.73 II 14.70 4.03

DD and II DD 15.46 II 14.70 0.76

DI and ID DI 18.73 ID 18.69 0.04

a _{ROCI-1 is designed to measure the self-report of con¯icts arising from dyadic interaction. It has six questions framed to assess a}

subject's perception of his or her relationship with the other subject in the dyad. The instrument uses a ®ve-point Likert like scale to measure con¯ict. The scores can range from 6 to 30. A higher score represents a higher perception of individual con¯ict in a dyad.

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Table 5

Complementary arrangements of organizational factors aecting negotiated transfer prices and its impact on con¯ict measured as the dierence between divisional pro®ts (for H2)

A. Repeated measures analysis of variance (n=52 dyads)

Source df SS (111) Mean2 _F_value _P_value

Between subjects

Complementary 1 886.851 886.851 13.39 0.0006

Within subjects

Period 2 1.798 0.899 0.01 0.9859

Periodcomplementary 2 146.814 73.407 1.16 0.3178

B. Comparisons of cell means Ð Schee's test (n=13 dyads in each cell)

DD and DI DD 6.18 DI 10.94 4.76*a

ID and II ID 10.75 II 5.98 4.77

DD and ID DD 6.18 ID 10.75 4.57

DI and II DI 10.94 II 5.98 4.96

DD and II DD 6.18 II 5.98 0.20

DI and ID DI 10.94 ID 10.75 0.19

a _{*Signi®cant at 0.01.}

Table 6

Complementary arrangements of organizational factors aecting negotiated transfer prices, competitive/cooperavtive negotiator behavior and ®rm pro®t from transfer prices (for H3)

Between subjects

Cell 3 16539.33 5529.78 20.13 0.0001

Within subjects

Period 2 3051.10 1525.55 8.60 0.0004

Periodcells 6 3375.55 562.59 3.17 0.0070

DD and DI DD 316.22 DI 324.03 7.81*a

ID and II ID 330.73 II 344.31 13.59

DD and ID DD 316.22 ID 330.73 14.51

DI and II DI 324.03 II 344.31 20.28

DD and II DD 316.22 II 344.31 28.09

DI and ID DI 324.03 ID 330.73 6.70**

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was signi®cantly more in cells `DI' and ÌD' (both collaborative cells) compared to cell `DD' (the cooperative cell). Also, ®rm pro®t in cell ÌI' (the competitive cell) was signi®cantly more than cells `DI' and ÌD'. But ®rm pro®t in cells `DI' and ÌD' were not signi®cantly dierent (at P=0.10) from each other. The above results, thus, are consistent with hypothesis H3.5

3.2.4. Time

Hypothesis H4 states that during negotiation of transfer prices, a complementary arrangements of sourcing and compensation structure should result in lesser time to come to an agreement compared to when there is a noncomplementary arrange-ments of sourcing and compensation structure. The dependent variable was the time (in minutes) taken in each period by the negotiators to reach an

Table 7

Complementary arrangements of organizational factors aecting negotiated transfer prices and its impact on time (in minutes) to reach a negotiated agreement (for H4)

Between subjects

Complementary 1 38.611 38.611 252.61 0.0001

Within subjects

Period 2 2.315 1.157 9.75 0.0001

Periodcells 2 1.018 0.661 5.57 0.0051

DD and DI DD 8.042 DI 9.239 1.197*a

ID and II ID 9.296 II 8.503 0.793

DD and ID DD 8.042 ID 9.296 1.254

DI and II DI 9.239 II 8.503 0.736

DD and II DD 8.042 II 8.503 0.461

DI and ID DI 9.239 ID 9.296 0.057

a _{*Signi®cant at 0.01.}

5 _{The most commonly used cooperative solution concept}

for the bargaining games is Nash (1950) solution. For exam-ple, when a fair 50/50 split is also eciaent (in the sense that there is nothing left on the table), this outcome is speci®ed by the Nash solution. Thus, in a divide-the-dollar game, eciency involves maximising thesum of the payos. Both these are achieved at the 50/50 split. When the outcome is not ecient, the Nash solution essentially provides a compromise. Loosely speaking, Nash speci®ed assumptions about the bargaining outcome that, if satis®ed, imply that the outcome must max-imize the productof the two players utility gains (over the disagreement outcome). In the divide-the-dollar game, the product of the payos is maximized by giving 50 cents to each bargainer since utility is directly associated with the outcome.

