PowerPoint Slides © Michael R. Ward, UTA 2014

Divisions of a Firm• A Division is any logical sub-organization of the firm • Sometimes referred to as its Organizational Architecture• Ex Functional

• R&D -> Engineering -> Production -> Marketing -> Sales

• Ex Workflow Related• Plant 1, Plant 2, Plant 3 -> Assembly

• Ex Locational• Store 1, Store 2, Store 3 -> Region• Region 1, Region 2, Region 3 -> Sales Div.

• Usually, clear hierarchy within a division

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Divisional Conflicts• Conflicts can arise between divisions because:

• There may be gains to the firm from coordination across divisions• But there may be weak incentives to divisional managers to

coordinate

• Managers are often evaluated on their divisional performance

• Any impacts their decisions have on other divisions are irrelevant to the metrics upon which they are evaluated

• We can apply principal/agent analysis where the transactions the company is the principal and divisions are the agents

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Profit Centers• Often, parent companies are organized so that each

division is an autonomous and a separate profit center • A profit center is a division that is evaluated based on the

profit it earns • The benefit: they are easy to evaluate (and manage)

• Manager has appropriate information, expertise, incentives, etc.• Tie compensation to divisional performance

• The cost: they ignore affects on the rest of the company• There are cases in which one division’s profits come at the

expense of another division’s

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Transfer Pricing• Transfer prices there is a simple mechanism to get

divisional managers to heed the affects they have on other divisions

• When an upstream division’s output is an input to a downstream division, this intermediate good is transferred at an accounting price, the transfer price• The upstream (“selling”) division’s revenues and the downstream

(“buying”) division’s costs are based on this value• For example, a higher transfer price “transfers” some of the value

creation from the downstream division to the upstream division

• But they also affect decisions

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Acme Paper• A by-product of producing Acme paper is “black liquor

soap” that is converted into “crude tall oil” used in resin manufacturing

• The Paper division at Acme sold it’s soap to the Resin company at a transfer price set by senior management

• But both divisions fought over the transfer price• The Resin division wanted a low transfer price• The Paper division wanted a high price• The corporate parent company set a very low transfer price

• As a result, the Paper division began burning the soap as a fuel instead of selling it to Resin

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Acme Paper• The soap’s value as a fuel was below its value as an input

into resin manufacturing• But the soap’s value as a fuel was above the transfer price• An inappropriate transfer price was at the center of the

incentive conflict between the Resins and Paper Divisions• It increased the profit of one but decreased the profit of

the other

• Transfer prices do “transfer” profits from one division to another, but they also affect decision making and thus firm profitability

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Three Questions• To understand the source of conflicts that arise between

divisions, personify the divisions and consider each to be a rational actor

• Then ask the same three questions:1. Which division is making the bad decision?2. Does the division have enough info. to make a good decision? 3. Does it have the incentive to do so?

• Without proper control, these conflicts can deter profitable transactions from occurring

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Three Answers• The three questions suggest three possible solutions

1. Change the division that does the decision making 2. Change the flow of information3. Change a division’s evaluation and compensation schemes

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Acme Paper• Who is making the bad “black liquor soap” decision?

• The Paper Division made the bad decision to burn the soap for fuel instead of transferring it to the Resins Division

• Did they have enough information to make a good decision?• The Paper Division had enough information to know that the

soap’s value as a fuel was below its value as an input to resin manufacturing

• And the incentive to do so?• The Paper Division was rewarded for increasing its own profit,

even if it decreased the profits of the Resin Division and the company

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Acme Paper• The three questions suggest three possible solutions

1. Change the where the decision is made2. Change the flow of information3. Change a division’s evaluation and compensation schemes

• In this case:1. What are consequences of the “black liquor soap” decision

being made at the Resin division or at corporate headquarters?2. Who is uninformed? Corp Headquarters micromanaging?3. Raise the transfer price. Simple enough if you know the

appropriate transfer price. What is the appropriate transfer price?

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Transfer Pricing• It is profit maximizing to set the price-cost margin just

once• Ex Two divisions

• Upstream division has MCU and downstream has MCD

• MC for the final product is MC = MCU + MCD

• Set (P-MC)/P = 1/|e| same as (P-MCU-MCD)/P = 1/|e|

• To the downstream division, the transfer price, Tp, is the marginal cost of the upstream intermediate product

• So, ideally we have (P- Tp-MCD)/P = 1/|e|

• So we need Tp = MCU for profit-maximization

• The efficient transfer price is the marginal cost (or opportunity cost) of the intermediate good

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Transfer Pricing• This may be efficient but it may not be common• Transfer pricing is a problem between two profit centers

because they “fight” over setting the transfer price• The upstream division manager wants a high transfer price – even

if it is greater than the opportunity cost• The downstream division manager wants a low transfer price –

even if it is less than the opportunity cost• Corporate headquarters does not know what is appropriate

• Why not?

