Individual Reflection, select concepts or topics that resonated with you during this course and commit to learning more about themManagement Accounting Skills

This will be a blueprint as well as Executive summary for this paper.  Your BPPG, including the Executive Summary (which will typically be 2–3 paragraphs in length and no more than one page if single spaced) 

Must be APA format within 5 to 6 pages excluding reference page and title page . Reference articles are listed below for references which is a must , as well as can use more scholar sources.  

The rubric is listed in the attachment. Please follow the particular order from the rubric. 

What can you do now to integrate the experiences and insights you had in this course with your personal and professional development goals?

What are the most important things you are taking from this course that will shape your future and enable you to make a positive difference?

The Assignment:

All components of the Assignment must be turned in as one document:

The executive summary: Write an Executive Summary of the course (2–3 paragraphs) that addresses the following questions:

1. Which content and Assignments in this course improved your understanding of using accounting information to make decisions for your organization ( such as Analyze differences between cost, profit, and investment centers Analyze methods of performance evaluation of cost, profit, and investment centers Analyze standard costing in terms of improving efficiency Analyze material and labor variances (or one with which you are familiar)?

·

What impact has your improved understanding had (or you anticipate it will have) on the value you will bring to your role within an organization?

· In what ways does the content from this course affect a manager’s ability to create positive change within an organization?

· To what extent can the content from this course help you contribute to social responsibility and positive social change?

· How have the content and Assignments changed the way you will use accounting information to make management decisions?

· How have the content and Assignments shaped your goals now and how do you anticipate they will shape your goals in the future?

· After considering what you have learned in the course, create a focused and succinct strategy for your professional or personal life that will enable you to improve profitability for an organization or improve your personal financial resources while demonstrating social responsibility. This strategy could take the form of increasing revenue or reducing expenses.

As part of your strategy, be sure to include responses to the following:

· List three areas you could focus on for your strategy relative to your own organization, an organization for which you would aspire to work, or your personal life. Describe the importance of each of the focus areas chosen, including how they will enable you to demonstrate social responsibility and positive social change. Provide examples with support from the resources.

Describe how you will measure progress toward your success.

·

3. Your action plan: Write a detailed action plan for one new goal for professional and personal development. (You will continue to build on the list of goals you selected in your previous course.) Include the following in your action plan:

· Describe your specific goal for professional and personal development with an explanation as to why you selected this goal. Be sure to provide concrete and specific examples of why the goal is important, the extent to which this goal enables you to be an agent for positive social change, and the personal or professional value you expect from achieving each goal, and how the goal relates to the resources reviewed in the course.

· Provide at least two objectives for the goal you have identified. Also, provide a rationale that explains how your objectives support the goal.

22M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

M
ost companies now operate in an envi-

ronment in which their products, mar-

kets, customers, employees, and

technology are constantly changing. In

such circumstances, the appropriate

organizational form becomes important, and a decen-

tralized organization is very common. The essence of

decentralization is the freedom managers have at vari-

ous levels to make decisions within their sphere of

responsibility. This frequently involves determining a

transfer price system within the company, which has the

potential to become the most important and possibly

the most interesting problem of management control.

Decentralization can simulate market conditions

within a company between autonomously acting sub-

units—i.e., they reflect competition. Managers in such

subunits or “business units” have different degrees of

autonomy and a range of company decisions for which

they are responsible. The cost center manager is typi-

cally responsible for costs, the profit center manager for

costs and revenues, and the investment center manager

for generating an adequate return on investment.

Because of the decentralization of decision making,

the role of performance measurement and performan

ce

assessment within these responsibility centers becomes

important. These issues lead to discussion and system-

atic analysis of transfer price functions between seg-

ments.1 Companies often use transfer prices as

substitutes for market prices either because market

prices do not exist or because they do not facilitate

internal trading and the synergies it creates. Even if

synergies exist for internal trade, it is possible that mar-

ket prices may not encourage this to happen. Thus top

management often imposes a transfer price in order to

benefit from these synergies. An added complication,

however, is that sharing the synergistic benefits

between responsibility centers is arbitrary, so the

“correct” transfer price cannot exist. It is obvious that

transfer prices affect the profit reported in each respon-

sibility center, and, more importantly, companies can

use transfer pricing to influence decision making.

We will look at the functions and different types of

transfer prices and their possible behavioral conse-

quences. The analysis, which is from a managerial point

Transfer Prices:
Functions, Types,
and Behavioral
Implications

TRANSFER PRICES AFFECT THE PROFIT REPORTED IN EACH RESPONSIBILITY CENTER OF A

COMPANY AND CAN BE USED TO INFLUENCE DECISION MAKING. SHOWING A VARIETY OF

EXAMPLES, THE AUTHORS DESCRIBE THE FUNCTIONS AND TYPES OF TRANSFER PRICES

AND DISCUSS THE POSSIBLE BEHAVIORAL CONSEQUENCES OF USING THEM.

B Y P E T E R S C H U S T E R , P H . D . , A N D P E T E R C L A R K E , P H . D .

Winter
2010

VOL.11 NO.2

Winter
2010

23M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

of view, argues that neither a single “true” nor a “fair”

price exists, but, rather, the transfer price is conditional

on the decision context. Our article also highlights pos-

sible dysfunctional behavior. We outline some examples

and propose possible solutions that we assess in the

light of behavioral effects, highlighting how complex,

difficult, and insolvable the issue of transfer pricing is in

reality. In order to understand the effects resulting from

asymmetric information and finding suitable transfer

prices, we will first discuss the functions of transfer

prices.

F U N C T I O N S O F T R A N S F E R P R I C E S

The decentralized organization is a connection of partly

independent business units. An important task for man-

agement is the performance measurement and assess-

ment of these units. This requires, for example, that

the reported profit figure for, say, profit or investment

centers for the relevant period, should be reliable and

trustworthy. Where these business units trade with each

other, the transfer pricing system has the potential to

distort reported profit performance. Therefore, the

internal profit-allocation function and related perfor-

mance measurement of business units are crucial ele-

ments of transfer pricing.

Transfer prices should also influence managerial

decision making because they should provide an incen-

tive to maximize the business units’ profit targets. We

refer to this as the coordination function. If managerial

decisions lead to maximized profits within all the

autonomous business units, then this should also maxi-

mize the total company or, in the following “group,”

profits, ignoring tax and foreign exchange considera-

tions. Business unit managers’ decisions then are identi-

cal to the decisions that the group’s top managers would

make if they had all the necessary information.

