Foundations and Trends® in Accounting > Vol 7 > Issue 3

Competition and Cost Accounting

V. G. Narayanan, Harvard University, USA, Michael Smith, Boston University, USA,
Suggested Citation
V. G. Narayanan and Michael Smith (2013), "Competition and Cost Accounting", Foundations and TrendsĀ® in Accounting: Vol. 7: No. 3, pp 131-195.

Published: 11 Apr 2013
© 2013 V. G. Narayanan and M. Smith
Cost management,  Management control,  Industrial Organization
M41 accounting
BertrandCournot competitionTransfer pricingCost measurement

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In this article:
1. Introduction
2. The Strategic Value of Transfer Prices
3. Cost Allocations and Endogenous Costs
4. Conclusion


Two of the most pervasive cost accounting systems for coordinating activities and facilitating decisions within firms are transfer pricing and product costing. These systems allow decentralized decision making that can take advantage of the local knowledge of managers. The choice of transfer prices and product costs also affects, and is affected by, the choice of similar systems by competing firms. In this monograph, we show that transfer prices, organizational structure, and firms' cost allocation system choices have a strategic impact on the product market in both Bertrand and Cournot settings. We show that the observability of and commitment to transfer prices are important factors that affect transfer prices and the strategic effect of transfer prices on the rival firm. But even in the absence of observability and commitment, we show that transfer prices have strategic effects, albeit more muted than in a setting that affords observability and commitment. Similarly, we show that firms' cost system choices have a strategic impact on rival firms. Surprisingly, these strategic effects sometimes have the result of an inferior cost system being chosen in equilibrium. Lastly, we consider a situation in which firms choose to specialize in a product market in order to obtain superior cost information. We show that sometimes firms may choose this strategy in equilibrium as an alternative to traditional costs systems that average costs across products without regard to their true consumption of resources. At other times, firms may choose a more refined cost system that yields better cost information in lieu of traditional cost systems. We thus show that a focused strategy of specializing in a product and a superior cost system may act as substitutes.

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Table of contents:
1. Introduction
2. The Strategic Value of Transfer Prices
3. Cost Allocations and Endogenous Costs
4. Conclusions

Competition and Cost Accounting

The central theme of Competition and Cost Accounting is that strategic considerations may make it desirable for a firm to have divisions and product managers internalize something other than their true costs. In the case of transfer prices, a high transfer price serves as a means of promoting tacit collusion. When transfer prices are not observable to the rival firm, decentralization, motivated by the superior knowledge of divisions about their own costs, can promote tacit collusion. In the case of product cost measurement, an inferior cost allocation system that just spreads costs evenly can promote tacit collusion. The authors show that it may not be an equilibrium for firms to adopt a more accurate cost system or compete in multiple markets. The strategic nature of their interaction with their rivals may influence their cost and cost accounting choices in surprising ways.

After an introduction, the authors analyze the strategic value of transfer prices in both Bertrand and Cournot settings. They demonstrate the importance of observability and commitment, and show that even in the absence of observability and commitment, decentralization to exploit the private information of upstream managers can have strategic consequences through double marginalization. These strategic effects become stronger with observability and commitment. They also analyze the strategic value of cost allocation systems in both Bertrand and Cournot settings before concluding the monograph.