Topic 8

Topic
CHAPTER 8 Organizational Design

Main Points
● Principle-Agent Problem
● Transfer Pricing （ Topic 6 ）
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
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Main Points
● Getting Employees to Work in the Firm’s Best Interest
● Getting Divisions to Work in the Firm’s Best Interest
Compensation and the Principal-Agent Problem
● Having learned about the principal factors in selecting

the best methods of acquiring inputs, we now explain
how to compensate labor inputs to put forth maximal
effort.
● The primary obstacle is the separation of ownership and
control.
• Principal-agent (P-A) problem leads to the following
question: Is poor performance due to
• back luck?
• low manager effort?
• Owners have to incentivize managers since they are not
present to monitor.
Managers’ Compensation Mechanisms
● Manager’s economic trade-off

• Leisure.
• Labor.
● Fixed salary
• Receives wage independent of labor hours and effort.
• No strong incentive to monitor other employees labor hours
and effort.
• Adversely impacts firm performance.
● Incentive contract
• Tie manager wage to firm performance (like profits).
• Manager makes labor-leisure choice and is
compensated accordingly.
Incentive Contracts
● A way to align owners’ interests with that of the
actions of its manager.
● Examples include:
• Stock option
• Other bonuses directly related to profits.
External Incentives
● Outside forces can provide manages with the
incentive to maximize profits, and include:
• Reputation.
• Takeover threat.
The Manager-Worker Principal-Agent Problem
● The owner-manager, principal-agent problem is not

unique.
• A similar problem exists between the firm’s managers
and the employees he or she supervises.
Solutions to the Manager-Worker Problem
● Manager-worker principal-agent problem solutions:

• Profit sharing.
• Revenue sharing.
• Piece rates.
• Time clocks and spot checks.
To overcome the owner-manager and manager-worker

principal-agent problems, principals must align the
agents’ interests with the principals’ interests.
Main Points
ASI
● Auction Service International (ASI) employed art experts to convince

owners of valuable art to use auction services to sell their artwork.
• The auction house profited by charging the art owners a percentage of
the sell price at auction.
• This percentage was negotiated by the young art experts.
● A problem arose, the negotiated prices (“commissions” to the auction
house), which were supposed to be between 10 and 30%, were
consistently low, near 10%.
● The CEO of ASI began investigating this phenomenon and found that
the art experts were “trading” low prices for kickbacks from the art
owner.
● Discussion: What are two possible solutions for this problem?
Principal-Agent Relationships
● When studying firm-employee relationships we use

principal-agent models.
● Definition: A principal wants an agent to act on her
behalf. But agents often have different goals and
preferences than do principals.
• The auction house is a principal;
the art expert is an agent.
Note: for convenience only, we adopt the linguistic convention
of referring to principals as female and agents as male.
Incentive Conflict
● Because the agent has different incentives than the principal,

the principal must manage the incentive conflict, which
comes down to two problems with which you should by now
be familiar:
• Adverse selection: the principal has to decide which
agent to hire
• Moral hazard: once hired, the principal must find a way to
motivate the agent.
• Both problems are caused by asymmetric information: adverse
selection implies that only the agent knows his “type”; while
moral hazard means that only the agent knows how much effort
he is exerting.
● The costs of addressing moral hazard and adverse selection
are known as agency costs, because they are often analyzed
by principal-agent models.
Agency Costs
● A principal can reduce agency costs if she gathers

information (reduces information asymmetry)
• about the agent’s type (adverse selection); or
• about the agent’s actions (moral hazard).
● Information gathering:
• To mitigate adverse selection problems, firms can run
background checks on agents before they are hired.
• To mitigate moral hazard problems, firms can monitor
an agent’s behavior while working.
• This difference in timing leads to the characterization
that adverse selection is a pre-contractual problem,
while moral hazard is a post-contractual problem.
Incentive Pay vs. Risk
● Incentive pay can help align the incentives of employees

(agents) with the goals of the organization (principal).
• For example, if harder work leads to higher sales, then create
incentives by tying the employee’s reward to sales
performance, e.g., with a sales commission.
● But incentive pay also imposes risk on agents.
• Commissions mean a portion of an agent’s compensation is
dependent on factors beyond the agent’s control, e.g., weather.
• Agents must be compensated for taking on this additional risk.
● So, incentive compensation represents a tradeoff:
• Does the benefit (harder work by agent) outweigh the cost
(extra compensation for bearing risk)?
Controlling incentive conflict
● In an ideal organization
• Decision-makers have all the information necessary
to make profitable decisions; and
• The incentive to do so.
● When designing an organization, you should consider how to
structure the following three items.
• Decision rights: who should make the decisions?
• Information: is the decision-maker provided with enough
information to make a good decision?
• Incentives: does the decision-maker have the incentive to do so.
Incentives are created by linking performance evaluation and
reward systems (rewarding good performance).
Decision Rights and Information
● Who should make decisions?

