The two

1
The Firm as a Production Function

• Objective Maximize Profit

Labor
Firms
Output
Capital
2
The Firm as a Contractual Focal Point
Employees
Labor Unions
Suppliers
Insurance Providers
Stockholders
The Firm
Bondholders
Customers
Banks
3
Conflicts within the firm

• Owners vs. Managers
• Top Managers vs. underlings
• Creditors and stockholders
• Managers and labor unions
• Buyer-supplier conflicts
• Partner-owners may free ride on each others
  effort

4
Divisional Performance Evaluation

• Cost Centers
• Expense Centers
• Revenue Centers
• Profit Centers
• Investment Centers

5
Cost Centers

• Objectives Are these equivalent?
• Minimize Costs for a given output
• Maximize Output for a given budget
• Minimize Average costs
• Decision Rights
• Input mix
• Requirements
• When would a cost center be appropriate?

6
Marginal, Not Average
Price
MC
AC
Output
7
Marginal, Not Average
Price
MC
AC
Demand
Output
MR
8
Expense Centers

• Maximize service given budget
• Problems
• If users arent charged for the service they will
  overuse it.
• Managers sometimes build empires
• Solutions
• Benchmark size against other firms
• Place under the control of the largest user

9
Revenue Center

• Maximize revenue given price and budget
• Problems
• Cant let managers set prices
• Central management must set the product mix or
  sales will focus on expensive items.

10
Profit Center

• Objectives
• Actual profit
• Actual profit vs. Expected Profit
• Expected Present Value of current and future
  profit
• Decision Rights
• Input mix
• Product mix
• Selling prices
• Requirements

11
Investment Centers

• Objectives
• Maximize ROA (Acct Net Income)/(Total Assets)
• Decision Rights
• Input mix
• Product mix
• Selling prices
• Capital invested
• Requirements

12
Investment Center

• Problems
• ROA may cause managers to avoid profitable
  projects with low ROA
• Risky projects often have high ROA
• Near retirement managers may adopt projects with
  high short term ROA

13
Transfer pricing

• Costless Information

Rule The most profitabletransfer price is equal
toopportunity cost.
Retail in the USP 15
ManufacturingMC 5AC 20
European RetailP 20
14
Transfer Pricing Who Can You Trust?

• Successive Monopoly / Double Monopoly Markup

Price
Price
Retail
Manufacturing
D
D
85
MC
60
10
MC
MR
MR
Quantity
22
11
11
5
5
Quantity
MR
15
Transfer Pricing Common Methods

• Market Based Transfer Price
• Competitive prices minimize long-run costs
• Beware of synergies
• There may be costs of writing and enforcing
  contracts with others
• Marginal Production Cost (MPC)
• MPC may not be MC
• May not be relevant near capacity

16
Transfer Pricing Common Methods

• Full Cost Transfer Prices
• May work well when near capacity
• Doesnt maximize profit
• Negotiated Transfer Prices
• The right people are at the meeting
• Time consuming
• Negotiating skills are critical

17
17-1 Auto-fit is a multidivisional firm that
produces auto parts. It has the capacity for
annual production of 100 units of a particular
part. The marginal cost of producing each unit
is 10. These units can be sold internally
either to other divisions or to external
customers. The external market price is 20.
The allocated share of corporate overhead for
each part produced is 5. Total corporate
overhead expenditures do not vary with the
production of the part. How many units of the
part should the company produce? What is the
theoretically correct transfer price (should the
company decide to transfer the part internally)?

18
17-4 The Xtrac Computer company is organized
into regional sales offices and a manufacturing
division. The sales offices forecast sales for
the upcoming year in their territories. These
figures are then used to set the manufacturing
schedules for the year. Prices of the computers
are determined by corporate headquarters and the
sales people are paid a fixed wage and a
commission based on sales. The regional sales
offices are evaluated as revenue centers. The
regional sales manager is paid a small wage
(about 30 of pay) and a commission based on the
sales of her territory that exceeds the budget
(about 70 of pay). Xtrac has a notoriously bad
track record for forecasting computer sales. Its
budgets always under-forecast sales, and then,
during the year, manufacturing scrambles to
produce more units, authorizes labor overtime,
and buys parts on rush orders. This drives up
manufacturing costs. In fact, Xtrac even
under-forcasts sales when the economy is
slow. a. What is the likely reason for the
under-forecasting? b. Propose solutions to the
problem