Chapter 19
Getting Divisions to Work in
the Best Interests of the Firm
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson
Corporation. Thomson, the Star logo, and SouthWestern are trademarks used herein under license.
Review of Chapter 18
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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.
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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.
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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.)
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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
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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
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Rather than transfer, Paper Division decided to
burn its black liquor soap as fuel
Use as fuel risked explosion
Incentive Conflicts between Divisions
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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
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Transfer pricing
Corporate budgeting
Analyze Division Conflict Same Way
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Ask three questions
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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
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Change decision making
Transfer information
Change evaluation and compensation
Division Performance Evaluation
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Profit Centers
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Cost or Expense Centers
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How sensitive are profits to performance?
Sunk cost of capital
Hidden cost of capital
Shirking on quality if quality is hard to measure
Revenue Centers
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Don’t consider costs
Who has decision rights on price?
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Should salespeople be charged for “overhead?”
Analyzing Black Liquor Soap Problem
Who is making the bad decision?
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
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?
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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?
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The Paper Division was rewarded for increasing its own
profit, not that of the Resin Division.
Transfer Pricing
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Myth: Transfer pricing just shifts profits between divisions
& doesn’t affect firm profits
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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
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Right way: opportunity cost = transfer price
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But possible shirking on quality
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
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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
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Functional (U-form): Each division performs separate
tasks
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Advantages
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Disadvantages
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Workers develop high functional expertise
Information is shared easily within division
Easier to tie pay to performance
Requires management investment to coordinate divisions
M-Form: Each division performs all tasks to serve
customers of particular product or area
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Advantages
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Responsiveness to local markets
Consistent customer relationships
Disadvantages
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Less functional expertise
Banking Coordination Problem
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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
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Problem: Excess inventories at individual
business unit level of toy company
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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
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Creates coordination problems
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Creates incentives to “game” the system
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If marketing department managers negotiate lower
budgeted sales (so it’s easier to make their bonuses),
manufacturing will produce too little
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?
Total Compensation
Corporate Budgeting
$115,000
Compensation 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.
$95,000
$75,000
$4 million

$5 million
(Target)
$6 million
Profit
Threshold compensation scheme creates
incentive to lie
Total Compensation
Corporate Budgeting
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.
Compensation
Level
$4 million

Realized
Profit
Performance
$6 million
Profit
Adopting linear compensation scheme solves
problem
Alternate Intro Anecdote
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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.)
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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