Offshoring procurement systems with internal decentralization

Abstract The extant literature has mostly blamed the setup costs and added transportation costs for the failures of relocating procurement centers overseas, whereas internal decentralization has long been ignored. In practice, issues such as the arm's length principle and information asymmetry can prevent the headquarters from fully centralizing its divisions when offshoring its procurement center overseas. To examine the impact of internal decentralization, we investigate the decision of a firm's headquarters regarding whether to set up an overseas procurement center and whether to further decentralize the procurement center. This article investigates a stylized model and reveals that, even without the setup and transportation costs, it is not always beneficial for the firm to offshore procurement centers under the impact of transfer pricing unless the tax advantage is big enough. An offshoring procurement system with a decentralized procurement center can outperform one with a centralized procurement center when the tax rate disparity is large, because the headquarters' procurement cost information screening makes it benefit more from a decentralized procurement center when the tax rate gap is big. Besides the intuitive trade‐off between the tax‐saving effect and the double marginalization effect caused by the internal decentralization, some indirect effects—cost‐saving effect of the procurement effort and the tax‐paying asymmetry effect (i.e., the procurement center still pays a positive tax even if the headquarters is not profitable)—are found to have a significant impact on the headquarters' choice. Screening the procurement cost information amplifies the advantage of the procurement independent accounting system when the tax rate disparity is big but decreases it otherwise.