Performance Evaluation
Chapters 16 and 17
Arthur Anderson LLP
Let’s Play a Pricing Game
• Please use Groups of 2-3 students
• ½ of the class will be manufactures
– A monopoly wholesaler sells to the monopoly
retailer in its territory
• ½ of the class will be retailers
– A retailer buys from the only supplier in its
territory
– A retailer sells to the consumers in its territory
• Please be sure to pick up a handout before
class
Retail Demand Curve
Retail $12 $11 $10 $9 $8
Price
$7 $6 $5 $4 $3 $2 $1
$0
Units
Sold
5
12
0
1
2
3
4
6
7
8
9
10 11
The role of divisional evaluation in
organizational architecture
• Divisional
performance
evaluation should
help, not hinder, the
firm’s ability to
maximize value given
the division’s decision
rights
• E.g. bad/good transfer
pricing decisions
Transfer Pricing Basics
• Transfer pricing = valuation of intermediate
goods and services within the firm
– Also called "charge-back system“
• Transfer price – internal price at which an
intermediate good or service is exchanged
between divisions
– One division “pays” the supplying division for
the intermediate good or service.
• Funds are thus transferred from the paying
division’s budget to the supplying division’s
budget.
Anecdotes about Transfer Pricing
• “Divisions in my firm are always fighting over transfer
prices. As a CEO, I am not very concerned about this
issue. Transfer prices simply affect the division of firm
profits among subunits within the firm. I am interested in
total firm profits.”
- Anonymous CEO
• “Bellcore is the research arm of AT&T. In the late 1980s
highly talented and well paid engineers and scientists were
discovered to be typing their own letters, memos and
research papers and using typists outside the company,
risking the security of internal communications.
Meanwhile the typing pool that was supposed to do this
work was laying people off because there was not enough
for them to do.”
- E. Kovac and H. Troy, 1989, Harvard Business Review,
Sept. – Oct.
Transfer pricing results
• Decentralization of decision rights for transfer
pricing is common
• Transfer price affects distribution of profits among
units
• Transfer price affects overall profits
• Some divisional evaluation criteria give incentives
to pump up transfer prices
“cost” of goods overblown
Product pricing too high
lowers firm value
Example
No transfer pricing: BASELINE
• Pricing set by CEO who has the relevant
information
– Retail unit receives customer orders and asks for
required units from manufacturing (e.g. wholesale)
• Overall firm profitability possibilities:
Q (#shipmts)
0
1
2
3
4
5
6
7
8
9
10
11
12
Price
$ 12.00
$ 11.00
$ 10.00
$ 9.00
$ 8.00
$ 7.00
$ 6.00
$ 5.00
$ 4.00
$ 3.00
$ 2.00
$ 1.00
$0.00
$
$
$
$
$
$
$
$
$
$
$
$
TR
11.00
20.00
27.00
32.00
35.00
36.00
35.00
32.00
27.00
20.00
11.00
$0.00
MR
$
$ 11.00
$ 9.00
$ 7.00
$ 5.00
$ 3.00
$ 1.00
-$1.00
-$3.00
-$5.00
-$7.00
-$9.00
-$11.00
MC=$4
$ $ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$
$
$
$
$
$
$
$
$
$
$
$
TC
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
44.00
48.00
Profit
$0.00
$ 7.00
$ 12.00
$ 15.00
$ 16.00 Profit Max
$ 15.00
$ 12.00
$ 7.00
$0.00
-$9.00
-$20.00
-$33.00
-$48.00
Example
MC Transfer Pricing: Mimics Baseline
•
•
•
•
Manufacturing charges transfer price to retail
Company policy requires Pt (transfer price) = MC of production
Retail is a profit center & has pricing authority
No overhead for simplicity
Q (#shipmts)
0
1
2
3
4
5
6
7
8
9
10
11
12
Price
$ 12.00
$ 11.00
$ 10.00
$ 9.00
$ 8.00
$ 7.00
$ 6.00
$ 5.00
$ 4.00
$ 3.00
$ 2.00
$ 1.00
$0.00
$
$
$
$
$
$
$
$
$
$
$
$
TR
11.00
20.00
27.00
32.00
35.00
36.00
35.00
32.00
27.00
20.00
11.00
$0.00
MR Pt=MC=$4
$
$ $ 11.00 $ 4.00 $
$ 9.00 $ 4.00 $
$ 7.00 $ 4.00 $
$ 5.00 $ 4.00 $
$ 3.00 $ 4.00 $
$ 1.00 $ 4.00 $
-$1.00 $ 4.00 $
-$3.00 $ 4.00 $
-$5.00 $ 4.00 $
-$7.00 $ 4.00 $
-$9.00 $ 4.00 $
-$11.00 $ 4.00 $
TC
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
44.00
48.00
Profit
$0.00
$ 7.00
$ 12.00
$ 15.00
$ 16.00 Profit Max
$ 15.00
$ 12.00
$ 7.00
$0.00
-$9.00
-$20.00
-$33.00
-$48.00
•MC transfer pricing does not distort incentives.