There is a potential conflict between these two func-

tions of transfer prices, namely the profit-allocation

function (reliable and trustworthy prices and, thus,

reported profits) and the coordination function (guiding

behavior of decentralized managers by using the trans-

fer prices). One solution is to reduce the discretion of

subunit managers in setting transfer prices. This

approach, however, partly defeats the original purpose

of decentralization and reduces the validity of assessing

such responsibility units on the basis of reported profit

as it is no longer an aspect for which companies can

hold them directly responsible.

There are additional functions for

transfer prices.

Besides the primary functions of profit allocation and

coordination functions, transfer prices fulfill other tasks,

such as complying with financial reporting regulations

in addition to tax considerations.2 We will not discuss

them here, however. Instead, we will concentrate on

the two primary functions of transfer prices together

with their behavioral consequences, which companies

often do not understand.

T Y P E S O F T R A N S F E R P R I C E S A N D T H E I R

D E T E R M I N AT I O N

Generally, companies can determine transfer prices

three different ways: market-based transfer prices, cost-

based transfer prices, and negotiated transfer prices.

Although each method provides a different “answer,”

their commonality is that transfer prices represent an

intracompany market mechanism. We will now discuss

each type of transfer price.

Market-Based Transfer Prices

Market-based transfer prices represent market condi-

tions and, therefore, simulate the market-within-the-

company idea. Their advantage is that they support and

implement corporate strategy and allow performance

measurement of responsibility centers using market-

oriented data. A prerequisite for this method is a stan-

dardized, existing market of the product or a substitute.

Companies can determine a market-based transfer price

by comparing current prices if the business unit also

sells to the market. Alternatively, they can obtain trans-

fer prices from the marketplace if a comparable com-

petitive product exists. Problems do occur with this

approach, however, if, for example, a company uses

“marginal prices” in order to use idle capacity. In such

circumstances, the short-term price may not be equiva-

lent to the long-term price. Furthermore, should one

include special discounts? Another major problem with

market-based prices is their trustworthiness, and this

raises questions such as:

◆ Who submits the information?

◆ Who decides which suppliers are asked for an offer,

24M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

and how often should the information be requested?

◆ Should there be a “favored” clause for intracompany

trading compared to market suppliers?

Figure 1 shows a case of two responsibility units in

the situation of a perfect market.3 The costs of the busi-

ness units remain unaffected by their decisions whether

to purchase externally in the marketplace or to engage

in intracompany trading. The example shows that

under normal circumstances subunit 1 produces an

intermediate product and can sell it in the market at

$125 or to subunit 2 for an agreed transfer price that the

company will determine. Subunit 2 transforms this into

a final product that it sells on the market at a normal

price of $300. A supplier, however, has offered $240 for

subunit 2’s product, and this subunit has idle capacity to

produce the product.

Managers should base suggested transfer prices on

how well they fulfill the two functions of “profit alloca-

tion” and “coordination.” In this example, the reported

profits of both subunits are reliable and trustworthy

because the company bases them on a transfer price

equal to the market price of the intermediate product

($125). The selling division (subunit 1) always has the

incentive to sell internally because the market-based

transfer prices mirror current market conditions. Equal-

ly, the buying division (subunit 2) does not overpay for

the intermediate product. Table 1 summarizes the deci-

sions and profits of the two subunits. Both subunits

have the incentive to trade internally using market

prices to determine the transfer price and the overall

group benefits accordingly.

We now adapt this example to case 2, where the pro-

cessing costs of subunit 2 are $120 per unit rather than

$80 (see Figure 2).

In case 2, subunit 2 still has the incentive to trade

internally, but, with a transfer price of $125, subunit 2

will reject the supplementary offer. Table 2 summarizes

the alternatives. By selling the product to the market,

the market-based transfer price leads to subunit 1’s

profit of $25. In contrast, internal trading would result

in an accounting loss of $5. Subunit 2 will not produce

the final product, so subunit 2 will sell the intermediate

product on the market. This, then, is also the profit-

maximizing decision from the group perspective

because it generates a total profit of $25 ($1252$100)

compared to only $20 ($2402$1002$120) for a supple-

mentary order.

Figures 1 and 2 illustrate the fulfillment of the

profit-allocation function as there is an obvious homoge-

nous market price that can be the transfer price. Addi-

Figure 1: Case 1—A Market-Based Transfer Price
in a Perfect Market Situation

SUBUNIT 1 SUBUNIT 2

Input factors

Intermediate

product
Final product

Costs: $80
(case 1)

Costs: $100

Market for intermediate
product: p1 = $125

Regular market price
of the final product:

p = $300

Input factors

Table 1: Decisions and Profits of the Subunits in Case 1
CASE PROFIT SUBUNIT 1 DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT GROUP

Case 1 125 2 100 = 25 Produce and sell 240 2 125 2 80 = 35 Buy intermediate product 240 2 100 2 80 = 60
intermediate product and produce and sell
(to subunit 2) supplementary order

Supplier offer:
Price = $240

25M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

tionally, both subunits make the same decision as

would top centralized management if they possessed all

available information. This is highlighted by the deci-

sion about a one-off supplementary offer for an addi-

tional customer for a price of $240: In case 1, both

subunits independently decide to trade internally, and

top management would approve this in the company

headquarters as the supplementary order increases com-

pany profit by $60. A variation of this, case 2, in which

subunit 2 has production costs of $120, shows that it is

preferable to sell the intermediate product in the mar-

ket. Thus the subunits do not trade with each other

when they use the market-based transfer price. This

decision leads to an overall profit of $25. If interdivi-

sional trading took place at a transfer price of $125, it

would lead to additional group profit of only $20. Thus

this also fulfills the coordination function. Top manage-

ment would have made this decision if they had access

to all the information.

We can further adapt the previous example. Figure 3

indicates that subunit 1 incurs costs of $100 per unit

when selling internally and costs of $116 when selling

to the market. The incidence of selling and distribution

costs could explain this phenomenon. In case 3, the

production costs of subunit 2 are $120, which are the

same as in case 2, and the necessary intermediate prod-

uct is bought internally from subunit 1. This example

builds on the previous example with one exception: the

existence of synergies, represented by a different cost

situation when subunit 1 sells its product internally or

to the market and when subunit 2 buys internally or

from the market.

