Divisional Autonomy and Sub-optimization

Divisional Autonomy and Sub-optimization:

How much autonomy should be granted to divisions in setting their own transfer prices and in making decisions concerning whether to sell internally or to sell outside?

Should the divisional heads have complete authority to make these decisions, or should top corporate management step in if it appears that a decision is about to be made that would result in sub-optimization? For example, if the selling division has idle capacity and divisional managers are unable to agree on a transfer price, should top corporate management step in and force a settlement?

Efforts should always be made, of course, to bring disputing managers together, but if a manage flatly refuses to change his of her position in dispute. then this decision should be respected even if it results in sub-optimization. This is simply the price that is paid for divisional autonomy. If top management steps in and forces the decision in difficult situations, then the purposes of decentralization are defeated and the company simply becomes a centralized operation with decentralization of only minor decisions and responsibilities. In short, if a division to be viewed as an autonomous unit with independent profit responsibility, then then it must have control over its own destiny–even to the extent of having the right to make bad decisions.

We should note, however, that if a division constantly makes bad decisions, the result will sooner or later reduce its profit and rate of return, and divisional manager may find that he or she has to defend the divisions performance. Even so, the manager’s right to get into and embarrassing situations must be respected if decentralization is to operate successfully. Divisional autonomy and independent profit responsibility are thought to lead to much greater success and profitability than closely controlled, centrally administrated operations. Part of the price of this success is occasional sub-optimization due to pettiness, bickering, or just plain stubbornness.

Furthermore, one of the major reasons for decentralizing is that top managers cannot know enough about every detail of operation to make every decision themselves. To impose the correct transfer price, top management would have to know details about the outside market, variable costs, and capacity utilization. If top managers have all of this information, it is not clear why they decentralized in first place.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

  1. Decentralization in organizations
  2. Traceable and common fixed costs
  3. Segment reporting and profitability analysis-segmented income statements
  4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
  5. Segmented Financial Information on External Reports
  6. Return on Investment (ROI) for Measuring Managerial Performance
  7. Controlling and Improving Rate of Return on Investment
  8. Return on Investment (ROI) and Balanced Scorecard
  9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
  10. Residual Income-Another Method to Measure Managerial Performance
  11. Limitations, Criticism or Disadvantage of Residual Income Method
  12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
  13. Set transfer prices at cost using variable or full (absorption) cost
  14. Set transfer prices at the market price
  15. Divisional Autonomy and Sub optimization
  16. International Aspects of Transfer Pricing

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