Chapter 22: How to get divisions to work in the best interest of the parent firm. 1. Introduction

This is Professor Luke Froeb and I, along with Brian McCann, am the author of “Managerial Economics: A Problem Solving Approach.” This video is designed to complement Chapter 19: The Problem of Adverse Selection. 22. GETTING DIVISIONS TO WORK IN THE BEST INTERESTS OF THE FIRM Incentive Conflict between Divisions Transfer Pricing Functional Silos versus Process Teams Budget Games: Paying People to Lie

Main Points

 Companies are principals trying to get their divisions (agents) to work profitably in the interests of the parent company.

 Transfer pricing does not merely transfer profit from one division to another; it can result in moving assets to lower-value uses. Efficient transfer prices are set equal to the opportunity cost of the asset being transferred.

 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.

 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 project on which they are working.

 When divisions are rewarded for reaching a budget threshold, they have an incentive to lie to make the threshold as low as possible, thus ensuring they get their bonuses. 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 solves this problem.

Supplementary Material ManagerialEcon.com (Chapter 22)

Michael Jensen, “Corporate Budgeting Is Broken, Let’s Fix It,” Harvard Business Review (November 2001). Froeb, Luke, Paul Pautler, and Lars-Hendrik Roeller, The Economics of Organizing Economists, (July, 2008). Available at SSRN: http://ssrn.com/abstract=1155237

Note: this is an analysis of the tradeoff between a functional organization (economists in their own division) and a divisional organization (attorneys and economists in same division).

Teaching Note There are four main points I want to get across in class:

1. The analytic tools of principal-agent analysis can be applied to company-division analysis

Since this topic uses analytic tools very similar to the principal-agent problems of the previous chapter, I want to give students practice in solving real problems. I would describe the toner pricing problem from the additional introductory anecdote, (that the cartridge division ended up buying toner from an external supplier who had bought it from the same company’s toner division, marked it up, and sold it back to the same company). Ask students if they can figure out what is wrong by asking yes or no questions. Steer them towards the same the three questions we have been using all along, except “personify” the Division (which division is making the bad decision; do they have enough information to make a good decision; and the incentive to do so).

Once they figure it out, ask them how to fix it. Steer them towards the same three solutions (change decision rights; change information flows; change incentives). Identify at least three solutions (senior management mandates a transfer price; change upstream toner division into a cost center; and “do nothing”); and then ask the students what are the advantages and disadvantages of each. If the upstream toner division sells a significant amount of product to the outside market, then it may be best to “do nothing” because the magnitude of the problem is relatively small and implementing the other solutions would require significant organizational change.

2. Transfer pricing

I forgo the double marginalization analysis, and just tell them that any transfer price greater than MC will result in a price that is too high to maximize parent company profit. Draw a vertical supply chain on the board, and show explicitly how this works. Make them aware that this is the same problem as competition between complements (Chapter 15) and pricing jointly owned complementary products (Chapter 12). In general, tell them that there are lots of incentive conflicts between divisions or firms in the same vertical supply chain, the subject of the next chapter. Make the link to the problem of incentive conflict between sales and marketing, where you have, effectively, a transfer price that is set too low (at zero) because the salespeople are compensated based on revenue.

3. Functional silos vs. process teams

There are lots of good stories you can use to tell this story (banks, jet engine). If students have NOT read the chapter in advance, describe the problem of Pratt & Whitney designing an engine that cost more than anyone was willing to pay for it. Let them guess the problem using “yes or no” questions.

If you want to hit close to home talk about the problem with MBA programs designed around functional areas. Each professor becomes a narrow academic expert in his or her field and ends up producing knowledge that is useful to the narrow functional discipline but problems don’t lie in narrow functional disciplines.

4. Corporate budgeting.

Michael Jensen’s article is terrific. Even more than transfer pricing, this is an area in which every business has problems. Begin with the problem, not enough toys, or too many toys produced for the holidays. Let students try to figure out what is wrong.

In-class Problem QUESTION: Oracle notices that its sales of its enterprise software are concentrated at the beginning of each quarter and at the end of each quarter, with fewer any sales in the middle. The sales at the beginning of the quarter and at the end of the quarter have much lower prices, about 7% lower than earlier sales. Why?

ANSWER: Salespeople are compensated with strong incentive packages that increase dramatically once a salesperson reaches his “goal.” This gives sales people an incentive to push sales forward to the beginning of next period; or pull sales back from the next period to the present in order to reach goals. The discounts reflect the gains to the salesperson (remember the non strategic view of bargaining) as there is more potential gain to the salespeople.