This proves that the market-based transfer price will

not fulfill the profit allocation and the coordination

function when synergies exist. That is to say, the obvi-

ous solution for a transfer price of a decentralized orga-

nization will not work in the real world where synergies

exist. As shown in the example, the two functions are

not fulfilled because neither the “correct” profit can be

reported by the use of the transfer price nor are the

subunit’s decisions in the best interests of the company

as a whole. Yet synergies can be seen as a reason for the

existence of companies because companies then can

produce something better and cheaper, i.e., in principle

favorable to customers.

Despite the fact that there is an obvious homogenous

market price, the profit-allocation function is not ful-

filled anymore because of synergies represented by the

lower internal costs of subunit 1 when avoiding the use

of the market—i.e., when selling the intermediate prod-

Figure 2: Case 2—A Market-Based Transfer Price
in a Perfect Market Situation

SUBUNIT 1 SUBUNIT 2Input factors
Intermediate

product
Final product

Costs: $120
(case 2)

Costs: $100
Market for intermediate
product: p1 = $125
Regular market price
of the final product:
p = $300

Input factors Supplier offer:
price = $240

Table 2: Decisions and Profits of the Subunits in Case 2
CASE PROFIT SUBUNIT 1 DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT GROUP

Case 2 125 2 100 = 25 Produce and sell 240 2 125 2 120 = 25 Decline 125 2 100 = 25
intermediate product supplementary order (for intermediate
(to market) product only)

26M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

uct to subunit 2 rather than to the market—and by the

additional costs of subunit 2 when utilizing the market.

The synergies, therefore, comprise $16 (subunit 1) and

$15 (subunit), which equals $31, symbolized by

increased cost functions of both business units (e.g., for

higher marketing costs of business unit 1 or higher

quality-control costs of business unit 2). The reporting

of the “correct” profit supposedly shows the correct

division of the synergies, but any division of these

advantages is arbitrary.

So who should benefit from synergy when subunit 1

produces the intermediate product that it sells to sub-

unit 2, who processes it into the final product sold as

the supplementary order at the price of $240? For

example, at a price of $110 for the intermediate prod-

uct, both subunits end up with a profit of $10 each:

Subunit 1 is $110 2 $100 = $10; subunit 2 is $240 2

$120 2 $110 = $10. Both share the maximum achievable

profit, which equals $20 for an intracompany solution of

the supplementary order versus a profit of $9 when sub-

unit 1 sells the intermediate product to the market and

when the supplementary order is rejected. At that price,

both subunits report a profit, even though the amounts

are arbitrary and not in accordance with the market

price of the intermediate product but $15 lower.

An analysis of the next function, the coordination

function, reveals that the company’s decision is not

identical to the subunits’ decisions: A company can

achieve maximum profit by producing the supplemen-

tary order at a profit of $20 per product. Subunit 1 also

prefers the profit of $25, but subunit 2 rejects this

because of a loss of $5, so the only business consists of

selling the intermediate product to the market with a

combined profit of $9 for subunit 1 and the company.

Because of synergistic effects, the market-based transfer

price in the example is too high for both subunits to

decide to accept the one-time order. A price that would

lead both business units to decide positively about the

order is in the range of $109 and $120. At a price of

$109, subunit 1 earns a contribution margin internally in

the amount of $9, which is identical to the amount it

could earn at the market price. It is the minimum price

it would ask for in case of internal business. At a price

of $120, subunit 2 starts to earn a positive contribution

margin—i.e., it is the maximum price subunit 2 is will-

ing to pay. The rejection of the supplementary order

cuts the possible company profit from $20 to $9, so the

market-based transfer price does not support indepen-

Figure 3: Case 3—A Market-Based Transfer Price
in an Imperfect Market Situation

SUBUNIT 1 SUBUNIT 2Input factors
Intermediate
product
Final product

Costs:
Internal = $120
Market = $135

Costs:
Internal = $100
Market = $116

Market for intermediate
product: p1 = $125
Input factors Supplier offer:
price = $240

Table 3: Decisions and Profits of the Subunits in Case 3
PROFIT SUBUNIT 1 DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT COMPANY

Intracompany 125 2 100 = 25 Intracompany 240 2 125 2 120 = 25 Reject 240 2 100 2 120 = 20
Market 125 2 116 = 9 preferred 240 2 135 2 125 = 220 supplementary order 125 2 116 = 9

27M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

dent decisions in the company’s best interests.

In summary, the main advantage of market-based

transfer prices is that they are objective and unbiased

measures, although they might fluctuate because of mar-

ket conditions over time. Further, they are difficult to

manipulate. As case 3 shows, market-based transfer

prices perform the profit-allocation function except when

synergies and interdependencies exist. When an imper-

fect market exists, a company may not fulfill the coordi-

nation function. Further questions remain,

such as:

◆ What if the market price cannot be determined?

◆ How often are market prices measured?

◆ Will they be based on short-term single-production-

run offers or long-term high-volume offers?

These questions indicate that using market-based

transfer prices presents practical difficulties.

Cost-Based Transfer Prices

Depending on one’s definition of cost, cost-based trans-

fer prices can provide a variety of figures for determin-

ing intracompany trading. Cost-based prices are the

most common type in practice, and they represent an

alternative if a market price does not exist. In account-

ing terms, “cost” can be defined in a variety of ways,

including actual versus budget (or standard); marginal

versus absorbed (full) cost; and whether one uses pure

cost or cost-plus to determine transfer prices. The

first classification, actual versus standard costs, concerns

the issue of who will take the risk of cost deviations

and variances. Using actual costs—i.e., ex-post price

determination—transfers the risk associated with cost

deviations to the purchasing subunit. In contrast, stan-

dard costs require the ex-ante determination of the

prices and shift the risk to the supplying subunit.

Marginal versus full cost represents the next category.

Marginal costs fulfill the function of coordination

because the marginal-cost-based transfer price leads to

“optimal” decisions of the purchasing subunits, and the

independence of the subunits remains unchanged. As a

result, the supplying subunit makes an accounting loss

by approximating the fixed costs per unit, assuming lin-

earity of cost behavior. The purchasing subunit regular-

ly earns high profits, and the issue of profit allocation is

unresolved.

