Cold Heart in a Heatwave II*

In a conference room at Warner Music Group (WMG) headquarters, Executive Vice President of
WMG, Lakshmi Agarwal, found herself glaring at her employee and friend, Jim Garcia. Jim was
the Executive Director of Atlantic Records, one of the many labels run by WMG. He was talking
about Miller Xchange, whose last album, Cold Heart in a Heatwave, was a breakout hit for the
company. Although Garcia and Miller Xchange decided to use in-house talent for the first album,
they were hesitant to do the same for the sequel.
Like Cold Heart in a Heatwave, the sequel album would be recorded and sold by Atlantic
Records. For the last decade, WMG evaluated each label independently based on its net profit
and return on investment, and artists’ compensation was a function of their labels’ performance.
The WMG Chairman and CEO made clear that this approach to performance evaluation and
management has contributed to the organization’s recent success.
For his first album, Xchange was exclusively produced by XRELLA (pronounced za-reh-la), and
sound edited by Miss Xcargot, both WMG talent (working for the WMG labels Elecktra Music
Group and Parlophone, respectively). Now, Garcia wanted a lower-cost option. For about 10%
less, he could hire external producer Dre Drooper and sound editor Shea Sounds, both artists
with rival Sony Music Entertainment. Under this arrangement, Sony promised to bring in
XRELLA and Xcargot in more minor consulting capacities. Another option was to work with
Universal Music Group, which would not bring on XRELLA or Xcargot.
“Sorry, no dice; we can’t work exclusively with XRELLA and Xcargot; their rates are just too
high,” said Garcia. “XRELLA’s rate is out of this world; I need to make sure Xchange is getting
his fair share, and we’re not blowing the whole budget on the producer. And, since XRELLA
refuses to work with any sound editor except Xcargot, we’d have to pay her inflated rate too!”
“I understand their rates are higher, but I wouldn’t call them inflated,” said Agarwal. “All WMG
labels are expected to charge each other market price, and this is their market price. Look, the
CEO of Warner is hounding me to hire other WMG talent. These three worked great together last
time; I think we run it back and make this album a smash hit.”
Garcia was not convinced. “Look, Xchange likes XRELLA and Xcargot, but they have to bring
their rates down. If they can match what Shea and Dre are offering, we’re happy to work
together. Otherwise, I have to do what is best for my label.”
The two shook hands before Garcia left the room, leaving only Agarwal and a printout of a
payment map she created to help make sense of the options (see Exhibit 1). As far as she could
tell, there were three possible ways to set up the deal:
*
Adapted from a case by Neil E. Harlan and William Rotch. Please do not quote or distribute. Revised September
2022.
 1. Hire in-house talent XRELLA and Xcargot to be the exclusive producer and sound editor,
bypassing any external label. Atlantic Records would pay $480,000 to Parlophone for the
two artists. Parlophone would then pay Miss Xcargot $120,000 directly and transfer
$280,000 to Elecktra Music Group. Of the $280,000, Elektra Music Group would pay
$168,000 to XRELLA, with the remaining $112,000 being retained by the label to cover
overhead and increase label profit.
2. Hire Dre Drooper and Shea Sounds with Sony, which would bring in Xcargot and
XRELLA as consultants. Atlantic Records would pay Sony $432,000. Sony would then
pay Parlophone $30,000 for services, with Miss Xcargot receiving $25,000. Sony would
also pay Elecktra Music Group $90,000, of which $54,000 would be paid to XRELLA.
3. Hire external artists with Universal. Atlantic Records would Universal $430,000, with no
payments to Parlophone or Elecktra Music Group. XRELLA and Xcargot would not be
involved with the album.
Agarwal was frustrated. The CEO of Warner Music Group had instructed Agarwal to ensure
Atlantic Records hired in-house talent for the album, but the CEO didn’t understand how
difficult this negotiation would be or how expensive it would be to keep everything in-house.
Agarwal suspected that one of the reasons the CEO was so eager to hire in-house talent was
because both Parlophone and Elektra Music Group were struggling to find work for their artists
and staff, leaving them with excess time on their hands. If Agarwal could not find a way to
convince Garcia and Miller Xchange to hire in-house talent, she might be in trouble with the
boss. Agarwal knew that the CEO had no qualms about stepping in and forcing the hire of in-
house talent. But what would that do to Atlantic’s long-term relationship with Miller Xchange?
And why sacrifice Atlantic Records’ profits to help the other two struggling labels?
Another issue was that Parlophone had recently completed some work for an extended mix of a
hit song from Cold Heart in a Heatwave. As a favor, Parlophone agreed to do this work for
Atlantic at cost. Agarwal worried that if she hired outside talent, Parlophone would be less
willing to be so kind in the future.
One potential solution Agarwal considered was to see if Elektra Music Group and Parlophone
would reduce their service fee. Unfortunately, this looked like a dead end. “We need to charge
full-cost plus a profit margin if we want to stay in business,” the Executive Director of
Parlophone said, “You know how expensive it is to run a label! Not only do we have the out-of-
pocket cost for Miss Xcargot, but we also have to pay the label executives, the accountants, and
the allocation of corporate overhead for the office space we use. Plus, we didn’t even charge a
margin for work we just did for that extended mix Atlantic wanted. We need to make a profit
somewhere.”
Looking for a way out of this predicament, Agarwal called up her coworker, who recently
graduated from the University of Washington with a Master of Business Administration. What
Agarwal heard surprised her. Within minutes, they were both hunched over Agarwal’s desk with
a printout of the payment map.
“Look,” the UW graduate said, “you have to take the perspective of the CEO; you have the take
the firm-level perspective. We have Elektra, Atlantic, and Parlophone; these are all WMG
brands. If any of these brands makes a profit, WMG makes that profit. But if we hire artists from
Sony or Universal, any profit they make is lost to us. We need to consider how much profit each
option contributes to the firm.”
The UW graduate continued, “The thing I’m wrestling with is whether it makes sense for the
CEO to intervene. It seems messed up but I guess it’s necessary—the different labels are just
looking out for themselves. Maybe this is just the price of decentralization.”
With that, the UW graduate left the office, leaving Agarwal to gather her thoughts.
Answer the following.
1. Calculate the effects of each of the three alternatives on the contribution margins of
Atlantic, Elektra, and Parlophone.
Alternative Atlantic Elektra Parlophone
1 -$480,000 $112,000 = ($280,000 - $168,000) $168,000 = ($120,000 + $112,000)
2 -$432,000 $54,000 = ($90,000 - $36,000) $25,000 = ($30,000 - $5,000)
3 -$430,000 $0 $0

