Measuring SBU Level

Performance
 Strategy Levels
Strategies can found at two levels;
1. Strategies for a whole organization-
Corporate Strategies
2. Strategies for business units within the
organization- Business unit strategies
 Although strategic choices are different at
different hierarchical levels, there is a clear
need for consistency in strategies across
business unit and corporate levels.
 SBU
• Concept of SBU:
– Strategic Business Units or SBUs have been
defined as autonomous divisions or
organizational units, enough to be flexible and
large enough to exercise control over most of the
factors affecting their long-term performance.
 Exhibit-2 summarises the strategy concern at the two
organizational levels and generic strategic option at each level.

Strategy Level Key strategic issues Generic strategic Primary

options organizational
level involved
Corporate Level Are we in the right Single industry Corporate office
mix of industries related
Related
What industries or diversification
sub-industries Unrelated
should we be in diversification
Business Unit Level What should be the Build, Hold, Corporate office
mission of the Harvest, Divest and business unit
business unit general manager
How should the Low cost Business unit
business unit differentiation general manager
compete to realize
its mission
 Business Unit Strategies
• Competition between diversified firms does not take place at the
corporate level. Rather, a business unit in one firm (P&G’s- Pampers
Unit) competes with a business unit in another firm (Kimberly
Clark’s Huggies unit).
• The corporate office of diversified firm does not produce profit by
itself; revenues are generated and cost are incurred in the business
units.
• Business unit strategies deals with how to create and maintain
competitive advantage in each of the industries in which a company
has chosen to participate.
• The strategy of a business unit depends on two interrelated
aspects;
1. Its mission (what are its overall objectives?) and
2. Its competitive advantage (how should the business unit compete in
its industry to accomplish its mission)
 BCG-Matrix
Cash Source Low
High
High
Industry Growth Rate High
“Star” “Question
Hold Mark”

Cash Use
Build

“Cash Cow” “Dog”

Harvest Divest

Low Low
High Low

Relative market share

 Centralization versus Decentralization

• Centralized • Decentralized
Decisions are handed Decisions are made at
down from the top divisional and
echelon of departmental levels.
management and
subordinates carry
them out.
 Decentralization
 Decentralization - assigning of specific Total decentralization
responsibilities to subunits of
organizations.
 When an organization has a
decentralized structure, it has several
separate profit centers.
 Benefits of Decentralization
 Creates greater responsiveness to local
needs
 Leads to gains from quicker decision making
 Increases motivation of subunit managers
 Assists management development and
learning
 Sharpens the focus of subunit managers. Total centralization
 Decentralization enables country managers
to make decisions that exploit their
knowledge of local business and political
conditions.
 Goal Congruence
Goal congruence - when subunit managers in
the organization hold a common set of objectives.
Individual goal congruence - when a
member’s personal goals are consistent with those
of the organization as a whole.
Behavioral congruence - when individuals
behave in the best interest of the organization
regardless of their own goals.
 Goal Congruence
• Goal Congruence means that, insofar as is feasible,
the goals of an organization's individual members
should be consistent with the goals of the
organization itself.
• In a Goal Congruence process, the actions people
are led to take in accordance with their perceived
self-interest are also in the best interest of the
organization
 Transfer Pricing
 In a decentralized organization, much of the decision-making power resides
in its individual subunits. Those subunits often supply goods or services to one
another.
In that case, top management uses transfer prices to coordinate the actions
of the subunits and to evaluate the performance of their managers.
Transfer price—the price one subunit (department or division) charges for a
product or service supplied to another subunit of the same organization.
The transfer price creates revenues for the selling subunit and purchase
costs for the buying subunit affecting each subunit’s operating income.
The operating incomes can be used to evaluate the subunits’ performances
and to motivate their managers.
Intermediate product—the product or service transferred between subunits
of an organization.
 Transfer Pricing
• Goods and services are transferred internally from one profit center to
another, before the final product/service is brought to the market.
• Companies find it useful to account for the value of goods and services
exchanged, even if the exchange is only internal and does not involve the
market at all.
• This helps the company to assess the contribution of each of the profit
centers separately.
• To help in such assessment, a mechanism called transfer pricing has been
developed.
• Transfer pricing helps to determine the value of goods and services
transferred before calculating the profits of the company.
• A transfer price is the price one subunit charges for a
product or service supplied to another subunit of the same
organization.
 OBJECTIVES OF TRANSFER PRICING
The main objective of transfer pricing is
proper distribution of revenue between
profit centers.
If two or more profit centers are jointly responsible for
product development and marketing, then the resulting
profit has to be shared between the profit centers.
Providing relevant information to the profit centers
regarding the trade-off between costs and revenues of
the company.
 OBJECTIVES OF TRANSFER PRICING

• Inducing goal-congruent decisions, i.e., decisions

that improve the profits of business units and also
improve the profits of the company.
• Helping to measure the economic performance of
profit centers.
• Minimizing tax liability.
 PRINCIPLE OF TRANSFER PRICING
The fundamental principle of transfer pricing is that the
“transfer price should be similar to the price that would
be charged if the product were sold to outside customers
or purchased from outside vendors”.
Goal Congruence
While designing the mechanism for transfer pricing, the
interests of profit centers should neither supersede the
interests of the overall organization, nor should there be a
clash of interests between the organization and its profit
centers.
In other words, there should be goal congruency between
profit centers and parent organization.
 PRINCIPLE OF TRANSFER PRICING