• Decentralize decision making: move decision rights
down in the hierarchy, closer to those with better
information; or
• Centralize decision making: move decision rights up
in the hierarchy, closer to those with better incentives.
● If you decentralize decision-making authority, you
should also strengthen incentive-compensation
schemes.
● If you centralize decision-making, find a way to
transfer information to those making decisions.
Incentives (performance + reward)
● Performance evaluation
• Informal: using subjective performance evaluation, or
• Formal: using objective measures such as sales or
accounting profit, stock price, relative performance
metrics.
● Rewards: Decide how compensation is tied to
performance evaluation.
• Reward good performance and/or penalize
bad performance.
• Examples: bonus, increased probability
of promotion, faster promotion.
Example: Marketing vs. Sales (1)
● Sales and marketing divisions often have incentive conflict

• Sales wants to maximize revenue, i.e., make all sales
where MR > 0
• Marketing wants to maximize profit, i.e., make all
sales where MR > MC.
• In other words, sales prefers a higher level of sales and a lower
price than does marketing.
● For example, a large telecommunications equipment company
that serves government agencies that buys telecom equipment.
• Sales people want to bid more aggressively to make sure that they
win the contract (they care about maximizing sales)
• Marketing wants the sales agents to bid less aggressively, so that
when they do win, the contracts are more profitable (they care
about maximizing profit).
Marketing vs. Sales (2)
● Two solutions:
• Centralize bidding decisions to marketing; and try to transfer
enough information to marketing managers so they know how
aggressively to bid.
• Decentralize bidding decisions (keep decision rights with the sales
people) and change incentives – Instead of a 10% commission on
revenue, give sales people a 20% commission on profit, (revenue
neutral if the contribution margin is 50%)
● Discussion: How well do threshold compensation schemes
work, e.g., a bonus if you open hit a target sales number.
● Discussion: How well do high-powered sales commissions
work, e.g., 5% commission for sales of $1M; 10% commission
on sales of $2M, work?
Example: Franchising (1)
● Incentive conflict exists between franchisors (McDonalds) and

its franchisees. McDonalds wants big franchise fees and high
quality at franchisees to protect its reputation. Franchisees want
smaller fees and lower quality (cheaper).
● McDonalds has both company owned stores and franchisees.
• In a company-owned store, both adverse selection and moral
hazard are concerns – managers don’t work as hard as they would
if they owned the restaurant, and a salaried manager position
might attract lazy workers.
• Franchisees have bigger incentive to work hard (because they are
the “residual claimants” of profit), but they are also exposed to
more risk. Franchisees have to be compensated (lower franchise
fees) for bearing risk.
Franchising (2)
● Another option is to use a sharing contract: instead of

a fixed franchise fee, the franchisor might demand a
percentage of the revenue or profit of the restaurant.
• This arrangement reduces franchisee risk by reducing
the amount the franchisee pays to the franchisor when
the store does poorly.
• Sharing contracts may also encourage shirking because
the franchisee no longer keeps every dollar he earns.
● Discussion: Why does McDonalds use company-
owned stores along freeways, but franchises in towns?
Diagnosing and solving problems
● To analyze principal-agent problems, begin with the bad

decision that is causing the problem, and then ask three
questions.
1) Who is making the (bad) decision?
2) Did agent have enough information to make a good
decision?
3) Did agent have the incentive to do so, i.e., how is the
employee evaluated and compensated?
● Answers to these questions generally suggest alternatives
for reducing agency costs. You can,
• Let someone else make the decision, or
• Change the information flow, or
• Change the incentives.
Example: Declining Store Profits
● The CEO of a large retail chain of “general stores” that target low-
income customers has noticed that newly opened stores are not
meeting sales projections.
● What is the problem here? And how can it be fixed?
● Some helpful information about the stores is,
• The company uses development agents to find new store locations
and negotiate the leases with property owners – the company rewards
these agents with generous bonuses (stock options) if they open fifty
new stores in a single year.
• Agents are supposed to open new stores only if their sales potential is
at least one million dollars per year, but recently opened stores earn
half this much.
● What is the problem; and what is the solution?
Example
● Whaling ventures in the 1800s were managed by agents, who

