Chapter 19Getting Divisions to Work in the Best Interests of the Firm

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Review of Chapter 18

Principals want agents to work in their best interests, but typically agents have different goals than principals; this leads to moral hazard and adverse selection problems when agents have better information than principals

Approaches to controlling incentive conflicts. Fixed payment and monitoring Incentive pay and no monitoring Sharing contract and some monitoring

In a well-run organization, decision makers have (1) the information necessary to make good decisions, and (2) the incentive to do so.

If you decentralize decision-making authority, then you should strengthen incentive compensation schemes.

If you centralize decision-making authority, then you should make sure to transfer needed information to the decision makers.

Review (cont.)

To analyze principal agent-conflicts, focus on three questions: Who is making the (bad) decisions? Does the employee have enough information to make

good decisions; and Does the employee have the incentive to make good

decisions? Alternatives for controlling principal-agent conflicts

center on one of the following: Re-assigning decision rights Transferring information Changing incentives

Transfer Pricing Anecdote

Paper Division of a large company trying to decide what to do with its black liquor soap

Normally sold to Resins Division Disagreement arose between Resins and

Paper Division on transfer price Corporate set a low transfer price

Rather than transfer, Paper Division decided to burn its black liquor soap as fuel

Use as fuel risked explosion

Incentive Conflicts between Divisions In a multidivisional company, transactions

between divisions involve incentive conflicts Company is principal; divisions are agents Without proper control, these conflicts deter

profitable transactions from occurring Transfer pricing Corporate budgeting

Analyze Division Conflict Same Way Ask three questions

Which division is making the bad decision? Does it have enough information to make a good

decision? Does it have the incentive to do so?

Answers suggest solutions Change decision making Transfer information Change evaluation and compensation

Division Performance Evaluation Profit Centers

How sensitive are profits to performance? Sunk cost of capital Hidden cost of capital

Cost or Expense Centers Shirking on quality if quality is hard to measure

Revenue Centers Don’t consider costs Who has decision rights on price?

Should salespeople be charged for “overhead?”

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

Myth: Transfer pricing just shifts profits between divisions & doesn’t affect firm profits Sometimes they move assets to lower valued uses, e.g. “black

liquor soap.” Transfer pricing is always a problem between two profit

centers because they “fight” over the price Get rid of the conflict turning one division into a cost center

But possible shirking on quality Right way: opportunity cost = transfer price

Marginal cost (no capacity constraint) Market price (capacity constrained)

Discussion: Are your transfer prices set equal to the opportunity cost of the product? If not, why not?

Paper Company Anecdote

Transfer of paper from upstream paper division to downstream cardboard box division

Company set transfer price to guarantee profit of 25% to Paper division

Assume Paper MC of $100, so transfer price of $125 MC of paper to Box Division is now $125; makes all

sales where MR>MC, but MC is overstated Discussion: Solution?

Organizational Options Functional (U-form): Each division performs separate tasks

Advantages Workers develop high functional expertise Information is shared easily within division Easier to tie pay to performance

Disadvantages Requires management investment to coordinate divisions

M-Form: Each division performs all tasks to serve customers of particular product or area Advantages

Responsiveness to local markets Consistent customer relationships

Disadvantages Less functional expertise

Banking Coordination Problem Loan Origination Division identifies potential borrowers, lends

money to them, and then hands them over Loan Servicing Division collects interest on the loan and makes

sure that borrowers repay the loans when they come due The problem was an unusually high number of defaults 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 most sales organizations, the Loan Origination Division managers were evaluated based on the amount of money they were able to lend.

Corporate Budgeting: Paying People to Lie Problem: Excess inventories at individual

business unit level of toy company HINT: each business unit is rewarded with a big

bonus if it meets budget Creates incentive for business units to set

low budgets CEO knows this and “stretches” each budget goal

without specific information about business unit If goals are set too high, inventory is not sold and

accumulates

Corporate Budgeting: Paying People to Lie Creates coordination problems

If marketing department managers negotiate lower budgeted sales (so it’s easier to make their bonuses), manufacturing will produce too little

Creates incentives to “game” the system Accelerate sales or delay costs if just short of target Delay sales or accelerate costs if target already met

Discussion: How should it be fixed?

Corporate Budgeting

Threshold compensation scheme creates incentive to lie

$75,000

$4 million $5 million (Target)

$6 million

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Profit

$95,000

$115,000Compensation depends on realizing a minimum profit level. Managers have an incentive to game the system to reach the $4 million level. Also, managers have no additional incentives once profit has reached $6 million.

Corporate Budgeting

Adopting linear compensation scheme solves problem

Compensation Level

$4 million Realized Profit

Performance

$6 million Profit

Compensation no longer depends on realizing a minimum profit level. With no incentive to game the system (pay is the same whether profit was targeted at $4 million or at $6 million), budgets will be more accurate and useful in the planning process.

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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