Full-cost transfer pricing and cost management

Full-cost transfer pricing has been criticized for providing production units with insufficient incentives to economize. Our empirical study based on data from a large producer of consumer goods shows that charging fullcost transfer prices to downstream sales units can send upstream production units into a death spiral. However, our results also suggest that production units reduce costs to prevent the death spiral. We observe that managers focus their cost-cutting efforts on unit variable costs and on products with the best sales prospects. These results also suggest that, when production units are at risk of falling into a death spiral, full-cost transfer pricing can serve as a credible commitment device to motivate managers to reduce costs.