Additional Anecdotes: Toner Supplier, Sears Auto Repair, & Functionally Organized Banks TONER SUPPLIER: Company X, one of the world’s largest suppliers of supplies for printers, copiers, and fax machines, included two separate divisions. The 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. Since a lower transfer price raised the profit of the buying division while simultaneously reducing the profit of the selling division, each division spent a considerable amount of time trying to obtain the most favorable transfer price.

The Toner Division wanted to sell toner at its customary external market price while the Cartridge Division argued for a price much nearer the Toner Division’s cost. After negotiations were unsuccessful in reaching any agreement, both divisions elected not to transact. The Toner Division continued to sell to the external market at its customary price, while the Cartridge Division elected to buy toner from an external supplier.

An astute aficionado of irony might predict where this story ended up. The Cartridge Division ended up buying its toner from the exact same supplier to whom the Toner Division was selling. But, 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 (a 38 percent higher cost than originally proposed in negotiations). The problem became especially apparent to senior management, as the external supplier’s shipment arrived at Company X’s docks with the products still emblazoned with Company X’s logo. Senior management stepped in and mandated a transfer price.

In this chapter, we apply the lessons of the last chapter, showing how to control the incentive conflict between a principal and an agent, to the problem of controlling incentive conflict between a company and its various divisions.

SEARS AUTO REPAIR: In 1992 charges were brought against Sears whose mechanics were recommending unnecessary auto repairs. The problem was traced to the incentive system used by Sears (and others in the industry), [the] use of quotas, commissions, or similar compensation may provide incentives for sales personnel to sell unnecessary auto repair services in order to meet quotas or receive larger commissions.

Sears tried to fix the problem by re-organizing into two divisions, one responsible for recommending repairs; and the other responsible for doing them. Rather than solving the problem, however, the two divisions got together and began colluding. In exchange for recommending unnecessary repairs, the service division paid the recommending division for recommending them. Sears finally adopted flat pay for the mechanics, which led to shirking.

I used this example in Vanderbilt's MMHC class (syllabus) to illustrate the difficulties of aligning the incentives of providers with the goals of payers. President Obama tried to make the same point when he accused physicians of performing unnecessary tonsillectomies. However, as the Sears example suggests, there are no "fixes" to the problem, only tradeoffs: Incentives matter, yet maybe the truth is that medicine is a highly complex science in which the evidence changes rapidly and constantly. That’s one reason tonsillectomies are so much rarer now than they were in the 1970s and 1980s— but still better for some patients over others. As the American Academy of Otolaryngology put it in a press release responding to Mr. Obama’s commentary, clinical guidelines suggest that “In many cases, tonsillectomy may be a more effective treatment, and less costly, than prolonged or repeated treatments for an infected throat.”

Mr. Obama seems to think that such judgments are easy. “If there’s a blue pill and a red pill and the blue pill is half the price of the red pill and works just as well,” he asked, “why not pay half price for the thing that’s going to make you well?” But usually the red and blue treatments are available—as well as the green, yellow, etc.—because of the variability of disease, human biology and patient preference. And the really hard cases, especially when government is paying for health care, are those for which there’s only a red pill and it happens to be very expensive.

FUNCTIONALLY ORGANIZED BANKS: Managers of a functionally organized firm must coordinate the activities of each division. Otherwise, the divisions may end up working at cross purposes.

The incentive conflict between bank deposit and lending divisions is a classic example. The S&L crisis of the early 1980's was caused, in part, by the behavior of S&L's which borrowed short (deposits) and lent long (home mortgages). When interest rates skyrocketed in the early 1980's, S&L borrowing costs increased dramatically as depositors demanded higher rates, but revenue did not change on the 30-year, fixed-rate mortgages. Good managers would recognize the mismatch between deposit and loan maturities and use financial markets to offload some of the risk.

It seems as if something similar may be going on in today's banks. The loan originators and (mortgage brokers) are compensated mainly on volume, but not the quality of the loans they make. This leads to risky loans that may not be recognized as risky until housing prices start falling, and borrowers find it more profitable to forfeit the house to the bank. Again, good managers will recognize the incentive conflict between loan origination and servicing, and try to control it.

In an earlier post, we suggested that investors ignored risk in search of higher returns as they drove risk premia on all kinds of exotic and risky investments down to historic lows. It may be that functional specialization has been partly responsible for the failure of subprime lenders to recognize risk. When loan originators make loans that no investor wants to fund, lenders go bankrupt.