2. Which of the three alternatives is preferred from the perspective of (1) Atlantic, (2)
Elektra, and (3) Parlophone? Explain your answer.
(1) From the perspective of Atlantic, Option 3 would be the preferred alternative as it results in
the lowest cost for the album.
(2) From the perspective of Elektra, Option 1 would be the preferred alternative as it results in
the highest contribution margin.
(3) From the perspective of Parlophone, Option 2 would be the preferred alternative as it results
in a positive contribution margin.

3. Which of the alternatives is preferred from the perspective of WMG as a whole? Explain
your answer.
From the perspective of WMG as a whole, Option 1 would be the preferred alternative as it
results in the highest total contribution margin of $168,000 for Elektra and $112,000 for
Parlophone. Option 2 also generates a positive contribution margin for Parlophone, but the total
contribution margin for Elektra is lower at $54,000. Option 3 generates no contribution margin
for either Elektra or Parlophone.

4. In any organization, many different prices could be used for the internal transfers. Among
other options, managers could set transfer prices based on market prices, variable cost,
full cost, or negotiated prices. What would you recommend in the case of WMG and
why?
In this case, I would recommend to use negotiated prices for internal transfers. This would allow
for the most flexibility in determining transfer prices that are acceptable to both parties and can
lead to a mutually beneficial outcome. Negotiated prices can also consider the specific
circumstances of the transfer, such as the availability of in-house talent and the cost savings of
working with external artists. By negotiating transfer prices, WMG can optimize its overall
contribution margin and ensure that all parties involved are satisfied with the arrangement.

5. The final paragraph of the case discusses possible intervention by the WMG CEO.
Should the CEO intervene? Why or why not? If you believe they should intervene, how?
As a final measure, the CEO's intervention should be avoided. Instead, a more effective approach
to aligning incentives would be to link profits to ownership: Atlantic could purchase either of the
labels as a subsidiary, which would ensure that any profits generated by the label would be
attributed to Atlantic. This would naturally alter Atlantic's incentives, making them more
inclined towards Option 1.
 Exhibit 1: Payment Flow

Option 1 Option 2 Option 3

Atlantic Records Atlantic Records Atlantic Records

(WMG label) (WMG label) (WMG label)

$480,000 $432,000
$430,000

Parlophone Sony Music

Entertainment Universal Music
(WMG label)
(external label) Group

$120,000 $30,000 $90,000 (external label)

$280,000

Miss Xcargot Elektra Music Group Parlophone Elektra Music Group

(sound editor) (WMG label) (WMG label) (WMG label)

$168,000 $25,000 $54,000

XRELLA Miss Xcargot XRELLA

(producer) (consulting editor) (consulting producer)