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agreement (i.e. a dyadic measure). As before, the independent variables had two levels. The hypothesis was examined using repeated measures ANOVA where Period was used as a repeated-measures with three levels. Since the results (refer part A of Table 7) indicate that the com-plementarity of organizational arrangements had a signi®cant impact on time (F=252.61;

P=0.0001), the means of time were compared for the complementary and noncomplementary cells. As predicted, (refer to part B of Table 7) time to reach an agreement was signi®cantly less in the case of complementary cells (cells `DD' and `II') compared to noncomplementary cells (cells `DI' and `ID'). Moreover, time required in the com-plementary cells was not signi®cantly dierent from each other, as was the case in the non-complementary cells. In summary, the results sup-port hypothesis H4.6

4. Conclusion

Complementarity gives substance to the notion of ®t and synergies among the elements of an organization's factors. Failure to recognize it may have negative implications for the organization (Milgrom & Roberts, 1995), including increased transaction costs of bargaining (Milgrom & Roberts, 1990). Complementarity entails the

necessity of considering the joint operations of pairs or clusters of factors. Hence, this study examined the eect of complementarity of two organizational factors considered important when the trading divisions negotiate the transfer price: sourcing ± internal versus external ± and compen-sation structure ± based on division pro®t versus ®rm pro®t. The variables examined were perceived fairness of the transfer pricing policy, con¯ict between the trading divisions, the economic out-come measure of ®rm pro®t and the time taken to negotiate the transfer price. The results are con-sistent with the theoretical predictions. Speci®-cally, complementary arrangements between organizational factors increased the perception that the transfer pricing policy was more fair, reduced con¯ict between the trading divisions and reduced the time taken to come to a negotiation agreement. Regarding ®rm pro®t, the results are aected by negotiators' competitive behavior, which occur as a consequence of organizational factor arrangements. Speci®cally, during negotia-tion, organizational arrangements of factors which are more independent in nature induced competi-tive behavior and achieved the highest ®rm pro®t, while arrangements of factors which are more dependent in nature induced cooperative behavior and achieved the least ®rm pro®t. However, arrangements of factors one of which is more independent and the other more dependent in nature thus inducing collaborative behavior, achieved ®rm pro®t between those from competi-tive and cooperative behavior. Competitive (cooperative) behavior in this experimental was a result of complementarity of external (internal) sourcing and compensation structure based on division (®rm) pro®t while collaborative behavior was due to noncomplementary arrangements of the two factors.

An additional analysis was done (footnote 6) to explore the relation between the ®rm pro®t achieved and the time taken to reach an agree-ment. There was no explicit procedure to oper-ationalize cost of the negotiation process in the experiment. However, most bargaining studies recognize that there are non-negligible costs to continuing a negotiation, primarily through a longer period of time to arrive at a settlement or

6 _{An additional analysis was done to examine the ratio of}

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through the exchange of more proposals (Rapo-port, Erev & Zwick, 1995; Rubenstein, 1982). Support for hypothesis H4 con®rmed that time for settlement was less in the complementary cells compared to the noncomplementary cells. The average number of rounds to reach a settlement re¯ected a similar pattern (see Table 2). Thus, if the time to reach an agreement can be considered as a surrogate measure for negotiation cost, this analysis is quite revealing. It suggests managers' time is better utilized to generate ®rm pro®t in the complementary cells compared to the non-complementary cells and gives credence to the suggestion that there are increased bargaining cost associated with noncomplementarities by (Mil-grom & Roberts, 1990). Future studies on transfer pricing should examine more explicitly the cost associated with setting the transfer price instead of just focusing on the ®nancial bene®ts emanating from that pricing.