• The parties with the information have bad incentives• The party with the incentive has bad information

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Paper & Box Company• The firm transfers paper from its upstream Paper division

to its downstream Cardboard Box division• The firm set a transfer price to guarantee a contribution

margin of 25% to the Paper division• If the Paper MC is $100, the transfer price would be $125• The Box Division considers the transfer price to be its MC,

and then marks up the cost again• The Box division makes all sales where MR > MC, but now

the MC is overstated (because of the included contribution margin of the Paper division)

• Solution?

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Paper & Box CompanyInitial situation

MC

D

P*

Q

P

MR

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Paper & Box CompanyTransfer price added 25% to upstream MC

D

P*

Q

P

MC

MR

Transfer price

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Paper & Box CompanyDownstream raises price to P’ and gives up some profitable sales

Q

P*P’

D

P

MC

MR

Transfer price

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Paper & Box Company1. Who is making the bad decision?

• The Paper Division is charging too much for paper. This raises the cost of the downstream boxes, reducing downstream sales and profit

2. Did the division have enough information to make a good decision? • Yes. Paper Division managers are familiar enough with the

parent company’s operations to know better

3. Did the division have the incentive to do so? • No. The divisions are run as separate profit centers, so they

work to increase profit of their own divisions, even if it means reducing parent company profit.

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Paper & Box Company• The analysis makes clear that the conflict arises because

two profit centers are each trying to extract profit from a single product

• This creates a “double markup” problem • One way to solve the problem is to make the Paper

division a cost center • Cost centers are not evaluated based on the profit they

earn, and so don’t care about the transfer price• Once the Paper division began transferring at MC the Box

division began winning more jobs from its rivals

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Common SolutionsPossible solutions for setting transfer prices:1. Approximate MC with AC

• Easy but too large if ATC big

2. Approximate MC with AVC• Subtract FC from TC and divide by Q. OK if FC is identifiable and

division makes a single intermediate good

3. Run upstream division as a cost center• A cost center is rewarded for reducing the cost of producing a

specified output.

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Human Resources Training• The HR division for a large corporation provides training

to different divisions for such things as equal employment opportunity, data security, retirement planning, etc. The HR manager is compensated based on "charge backs" that other divisions "pay" for these services. Increasingly, these divisions have been hiring outside consultants for this training.

• What does this tell you about the HR division?

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Human Resources Training• Charge backs” are a form of transfer prices set up

between upstream and downstream divisions that operate as profit centers

• The profit maximizing transfer price is the marginal cost of providing these HR services

• If the HR manager can set a charge back rate higher than opportunity cost, he is likely to be rewarded for making his division is more profitable

• Setting a rate so high that downstream divisions purchase outside of the firm indicates a transfer pricing problem

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Human Resources Training1. It could be that the transfer price is too high with

P(transfer) > P(outside) > MC• This problem is “simply” setting the appropriate charge back

2. It could be that the upstream division is just inefficient with P(transfer) > MC > P(outside)• This suggests mismanagement of the upstream division

3. It could be that the quality or other characteristics of the inside and outside options differ• For example, downstream divisions are required to undergo

unwanted training and find an outside vender that provides a perfunctory service

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U-Form versus M-Form• How should you organize the various staff functions that

serve various customer groups into divisions?

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Customer A Customer B Customer C

Function 1 X X X

Function 2 X X X

Function 3 X X X

U-Form versus M-Form• You can organize by Function (U-Form)

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Customer A Customer B Customer C

Function 1 X

X

X Manager 1

Function 2 X

X

X Manager 2

Function 3 X

X

X Manager 3

U-Form versus M-Form• Functional or “Unitary” form (U-form): A functionally

organized firm is one in which various divisions perform separate tasks, such as production and sales

• Example of functional organization are Henry Ford’s automobile assembly line, or Adam Smith’s pin factory

• Advantages:• Workers develop high functional expertise• Information can be shared easily within a division• It’s easier to tie pay to performance because performance is

easily measured

• Disadvantages:• Each division must coordinate with each other, a burden that falls

on management; and change is costly

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U-Form versus M-Form• You can organize by Customer Group (M-Form)

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Customer A Customer B Customer CManager A Manager B Manager C

Function 1 X X X

Function 2 X X X

Function 3 X X X

U-Form versus M-Form• An M-form firm is one whose divisions perform all the

tasks necessary to serve customers of a particular product or in a particular region

• Example: re-organize a bank into “home” and “business” divisions, where both divisions originate and service loans

• Advantages:• Divisions can respond more easily to change.• Easier to establish customer relationships because one person

can serve each customer’s needs

• Disadvantages:• Individual workers develop less functional expertise

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Matrix Form• You can organize by Both (Matrix Form)

