Topic 11; Divisional performance Evaluation (2017)

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Universidad Universidad Pompeu Fabra (UPF)
Grado International Business Economics - 1º curso
Asignatura Business economics
Año del apunte 2017
Páginas 4
Fecha de subida 02/08/2017
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DIVISIONAL PERFORMANCE EVALUATION: TO P I C 1 1 We have here two "sub topics": transfer pricing (vertical boundaries of the firm, and we compare vertically integrated firms and firms that use the market; and how do they internally calculate the transferences that they make) and divisional performance measurement.
Divisional Performance Evaluation  Once a firm has established a set of decision rights, it must decide how to measure performance  We now discuss performance evaluation at the divisional level  This is obviously tied to the goals that the firm sets for a division  We will focus on how the way divisional performance is evaluated affects the incentives of those manageing them Divisions with objective evaluation  Cost center  Revenue center  Profit center  Investment center Cost center: Common for production units  Cost centers are assigned the task of:  Minimizing costs for given output  Maximizing output for given total cost  This allows cost center managers to focus on increasing the efficiency of the production process Is typically used for production unis, and there are the input markets. A really simple firm would've sales and production. Sales is the one that is the one that sales to the consumers (the one that gives outputs), they produce goods or services. The principal that controls the cost unit must hve knoledge about how the costs of the factory work. In production, the information that they have is about the inout mix, while the sles part has knowledge of the output.
Problems: -If quantity is costly to produce, the cost center manager has an incentive to reduce quality to reduce quantity to save costs.
If quality is costly to produce, the cost center manager has an incentive to reduce quality to save costs  If the quantity that the cost center must produce is not controlled, it has an incentive to minimize average costs  Thus, cost centers are appropriate when:  Upper level managers know cost structure of production, but not necessarily the optimal input mix  local managers know this input mix, can establish Q that max. center’s profit, and the correct incentives  Quality can be easily monitored Revenue Center  Usually employed for sales, distribution and after-sales services  Revenue centers are assigned the task of:  Maximizing total revenues for a given price  Maximizing total revenues for a given quantity of sales  They allow managers to focus on marketing and sales Problems: a) Without quantity controls, revenue centers have an incentive to expand production to the point where marginal revenue is 0 b) If a revenue center sells different products, the manager has an incentive to sell the most expensive items Thus, revenue centers work best when:  General managers can decide appropriate prices and quantities (linked to a)  General managers has the necessary knowledge to establish the optimum product mix (linked to b)  Managers of revenue centers know well the local clients’ demand characteristics.
Profit center  A profit center is given fixed capital budget and evaluated on the difference between revenues and costs  Much more decentralized than cost and revenue centers, with broader set of decision rights (includes cost/revenue centers)  Useful when senior management does not know profit maximizing quantity, quality, input mix and product mix  these are specific to the center  Measurement problems:  Transfer prices (see later slides)  Overhead costs * Managers are responsible of their divisions profits, so they have to decide the perfect input/output mix, because they have better onformation than higher managers.
Transfer prices become relevant when you use profit center rather than bothcost and benefit centers. The costs of buying input and the value that they charge clients for their produvcys are easy to find, but the transfer prices aren't. TP are important because they are useful for the production department to know their "benefits", and for the sales department to learn the costs that they have.
In the presence of interdependencies between units, division profit maximization is not compatible with firm profit maximization  Good substitutability (negative externality)  Investment in reputation (positive externality)  Measure for profit center may differ from the best measure for the manager (fixed costs are not controllable)  Firms often base profit center manager compensation on a combination of division and firm profits  Problems of dependency/effect on sales of other profit centers or units of the firm  Reputation issues linked to other profit centers of the firm For the profit center it can be misalignements of interest, and this might be good, because even though managers from production and mnagers of sales have lots of specific knowledge, maybe it's better to centralize, rather thsan falling into double marginslizationm.
Investment Center Investment centers are essentially profit centers that also control capital expenditures (often composed of several profit centers)  Useful when senior management does not have adequate knowledge about investment opportunities  Investment center incentives depend crucially on performance measure Problems Managers may seek to boost net income in the short run at the expense of long-term profitability. They may avoid taking projects that lose money in the short run but create value in the long run.
Double marginalization ***** We want to understand how PT is going to be set; because the sales manager they want to maximize cost. If PT is equal to the marginal cost, the benefits will be 0, so they want a higher price. The PT that will maximize the price of the production division they have to take into consideration the demand, so they need the internal demand function, that comes from the sales division. So, to calculate the optimal PT (transfer price) Input we have to calculate first what's the quantity that's optimal for the sales division.
price π =P*Q-P_t*Q; → following the ppw; demand curve = 110-5Q PRODUCTION π =(110-5Q)*Q-P_t*Q → we think about the marginal revenues PT d π /dQ=110-10Q-P_t → Q'=(110-P_t)/10; SALES π _p=P_t*Q'-10Q'=P_t((110-P_t)/10)-110+P_t=11P_t-P_t^2/10-110+P_t Output → Se iguala a cero; P_t'=60; Q_t'=(110-60)/10=5 price Optimal quantity → 5; at which price will it sell? the market price is 110-5*5=85 → we just put it in the normal demand function and get the P A centralized firm acts like one monopoly with their transfer prices, which helps to maximize the profits, while a decentralized firm, with a profit and a sales division, cannot have as much profit as a centralized form does.
BIGGER PICTURE There are a number of reasons to produce goods internally. We focus on two: -Specific investments/hold up - Double marginalization (once you have vertically integrated; how to put the organizational architecture) **** Pedir a rosó TRANSFER PRICING METHOD 1. Hire consultants to determine costs (it might be expensive, migh need a change in technology) 2. Use market price for intemediate goods (but internal production then implies market price, and not opportunity cost) 3. Full cost transfer price (but no incentive for production to become more efficient, and also, it isn't economically efficient) 4. Negotiated transfer price → bargain; this one is closer to the market price CONCLUSION There's a problem that emerges here, and has emerged before: the tension between the need to give up authority to those with relevant information and the need to control their actions. This is the central trade-off that organizational architecture addresses ...