These results have important implications for outcomes of negotiated transfer prices. Watson and Baumler (1975) argue that the transfer price will likely be negotiated to aid integration when divisions are strongly dierentiated and highly interdependent. But Ackelsburg and Yukl (1979) show that smoothing and an integrative problem-solving process occurred through the use of nego-tiation when the evaluation of the manager was based on ®rm pro®t rather than divisional pro®t. And Eccles (1983) found that in highly integrated ®rms where bonuses are based on ®rm perfor-mance and individual perforperfor-mance, a ``shared fate'' mentality existed. Based on the above evi-dence, Grabski (1985) points out the two impor-tant co-variates neglected by Watson and Baumler (1975), namely, evaluation process and the orga-nization type, both of which are orgaorga-nizational factors. Further, Grabski suggests that ``...a determination must be made whether the inte-grating factor is the negotiation process, the eva-luation process, or the organizational structure, or whether all are necessary but not sucient reasons independent of one another but are necessary and sucient together'' (p. 44). The results from this research, while con®rming the importance of the two co-variates for understanding the outcomes of negotiated transfer prices, suggest that both the

factors and their complementarity are necessary for understanding the outcomes of negotiated transfer prices. The results also suggest that the proposition made by Watson and Baumler (1975) that negotiation can aid integration is limited in its scope in explaining actual outcomes of negotiated transfer prices, perhaps because it neglects the two co-variates. Finally, as voiced by the managers in Eccles (1985) study, the results here underscore the importance of considering the time taken by man-agers to set the transfer price.

The results here also suggest that competitive behavior enhances negotiator eectiveness irre-spective of complementarity. However, to eec-tively manage inter-pro®t center relations, it is important to understand how to aect the moti-vational forces underlying the behavior during transfer pricing negotiations. For example, for a transferred product, if the selling division has to make speci®c investments and the buying division has to invest in market research or advanced pro-motion, then both managers' compensation should be based on ®rm pro®t. In general, to achieve overall bene®ts from negotiated transfer price, organizational arrangements should be such that the negotiating managers have a singular motive (i.e. either cooperative or competitive) and not adopt a mixed motive (i.e. collaborative). These motives, as discussed earlier, are a con-sequence of complementarity of organizational factors.

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(Robey & Farrow, 1982). Future research, thus, should consider more number of negotiation peri-ods to capture all aspects of collaborative beha-vior. In conclusion, the results from this research, while con®rming the importance of the two cov-ariates for understanding the outcomes of nego-tiation in organizations, provide evidence that both the factors are necessary and sucient toge-ther to understand the decisions and outcomes of organizational negotiators. Complementary fac-tors, after all, as per Bohr's (1958) de®nition, are always jointly necessary for a comprehensive description and analysis.

As with any research eort, limitations exist, and the results of the present experiment must be considered in light of those limitations. For example, the results are parameterized by features of the experimental design, such as the oper-ationalization of sourcing and compensation structure and the amount of compensation paid to the subjects. Also, the price-quantity range and the duration of each period were arbitrary; thus, it is unknown if the competing treatments contained too little or too much information. Finally, nego-tiation between two groups, versus negonego-tiation between two individuals, may yield dierent results. Future research should investigate the implica-tions of this study for other issues which are negotiated between managers; for example, setting budgets. Although in practice, budgets are usually set through negotiation (Anthony, Dearden & Govindarajan, 1994), little is known about the planning and motivational aspects of negotiated budgets. Future research should also examine complementarities of other organizational factors impacting transfer pricing. These factors, such as investment characteristics of the trading divisions, frequency and volume of transfers and the level of complexity of the transferred product (Spicer, 1988), are often re¯ected in sourcing decisions; therefore, their complementary arrangements are worth examining. Finally, what are the implica-tions for transfer pricing and organizational fac-tors for ®rms competing in the modern manufacturing environment which is characterized by extensive communication and long-term, trust-based relationships, and which emphasizes the need for cooperation and adaptability? The focus

of these streams of research should be to aid in the development of theoretical work which, in turn, should provide additional issues for empirical testing, all with the objective of evolving an orga-nizational theory of transfer pricing.

Acknowledgements

I would like to thank Steve Butler, Marlys Lipe, Sue Haka and the two anonymous reviewers for theie valuable comments.

