Chapter 22:
Getting Divisions to Work in
the Firm’s Best Interest
Managerial Economics: A Problem Solving Appraoch (2nd Edition)
Luke M. Froeb, luke.froeb@owen.vanderbilt.edu
Brian T. McCann, brian.mccann@owen.vanderbilt.edu
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks
used herein under license.
Summary of main points
• Companies are “principals” who try to align the
incentives of divisions (“agents”) with the goals of the
parent company.
• Transfer pricing is a big source of conflict between
divisions because they transfer profit from one division
to another; they can also result in too few goods being
transferred. Transfer prices should be set equal to the
opportunity cost of the transferred asset.
• A profit center on top of another profit center can
result in too few goods being sold; one common way of
addressing this problem is to change one of the profit
centers into a cost center. This eliminates the
incentive conflict (about price) between the divisions.
Summary of main points (cont.)
• Companies with functional divisions share functional
expertise within a division and can more easily evaluate
and reward division employees. However, change is costly,
and senior management must coordinate the activities of
the various divisions to ensure they work towards a
common goal.
• Process teams are built around a multi-function task and
are evaluated based on the success of the task.
• When divisions are rewarded for reaching a budget
threshold, they have an incentive to lie to make the
threshold as low as possible, to make the threshold easier
to reach. In addition, they will pull sales into the present,
and push costs into the future, to make sure they reach the
threshold. A simple linear compensation scheme eliminate
this incentive conflict.
Introductory anecdote: Acme
• The 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 “gave” the Resin
department a very low transfer prices. As a result, the
Paper division began burning the soap as a fuel instead of
selling it to Resin.
• The soap’s value as a fuel was below its value as an input into
resin manufacturing.
Incentive Conflicts between
Divisions
• In a multi-divisional company, transactions between
divisions can create incentive conflicts.
• In these transactions the company is the principal and
divisions are the agents.
• 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.
Incentive conflicts (cont.)
• Again the answers suggest three possible solutions
• Change the division that does the decision making,
• Change the flow of information, or
• Change a division’s evaluation and compensation
schemes
• Often, parent companies organize so that each
division is an autonomous, and separate profit
center.
• Definition: A profit center is a division that is
evaluated based on the profit it earns.
• The benefit of a profit center is that they are easy
to evaluate (and manage); the cost is that they
are concerned only with their own division profit.
Analyzing Black Liquor Soap
Problem
•
Who is making the bad 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, not that of the Resin Division.
Transfer Pricing
• One common belief is that transfer pricing just shifts
profits between divisions & doesn’t affect firm profits.
• THIS IS A MYTH.
• Sometimes they move assets to lower valued uses, i.e. the
“black liquor soap” incident.
• Transfer pricing is always a problem between two profit
centers because they “fight” over the transfer price.
• You can get rid of the conflict by turning one division into
a cost center.
• A cost center is rewarded for reducing the cost of
producing a specified output. (but remember, cost centers
can come with problems of their own.)
• Discussion: Are your transfer prices set equal to the
opportunity cost of the product? If not, why not?
Paper Company Anecdote
• A company can transfer paper from its upstream Paper
division to its downstream Cardboard Box division.
• The company set a transfer price to guarantee a
contribution margin of 25% to the Paper division.
• So, 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).
• Discussion: Solution?
Paper company anecdote (cont.)
• 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.
Organizational options: U-form
• Functional (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.
Banking Coordination Problem
• Banks have 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”) identifies potential borrowers,
lends money to them, and then hands them over to
• The Loan Servicing Division, which collects interest
on the loan and makes sure that borrowers repay
the loans when they come due.
• For the bank in question, there was an unusually
high number of defaulted loans.
• What caused this to occur, and how can it be fixed?
Banking problem (cont.)
• Three questions:
• Who is making the bad decision?
The Loan Origination Division was making risky loans.
• Did the Division have enough information to make a
good decision?
The Division could have easily verified the credit
status of the borrowers.
• 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.
Organizational options: M-form
• 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.
• 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.
• Example: re-organize a bank into “home” and “business”
loans, where both divisions originate and service loans.
This reduces incentive to make bad loans.
Corporate Budgeting: Paying
People to Lie
• A toy company’s Marketing Division creates sale
projections for each season. The Manufacturing Division
uses the forecast to plan production.
• Problem: There was excess inventory at the individual
business units within the toy company.
• HINT: 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.
Corporate Budgeting: Paying
People to Lie (cont.)
• 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.
• Discussion: How should it be fixed?
Corporate Budgeting: Typical Problem
• This threshold compensation scheme creates incentives to lie
Corporate Budgeting: solution
• Adopting a linear compensation scheme solves problem
Alternate Intro Anecdote
• 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.
Alternate Intro Anecdote (cont.)
• After negotiations were unsuccessful, both divisions elected not
to transact.
• Toner Division continued to sell to the external market at its
customary price
• Cartridge Division elected to buy toner from an external
supplier.
• 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 percent 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. CEO
noticed this.
21
1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3.Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7.Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19.The problem of adverse selection
20.The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?