Role of Internal Prices Within Corporations

Subject: Finance
Pages: 8
Words: 2246
Reading time:
9 min
Study level: PhD

Introduction

Internal prices are the rates of prices, which are made use of when making transactions involving goods and services between company divisions and departments or to a greater extent between a parent company and a subsidiary.

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Over the past century, large corporations have used internal prices in the aim to achieve efficiency in coordination of organization activities, which broadly can be categorized into primary and support activities. As a result, of internal pricing operating departments within the organization achieved a great deal of autonomy from the central office. For instance, four pioneering companies—Sears, DuPont, General Motors, and Standard Oil of New Jersey—upper management found out that there is the need for coordination across different departments, but there was the realization by managers that central office could not tackle the needs for all departments.

By the end of 1950s, the corporation’s multi-departmental form was widely employed in the automobile, electrical, power machinery and chemical industries. Some retailers reorganized along departmental lines; Montgomery Ward, A&P, Kroger and Safeway. Majority of the firms in the petroleum, rubber and processed agricultural products industries adopted the new form of organization. They included B.F. Goodrich, United States Rubber, Procter & Gamble, General Mills, General Foods and Borden (Chandler, 1962). ‘If decentralization [the M-Form] was a managerial invention in 1920’, note Vancil and Buddrus, ‘it was an articulated philosophy by 1950, a reorganization trend by 1960, and a universal practice by 1970’ (Geranmayeh & Pourdehnad, 1993). • In the case where, a company decides to shift its resources and enter a new line of business or be integrated into another business. This may be as a result of constant transformation, adjusting and responding to organizational demands. The demands may be from legal authorities or from the clients. This may involve flexibility to increase and contract the workforce and all support costs to meet the changing needs in a drastic change and high uncertainty. This comes under the strategic changes of the organization.

The concept of internal pricing gained fame in the 1980s, when innovative companies started to give powers to the support activities and letting decision from these activities determine their course, internal customers were given the opportunity to choose the services they wanted to buy (Halal et al.,1993). Internal pricing thus can be seen as the strategy that a large corporation need to employ to achieve efficiency in the coordination of the different departments. This helps people to look at what they are able to produce, and compare it to the change results expected. They are then able to state the deficits in terms of resources such as labor and equipments and other expertise that would be required

Roles of internal price within corporation

Reduced cost

Internal pricing gives an opportunity for departments to purchase or sell goods and services to other departments at lower cost than the original cost. This is because, in most cases, prices reflect the real cost as depreciation is factored. In addition, the goods prices to some extent reflect the actual cost of production, as the sole aim of most of the departments is to ensure efficiency within the corporation and not to make supernormal profit (Chandler, 1991).

Reduces transportation costs

In some cases, transportation of goods is usually involved in the transaction. This is so since some of the goods may need transportation due to their bulkiness thus the need for further transaction costs to cater for the transportation purpose. In using the internal pricing mechanism, there is a fixed price per unit to be transferred thus reduces the cost of transportation. This also reduces some of the additional costs that may be needed to cover up the shipping costs (Coase, 1937).

Reduces bulky accounting records

Internal pricing helps to ease the problem of preparing many accounting entries such as receivables or accounting payable since goods are merely passed from one department to another as general transfer reflecting the cost of material transferred (Foss, 1997). To a greater extend, transaction cost are reduced as transactions are from the corporation.

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It can lead to the evasion of tariffs

some of the corporations are internationally managed. This means that other subsidiaries are placed in other countries where they are making their sales and marketing. This may lead to the evasion of tariffs if the government of the state where one of the subsidiaries is placed has no strict regulations. Tariffs usually add cost to production thus increase transactions costs (Donaldson, & Lorsch, 1983). If, in the state where there are no strict measures, the parent company may use the opportunity to transfer goods and services to the subsidiary without paying at the border.

Generation of revenue for the department

In the production of certain services or goods, there is the reward that is got from what is being produced. For instance, if there is a department that produces transportation services, when there is a need for transportation, there is the cost that is paid to the department providing the service. This is a gain to the transportation department as it gets revenue from services (Gable & Ellig, 1993).

Improves resource allocation

Traditional model of an organization has long been based on centralized form of management. According to this approach, each business unit of a company is entirely subjected to the top-management. This principled is applied to allocation of resources. For example, the decisions about cost-cutting, development of training programs were usually taken by senior management (Ellig, 1993, p 1). However, in many cases, these people did not know exact what different departments actually needed. In contrast, the advocates of decentralized model argue that managers of primary activities should be given more autonomy, especially while determining what kind of corporate services they need (Ellig, 1993). The strategy will contribute to improved time management, resource allocation, and better performance of different business units.

Shifting of profits

Many institutions have argued that internal pricing is used by many corporations with the aim of shifting profits at will around the globe. (Beker, 2005). The mobilization of the internal pricing for the avoiding of tax or compromising tax is largely invisible to the public. It is also seen to be very difficult and very expensive for regulatory authorities to detect such problems. This is so since there is a complex game that involves numerous people in the system including corporations, accountants, government agents, multinational agencies, NGOs etc. which engage in the formulation and implementation of the rules of the game which formulate strategies for calculation of prices to be used. Also, it is hard to follow up the ways they manipulate and escape or rather sub diverting these rules and methods, thus a profit to the corporation (Hansmann, 1988).