Appendix: Part of the instructions to subjects (sellers only) explaining their reward structure

The following illustration may help you to understand the negotiation process and how you will earn your compensation. As the manager of the Motors Division, assume you are given the following pro®t schedule for internal transfer (Note: This table was common to all the four cells):

Pro®t schedule (in dollars) for the motor division (seller) [if motor are sold to the fans division (buyer)]

Quantity

Selling price ($) 1 2 3 4 5 14.90 1.10 2.80 4.10 6.00 7.50 15.20 1.40 3.40 5.00 7.20 9.00 15.50 2.70 4.00 5.90 8.80 9.60 15.80 3.60 4.60 6.20 8.90 9.40 16.10 3.70 4.70 6.10 8.70 9.30

. For internal sourcing and compensation struc-ture based on ®rm pro®t (Cell #1)

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at a price of $15.50 each, your divisional pro®t from internal transfer will be $9.60. Assume that from your external sales (which is 25% of your division's sale) you earned a ®xed pro®t of $3.00. Therefore, your total divisional pro®t is $12.60 (i.e. $9.60 + $3.00). Similarly, the Fans Division will achieve a certain divisional pro®t; assume it is $10.00. As stated earlier, you and the manager of the Fans Division will share equally 3.0% of the ®rm pro®t, determined as the total of your and Fans Division's pro®t. Therefore, with the ®rm pro®t being $22.60 ($12.60 of your pro®t and $10.00 from Fans), your compensation will be half of $0.68 (3% of $22.60=$0.68); that is, $0.34. However, if you and your trading partner are unable to come to an agreement within a certain time limit, then both you and your partner earns zero pro®t from internal transfer. In which case, ®rm pro®t will only be the sum of the ®xed pro®t from each division.

. For internal sourcing and compensation struc-ture based on division pro®t (Cell #2)

Selling prices per motor are listed on the left side of the table, quantities across the top. The ®gures in the body of the table represent the divisional pro®t only from transfer of the motors to the Fans Division. For example, if you agree to sell ®ve motors at a price of $15.50 each, your divisional pro®t from internal transfer will be $9.60. Assume that from your external sales (which is 25% of your division's sale) you earned a ®xed pro®t of $3.00. Therefore, your total divisional pro®t is $12.60 (i.e. $9.60 + $3.00). As stated earlier, your compensation will be 3.0% of your divisional pro®t. Therefore, your compensation will be 3.0% of $12.60, or $0.38. However, if you and your trading partner are unable to come to an agreement within a certain time limit, then you earn zero pro®t from internal transfer. If this occurs, then your compensa-tion will be based only on the ®xed pro®t from external sales which is $3.00 in the above example.

. For external sourcing and compensation structure based on ®rm pro®t (Cell #3)

Selling prices per motor unit are listed on the left side of the table, quantities across the top. The ®gures in the body of the table represent the divisional pro®t only from transfer of the motors to the Fans Division. For example, if you agree to sell ®ve motors at a price of $15.50 each, your divisional pro®t from internal transfer will be $9.60. Assume that from your external sales (which is 75% of your division's sale), you earned a pro®t of $38.40. Therefore, your total divi-sional pro®t is $48.00 (i.e., $9.60 + $38.40). Similarly, the Fans Division will achieve a certain divisional pro®t; assume it is $46.00. As stated earlier, you and the manager of the Fans Division will share equally 1.0% of the ®rm pro®t, determined as the total of your and Fans Division's pro®t. Thus, with the ®rm pro®t being $94.00 ($48.00 of your pro®t and $46.00 from Fans), your compen-sation will be half of $0.94 (1.00% of $94.00=$0.94); that is, $0.47. However, if you and your trading partner are unable to come to an agreement within a certain time limit, then both you and your partner earn zero pro®t from internal transfer. If this occurs, then ®rm pro®t will only be the sum of the ®xed pro®t from each division.

. For external sourcing and compensation structure based on division pro®t (Cell #4)

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trading partner are unable to come to an agreement within a certain time limit, then you earn zero pro®t from internal transfer. If this occurs, then your compensation will be based only on the ®xed pro®t from external sales which is $28.80 in the above example.

Cell references

Sourcing Compensation structure

Firm pro®t Division pro®t Internal Cell #1 Cell #2

(complementary) (noncomplementary) External Cell #3 Cell #4

(noncomplementary) (complementary)

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