UNIT SEVEN: DECENTRALIZATION AND TRANSFER PRICING

Decentralization

Decentralization Defined: Firms that grant substantial decision making authority to the
managers of subunits are referred to as decentralized organizations. Most firms are neither
totally centralized nor totally decentralized.

In centralized decision making, decisions are made at the very top level, and lower level
managers are charged with implementing these decisions.

Decentralized decision making allows managers at lower levels to make and implement key
decisions pertaining to their areas of responsibility. The practice of delegating decision-making
authority to the lower levels of management in a company is called decentralization.

Advantages/Disadvantages of Decentralization

Advantages

o Better information, leading to superior decisions.

o Faster response to changing circumstances.
o Increased motivation of managers
o Excellent training for future top level executives.

Disadvantages

 Costly duplication of activities.

 Lack of goal similarity

Reasons for Decentralization

o Better access to local information

o More timely response
o Focusing of central management
o Training and evaluation of segment managers
o Motivation of segment managers
o Enhanced competition

Decentralization involves a cost-benefit trade-off. As a firm becomes more decentralized, it

passes more decision authority down the managerial hierarchy.

Decentralization usually is achieved by creating units called divisions.

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Divisions can be differentiated a number of different ways, including the following:

 Types of goods or services

 Geographic lines
 Responsibility centers
 Responsibility Center: A responsibility center is a segment of the business whose
manager is accountable for specified sets of activities.
 Measures the results of each responsibility center
 Compares those results with some measure of expected or budgeted outcome.
 Managers should only be held responsible for costs and revenues that they control.
 In a decentralized organization, costs and revenues are traced to the organizational level
where they can be controlled.

Types of Responsibility Centers

Cost center: A cost center is a subunit that has responsibility for controlling costs but not for
generating revenues.

Most service departments (i.e., maintenance, computer) are classified as cost centers.

Production departments may be cost centers when they simply provide components for another
department.

Cost centers are often controlled by comparing actual with budgeted or standard costs.

Revenue center: Manager is responsible only for sales, or revenue.

Profit center: A profit center is a subunit that has responsibility of generating revenue and
controlling costs.

Profit center evaluation techniques include:

 Comparison of current year income with a target or budget.

 Relative performance evaluation compares the center with other similar profit centers.

Investment center: An investment center is a subunit that is responsible for generating revenue,
controlling costs, and investing in assets.

An investment center is charged with earning income consistent with the amount of assets
invested in the segment.

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 Transfer Pricing

In many decentralized organizations, the output of one division is used as the input of another.

As a result, the value of the transferred good is revenue to the selling division and cost to the
buying division. This value, or internal price, is called the transfer price.

Impact of Transfer Pricing on Divisions and the Firm as a Whole

When one division of a company sells to another division, both divisions as well as the company
as a whole are affected.

The price charged for the transferred good affects both

 The costs of the buying division

 The revenues of the selling division

Thus, the profits of both divisions, as well as the evaluation and compensation of their managers,
are affected by the transfer price.

Since profit-based performance measures of the two divisions are affected, transfer pricing often
can be an emotionally charged issue. The above exhibit illustrates the effect of the transfer price
on two divisions of a company. Division A wants the transfer price to be as high as possible
while Division C prefers it to be as low a as possible.

Transfer Pricing Policies

Several transfer pricing policies are used in practice, including:

o Market price
o Cost-based transfer prices
o Negotiated transfer prices

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Transfer Pricing Policies: Market Price

 If there is a competitive outside market for the transferred product, then the best transfer
price is the market price.
 In such a case, divisional managers’ actions will simultaneously optimize divisional
profits and firm-wide profits.
 Furthermore, no division can benefit at the expense of another. In this setting, top
management will not be tempted to intervene.
 The market price, if available, is the best approach to transfer pricing.

Transfer Pricing Policies: Cost-Based Transfer Prices

 Frequently, there is no good outside market price.

 The lack of a market price might occur because the transferred product uses patented
designs owned by the parent company. Then, a company might use a cost-based transfer
pricing approach.
 Since a transfer price at cost does not allow for any profit for the selling division, top
management may define cost as ‘‘cost plus, ’’ which allows a certain percentage to be
tacked onto the cost.

Transfer Pricing Policies: Negotiated Transfer Prices

Finally, top management may allow the selling and buying division managers to negotiate a
transfer price.

This approach is particularly useful in cases with market imperfections, such as the ability of an
in-house division to avoid selling and distribution costs that external market participants would
have to incur.

Using a negotiated transfer price then allows the two divisions to share any cost savings resulting
from avoided costs.

Negotiated Transfer Prices: Bargaining Range

When using negotiated transfer prices, a bargaining range exists.

Minimum Transfer Price (Floor): The transfer price that would leave the selling division no
worse off if the good were sold to an internal division than if the good were sold to an external
party. This is sometimes referred to as the ‘‘floor’’ of the bargaining range.

Maximum Transfer Price (Ceiling): The transfer price that would leave the buying division no
worse off if an input were purchased from an internal division than if the same good were
purchased externally. This is sometimes referred to as the ‘‘ceiling’’ of the bargaining range.

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