This model, known as the Hirshleifer model, is the

next example: The business units’ decisions are identi-

cal to the decisions of corporate headquarters if head-

quarters had all the information. It supports the

academic logic of management accounting in which

only marginal costs are relevant in the short-term view.

To analyze this point and shed some light on the specif-

ic problems of it, we introduce a new example where

the cost functions of subunits 1 and 2 are simple linear

equations as follows: C1 = 100 + 0.3x and C2 = 30 + x.

The demand curve for the final product is given as:

p(x) = 31 – 1.2x. Based on profit-maximization theory,

which equates marginal cost with marginal revenue, the

optimal solution is an output of 12,375 units and a loss

of $100 (subunit 1) and $153.77 (subunit 2). Table 4

summarizes profit functions and decisions.

We assumed linear cost functions in the example. In

a modification of the previous example, now we assume

a nonlinear cost function of subunit 1 because this

shows that the described solution of the Hirshleifer

model will not work anymore. The cost function of the

supplying business unit changes to C1 = 100 + 0.3 * x2,

Table 4: Decisions and Profits of the Subunits Based on a
Marginal-Cost-Based Transfer Price with Linear Cost Functions

PROFIT SUBUNIT 1 0.3 • x 2 100 2 0.3 • x = –100

DECISION SUBUNIT 1 Irrelevant, as marginal costs = variable costs and thus profit always = a loss in the amount of the fixed costs

PROFIT SUBUNIT 2 31 • x 2 1.2 • x2 2 0.3 • x 2 30 2 x = 21.2 • x2 + 29.7 • x 2 30

DECISION SUBUNIT 2 x opt = 29.7/2.4 = 12.375 (Profitmax = 153.77)

PROFIT GROUP 31 • x 21.2 • x2 2 100 2 0.3 • x – 30 2 x = 21.2 • x2 + 29.7 • x 2 130

DECISION GROUP Identical to Subunit 2 (Profitmax = 53.77)

28M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

and this Hirshleifer model proves that marginal-cost-

based transfer prices, while seemingly supporting the

coordination function, provide an apparent solution.

This is so because the company headquarters has to

announce the transfer price (where TP= $6 (for xopt =

10); profit subunit 1 (2) = 2$70 ($90)). In the case of a

nonlinear cost function, this requires the knowledge of

x, the amounts of product units. Marginal costs of sub-

unit 1 are 0.6 * x; i.e., x remains unknown, and, there-

fore, xoptimum must be known to determine xoptimum,

and, with it, a circularity problem exists, and headquar-

ters can find a solution by announcing the transfer price

after determining xoptimum. In other words, only an

apparent solution is found because independent sub-

units are not independent anymore as headquarters

must know x and use it for presenting the transfer

price. This problem is only linked to nonlinear cost

functions. Therefore, the example started with a linear

cost function C1, and we then modified it to a nonlinear

function to illustrate the unsuitability of transfer prices

based on marginal costs.

Another problem is that profit allocation is not per-

formed because there is an arbitrary split of the profits

between the business units that typically favors the pur-

chasing business units.

Table 5 shows the profits of both subunits, summa-

rizes their decisions, and represents the subunits’ deci-

sions (decentralized decisions) in comparison to the

company’s perspective as a whole (centralized decision).

The decisions are identical in each case (xopt=10).

In regard to behavioral effects, two problems become

obvious: First, from the viewpoint of the supplying

business unit, the unit probably will end up with a loss.

The loss in the previous example is $70. Understanding

Table 5: Decisions and Profits of the Subunits
Based on a Marginal-Cost-Based Transfer Price

with Nonlinear Cost Functions

PROFIT SUBUNIT 1 TP • x 2 100 2 0.3 • x2

DECISION SUBUNIT 1 Because of nonlinear cost function, headquarters has to set transfer price at 0.6 x (knowing x!):

TP=6 (Profit = 270) xopt = 10

PROFIT SUBUNIT 2 31 • x 2 1.2 • x2 2 6 • x 2 30 2 x = 21.2 • x2 + 24 • x 2 30

DECISION SUBUNIT 2 xopt = 24/10 = 10 (Profitmax = 90)

PROFIT COMPANY 31 • x 2 1.2 • x2 2 100 2 0.3 • x2 2 30 2 x = 21.5 • x2 + 30 • x 2 130

DECISION COMPANY xopt = 10 (Profitmax = 20)

Figure 4: Case 4—A Marginal-Cost-Based Transfer Price
with Nonlinear Cost Function

SUBUNIT 1 SUBUNIT 2Input factors
Intermediate
product
Final product

Market price of final
product:

p(x) = 31 – 1.2 • x

Costs:
C2 = 30 + x

Costs:
C1 = 100 + 0.3 • x2

Input factors

29M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

the procedure, the subunit can gain advantages by

reporting a distorted cost function by, for instance,

increasing the reported variable costs that lead to higher

marginal costs and, thus, transfer price. In this example,

the distortion to a cost function of C1= 100 + 0.4 * x2

changes the company’s and business units’ decisions

and reduces the loss from $70 to $64.84 (TP=$7.50, xopt.
= 9.375). The total company profit falls by about 47%

from $20 to $10.63 (by 88% for C1= 100 + 0.5 * x2, etc.).

Second, from the viewpoint of the purchasing business

unit, understanding the procedure changes the unit’s

profit function because the business unit realizes that

the transfer price is not independent of the amount of

products. The transfer price is a function of x and there-

fore maximizes the following profit function using the

initial cost function: C1= 100 + 0.3 * x2: Profit2 = p(x) x

– TP(x) x – K2(x) = (31 – 1.2x) x – 0.6×2 – 30 – x. As a

result, a different optimum amount of units produced

arises and is not consistent with the initial solution (x =

8.33 versus x = 10). The profit of subunit 2 rises from

$90 to $95, exemplifying the dysfunctional incentive.

Marginal-cost-based transfer prices cause other dys-

functional behavior. The supplying business unit has an

incentive for untruthful reporting and, in general, to

qualify the highest possible portion of the costs as being

variable. Further, supplying business units will oppose

investments that will lead to smaller variable and higher

fixed costs, known in literature as the hold-up problem

of investments.4

This example shows that the theoretical view of

solutions—the optimum achieved by applying marginal

costs—may not work in company practice because of

other considerations, such as behavioral effects. Theory,

however, does provide insights for issues highly rele-

vant in practice.

