Budgets, Divisions, and Transfer Prices

A sensible purchase that makes Cedar worse off

Cedar Components has a Parts Division that makes components and an Assembly Division that uses them in finished products. Assembly needs one component for an order it is already committed to filling. Parts has unused capacity and could make it for $40 in additional resource cost. An outside supplier offers Assembly an equivalent component for $65.

Producing internally would save Cedar $25. But Cedar credits Parts with $70 for every component it supplies to Assembly and charges Assembly the same amount. Each division’s manager is evaluated on its own reported profit. Assembly’s manager chooses the outside supplier and reports a $5 saving against the internal price.

The manager has followed the purchasing incentive Cedar supplied. The firm nevertheless pays $65 for something it could produce for $40. A favorable result on one division’s report is not necessarily a favorable result for the organization.

Chapter 9 asked how work should be grouped. Grouping work into divisions creates another question: how should the firm evaluate those divisions and coordinate transactions between them? Budgets and internal prices help answer it. They also create incentives to protect local results, negotiate easier targets, or shift costs to someone else.

Responsibility should match the decisions assigned

A responsibility center is an organizational unit whose manager is evaluated on specified results. The relevant question is not just which numbers appear on its report. It is what decisions the manager can make that affect those numbers.

A cost center is evaluated primarily on the cost of providing a specified output or service. Imagine Cedar’s inspection unit has no authority to set product prices or choose customers. Its manager controls staffing arrangements and inspection methods within technical requirements. Cost information is useful, but “spend as little as possible” would be an incomplete instruction. Skipping inspections could lower spending while sending defective parts to Assembly. The output, quality requirements, and scope of authority must accompany the cost target.

A profit center is evaluated on revenue less the costs assigned to it. Giving Parts this responsibility can encourage its manager to consider customer orders and production costs together. But the profit figure also depends on the internal price Cedar chooses. A manager who negotiates a higher internal charge may improve the division’s reported result without reducing resource use or attracting another customer.

An investment center adds responsibility for capital employed and investment decisions within delegated limits. Its manager must consider whether additional equipment earns enough to justify the resources committed to it. Higher profit alone does not establish that an expansion was worthwhile if it required substantially more capital. This extends Chapter 2’s opportunity-cost reasoning; it does not require treating a single year’s accounting return as a complete investment appraisal.

These are different assignments of responsibility, not a ladder from poorly managed to well-managed units. A supervisor without authority over major equipment purchases should not be treated as though they chose the firm’s entire asset base. Conversely, a manager authorized to expand capacity should face the consequences of tying up capital, not merely receive credit for additional sales.

Jensen and Meckling (1999) connect divisional measurement choices to the location of knowledge and decision authority. Cedar’s practical test is whether the assigned measure directs attention to decisions the manager can usefully make. That does not mean ignoring consequences outside the manager’s control. Those consequences may still matter for planning, and their causes need to be distinguished when evaluating the manager.

Follow the resources before choosing the internal price

A transfer price is the amount one unit records for supplying another unit within the same organization. For Parts it is internal revenue; for Assembly it is an internal purchase cost. Cedar may record these entries without money leaving the firm.

The component and the accounting entry are different things. Making the component uses resources. Moving an internal charge from one division’s report to another does not, by itself, use additional resources or create another customer payment. Once the divisions are combined, the internal credit and charge cancel.

That does not make transfer pricing unimportant. If the charge changes Assembly’s sourcing choice or Parts’ willingness to supply, it can change actual costs and revenues. We therefore need two comparisons: what the firm should do given the available alternatives, and what each manager has a reason to do under the internal rule.

For the following example, hold Assembly’s final order and revenue fixed. Parts’ additional production cost is $40 per component. Its outside selling price is $70; Assembly’s qualified outside buying price is $65. Assume equal quality for Assembly’s use, no transport or tax differences, and no additional transaction costs. Fixed costs and other operations are unchanged.

These are separate trading opportunities, not one competitive market with a single price. The external customer requires a Cedar-made part, so Cedar cannot buy the $65 item and resell it to fulfill that order. Nor does a quoted $70 selling price guarantee an additional buyer whenever Parts has idle capacity. Those details determine which alternative an internal transfer actually displaces.

Unused capacity: an outside price is not a lost sale

First suppose Parts can make the required component without giving up another order. The relevant internal cost is $40. Buying outside costs $65. Internal supply therefore changes Cedar’s contribution by:

$65 − $40 = $25.