•No value reduction compared to baseline
•Profits accruing to wholesale are ($4-$4)x4 = $0
•Profits accruing to retail are $16
•Total profits are $16, same as baseline
Bad Economist Joke
Q: What’s worse than one monopolist?
A: Two monopolists
Example
The creation of 2 monopolists: 2 profit centers
•
•
Retail and manufacturing both profit centers
Manufacturing has decision rights for transfer price (Pt)
Manufacturing production costs: MCt=4
Demand for Retail:
P = 12-Q
Retail profit max MR = MC
12 – 2Q = Pt
Demand for Mfct’g: Pt = 12 – 2Q
Mfct’g profit max MRt = MCt
12 – 4Q = 4
Q=2
So set Pt at
Pt = 12 – 2Q = 12 – 2(2) = $8
Example
The creation of two monopolists: 2 profit
centers
• With Pt = $8, above true MC
Q (#shipmts)
0
1
2
3
4
5
6
7
8
9
10
11
12
Price
$ 12.00
$ 11.00
$ 10.00
$ 9.00
$ 8.00
$ 7.00
$ 6.00
$ 5.00
$ 4.00
$ 3.00
$ 2.00
$ 1.00
$0.00
TR
$ $ 11.00
$ 20.00
$ 27.00
$ 32.00
$ 35.00
$ 36.00
$ 35.00
$ 32.00
$ 27.00
$ 20.00
$ 11.00
$0.00
MR
$ $ 11.00
$ 9.00
$ 7.00
$ 5.00
$ 3.00
$ 1.00
-$1.00
-$3.00
-$5.00
-$7.00
-$9.00
-$11.00
Pt=8
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$8.00
$
$
$
$
$
$
$
$
$
$
$
$
TC
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
44.00
48.00
Profit
$0.00
$ 7.00
$12.00 new retail choice
$15.00
$16.00 Firm profit max
$15.00
$12.00
$ 7.00
$0.00
-$9.00
-$20.00
-$33.00
-$48.00
• Retail has no choice but to mark up to P = $10; lowers firm
profit from $16 to $12.
Double Marginalization Problem
• Upstream profit center will raise transfer price too
high
• Downstream profit center bears higher costs, thus
has to raise its product price
• Two monopolistic mark-ups
• Gains to trade (internal and external) are reduced
• The internal reduction in gains to trade reduces the
firm’s value
Market-based transfer price
• Market-based transfer price = transfer price that matches
market price
• Assumes transferred product can be obtained from other
companies
• Perfectly competitive market model says product sells at
marginal cost. Therefore, Pt = MC IDEAL
• Non-competitive market: Pt = P > MC
– NOT IDEAL; might want to lower transfer price
• Other advantages to internal purchasing? Can raise
transfer price above competitive market price.