In summary, using marginal-cost-based transfer prices

leads to the central optimum in the short-term view,

i.e., the fulfillment of the coordination function. This

may only be an apparent solution and does not work in

the case of nonlinear cost functions. The profit-allocation

function is not fulfilled, and the supplying business unit

usually ends up with a loss. This might be overcome by

multitier schemes we will describe.

The capacity limit of the marginal costs is the point

that includes opportunity costs. Opportunity costs

increase with higher volume, and, in principle, this

leads to an approximation toward the market-based

transfer prices.

As an alternative to marginal costs, companies can

use fully absorbed cost-based transfer prices. The basic

idea is that the supplying subunit should be able to

meet all of its costs and should not incur an accounting

loss on the internal transaction. Certain variations of

costs exist, such as using production costs or, alterna-

tively, total costs to include a portion of selling, distribu-

tion, and administrative overheads.

A major problem of this type of transfer price is the

distortion of the group’s cost structure. The reason is we

can regard the transfer price from the viewpoint of the

purchasing unit, and it regards the transfer price as a

variable cost even though it includes an element of

fixed cost. Therefore, decisions made seemingly on

variable cost actually include fixed-cost portions, and

this distortion leads to suboptimal decisions. The prob-

lem that full cost includes irrelevant parts for short-term

decisions highlights the problem that the allocation of

fixed overhead costs is always arbitrary. The distortion

intensifies if we use cost-plus transfer prices that

include a surcharge, such as a percentage of full costs,

the required return on capital employed (ROCE), or

the return on investment (ROI).

A step toward a solution may be the multitier transfer

price. Figure 5 shows a two-tier scheme: a single period-

ic amount for reserving capacity as an equivalent to the

fixed costs this capacity level causes and current prod-

ucts the company will buy at marginal (variable) costs.

Effects arising from this two-tier scheme are that the

Marginal Costs/per unit

Single Payment/per period

Production Volume

Tr
an

sf
er

P
ri

ce

Figure 5: Multitier Transfer Price
(Two-Tier Scheme)

30M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

supplying subunit is reimbursed for its full costs and

can possibly even earn a profit and that the periodic

payment does not affect short-term decisions about

single product orders that are made based solely on

marginal costs. The two-tier scheme achieves the

coordination function. Yet problems arise for capacity

planning because several questions come up,

such as:

◆ What happens with idle capacity?

◆ What type of fixed costs will we use to determine

the single payment—actual capacity use (known ex-

post only), former average capacity use, or reported

planned capacity use?

◆ When will the payment be renegotiated—periodically

or when the capacity is adjusted?

Another version of a cost-based transfer price is a

dual transfer price. Its main idea is that two different

transfer prices will be used—one for the supplying unit

and another for the purchasing subunit. The example in

Figure 6 suggests that the supplying subunit receives

the average net margin of the purchasing subunit and

that the purchasing subunit pays only the average full

costs of the supplying subunit. As a result, the head

office subsidizes the supplying subunit.

One effect of negotiated transfer prices is that the

subunits’ profits and the company’s profits become iden-

tical. Therefore, the transfer prices fulfill the coordina-

tion function because the subunits maximize identical

profit functions and will come to identical decisions, the

decisions that headquarters would also come to if it had

all the necessary information. The following example

illustrates this with the data from Figure 6.

Through maximizing the total profit, the central solu-

tion leads to an output volume of 10 units and a profit

of $20. The transfer price, TP1, as the sales price of the

supplying subunit, is deducted from the average net

margin of the purchasing subunit, and, in the example,

TP1 is: 21.2x + 30 – 30/x. The maximized profit, P1, is

identical to the company’s total profit and, therefore,

leads to an identical decision about units produced and

sold. The transfer price, TP2, as the average full cost of

the supplying subunit in this example, is 0.3x + 100/x,

and the profit function, P2, is also identical to the previ-

ous profit functions, as are the decisions.

This procedure is characterized by a subsidization of

the supplying subunit. Because of increased subsidiza-

tion, an untruthful reporting of cost functions can be

beneficial to all subunits, provided that a collusive

agreement between the subunits on combined “distort-

ed” cost functions is made. In other words, the untruth-

fully reported cost functions relate to each other, with

both subunits calculating identical unit numbers pro-

duced and sold.

In summary, several problems arise with the dual

transfer prices. The subunits’ profits appear to be too

high because headquarters subsidizes them. There is a

strong incentive to do internal business because head-

quarters pays a subsidy to each unit to increase the sub-

unit’s profits. Both subunits report the same profit,

which means the profit-allocation function is not

achieved. Besides that, in general there is low accept-

ability because it is not obvious what the “real” or “cor-

rect” transfer price is. This type of transfer price

involves a number of organizational efforts.

Figure 6: Suggestions for Dual Transfer Prices

SUPPLYING
SUBUNIT

PURCHASING
SUBUNIT

Supplying subunit receives the average
net margin of the buying subunit

Purchasing subunit pays the average
full costs of the supplying subunit

Market

Headquarters subsidizes supplying subunitHEADQUARTERS

31M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

Negotiated Transfer Prices

Finally, one can determine transfer prices by way of

negotiation. Negotiated transfer prices simulate the

“market within the company.” These prices can be

determined in a situation that is characterized by highly

autonomous and independent subunits. It implies that

responsible managers have the option to refuse internal

“business,” and the process is similar to negotiations

with regular customers. Headquarters can have differ-

ent ways of influencing decisions, such as requiring

approval, having the right to reject, having veto rights,

and establishing procedural rules.

As a result, it is difficult to assess whether negotiated

transfer prices fulfill the coordination and/or profit-

allocation function because they depend on the negoti-

ating power and negotiating skills of the individuals

involved. Results of negotiations, which top manage-

ment can influence, depend on the alternatives avail-

able. If no market prices exist, it is especially

challenging to find a workable way.5 Negotiations can

be time-consuming and may lead to intracompany con-

flicts. Based on alternatives, these negotiated transfer

prices typically fluctuate between marginal cost and

market prices. Therefore, they will not generally fulfill

the primary functions of transfer prices.