This is a short-run comparison for one required component. It does not establish that Parts can cover all its long-run costs by charging $40, or that Cedar should build more capacity. It says that the specified available capacity can satisfy this order with $25 less resource cost.

Now consider the managers. If Parts receives an internal credit above $40, the additional unit improves its reported contribution. If Assembly pays less than $65, it saves against its available outside purchase. Any transfer price strictly between those amounts gives both divisions a gain under these assumptions. At $40 or $65, one side is indifferent rather than strictly better off.

An illustrative $50 price gives Parts $10 above its additional cost and saves Assembly $15. A $60 price divides the same gain differently. Neither price is uniquely implied by the $25 saving. Chapter 4’s distinction between creating a gain and bargaining over its division applies inside the firm as well as between separate firms.

The fixed $70 internal charge in the opening fails this test. It gives Assembly a reason to buy outside even though an internal unit would not displace a $70 sale. Using a market quotation without identifying a feasible forgone transaction mistakes a possible selling price for an opportunity cost.

Constrained capacity: the answer can reverse

Now change only the capacity condition. Parts has a real outside order at $70, and supplying Assembly would displace that sale. The forgone contribution is the selling price less the production cost that serving the outside customer would require:

$70 − $40 = $30.

The relevant cost of supplying Assembly is therefore the $40 production cost plus the $30 contribution sacrificed elsewhere:

$40 + $30 = $70.

Do not add the full $70 selling price to the $40 production cost. That would ignore the production cost associated with the outside sale and count too much as forgone value.

Assembly can still buy outside for $65. Cedar is now $5 better off letting Parts serve its external customer and procuring Assembly’s component externally. The apparent advantage of “keeping the business inside the company” disappears once the displaced opportunity is counted.

On a small screen, scroll the table sideways to see all columns.

All amounts are per required component. The negative gain in the second row means outside procurement is better, not that Cedar’s entire business loses money. Common final-product revenue is excluded from both alternatives.

At constrained capacity, Parts needs at least $70 to match its outside opportunity, while Assembly will pay at most $65 rather than buy outside. There is no mutually acceptable price interval. In this constructed case, that disagreement points toward the correct sourcing decision. Headquarters should not force internal trade merely to demonstrate cooperation.

The general rule is to include incremental resource use and contribution from the best displaced alternative. The ACCA transfer-pricing explanation uses this opportunity-cost logic. Applying it still requires credible information about costs, capacity, and outside opportunities.

Dividing profit is not the same as creating it

Return to unused capacity. Compare internal supply with Parts leaving that capacity idle while Assembly buys outside. The following amounts are changes in the divisions’ results relative to that alternative, not their total profits.

On a small screen, scroll the table sideways to see all columns.

Moving the price from $50 to $60 transfers $10 of reported gain from Assembly to Parts. It does not change production, outside purchases, or Cedar’s combined contribution. Praising Parts for that increase without examining its source would confuse a changed accounting allocation with improved operating performance.

At constrained capacity, forcing a $50 transfer has a different comparison. Parts earns $50 − $40 = $10 instead of the $30 contribution available outside, a $20 loss. Assembly saves $15 against its outside purchase. Together, −$20 + $15 = −$5. Assembly’s gain is real for its report, but smaller than the opportunity lost elsewhere.

This is why “the internal payment cancels” is not a sufficient defense of any transfer-price policy. It cancels in the combined accounts for a given transaction. A policy can still destroy value by encouraging the wrong transaction or discouraging the right one.

Choosing a rule also means choosing how to review it

A market-based price has an advantage when it reflects a genuine alternative available to the supplying division. Cedar’s $70 quote does that in the constrained case, but not in the idle case. A posted quotation is not enough; someone must establish whether the sale is available and would actually be displaced.

A cost-based price can support useful internal trade when capacity is idle. But reimbursing whatever cost Parts reports can weaken its incentive to economize. A previously agreed cost standard lets Parts retain the benefit of reducing actual cost, while creating a new question: when should an outdated standard be revised? An unrealistically low standard could make Parts resist valuable internal work.

Adding allocated fixed costs and a markup can help a division report a positive margin. It does not turn those assigned amounts into costs caused by this particular order. Cedar still needs to distinguish the immediate sourcing choice from whether its capacity and organizational arrangement are worthwhile over time. Neither ignoring fixed costs forever nor loading all of them onto the next unit answers both questions.

