The tension between short and long term is but one of a number of potential problems with using accounting profits as a part of a delegation strategy. We saw an example of another problem at Berns Garden Centre. It was a cool late-April afternoon, and the south-western Ohio planting season was about to swing into high gear. We parked out front and wandered into the store, which was packed to the rafters with lush greenery. Mike Berns, rotund with a gray beard, tinted glasses, and an easy-going, bantering sense of humour, led us to his office in the back.
Paul began our interview. “It seems like gardening might be a somewhat crowded retail space. Why do customers choose Berns?”
“We’re faaaabulous,” Mike B. said, drawing out the first syllable for effect. “When a potential customer thinks plants, we want her thinking, ‘Oh, I’ll go to Berns. I loooove that place.’ Pretty corny . . .but that’s what we want.”
“And what makes customers’ loooove it?” Paul asked, mimicking Mike B.’s dramatic delivery.
“We have a beautiful facility, open and airy with plenty of parking. Easy to get to. And we have a great retail crew. They’re very knowledgeable, but customers mostly like our people because they said, ‘Oh, what a pretty dog you have.’ Or ‘I like your glasses.’ We build a personal relationship because we want the customer to come buy from us for twenty years.”
Scott, perplexed, asked, “How do you get your sales team to compliment somebody’s dog?” “We tell them to do that,” Mike B. replied patiently.
“I tell my employees stuff all the time, and they ignore me,” Scott muttered half to himself, as he thought back to the Great Utah Chair Heist and his widely disregarded directive not to send accusatory late-night emails to co-workers.
Mike B. continued. “We hire a lot each spring, and it’s the song-and-dance people we keep through the winter. Our people are actors on a stage; I want themed employees who look like a character. One’s tall and gruff, and some customers like that. Another’s a sweet old lady who loves your dog.”
Scott pondered this idea, imagining both the impact of themed lecturers on students and the reaction of staid professors when instructed to choose between a “tall and gruff” or “sweet old lady” persona.
Berns is a family business, started by Mike B.’ s parents more than a half-century ago, and he and his two brothers comprise the top management team. “Each brother runs a division,” he explained. “Greg runs the production greenhouses, Jeff does the landscaping division, and I oversee our two retail stores in addition to being the general manager for the entire corporation. Each division has a P& L, which we run every month. We’re much segmented; everybody has to stay in their column because when they don’t, you get confusion and squabbles.”
“Stay in your column” combined with “maximizes your P& L” would seem to be a solid recipe for delegation. After all, if each brother simply maximizes the profit from his part of the business, then wouldn’t this result in maximizing the profit of the whole? The answer to this question— unfortunately for managers everywhere— is no. Paul asked about one area where across-column spillovers were likely: “If you’re the retail division, one of your most important vendors is the production greenhouse, right? So both P& Ls are going to depend on the price greenhouse charges to retail for petunias. How do you pick that transfer price?”
Getting this price “right” is important, and a quick numerical example (sorry!) will help make the point. Suppose retail is trying to decide how many yellow chrysanthemums to order in a given week. If it orders 30, it’s likely that it will sell each for $ 10. Ordering 50 increases the overall supply and means that retail will only be able to sell each for $ 8. Suppose further that the cost of growing a yellow mum is $ 4.
So what’s the best price for greenhouse to charge retail? The answer depends on whether we’re trying to maximize retail profit, greenhouse profit, or the Berns’s overall profit. A transfer price of $ 4— greenhouse’s cost —means that retail will buy 50 mums and earn profit of $ 4 on each. This yields a total profit of $ 200. Since greenhouse is pricing at cost, however, it will earn profits of zero.
If, on the other hand, we let greenhouse choose the transfer price, it will prefer something higher. Notice, however, that a higher transfer price will cut into retail’s margins; to boost margins and profitability, retail may well reduce the size of its order. If greenhouse sets a transfer price of $ 6, then an order of 50 mums would result in $ 2 of margin for retail, and just $ 100 in retail profit. Greenhouse, in this case, would earn profit of $ 100. An order of 30 mums, however, would result in $ 4 of retail margin, $ 120 in retail profit, and $ 60 in greenhouse profit.
Note that the greenhouse price— and retail’s response to it— will drive the garden center’s overall profitability. At a transfer price of $ 4, retail buys 50 mums and the company earns $ 200. At a transfer price of $ 6, retail buys 30 mums and overall profits fall to $ 180. Greenhouse reduces the overall size of the pie by pushing for a bigger slice.
In this example, maximizing greenhouse profit is simply inconsistent with maximizing the company’s overall profit. To use a bit of economics jargon, this is because of an “externality” associated with greenhouse’s price increase. As greenhouse raises the transfer price beyond cost, retail’s profit falls by more than the amount that greenhouse’s profit increases. But if the greenhouse manager cares only about his profit, he’ll tend to ignore the effect on retail— the effect on retail is “external” to his own P& L, hence the jargon— and we end up with an outcome that maximizes greenhouse profit but not the profit of the entire company.
Such externalities— or cross-column effects— are present any time a manager splits up a business’s overall profit into distinct P& Ls that are then used for delegation and performance evaluation. At Midwest Block & Brick, the company’s geographic dispersion leads to potential externalities any time salespeople from different regions compete for the same job. If a Union City salesman halves his normal margin to win business that otherwise would have been served by the Paducah plant at the normal margin, then Union City profit rises, but the overall profit falls.
Profit centres and delegation will fail to achieve overall-profit maximization whenever externalities are present, and as a result, these are decisions where top management needs to stay involved. Effective managers learn to spot potential externalities in their organizations and step in to guide local managers to the right choices.
We listened to both Pat Dubbert and Mike Berns talk about how they do this. “What counts in the big picture,” Mike B. said, “is the whole corporate bottom line, whether we shift it to one division or another.” But in order to maximize the whole corporate, he’s got to put limits in place when externalities are present. He doesn’t allow greenhouse to unilaterally set transfer prices; instead, he uses either market-based prices— the wholesale price set by outside greenhouses— or in some cases mandates that the retail buyer work directly with greenhouse to determine production quantities and then insists that the two divisions split the resulting profit . Mike B. uses similar techniques when his landscape division purchases from retail, mostly requiring retail to sell internally at wholesale prices.
Pat Dubbert described the case of a school being built in Columbia, Missouri. Local government projects, he said, often attract bidding contractors from a wide geographic area. His Columbia salespeople might be working with a Columbia contractor on a bid while the Saint Louis salesman works with a competing Saint Louis– based contractor. Pat stays involved to make sure the two works together to avoid giving away margins as they work to help their customer compete. Learn more about spotting externalities and keeping senior management involved only at the University Canada West, one of the best universities in Canada, offering various business and management related programs.