• Some of the prerequisites for achieving goal

congruency are:
– Competent people
– Good organizational atmosphere
– Details of market prices
– Freedom to source
– Availability of information
– Scope for negotiation
 Transfer-Pricing Methods
• There are 3 methods of transfer pricing

1. Market-based transfer prices

2. Cost-based transfer prices

3. Negotiated transfer prices

 Market-Based Pricing Method
Companies that use this method, price the goods and
services they transfer between their profit centers at a
price equal to that prevailing for those goods and
services in the open market.
This is similar to ‘arm’s length’ pricing as intra-company
transfers are priced the same as those for external
customers.
Advantage
business units can operate as independent profit centers with
the managers of these units being responsible for their own
performance as well as that of the business unit.
 Market-Based Pricing Method
When managers are made responsible for
performance of the business unit, it increases their
motivation and it also becomes easier for the
headquarters to assess the actual operating
performance of its business units.
 Market-Based Pricing Method
For some types of complex capital equipment, an external
market may not exist at all. In some cases, prices may be
distorted by monopoly elements.
Moreover, a definitive market price may be difficult to
determine because of variance in prices from one market to
another due to changes in exchange rates, transportation
costs, local taxes and tariffs etc.
In addition, a company may set its selling price depending on
the supply and demand conditions prevalent in a specific
market. In sum, these factors mean that a unique market
price for companies to follow does not always exist.
 Cost-Based Pricing Method
The cost-based pricing method calculates transfer
price on the basis of the cost of a good or service.
 The cost of a good or service is available in the
cost accounting records of the company.
Cost-based approaches are, however, not as
transparent as they may appear.
A company can easily manipulate its cost accounts
to alter the magnitude of the transfer price.
 Cost-Based Pricing Method
• Companies that adopt the cost-based transfer
pricing method have to choose between alternative
approaches, which are listed below:
– Actual costs approach
– Standard costs approach
– Variable costs approach
– Marginal costs approach- Full cost plus profit margin
 Cost-Based Pricing Method
Cost-based methods usually create difficulties for
the selling profit center, as their incentive to be cost-
effective may fall, if they know that they can recover
increased costs simply by raising the transfer price.
Without an incentive to produce efficiently, the
transfer price may erode the competitiveness of the
final product in the market place.
 Negotiated Pricing Method
In this approach, buying and selling business units
freely negotiate a mutually acceptable transfer
price.
Since each unit is responsible for its own
performance, this will encourage cost minimization
and encourage the parties to seek a transfer price
which yields them an appropriate profit return.
 UPSTREAM FIXED COSTS AND PROFITS

A typical transfer pricing problem is encountered in oil

companies, paper companies and other integrated
companies in which raw material is extracted and
processed further for production of the final product.
In such companies, in the absence of proper transfer
pricing, the division that sells the final product to outside
customers may not be aware of the fixed costs involved
in the internal purchase price.
For example, an oil company has three divisions: the
crude oil division, the refinery division and the sales
division.
 UPSTREAM FIXED COSTS AND PROFITS
 The final product of the company, say petroleum, is sold by the
sales division, but before this, the crude oil division sells its crude
to the refinery division, from where it is sent to the sales division.
 In this situation, the sales division may underestimate the costs
(particularly the fixed costs) incurred during extraction and
processing.
 So, it might sell the final product at a price that is not sufficient to
recover fixed costs.
 Due to this company may incur losses and there can be a conflict
between the two divisions.
 In order to tackle these kind of problems, companies should adopt
following methods.
 Two step pricing
 Profit sharing
 Two sets of prices
 Two Step Pricing
• Two step pricing involves charging for the product
being transferred twice.
• First, the product is priced on the basis of the
variable cost incurred in producing it.
• At the second stage of pricing, the fixed costs that
are incurred because of certain special facilities
used for production are also included.
• The sum of these two charges constitutes the
transfer price for the product.
 Profit Sharing
• Under this method, the product is transferred to the
marketing unit at the standard variable cost.
• After the product is finally sold, the business units
share the profit earned.
• But, this method may lead to disagreements over
the way the profit is divided between the two profit
centers.
 Profit Sharing
• Sometimes, senior management has to intervene to
settle these disputes.
• As the profits between units are divided arbitrarily, it
does not reflect accurately the profitability of each
segment.
• Also, as the manufacturing unit's contribution
depends on the marketing unit's ability to sell and
the actual selling price, this may be treated as unfair
by the manufacturing unit.
 Two Sets of Prices
Under this method, revenue is credited to the
manufacturing unit at the market sales price and the
buying unit is charged for the total standard costs.
The difference between the outside sales price and the
standard cost is charged to the parent company’s
account.
These charges are later eliminated while drawing
consolidated financial statements.
This method is used when there are frequent conflicts
between the buying and selling units and they cannot
 Two Sets of Prices
• The disadvantages of this method are:
It is difficult to maintain an additional book each time a
transfer of good is made.
It motivates the managers to concentrate only on
internal transfers (where they are assured of a good
markup) at the expense of outside sales.
Applicability of Transfer Pricing