would purchase supplies, hire a captain and crew, and plan the
voyage on behalf of the investors.
• Agent’s performance difficult for investors to observe or evaluate
• Actions of crew on multi-year voyages even more difficult to
evaluate
● Contracts and organizational forms century evolved in
response to these problems
• Most whaling enterprises were closely held by a small
number of local investors
• Ownership rights were allocated to create powerful
incentives for their managers
• Agents usually held substantial ownership shares
©2018 Cengage Learning. in their
All Rights ventures
Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
Example (continued)
● Attempting to run these ventures via corporation

form in the 1830s and 1840s failed
• They paid their crews the same ways, used similar
vessels, and employed agents with similar
responsibilities
• Only main difference was in ownership structures and
hierarchical governance
• They were unable to create the incentives requisite for
success in the industry. The managers of these
corporations, who did not hold significant ownership
stakes, did not perform as well as their peers in
unincorporated ventures.
SUMMARY OF MAIN POINTS (1)
● Principals want agents to work for their (the principals’) best

interests, but agents typically have different goals than do
principals. This is called incentive conflict.
● Incentive conflict leads to adverse selection (“which agent do I
hire?”) and moral hazard (“how do I motivate agents?”) when
agents have better information than principals.
● Three approaches to controlling incentive conflict are
• Fixed payment and monitoring (shirking, adverse selection, and
monitoring costs),
• incentive pay and no monitoring (must compensate agents for
bearing risk with a risk premium), or
• sharing contracts and some monitoring (some shirking and some
risk sharing which leads to lower risk premium).
● In a well-run organization, decision makers have

1) the information necessary to make good
decisions and
2) the incentive to do so.
● If you decentralize decision-making authority, you
should strengthen incentive compensation schemes.
● If you centralize decision-making authority, you
should make sure to transfer specific knowledge
(information) to the decision makers.
● To analyze principal–agent conflicts, focus on three

questions:
• Who is making the (bad) decisions?
• Does the employee have enough information to
make good decisions?
• Does the employee have the incentive (performance evaluation +
reward system) to make good decisions?
● Alternatives for controlling principal–agent conflicts center
on one of the following:
• Reassigning decision rights (to someone with better incentives or
information)
• Transferring information
• Changing incentives (performance eval. + reward system)
Main Points
Acme
● The by-product of producing Acme paper is “black liquor soap” that is

converted into “crude tall oil” used in resin manufacturing.
• The Paper division at Acme sold it’s soap to the Resin company
at a transfer price set by senior management.
● But both divisions fought over the transfer price.

• The Resin division wanted a low transfer price
• The Paper division wanted a high price
● The corporate parent company “gave” the Resin department a very low
transfer prices. As a result, the Paper division began burning the soap
as a fuel instead
of selling it to Resin.
• The soap’s value as a fuel was below its value as an input into resin
manufacturing.
Incentive Conflicts between Divisions (1)
● In a multi-divisional company, transactions between

divisions can create incentive conflicts.
● In these transactions the company is the principal and
divisions are the agents.
● To understand the source of conflicts that arise between
divisions, personify the divisions and consider each to be a
rational actor. Then ask the same three questions
1) Which division is making the bad decision?
2) Does the division have enough info. to make a good decision
3) Does it have the incentive to do so?
● Without proper control, these conflicts can deter profitable
transactions from occurring.
Incentive conflicts (2)
● Again the answers suggest three possible solutions

