The Firm as a Production Function

Objective: Maximize Profit
Labor
Firms
Output
Capital
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
The Firm as a Contractual Focal Point
Employees
Suppliers
Labor Unions
Insurance Providers
The Firm
Stockholders
Bondholders
Banks
Customers
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Conflicts within the firm
Owners vs. Managers
 Top Managers vs. underlings
 Creditors and stockholders
 Managers and labor unions
 Buyer-supplier conflicts
 Partner-owners may free ride on each
other’s effort

This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Divisional Performance Evaluation
Cost Centers
 Expense Centers
 Revenue Centers
 Profit Centers
 Investment Centers

This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Cost Centers

Objectives – Are these equivalent?




Decision Rights


Minimize Costs for a given output
Maximize Output for a given budget
Minimize Average costs
Input mix
Requirements

When would a cost center be appropriate?
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Marginal, Not Average
Price
MC
AC
Output
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Marginal, Not Average
Price
MC
AC
Demand
MR
Output
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Expense Centers
Maximize service given budget
 Problems




If users aren’t charged for the service they will
overuse it.
Managers sometimes build empires
Solutions


Benchmark size against other firms
Place under the control of the largest user
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Revenue Center
Maximize revenue given price and budget
 Problems



Can’t let managers set prices
Central management must set the product mix
or sales will focus on expensive items.
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Profit Center

Objectives




Decision Rights




Actual profit
Actual profit vs. Expected Profit
Expected Present Value of current and future
profit
Input mix
Product mix
Selling prices
Requirements
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Investment Centers

Objectives


Decision Rights





Maximize
ROA = (Acct Net Income)/(Total Assets)
Input mix
Product mix
Selling prices
Capital invested
Requirements
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Investment Center

Problems



ROA may cause managers to avoid profitable
projects with low ROA
Risky projects often have high ROA
Near retirement managers may adopt projects
with high short term ROA
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Transfer pricing

Costless Information
Retail in the US
P = $15
Manufacturing
MC = $5
AC =$20
Rule: The most profitable
transfer price is equal to
opportunity cost.
European Retail
P = $20
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Transfer Pricing: Who Can You Trust?
Successive Monopoly / Double Monopoly Markup

Price
Manufacturing
Price
Retail
D
D
85
MC
60
10
MC
MR
MR
MR
5
11
Quantity
5
11
22
Quantity
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Transfer Pricing: Common Methods

Market Based Transfer Price




Competitive prices minimize long-run costs
Beware of synergies
There may be costs of writing and enforcing
contracts with others
Marginal Production Cost (MPC)


MPC may not be MC
May not be relevant near capacity
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
Transfer Pricing: Common Methods

Full Cost Transfer Prices



May work well when near capacity
Doesn’t maximize profit
Negotiated Transfer Prices



The right people are at the meeting
Time consuming
Negotiating skills are critical
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
17-1
Auto-fit is a multidivisional firm that produces auto parts. It
has the capacity for annual production of 100 units of a
particular part. The marginal cost of producing each unit is
$10. These units can be sold internally either to other
divisions or to external customers. The external market price
is $20. The allocated share of corporate overhead for each
part produced is $5. Total corporate overhead expenditures
do not vary with the production of the part. How many units
of the part should the company produce? What is the
theoretically correct transfer price (should the company
decide to transfer the part internally)?
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.
17-4 The Xtrac Computer company is organized into regional sales
offices and a manufacturing division. The sales offices forecast
sales for the upcoming year in their territories. These figures are
then used to set the manufacturing schedules for the year. Prices of
the computers are determined by corporate headquarters and the
sales people are paid a fixed wage and a commission based on
sales. The regional sales offices are evaluated as revenue centers.
The regional sales manager is paid a small wage (about 30% of pay)
and a commission based on the sales of her territory that exceeds
the budget (about 70% of pay).
Xtrac has a notoriously bad track record for forecasting computer
sales. Its budgets always under-forecast sales, and then, during the
year, manufacturing scrambles to produce more units, authorizes
labor overtime, and buys parts on rush orders. This drives up
manufacturing costs. In fact, Xtrac even under-forcasts sales when
the economy is slow.
a. What is the likely reason for the under-forecasting?
b. Propose solutions to the problem
This slideshow was written by Ken Chapman, but is substantially based on concepts from Managerial Economics and
Organizational Architecture by Brickley Zimmerman & Smith, McGraw-Hill, 2004.