Example: Value-reducing decisions in revenue center
Sales division with decision rights to set price
Sales division head's compensation increases with sales revenue
Q (#shipmts)
0
1
2
3
4
5
6
7
8
9
10
11
12
Price
$ 12.00
$ 11.00
$ 10.00
$ 9.00
$ 8.00
$ 7.00
$ 6.00
$ 5.00
$ 4.00
$ 3.00
$ 2.00
$ 1.00
$0.00
TR
$ $ 11.00
$ 20.00
$ 27.00
$ 32.00
$ 35.00
$ 36.00
$ 35.00
$ 32.00
$ 27.00
$ 20.00
$ 11.00
$0.00
MR
$ $ 11.00
$ 9.00
$ 7.00
$ 5.00
$ 3.00
$ 1.00
-$1.00
-$3.00
-$5.00
-$7.00
-$9.00
-$11.00
MC=$4
$ $ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
$ 4.00
TC
$0.00
$ 4.00
$ 8.00
$ 12.00
$ 16.00
$ 20.00
$ 24.00
$ 28.00
$ 32.00
$ 36.00
$ 40.00
$ 44.00
$ 48.00
Profit
$0.00
$ 7.00
$ 12.00
$ 15.00
$ 16.00 Profit Max
$ 15.00
$ 12.00 Revenue Max
$ 7.00
$0.00
-$9.00
-$20.00
-$33.00
-$48.00
Loss in profit from giving pricing decision rights to this revenue center = $4.00 per
day
In general a revenue center would have a tendency to price "too" low in order to
sell more and earn higher divisional rewards
Transfer Pricing Conclusions
• Opportunity cost (MC of resources used) is the
conceptually correct transfer price
• Perfectly competitive market price approximates MC
transfer price
BUT
• Transfer prices often figure into divisional performance
evaluation
• So profit center managers may not necessarily have correct
incentives to charge a MC transfer price
• Asymmetric information means can't easily enforce MC
price
• Transfer prices can affect overall firm profits and can
affect distribution of profits between divisions
Arthur Andersen LLP Case
1. Discuss the environmental, strategic, and
organizational changes that occurred over the life
of Andersen in the context of Figure 11.1.
2. Evaluate Andersen’s claim that their problems on
the Enron audit were due to a few “bad partners”
in the organization. If you disagree with this
claim, discuss what you think were the root causes
of the problem.
3. Suppose you were Andersen’s managing partner in
the early 1990s. Would you have done anything
differently than the actual management (assuming
you knew only what they did at the time)?
Explain.
4. Discuss the relation between what happened at
Andersen and multitask principle agent theory.
Arthur Andersen LLP Case
5. Discuss the relation between the “hard” and “soft”
elements of a firm’s corporate culture in the context of
this case.
6. Do you think that the problems at Andersen were
unique to them or did they exist at the other big
accounting firms? Suppose you were the top partner at
one of the other major accounting firms at that time of
Andersen’s demise. What actions, if any, would you
take in response? Explain.
7. In 2000, the SEC proposed new regulations that would
limit consulting work by accounting firms. This
proposal was not passed by Congress. Do you think
that the legislators were trying to act in the public
interest when they failed to pass this proposal? Explain.
Arthur Andersen LLP Case
8. The American Institute of Certified Public Accountants is the primary
professional association for certified public accountants. It has
developed a Code of Professional Conduct that sets the standards of
conduct for CPA’s. People can file complaints about the ethical conduct
of a CPA with the AICPA, which can levy sanctions and other penalties
against its members. Do you think that the unethical conduct at
Andersen (and possibly other accounting firms) was the fault
of the AICPA for not setting and enforcing higher ethical standards
among its members? Explain.
9. The Sarbanes-Oxley Act of 2002 established a new five-person board to
oversee financial accounting in publicly traded corporations. The board
is appointed by the Securities and Exchange Commission. Prior to the
creation of this board the industry relied primarily on self-regulation
through the American Institute of Certified Public Accountants. Do you
think the establishment of the new oversight board was a good idea or
should the profession have continued to be self-regulated?
Looking Forward
Final Exam December 13, 14, and 16
– Open book, open notes ; full three hours
– On Blackboard
• Terms and Concepts
• Past Exams
• Answers to Past Exams
– Bring calculator
• I will mail back your course projects