F U R T H E R T H O U G H T S

Decentralized organizations, such as those made up of a

number of independent profit centers designed to

improve the entrepreneurial conduct of managers, lead

to increased motivation and better decision making.

This leads to a consideration of transfer pricing. We

argue, however, that there is no such thing as an ideal

solution for transfer prices, nor even a “correct” or

“fair” transfer price, as long as a perfect market condi-

tion applies.

How should management accountants deal with this

issue if none of the characteristics exists? We argue that

the main point is to see that, despite company practices,

demand is high for it, and there cannot be one solution

for a transfer price system. So it is essential to under-

stand that different functions require different, even

contradictory, transfer prices.

To determine a transfer price type, a company must

consider the primary functions, namely profit allocation

and coordination. Depending on the prioritized role,

companies prefer certain transfer price types. Yet the

possible dysfunctional behavioral effects arising from

the transfer prices indicate how complex, difficult, and

insolvable the issue of transfer pricing is in reality. Typi-

cally, a theoretical view presents a clear solution as a

suggestion to practice; here it does not. This might be

confusing, but it also shows how highly relevant the

theoretical reasoning can be. At least with the perspec-

tive on prioritized functions, we showed some solutions,

including the dangers that arise from including behav-

ioral effects. ■

Peter Schuster, Ph.D., is a professor of management

accounting and management control at Schmalkalden

University of Applied Sciences in Schmalkalden, Germany.

You can reach Peter at (0049) 3683 688 – 3112 or

Schuster@Fh-Schmalkalden.de.

Peter Clarke, Ph.D., is an associate professor of accountancy

and director of the academic centre-accouting/taxation

research at University College in Dublin, Ireland. You can

reach Peter at (00353)1 7164700 or Peter.Clarke@ucd.ie.

E N D N OT E S
1 Transfer prices have received a great deal of attention at all

times, and research on them goes back to the 1950s. See Jack
Hirshleifer, “On the Economics of Transfer Pricing,” The
Journal of Business, January 1956, pp. 172-184, and “Econom-
ics of the Divisionalized Firm,” The Journal of Business,
January 1957, pp. 96-108. Also see Paul W. Cook, “Decentral-
ization and the Transfer-Price Problem,” The Journal of Busi-
ness, January 1955, pp. 87-94, and Williard E. Stone,
“Intracompany Pricing,” The Accounting Review, October 1956,
pp. 625-627. Eugen Schmalenbach, one of the founding
researchers of management accounting in Germany, started
his research as early as 1903.

2 For information on tax objectives, see, for example, Tim
Baldenius, Nahum D. Melumad, and Stefan Reichelstein,
“Integrating Managerial and Tax Objectives in Transfer Pric-
ing,” The Accounting Review, July 2004, pp. 591-615.

3 Examples are adapted from Ralf Ewert, Alfred Wagenhofer,
and Peter Schuster, Management Accounting, Springer-Verlag,
Berlin, Germany, 2010.

4 Regina M. Anctil and Sunil Dutta, “Negotiated Transfer Pric-
ing and Divisional vs. Firm-Wide Performance Evaluation,”
The Accounting Review, January 1999, pp. 87-104.

5 For a suggestion in this situation in the form of a “Renegotiate-
Any-Time” system, see Joseph M. Cheng, “A Breakthrough in
Transfer Prices: The Renegotiate-Any-Time System,” Manage-
ment Accounting Quarterly, Winter 2002, pp. 1-8.

32M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 1 0 , V O L . 1 1 , N O . 2

R E F E R E N C E S
Regina M. Anctil and Sunil Dutta, “Negotiated Transfer Pricing

and Divisional vs. Firm-Wide Performance Evaluation,” The
Accounting Review, January 1999, pp. 87-104.

Bala V. Balachandran, Lode Li, and Robert P. Magee, “On the
Allocation of Fixed and Variable Costs from Service Depart-
ments,” Contemporary Accounting Research, Autumn 1987,
pp. 164-185.

Tim Baldenius, Nahum D. Melumad, and Stefan Reichelstein,
“Integrating Managerial and Tax Objectives in Transfer Pric-
ing,” The Accounting Review, July 2004, pp. 591-615.

Joseph M. Cheng, “A Breakthrough in Transfer Prices: The
Renegotiate-Any-Time System,” Management Accounting Quar-
terly, Winter 2002, pp. 1-8.

Paul W. Cook, “Decentralization and the Transfer-Price Problem,”
The Journal of Business, January 1955, pp. 87-94.

Robert G. Eccles, “Control with Fairness in Transfer Pricing,”
Harvard Business Review, November/December 1983, pp. 146-
161; The Transfer Pricing Problem, Lexington Books, Lexington,
Mass., 1985; “The Performance Measurement Manifesto,”
Harvard Business Review, January/February 1991, pp. 13-137.

Ralf Ewert, Alfred Wagenhofer, and Peter Schuster, Management
Accounting, Springer-Verlag, Berlin, Germany, 2010.

Robert Feinschreiber and Margaret Kent, “A Guide to Global
Transfer Pricing Strategy,” Journal of Corporate Accounting &
Finance, September/October 2001, pp. 29-34.

Jack Hirshleifer, “On the Economics of Transfer Pricing,” The
Journal of Business, January 1956, pp. 172-184, and “Economics
of the Divisionalized Firm,” The Journal of Business, January
1957, pp. 96-108.

Robert P. Magee, Advanced Managerial Accounting, John Wiley &
Sons, New York, N.Y., 1986.

Jeltje van der Meer-Kooistra, “The Coordination of Internal
Transactions: The Functioning of Transfer Pricing Systems in
the Organizational Context,” Management Accounting Research,
June 1994, pp.123-152.

Peter Schuster, “Verrechnungspreise bei Profit Center-Organization,”
in Handbuch Marktorientiertes Kostenmanagement, edited by
Werner Pepels and Hilmar J. Vollmuth, Renningen, Germany,
2003, pp. 71-80.

Barry H. Spicer and Van Ballew, “Management Accounting Sys-
tems and the Economics of Internal Organization,” Accounting,
Organizations and Society, Vol. 8, Issue 1, pp. 73-96.

Barry H. Spicer, “Towards an Organizational Theory of the Trans-
fer Pricing Process,” Accounting, Organizations and Society, Vol.
13, Issue 3, pp. 303-322.