Increased Specialization

Decentralized model of corporate government is based on the premise that managers of primary activities as well as employees of separate business units should be engaged in human resource development, strategic planning, or quality improvement programs because they know how this business unit is supposed to function and what kind of objectives it must achieve (Ellig, 1993, p 13). Furthermore, this approach will enable the division to develop new projects and ventures. In such scenario, every division of an organization can be transformed into a self-sufficient unit that focuses on specific products and markets. These are the major benefits of internal pricing and decentralization.

Congestion effect

Overall, congestion effect can be described as situation when the structure of a company becomes so large and complicated that the different elements of this system do not function as quickly as possible (Ellig, 2001, p 232). This concept can be applied to allocation of resources within the firm. According to club theory of the firm, different departments of the firm are regarded as people or entities which have common interests or goals (Ellig, 2001, p 230). These people or entities can interact with one another and even make financial transactions. Yet, if the number of members continuously increases, the club will not be able to provide adequate services to the members. To some extent, the concept of conception can be relevant to modern private companies that often grow very large and cumbersome.

Cost sharing

With internal pricing, as long as departments within the firm are capable of offering lower prices within the departments compared to external pricing then there will be increased number of players within the firm (Camerer, & Vepsalainen, 1988). In other words, a company, which has a great number of business units, will find easier to provide services to the departments if they can share these costs (Ellig, 2001, p 232). However, it is possible only in those case, when there are congestion costs.

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Reputation

The reputation of the firm can be explained as the way in which the community perceives the company, its mission, employees, and, most importantly product and services. This factor directly affects brand value and customer loyalty. The thing is that when a company expands through mergers and acquisitions, the value of its reputation can gradually decline. This situation is typical of those corporations which consist of dissimilar business units (Ellig, 2001, p 233). One can draw several examples of such a company; one of them is General Electric which operates in such markets as electrical distribution, finance, oil production, healthcare, or aviation (General Electric, 2010, unpaged). To some degree, this diversity reduced the value of its brand. The key issue is that managers must insure that expansion does not devaluate the brand as an asset.

Trade-off

Such concept as trade-off is used by the management when they need to determine the optimal size of the company. In this case, it is necessary to compare the contribution of a business unit to the financial performance of a company with the congestion costs that will be entailed. Hence, one can argue that the size of an organization is optimal only when the contribution of each business unit outweighs the congestion costs.

Flight of capital

Capital is normally used as a basement for starting in business. Rather, in exploring of different market experiences in different states, there is the need for the corporation to take advantage of the growing economy. This will lead to the diversification of knowledge to strategize how to increase capital allocation to the opportune state (Ellig, 1993). Since costs are taken care of under internal pricing shifting, capital is not an issue rather it is a factor to increase production.

Distribution of wealth and public goods

In the context of the firm theory, such notion as “public goods” can be explained as those benefits a business unit can receive by joining the firm (Ellig, 2001, p 223). One of them, reputation has already been described in the previous sections. Among other public goods, we can single out organizational capabilities such as technologies, competencies or experiences of the company or opportunity to enter new markets. Hence, a new member or business unit can join the firm if it cannot obtain these goods independently or their cost is too high. The key task of the top-management is to ensure that these “public goods” are distributed to each member. Nonetheless, the club theory of firm takes a slightly different view on an organization. According to it, club members as well as business units can interact with one another; for instance, they can join their efforts in order to develop new products or implement certain project. By adopting this approach, the business units can dramatically facilitate decision-making within the firm. Moreover, they will be able to better manage the capabilities of resources of the company. Again, one should emphasize the idea that central office or top-management will not be entirely excluded from this process. They can act assessors, facilitators, and even supervisors, who decide whether the strategies of business units are appropriate or not. However, they will not make decisions about resources allocation, investments, or training without considering the interests of people for whom these services are intended to. This is arguably the major organizational change.

Conclusion

Most corporations usually dominate the contemporary economic, political social landscape of most nations (Karten, 2009). According to logic of capitalism, one of the main primary objectives of a corporation is to increase the level of profit and dividends for the benefit of their shareholders. This will make in convention with practices of the corporation thus leading to aggregate increase in the services provided and implementation of some of the new strategies. In conventional accountancy literature, internal pricing is seen as a good technique used for the optimal allocation of costs and revenues among the departments in a corporation, subsidiaries of a main company and joint ventures within a group of related entities.

These representations usually acknowledge the fact that internal pricing is deeply implicated in the process of wealth retentiveness, profit maximization and fight of resources. The key benefit that can be derived in this way is that different business units can better decide what kind of corporate services they need or how they need to allocate the resources. Top-down bureaucratic approach is no longer suitable for the needs of modern companies, trying to survive in a competitive environment. They need to become more flexible and more agile. The management can achieve this goal by decentralizing the company and by allowing its departments to cooperate. However, they need to remember that continuous decentralization can lead to a point when different departments no longer work for the achievement of common strategic goal. Thus, the task of business administrators is to avoid this pitfall.

References

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