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Customer A Customer B Customer CManager A Manager B Manager C

Function 1 X X X Manager 1

Function 2 X X X Manager 2

Function 3 X X X Manager 3

Matrix Form• A Matrix Form tries to have the benefits of both a

functional focus and a customer focus• Each employee has two supervisors who are interested in

two different sets of issues causing potential conflicts• More common in firms that have a number of fixed term

projects• A consulting firm has expertise in various areas• Client contracts are for a year and include many different experts• Project Manager versus Director of Engineers

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Origination and Servicing• Banks had many different divisions, all of which must work

together for the bank to create profits • The Loan Origination Division (think of them as “mortgage

brokers”) identified potential borrowers, lent money to them, and then handed them over to …

• The Loan Servicing Division, which collected interest on the loan and made sure that borrowers repaid the loans when they came due

• For the bank in question, there was an unusually high number of defaulted loans

• What caused this to occur, and how could it be fixed?

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Origination and Servicing• Three questions:1. Who is making the bad decision?

• The Loan Origination Division was making risky loans

2. Did the Division have enough information to make a good decision? • The Division could have easily verified the credit status of the

borrowers

3. And the incentive to do so? • Like many sales organizations, the Loan Origination Division

(“mortgage brokers”) were evaluated based on the amount of money they were able to lend, regardless of the credit worthiness of borrowers

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Origination and Servicing• We could change the incentives of the Origination division

so that they are rewarded for making only profitable loans.

• But this is difficult to implement because unprofitable loans are discovered only after several years, when the borrowers do not repay the loans.

• Another solution, commonly used by banks, is to put the origination and servicing personnel in the same Division, essentially re-organizing the bank into an “M-form” company

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Lying Budgeting• A toy company’s Marketing Division creates sale

projections for each season• The Manufacturing Division uses the forecast to plan

production • But there was excess inventory at the individual business

units within the toy company• Why?

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Lying Budgeting• Each business unit is rewarded with a big bonus if it meets

budget• This system created incentives for business units to set

low budgets • The CEO knew this and “stretched” each budget goal, even

though he lacked specific information about business unit• When the goals were set too high, the inventory was not

sold and accumulated; if too low, stock-outs occurred

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Lying Budgeting• Once budget goals were reached, there was no incentive

to exceed them (“shirking”)• Also, there are incentives to “game” the system• Accelerate sales or delay costs if just short of target• Delay sales or accelerate costs if target already met to

make next year’s goals easier to reach• Accelerating or delaying sales can be costly, e.g., discounts

offered to customers to delay or accelerate demand.• How should it be fixed?

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“Threshold” Compensation• Artifact of “threshold” compensation schemes• Compare this “kinky” compensation schedule”

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“Linear” Compensation• To this:

• Simple solution is to “linearize” the kinks

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Toner Example• Company X, one of the world’s largest suppliers of

supplies for printers, copiers, and fax machines, included two separate divisions

• Toner Division produced toner, which it sold to the Cartridge Division and to the external market

• The Cartridge Division integrated the toner into cartridges sold to original equipment manufacturers and consumers

• Company management allowed the two divisions to negotiate the transfer price of toner and evaluated each division on its profitability

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Toner Example• After negotiations were unsuccessful, both divisions

elected not to transact • Toner Division continued to sell to the external market at

its customary price• So Cartridge Division bought toner from an external

supplier

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Toner Example• The Cartridge Division ended up buying its toner from the

exact same supplier to whom the Toner Division was selling

• Rather than paying one markup to the Toner Division, the Cartridge Division ended up paying that markup plus an additional margin to the external supplier

• Price was 38% higher cost than originally proposed in negotiations

• External supplier’s shipment arrived at Company X’s docks with the products still emblazoned with Company X’s logo

• The CEO noticed this

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From the Blog• Chapter 22• Soccer Incentives• U Florida falls victim to incorrect transfer prices• Centralizing at Microsoft

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Main Points• There often are agency problems for a firm’s divisions• Transfer pricing can facilitate moving assets to higher

valued uses• It does NOT merely allocate profit

• A profit center on top of another profit center can result in too few goods being sold due to “double markups.” Solutions are:• Appropriate transfer prices• Making the upstream division a cost center

• Divisions that based on functional expertise tend to be more easily evaluated and rewarded, but may lack customer focus

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Main Points• Process teams are built around complementary functions

where team success is closely aligned with customer satisfaction, but may suffer loss of functional expertise

• When divisions are rewarded for meeting a budget threshold, they have incentives to lie about the appropriate threshold• They want milestones that are too low while management wants

milestones that are too high• They can push or pull sales across periods to “game” the

incentives.• When possible, linearize incentives to solve this problem

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