• Change the division that does the decision making,
• Change the flow of information, or
• Change a division’s evaluation and compensation schemes
● Often, parent companies organize so that each
division is an autonomous, and separate profit center.
● Definition: A profit center is a division that is
evaluated based on the profit it earns.
● The benefit of a profit center is that they are easy to
evaluate (and manage); the cost is that they are
concerned only with their own division profit.
Analyzing Black Liquor Soap Problem
● Who is making the bad decision?The Paper Division

made the bad decision to burn the soap for fuel instead of
transferring it to the Resins Division.
● Did they have enough information to make a good
decision?The Paper Division had enough information to
know that the soap’s value as a fuel was below its value
as an input to resin manufacturing.
● And the incentive to do so?The Paper Division was
rewarded for increasing its own profit, not that of the
Resin Division.
Transfer Pricing
● One common belief is that transfer pricing just shifts profits

between divisions & doesn’t affect firm profits.
• THIS IS A MYTH.
• Sometimes they move assets to lower valued uses, i.e. the “black liquor
soap” incident.
● Transfer pricing is always a problem between two profit

centers because they “fight” over the transfer price.
• You can get rid of the conflict by turning one division into a cost
center.
• A cost center is rewarded for reducing the cost of producing a specified
output. (but remember, cost centers can come with problems of their
own.)
● Discussion: Are your transfer prices set equal to the

opportunity cost of the product? If not, why not?
Paper Company (1)
● A company can transfer paper from its upstream Paper

division to its downstream Cardboard Box division.
● The company set a transfer price to guarantee a
contribution margin of 25% to the Paper division.
• So, if the Paper MC is $100, the transfer price would
be $125
● The Box Division considers the transfer price to be its
MC, and then marks up the cost again.
• The Box division makes all sales where MR > MC, but
now the MC is overstated (because of the included
contribution margin of the Paper division).
● Discussion: Solution?
Paper company (2)
● The analysis makes clear that the conflict arises

because two profit centers are each trying to extract
profit from a single product.
● This creates a “double markup” problem.
● One way to solve the problem is to make the Paper
division a cost center.
● Cost centers are not evaluated based on the profit
they earn, and so don’t care about the transfer price.
● Once the Paper division began transferring at MC the
Box division began winning more jobs from its
rivals.
Organizational options: U-form
● Functional (U-form): A functionally organized firm is one in

which various divisions perform separate tasks, such as
production and sales.
● Example of functional organization are Henry Ford’s
automobile assembly line, or Adam Smith’s pin factory.
● Advantages:
• Workers develop high functional expertise.
• Information can be shared easily within a division.
• It’s easier to tie pay to performance because performance is
easily measured.
● Disadvantages:
• Each division must coordinate with each other, a burden that
falls on management; and change is costly.
Banking Coordination Problem (1)
● Banks have many different divisions, all of which must

work together for the bank to create profits.
● The Loan Origination Division (think of them as
“mortgage brokers”) identifies potential borrowers, lends
money to them, and then hands them over to
● The Loan Servicing Division, which collects interest on
the loan and makes sure that borrowers repay the loans
when they come due.
● For the bank in question, there was an unusually high
number of defaulted loans.
● What caused this to occur, and how can it be fixed?
Banking problem (2)
● Three questions:
1) Who is making the bad decision? The Loan Origination
Division was making risky loans.
2) Did the Division have enough information to make a
good decision? The Division could have easily verified
the credit status of the borrowers.
3) And the incentive to do so? Like many sales
organizations, the Loan Origination Division (“mortgage
brokers”) were evaluated based on the amount of money
they were able to lend, regardless of the credit
worthiness of borrowers.
Organizational options: M-form
● M-Form: An M-form firm is one whose divisions perform all

the tasks necessary to serve customers of a particular product
or in a particular region.
● Advantages:
• Divisions can respond more easily to change.
• Easier to establish customer relationships because one person
can serve each customer’s needs
● Disadvantages:
• Individual workers develop less functional expertise.
● Example: re-organize a bank into “home” and “business”
loans, where both divisions originate and service loans. This
reduces incentive to make bad loans.
All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
©2018 Cengage Learning.
Corporate Budgeting: Paying People to Lie (1)
● A toy company’s Marketing Division creates sale projections for

each season. The Manufacturing Division uses the forecast to
plan production.
● Problem: There was excess inventory at the individual business
units within the toy company.
• HINT: each business unit is rewarded with a big bonus if it meets
budget.
● This system created incentives for business units to set low
budgets.
• The CEO knew this and “stretched” each budget goal, even
though he lacked specific information about business unit.
• When the goals were set too high, the inventory was not sold and
accumulated; if too low, stock-outs occurred.
Corporate Budgeting: Paying People to Lie (2)
● Once budget goals were reached, there was no

