13 Decentralisation and Transfer Pricing (Preliminary Draft)

The following section is based on chapter 8 and chapter 22 of Horngren et al. (2014). One of the roles of budgets is to bring together all information and knowledge from different divisions ^[1] in an organisation. By combining and quantifying all information in one place, the firm can plan and coordinate the activities of the different divisions in a large integrated firm.

Decentralisation

The strategy of the firm will have a big impact on how a firm structures its different divisions. Some firms will split up the firm according to geographical locations, others choose to have divisions for different product lines, and others have different divisions for different business functions such as sales, production, and purchasing. Charley’s restaurants are organically organised according to the geographical location of the restaurants while Whirlpool is organised according to different product lines. Big international firms will often have an organisational structure over multiple dimensions in a so-called matrix structure.

The strategy will also affect which divisions in the firm take operational and investment decisions and to what extent the headquarters take the decisions. Centralisation and decentralisation will determines the role of the budget. In a centralised organisation, the budget serves as a repository of all information and
knowledge in the firm and helps central headquarters in taking strategic decisions. In a decentralised organisation, the budget helps the autonomous divisions to communicate with each other and coordinate investments that are dependent on each other. The following section on transfer pricing will explain in more details how budgets help the coordination between divisions. The important insight is that transfer prices are artificial prices for an intermediate product that is sold from one division to another and that price serves a similar function
as a [market price]] for independent firms.

The Costs and Benefits of Decentralisation

The remainder of the section focuses on how and why firms decentralise divisions. Every division is a responsibility center for the budgeting process. Cost centres are accountable for costs, while revenue centres are accountable for revenues only. Typically supporting divisions such as maintenance and accounting are cost centres while sales is the quintessential revenue centre. When a division is responsible for an entire product line it will often be accountable for both costs and revenues as a profit centre or when it is also accountable for investments as an investment centre. In the budgeting process, the investment centres performance will depend on the comparison between the revenues, costs, and investments in the planned budget with the actual revenues, costs, and investments.

There are multiple reasons why headquarters decide to decentralise decisions to divisions. Geographically decentralised divisions often have better specific knowledge about the preferences of customers, the capabilities of suppliers, and employees, or the local political environment. As a result, a decentralised division will be more responsive to its environment than headquarters. Because a decentralised division does not have to wait for directions from headquarters it will not only detect changes in the local environment quicker but also react quicker to changes in customer preferences or supplier capabilities.

In addition to improving decision making, decentralisation improves the motivation of managers in the division. In line with the idea of empowerment, managers with more responsibility are more likely to take initiative and work harder in the interest of the firm. For instance, lower level managers with more autonomy are more likely to develop management skills than managers who can take fewer decisions.

However, decentralisation can have a negative impact on the firm’s performance as well. Decentralised divisions focus more on their own responsibilities and performance while neglecting their negative impact on other divisions. Microsoft is a prime example of a company that instigated competition between its divisions. One of the main sources of competition between the divisions is for the limited
budget to develop new projects. The divisions have to convince headquarters that they deserve investments in their projects. However, that competition can turn ugly when different divisions do not want to accommodate their projects to benefit others. For instance, the Office division was for a long time not willing to adapt their software for a touch and stylus interface.

Another disadvantage of decentralisation is that some activities and functions of the firm might be duplicated. That is why firms often centralise some supporting functions such as HR administration, accounting, or purchasing. In Charley’s restaurants, Charley Turner is still responsible for the purchasing function for all four restaurants. Centralisation of these functions is an example of how firms can economise on the transaction costs of running a business.

Transfer pricing: On the intersection of cost accounting and budgeting

The Virginia Mason case shows the importance of setting the right price in order to coordinate cost reduction in the whole supply chain. Before the introduction of the Total Supply Chain Cost (TSCC) contract, that introduces a new pricing system, Owens & Minor bears
the cost of improving delivery while Virginia Mason reaps all the benefits. As a result, Owens & Minor has little incentive to improve delivery quality while Virginia Mason has little incentive to consider. the costs of better delivery. The TSCC contract and the gain sharing contract essentially redistribute the costs and benefits so that Virginia Mason bears part of the costs of just-in-time delivery while Owens & Minor reaps some of the benefits of reducing
the supply chain costs.

The use of a price mechanism to align the incentives of two independent entities is not only important between two firms. Transfer prices are used within firms to coordinate the actions of independent divisions. Because the transfer price is a revenue for the supplying division and a cost for the acquiring division, a transfer price also allows headquarters to evaluate both divisions as profit centres. The rest of this section focuses on the role of transfer prices to evaluate, motivate, and coordinate division. However, an important function of transfer prices is overlooked in this discussion. Multinational firms will use transfer prices mainly to
optimise their taxes ^[2]. The discussion here is restricted to transfer pricing of divisions in one country or where tax considerations are of a minor concern.

There are three different ways to set the transfer price. Firms can follow the market price of companies selling and buying the same product in a competitive market. Firms can calculate a transfer price based on the cost price for the product or service. Lastly, they can let the different divisions negotiate over the transfer price.