Williard E. Stone, “Intracompany Pricing,” The Accounting Review,
October 1956, pp. 625-627.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

96 Harvard Business Review | October 2009 | hbr.org

Ju
d

e
B

u
ff

u
m

| by Andrew Likierman

Performance
Measurement

The Five Traps of

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hbr.org | October 2009 | Harvard Business Review 97

IIN AN EPISODE of Frasier, the television sitcom that follows the fortunes of a Seattle-based psychoana-lyst, the eponymous hero’s brother gloomily sum-marizes a task ahead: “Diffi cult and boring – my favorite combination.” If this is your reaction to the challenge of improving the measurement of your organization’s performance, you are not alone. In my experience, most senior executives fi nd it an
onerous if not threatening task. Thus they leave it
to people who may not be natural judges of per-
formance but are fl uent in the language of spread-
sheets. The inevitable result is a mass of numbers
and comparisons that provide little insight into
a company’s performance and may even lead to
decisions that hurt it. That’s a big problem in the
current recession, because the margin for error is
virtually nonexistent.

So how should executives take ownership of per-
formance assessment? They need to fi nd measures,
qualitative as well as quantitative, that look past
this year’s budget and previous results to determine
how the company will fare against its competitors in
the future. They need to move beyond a few simple,
easy-to-game metrics and embrace an array of more
sophisticated ones. And they need to keep people on
their toes and make sure that today’s measures are
not about yesterday’s business model.

In the following pages I present what I’ve found
to be the fi ve most common traps in measuring per-
formance and illustrate how some organizations
have managed to avoid them. My prescriptions
aren’t exhaustive, but they’ll provide a good start.
In any event, they can help you steal a march on
rivals who are caught in the same old traps.

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The Five Traps of Performance Measurement

98 Harvard Business Review | October 2009 | hbr.org

Measuring
Against Yourself
The papers for the next
regular performance as-
sessment are on your
desk, their thicket of
numbers awaiting you.
What are those numbers?
Most likely, comparisons
of current results with a
plan or a budget. If that’s

the case, you’re at grave risk of falling into the fi rst
trap of performance measurement: looking only
at your own company. You may be doing better
than the plan, but are you beating the competi-
tion? And what if the estimates you’re seeing were
manipulated?

To measure how well you’re doing, you need
information about the benchmarks that matter
most – the ones outside the organization. They will
help you defi ne competitive priorities and connect
executive compensation to relative rather than ab-
solute performance – meaning you’ll reward senior
executives for doing better than everyone else.

The trouble is that comparisons with your com-
petitors can’t easily be made in real time – which is
precisely why so many companies fall back on mea-
surements against the previous year’s plans and

budgets. You have to be creative
about how you fi nd the relevant
data or some proxy for them.

One way is to ask your cus-
tomers. Enterprise, the car-rental
company, uses the Enterprise
Service Quality Index, which
measures customers’ repeat pur-
chase intentions. Each branch
of the company telephones a
random sample of customers
and asks whether they will use
Enterprise again. When the index
goes up, the company is gaining
market share; when it falls, cus-
tomers are taking their business
elsewhere. The branches post re-
sults within two weeks, put them
next to profi tability numbers on
monthly financial statements,
and factor them into criteria for
promotion (thus aligning sales
goals and incentives).

Of course you have to make
sure you don’t annoy your cus-

tomers as you gather data. Think about how res-
taurant managers seek feedback about the quality
of their service: Most oft en they interrupt diners’
conversations to ask if everything is OK; sometimes
they deliver a questionnaire with the bill. Either ap-
proach can be irritating. Danny Meyer, the founder
of New York’s Union Square Hospitality Group, gets
the information unobtrusively, through simple ob-
servation. If people dining together in one of his
restaurants are looking at one another, the service
is probably working. If they’re all looking around
the room, they may be wowed by the architecture,
but it’s far more likely that the service is slow.

Another way to get data is to go to professionals
outside your company. When Marc Eff ron, the vice
president of talent management for Avon Products,
was trying to determine whether his company was
doing a good job of fi nding and developing man-
agers, he came up with the idea of creating a net-
work of talent management professionals. Started
in 2007, the New Talent Management Network has
more than 1,200 members, for whom it conducts
original research and provides a library of resources
and best practices.

Looking Backward
Along with budget fig-
ures, your performance
assessment package al-
most certainly includes
comparisons between
this year and last. If so,
watch out for the second
trap, which is to focus
on the past. Beating last
year’s numbers is not the

point; a performance measurement system needs
to tell you whether the decisions you’re making
now are going to help you in the coming months.

Look for measures that lead rather than lag the
profi ts in your business. The U.S. health insurer Hu-
mana, recognizing that its most expensive patients
are the really sick ones (a few years back the com-
pany found that the sickest 10% accounted for 80%
of its costs), off ers customers incentives for early
screening. If it can get more customers into early or
even preemptive treatment than other companies
can, it will outperform rivals in the future.

The quality of managerial decision making is
another leading indicator of success. Boards must
assess top executives’ wisdom and willingness to
listen. Qualitative, subjective judgments based on
independent directors’ own experience with an ex-

Most senior executives fi nd »
performance measurement
diffi cult if not threatening, and
they’re reluctant to engage with
it in a meaningful way. As a result,
companies routinely fall into
fi ve traps.

Specifi cally, they use them- »
selves rather than competitors
as benchmarks, focus on past
indicators of success, overvalue
numbers at the expense of quali-
tative measures, set easy-to-game
metrics, and cling to systems that
have outlived their usefulness.

This article addresses each of »
the traps in turn, offering advice
about how to avoid them and ex-
amples of organizations that have
successfully done so.

trap

trap

IN BRIEF
IDEA

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hbr.org | October 2009 | Harvard Business Review 99

ecutive are usually more revealing than a formal
analysis of the executive’s track record (an unreli-
able predictor of success, especially for a CEO) or
his or her division’s fi nancial performance. (See

“Evaluating the CEO,” by Stephen P. Kaufman, HBR
October 2008.)