incentive to exceed them. (“shirking”)
● Also, there are incentives to “game” the system
• Accelerate sales or delay costs if just short of target
• Delay sales or accelerate costs if target already met to
make next year’s goals easier to reach
• Accelerating or delaying sales can be costly, e.g.,
discounts offered to customers to delay or accelerate
demand.
● Discussion: How should it be fixed?
Corporate Budgeting: Typical Problem
● This threshold compensation scheme creates

incentives to lie
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Corporate Budgeting: solution
● Adopting a linear compensation scheme solves

problem
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Example
● Company X, one of the world’s largest suppliers of

supplies for printers, copiers, and fax machines,
included two separate divisions.
• Toner Division produced toner, which it sold to the
Cartridge Division and to the external market.
• The Cartridge Division integrated the toner into
cartridges sold to original equipment manufacturers
and consumers.
● Company management allowed the two divisions to
negotiate the transfer price of toner and evaluated
each division on its profitability.
Example (continued)
● After negotiations were unsuccessful, both divisions elected not to

transact.
• Toner Division continued to sell to the external market at its customary
price
• Cartridge Division elected to buy toner from an external supplier.
● The Cartridge Division ended up buying its toner from the exact same
supplier to whom the Toner Division was selling.
• Rather than paying one markup to the Toner Division, the Cartridge
Division ended up paying that markup plus an additional margin to the
external supplier
• Price was 38 percent higher cost than originally proposed in negotiations
• External supplier’s shipment arrived at Company X’s docks with the
products still emblazoned with Company X’s logo. CEO noticed this.
● Companies are “principals” who try to align the incentives of

divisions (“agents”) with the goals of the parent company.
● Transfer pricing is a big source of conflict between divisions
because they transfer profit from one division to another; they
can also result in too few goods being transferred. Transfer
prices should be set equal to the opportunity cost of the
transferred asset.
● A profit center on top of another profit center can result in too
few goods being sold; one common way of addressing this
problem is to change one of the profit centers into a cost center.
This eliminates the incentive conflict (about price) between the
divisions.
● Companies with functional divisions share functional expertise

within a division and can more easily evaluate and reward
division employees. However, change is costly, and senior
management must coordinate the activities of the various
divisions to ensure they work towards a common goal.
● Process teams are built around a multi-function task and are
evaluated based on the success of the task.
● When divisions are rewarded for reaching a budget threshold,
they have an incentive to lie to make the threshold as low as
possible, to make the threshold easier to reach. In addition, they
will pull sales into the present, and push costs into the future, to
make sure they reach the threshold. A simple linear
compensation scheme eliminate this incentive conflict.

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CHAPTER 8 Organizational Design

● Having learned about the principal factors in selecting

● Manager’s economic trade-off

● The owner-manager, principal-agent problem is not

● Manager-worker principal-agent problem solutions:

To overcome the owner-manager and manager-worker

● Auction Service International (ASI) employed art experts to convince

● When studying firm-employee relationships we use

● Because the agent has different incentives than the principal,

● A principal can reduce agency costs if she gathers

● Incentive pay can help align the incentives of employees

● Who should make decisions?

● Sales and marketing divisions often have incentive conflict

● Incentive conflict exists between franchisors (McDonalds) and

● Another option is to use a sharing contract: instead of

● To analyze principal-agent problems, begin with the bad

● Whaling ventures in the 1800s were managed by agents, who

● Attempting to run these ventures via corporation

● Principals want agents to work for their (the principals’) best

● In a well-run organization, decision makers have

● To analyze principal–agent conﬂicts, focus on three

● The by-product of producing Acme paper is “black liquor soap” that is

● But both divisions fought over the transfer price.

● In a multi-divisional company, transactions between

● Again the answers suggest three possible solutions

● Who is making the bad decision?The Paper Division

● One common belief is that transfer pricing just shifts profits

● Transfer pricing is always a problem between two profit

● Discussion: Are your transfer prices set equal to the

● A company can transfer paper from its upstream Paper

● The analysis makes clear that the conﬂict arises

● Functional (U-form): A functionally organized ﬁrm is one in

● Banks have many different divisions, all of which must

● M-Form: An M-form ﬁrm is one whose divisions perform all

● A toy company’s Marketing Division creates sale projections for

● Once budget goals were reached, there was no

● This threshold compensation scheme creates

● Adopting a linear compensation scheme solves

● Company X, one of the world’s largest suppliers of

● After negotiations were unsuccessful, both divisions elected not to

● Companies are “principals” who try to align the incentives of

● Companies with functional divisions share functional expertise

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