A negotiated price lets the managers bring local information to the discussion. It can also consume time and reward bargaining skill. If the managers bargain only over the split of a known $25 saving, a prolonged dispute can use up part of the very gain they are dividing. A standing rule might save that cost, provided it can respond when the relevant conditions change.

For Cedar, a possible arrangement is a capacity-contingent rule. Parts records the resource requirement and any outside order that would be displaced. Assembly records its qualified outside quote. Routine cases within an agreed price range proceed locally. Disputes about capacity, comparability, or effects on other orders go to a named manager with a whole-firm responsibility.

This proposal is not a self-enforcing formula. Parts may have a reason to exaggerate how busy it is; Assembly may present a cheap quote that cannot meet the delivery requirement. Review should examine the evidence behind the claimed alternatives. It also costs time, so escalating every routine component would surrender much of the benefit of delegation.

Any compulsory transfer needs an evaluation rule as well as an instruction. If headquarters orders Parts to sacrifice a profitable outside sale for a wider reason, the review should record that decision rather than treating the resulting divisional loss as evidence of poor management. Otherwise managers have reason to conceal opportunities that might later be taken away.

A budget can answer several different questions

A budget is a quantified plan for a stated period and set of activities. Cedar needs estimates of orders, staff time, component requirements, spending, and cash availability. Parts and Assembly cannot independently plan to use the same scarce production capacity at the same time.

But one number can be asked to do several jobs. A forecast asks what is likely to happen. An authorization specifies what a manager may commit. A performance target states the result against which the manager will be evaluated. These uses can conflict.

Suppose Assembly learns that demand will be lower than previously expected. Cedar needs that information promptly to adjust staffing and production. If reporting the lower forecast is automatically treated as admitting failure, Assembly’s manager has a reason to delay it. If every lower forecast automatically reduces the reward target, the manager may instead report an unnecessarily pessimistic outlook.

Separating the questions does not mean they are unrelated. A changed forecast may justify changing authorized spending. It does mean that updating a prediction should not silently rewrite permissions or the basis of compensation. Cedar should identify who can make each change and what evidence is required.

Compare spending at a comparable level of activity

A budget variance is the difference between an actual result and the chosen budget benchmark. Its meaning depends on what the benchmark holds fixed.

Consider a separate Cedar inspection unit, not Parts’ component-production costs. It plans 100 inspections at $20 of variable cost each, plus $1,000 of fixed period cost. The original spending budget is:

100 × $20 + $1,000 = $3,000.

The unit actually completes 120 inspections and spends $3,400. Against the original budget it is $400 over. That difference alone does not show that the manager used resources poorly. The unit performed more activity than the original plan anticipated.

An activity-adjusted budget, often called a flexible budget, applies the original cost schedule to the actual activity level. Holding inspection scope and quality comparable, the benchmark becomes:

120 × $20 + $1,000 = $3,400.

On a small screen, scroll the table sideways to see all columns.

Actual spending equals the adjusted benchmark. The original $400 excess is explained by the additional inspections at the assumed cost schedule. The table does not establish the actual variable/fixed split, because only total spending was reported.

Nor does the zero adjusted variance prove efficiency or adequate quality. Inspections might have been unnecessary, poorly performed, or counted incorrectly. A cost schedule can itself be too generous. Conversely, spending above it might reflect a justified response to an unusual problem. The variance identifies a difference to explain, not the explanation itself.

The adjustment changes quantity while retaining the original cost standard. Replacing that standard with whatever the unit actually spent would remove the useful comparison. And a flexible-budget calculation does not retroactively authorize spending that the manager lacked permission to incur.

When a useful estimate becomes a bargaining position

Imagine Cedar asks the inspection manager to estimate next period’s staffing needs, then rewards the manager for spending less than that estimate. The information request now offers a way to influence the future performance hurdle. An inflated estimate could make the target easier to beat.

This is budgetary slack: deliberately building room into a target by overstating required resources or understating attainable results. It differs from openly allowing for uncertain workloads or a stated contingency. Cedar needs to know which risk a reserve covers and how the estimate was formed before labeling it waste or deception.

Jensen (2003) emphasizes how tying rewards to budget targets can distort both the information used to set them and the actions taken to meet them. Cedar’s problem is not simply finding employees willing to forecast honestly. It is avoiding an arrangement that makes a useful forecast personally costly.

