When the output of one division or company is the input to another vertical integration
When a single company controls various links in the production chain from basic inputs to final output transfer pricing
The pricing of products transferred among divisions of a firm
The transfer pricing problem results from the difficulty of establishing profitable relationships among divisions of a single company when each separate business unit stands in vertical relation to the other. A vertical relation is one where the output of one division or company is the input to another. Vertical integration occurs when a single company controls various links in the production chain from basic inputs to final output. Media powerhouse AOL-Time Warner, Inc., is vertically integrated because it owns AOL, an Internet service provider (ISP) and cable TV systems, plus a number of programming properties in filmed entertainment (e.g., Warner Bros.) and television production (e.g., HBO, CNN), commonly referred to as content providers. Vertically integrated companies in this field own and operate the distribution network and the programming that is sold over that network.
To combat the problems of coordinating large-scale enterprises that are vertically integrated, separate profit centers are typically established for each important product or product line. Despite obvious advantages, this decentralization has the potential to create problems. The most critical of these is the problem of transfer pricing, or the pricing of intermediate products transferred among divisions. To maximize profits for the vertically integrated firm, it is essential that a profit margin or markup only be charged at the final stage of production. All intermediate products transferred internally must be transferred at marginal cost.
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