Market price

The market price is often seen as the preferred method for transfer prices if there is a competitive market for the product or service.For instance, Horngren et al. (2014) give the example of Horizon Petroleum, a Houston based company, with a crude oil transportation
division and a refinery division that operate as independent profit centers. The market price for crude oil in the Houston market is $85/barrel. If Horizon Petroleum sets the transfer price at the market price, the transportation division has no incentive to sell crude oil on the market and the refinery division has no incentive to buy crude oil from the Houston market.

These incentives do not change when the market environment and the price change. As in the previous section, we see that the market price is a powerful aggregator of all necessary information. At the same time, both divisions have an incentive to manage costs because they are evaluated as a profit center. If the transportation center is inefficient, the costs of transportation will outweigh the revenues it receives from the transfer price. Similarly, if the refinery division makes many more additional costs in addition to the transfer price, they will have to sell the refined gasoline at a loss to the customers.

Cost-based transfer price

Another option for firms is to use transfer prices that are based on cost accounting calculations. The variable cost of transport at Horizon Petroleum is $1/barrel and the fixed cost is $3/barrel. Let us assume that the headquarters will allow the transportation division to have a 5% profit margin, so that the transfer price will be 1.05 times the total cost. To illustrate the problems with a full costing approach for transfer pricing, consider two alternatives for the refining division. They can either buy crude oil directly from the Houston market at 85$/barrel or they can ask the transportation division to buy from Gulfmex at another market for $79/barrel. The problem is that the transportation division has to transport the crude oil to Houston at the costs described above (Horngren et al. 2014).

In the current set-up, the transfer price would be 1.05 times (79 + 1 + 3) = $87.15. In other words, the refining division would prefer to buy on the Houston crude oil market. In contrast, the headquarters would prefer that the crude oil is bought from Gulfmex because the only relevant costs for the firm as a whole are the variable transport cost of $1/barrel and the purchasing price of 79$/barrel. These costs are lower than the cost of buying at the Houston crude oil market. In this case, the full cost transfer price creates incentives for the divisions to not act in the best interest of the firm. One option that the headquarters can take is to overrule the refining division but unfortunately that takes away the autonomy of the division ^[3].

An alternative approach to full cost transfer pricing is to only take into account the variable costs. In this case, the variable cost is $80 for the Gulfmex crude oil. The disadvantage of using the variable cost is that we can no longer evaluate the transportation division as a profit center because it will always be loss making as a result of the fixed costs, which are not covered by the transfer price. Furthermore, using costs for transfer prices creates perverse incentives for the transportation divisions. Because they will always recover the costs that are used in the transfer pricing calculations, they no longer have an incentive to manage these costs. Moreover, they actually have an incentive to exaggerate the costs in order to receive a higher transfer price.

Despite the theoretical advantages of market prices and the disadvantages of cost-based transfer prices, the latter are still quite popular in firms. A first obvious reason is that not for all products, there is a close to perfect market with an informative market price. Another problem with using a market price is that it indicates that the firm is not doing anything that can not be done by two independent firms. In other words, a firm that uses the market price does not have a competitive advantage compared to the market.

One advantage of the full costing approach is that it protects the divisions from volatility in the market price. The cost-based transfer price can be fixed for a longer period of time and guarantee the transport division of steady demand and the refining division of a steady supply which might help in planning their respective production schedules.

More complicated combinations are often used to set a range of possible transfer prices. For instance, the headquarters can decide that the transfer price should be between the variable cost ($80) and the market price ($85). The variable cost is the minimum price to convince the transportation division while the market price is the maximum the refinery is willing to pay. There are several options to split the difference between the minimum and the maximum. The headquarters can set an equal split rule ($82.5) or they can use more complicated rules based on the variable costs that each division bears to produce the final product. In the latter case, the division with the highest variable cost gets more of the surplus which might again lead to exaggerations of reported costs.

Negotiated transfer price

A last solution to split the difference is a negotiation between the two divisions. The advantage is that this allows the divisions to accept one-off offers to make use of excess capacity. Consider a one-off order for the refining division which they can fulfill if they can buy crude oil at $82/barrel. The market is not willing to supply at this price but the variable cost of the Gulfmex oil is only $80/barrel. If divisions are allowed to negotiate over the price, they will probably settle on a price of around $81/barrel and the firm as whole will make a profit of $5/barrel ^[4]. This example illustrates how the negotiated transfer price might provide firms with more flexibility than markets. The firms can decide to ignore fixed (sunk) costs when a special opportunity arises.

Another advantage of negotiations is that they might reveal specific knowledge of each divisions. The divisions can learn from each other and set up a transfer price that creates value for both divisions and thus the firm as a whole. This is an informal version of the TSCC contract in the Virginia Mason case study. The disadvantages (and hence the transaction costs) of negotiations are quite straightforward. First of all, the opportunity cost of negotiations is the time that the heads of the divisions spend on negotiations instead of managing the operations of their division. Second, negotiations can lead to conflict between the divisions and reduce the cooperation between divisions.