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 Econ 5313

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 Econ 5313

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 Econ 5313

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 Econ 5313

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 Econ 5313

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 Econ 5313

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 Econ 5313

Three Answers The three questions suggest three possible solutions 1.Change the division that does the decision making 2.Change the flow of information 3.Change a division’s evaluation and compensation schemes Econ 5313

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 Econ 5313

Acme Paper The three questions suggest three possible solutions 1.Change the where the decision is made 2.Change the flow of information 3.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? Econ 5313

Transfer Pricing It is profit maximizing to set the price-cost margin just once Ex Two divisions Upstream division has MC U and downstream has MC D MC for the final product is MC = MC U + MC D Set (P-MC)/P = 1/|e| same as (P-MC U -MC D )/P = 1/|e| To the downstream division, the transfer price, T p, is the marginal cost of the upstream intermediate product So, ideally we have (P- T p -MC D )/P = 1/|e| So we need T p = MC U for profit-maximization The efficient transfer price is the marginal cost (or opportunity cost) of the intermediate good Econ 5313

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 Econ 5313

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? Econ 5313

Paper & Box Company Initial situation MC D P* Q P MR Econ 5313

Paper & Box Company Transfer price added 25% to upstream MC D P* Q P MC MR Transfer price Econ 5313

Paper & Box Company Downstream raises price to P’ and gives up some profitable sales Q P* P’P’ D P MC MR Transfer price Econ 5313

Paper & Box Company 1.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. Econ 5313

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 Econ 5313

Common Solutions Possible 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. Econ 5313

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? Econ 5313

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 Econ 5313

Human Resources Training 1.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 Econ 5313

U-Form versus M-Form How should you organize the various staff functions that serve various customer groups into divisions? Econ 5313 Customer ACustomer BCustomer C Function 1XXX Function 2XXX Function 3XXX

U-Form versus M-Form You can organize by Function (U-Form) Econ 5313 Customer ACustomer BCustomer 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 Econ 5313

U-Form versus M-Form You can organize by Customer Group (M-Form) Econ 5313 Customer ACustomer BCustomer C Manager AManager BManager C Function 1XXX Function 2XXX Function 3XXX

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 Econ 5313

Matrix Form You can organize by Both (Matrix Form) Econ 5313 Customer ACustomer BCustomer C Manager AManager BManager 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 Econ 5313

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? Econ 5313

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 Econ 5313

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 Econ 5313

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? Econ 5313

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 Econ 5313

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? Econ 5313

“Threshold” Compensation Artifact of “threshold” compensation schemes Compare this “kinky” compensation schedule” Econ 5313

“Linear” Compensation To this: Simple solution is to “linearize” the kinks Econ 5313

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 Econ 5313

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 Econ 5313

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 Econ 5313

From the Blog Chapter 22 Soccer Incentives U Florida falls victim to incorrect transfer prices Centralizing at Microsoft Econ 5313

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 Econ 5313

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 Econ 5313