The target ratchet from Chapter 6 creates a related problem. If every demonstrated saving immediately produces a tighter future target, revealing a lasting improvement can reduce the employee’s future rewards. Yet permanently freezing targets would ignore genuine changes in what the unit can accomplish. The issue is how to learn from results without making the information itself something employees want to hide.

Period boundaries can also change choices. A manager who expects unused funds to disappear and next year’s allocation to fall may prefer spending now even on a low-value item. A manager close to a spending limit may postpone worthwhile maintenance. Either behavior depends on the rules and available choices; a year-end purchase or delayed expense alone is not evidence of gaming.

Return to the whole-firm decision

Cedar could maintain a current operating forecast alongside a separately documented reward target. Revisions would identify what changed in demand, input costs, or permitted activity, rather than quietly rewriting the earlier record. For inspection costs, reviewers could distinguish activity changes from spending differences at a common activity level and examine quality alongside both.

That arrangement still needs judgment. Someone decides whether a changed condition warrants an exception, whether a reserve is justified, and whether a favorable variance reflects improvement or deferred work. Giving reviewers discretion creates its own information demands and influence costs. Chapter 5’s distinction between applying a rule and changing it remains relevant.

The objective is not to remove budgets or divisional profit measures. Cedar needs information about resource use and responsibility for decisions. The objective is to keep those measures connected to what the firm gives up and obtains. A division should not look successful merely because it shifted costs, negotiated an easier standard, or refused work that was valuable for the organization.

Chapter 11 extends the comparison beyond Cedar’s divisions. Even when the relevant internal production cost is understood, buying from another firm introduces questions about quality, monitoring, adaptation, and control. The simplified quotes here hold those differences aside so the internal coordination problem can be seen clearly.

Study map: follow the alternative and the incentive

• Identify what the manager can decide before choosing the responsibility-center measure.
• Compare internal supply with the best feasible alternative, including contribution lost through constrained capacity.
• Separate a transfer of reported profit from a change in whole-firm contribution. Internal entries cancel; behavioral consequences need not.
• Ask whether each division has a reason to choose the action that benefits the firm, and who reviews disputed information.
• Distinguish a forecast, spending authorization, and reward target. A revision to one need not automatically revise the others.
• Compare spending at a relevant activity level, then investigate quality, causes, and incentives. A variance is not a verdict.

Practice and discussion

1. Parts has unused capacity and the outside buying price remains $65. Compare internal prices of $50 and $60. Calculate each division’s gain relative to outside procurement and explain why Cedar’s gain does not change. Would a $70 price preserve that conclusion if Assembly is free to buy outside?
2. Keep the constrained-capacity case, but change Assembly’s outside buying price to $75. Calculate the whole-firm gain from internal supply and the range of prices acceptable to both divisions. Explain what happens at the endpoints. Separately, return to idle capacity and change only the buying price to $60; repeat the comparison.
3. Parts claims every internal order displaces an outside sale. Assembly presents a lower outside quote. What evidence would you request from each? Propose one delegated rule, one reason to escalate, and one way the rule could be gamed.
4. The inspection unit completes 120 comparable inspections but spends $3,640. Calculate the variance against the original budget and the activity-adjusted budget. Give two different possible explanations for the remaining difference and identify information that would distinguish them.
5. Cedar wants managers to submit candid forecasts, improve productivity, and stay within authorized spending. Explain why automatically using each new forecast as both the spending permission and the bonus target may frustrate those aims. Recommend a limited separation of responsibilities and identify its cost.

Check your arithmetic

For question 2, constrained internal supply still has relevant cost $70. The gain is $75 − $70 = $5, with an acceptable interval from $70 to $75; one side is indifferent at either endpoint. In the separate idle-capacity variation, the gain is $60 − $40 = $20 and the interval is $40–$60.

For question 4, the original-budget variance is $3,640 − $3,000 = $640 above budget. The activity-adjusted variance is $3,640 − $3,400 = $240 above budget. The additional activity accounts for $400 of the first difference; the remaining $240 needs explanation, not an automatic judgment about effort.

Source note

Jensen and Meckling ground the limited connection between knowledge, authority, and divisional measures; the ACCA technical article supplies the standard transfer-price opportunity-cost relation; Jensen’s budgeting article motivates the distinction between obtaining information and rewarding target achievement. Cedar’s transactions, numbers, tables, budget, and proposed rules were created independently for this book. They are not empirical estimates, an adopted corporate policy, or accounting or tax advice.