It may sound trite, but how the company pre-
sents itself in offi cial communications oft en signals
the management style of top executives. In August
2006 the Economist reported that Arijit Chatterjee
and Donald Hambrick, of Pennsylvania State Uni-
versity, had devised a narcissism index on which to
rate 105 company bosses, based on the
prominence of the CEO’s photo in the
annual report, his or her prominence in
press releases, the frequency of the fi rst
person singular in interviews with the
CEO, and his or her compensation rela-
tive to that of the fi rm’s second-highest-
paid executive.

Finally, you need to look not only at
what you and others are doing but also
at what you aren’t doing. The managers
of one European investment bank told
me that they measure performance by
the outcomes of deals they’ve turned
down as well as by the outcomes of deals they’ve
won. If the ones they’ve rejected turn out to be lem-
ons, those rejections count as successes. This kind of
analysis seems obvious once stated, but I’ve noticed
a persistent bias in all of us to focus on what we do
over what we don’t do. Good management is about
making choices, so a decision not to do something
should be analyzed as closely as a decision to do
something.

Putting Your Faith
in Numbers
Good or bad, the metrics
in your performance as-
sessment package all
come as numbers. The
problem is that numbers-
driven managers often
end up producing reams
of low-quality data. Think
about how companies

collect feedback on service from their customers.
It’s well known to statisticians that if you want eval-
uation forms to tell the real story, the anonymity
of the respondents must be protected. Yet out of a
desire to gather as much information as possible at
points of contact, companies routinely ask custom-

ers to include personal data, and in many cases the
employees who provided the service watch them
fi ll out the forms. How surprised should you be
if your employees hand in consistently favorable
forms that they themselves collected? Bad assess-
ments have a tendency to mysteriously disappear.

Numbers-driven companies also gravitate to-
ward the most popular measures. If they’re looking
to compare themselves with other companies, they
feel they should use whatever measures others use.
The question of what measure is the right one gets
lost. Take Frederick Reichheld’s widely used Net

Promoter Score, which measures the likelihood
that customers will recommend a product or ser-
vice. The NPS is a useful indicator only if recom-
mendations play the dominant role in a purchase
decision; as its critics point out, customers’ propen-
sity to switch in response to recommendations var-
ies from industry to industry, so an NPS is probably
more important to, say, a baby-food manufacturer
than to an electricity supplier.

Similar issues arise about the much touted link
between employee satisfaction and profi tability.
The Employee-Customer-Profi t Chain pioneered by
Sears suggests that more-satisfi ed employees pro-
duce more-satisfi ed customers, who in turn deliver
higher profi ts. If that’s true, the path is clear: Keep
your employees content and watch those profi ts
soar. But employees may be satisfi ed mainly be-
cause they like their colleagues (think lawyers) or
because they’re highly paid and deferred to (think
investment bankers). Or they may actually enjoy
what they do, but their customers value price above
the quality of service (think budget airlines).

A particular bugbear of mine is the application of
fi nancial metrics to nonfi nancial activities. Anxious
to justify themselves rather than be outsourced,
many service functions (such as IT, HR, and legal)
try to devise a return on investment number to

trap

At one investment bank, if the deals that
managers have rejected turn out to be
lemons, those rejections count as successes.

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The Five Traps of Performance Measurement

100 Harvard Business Review | October 2009 | hbr.org

help their cause. Indeed, ROI is oft en described as
the holy grail of measurement – a revealing meta-
phor, with its implication of an almost certainly
doomed search.

Suppose an HR manager undertakes to assign
an ROI number to an executive training program.
Typically, he or she would ask program participants
to identify a benefi t, assign a dollar value to it, and
estimate the probability that the benefi t came from
the program. So a benefi t that is worth $70,000 and
has a 50% probability of being linked to the pro-
gram means a program benefi t of $35,000. If the
program cost $25,000, the net benefi t is $10,000 – a
40% ROI.

Think about this for a minute. How on earth can
the presumed causal link be justifi ed? By a state-
ment like “I learned a production algorithm at the
program and then applied it”? Assessing any seri-
ous executive program requires a much more so-
phisticated and qualitative approach. First you have
to specify ahead of time the needs of the program’s
stakeholders – participants, line managers, and
sponsors – and make sure that the syllabus meets
your organizational and talent-management objec-
tives. Once the program has ended, you have to
look beyond immediate evaluations to at least six
months aft er participants return to the workplace;
their personal feedback should be incorporated in
the next annual company performance review. At
the soft drinks company Britvic, HR assesses its ex-
ecutive coaching program by tracking coachees for
a year aft erward, comparing their career trajecto-
ries with those of people who didn’t get coached.

Gaming Your Metrics
In 2002 a leaked internal
memo from associates at
Cliff ord Chance, one of
the world’s largest law
firms, contended that
pressure to deliver bill-
able hours had encour-
aged its lawyers to pad
their numbers and cre-
ated an incentive to allo-

cate to senior associates work that could be done by
less expensive junior associates.

Lawyers aren’t the only ones: A number of prom-
inent companies have been caught trying to manip-
ulate their numbers. Since 2004 Royal Dutch Shell
has paid $470 million to settle lawsuits relating to
its overstatement of reserves. Morgan Stanley was
reportedly willing to lose €20 million on a securi-

ties trade for the Finnish government just before
closing its books for 2004 in order to improve its
position in the league table for global equity capital
market rankings.

You can’t prevent people from gaming numbers,
no matter how outstanding your organization. The
moment you choose to manage by a metric, you
invite your managers to manipulate it. Metrics are
only proxies for performance. Someone who has
learned how to optimize a metric without actually
having to perform will oft en do just that. To create
an eff ective performance measurement system, you
have to work with that fact rather than resort to
wishful thinking and denial.

It helps to diversify your metrics, because it’s a
lot harder to game several of them at once. Clif-
ford Chance replaced its single metric of billable
hours with seven criteria on which to base bonuses:
respect and mentoring, quality of work, excellence
in client service, integrity, contribution to the com-
munity, commitment to diversity, and contribution
to the fi rm as an institution. Metrics should have
varying sources (colleagues, bosses, customers) and
time frames. Mehrdad Baghai and coauthors de-
scribed in “Performance Measures: Calibrating for
Growth” (Journal of Business Strategy, July–August
1999) how the Japanese telecommunications com-
pany Soft Bank measured performance along three
time horizons. Horizon 1 covered actions relevant
to extending and defending core businesses, and
metrics were based on current income and cash
fl ow statements. Horizon 2 covered actions taken
to build emerging businesses; metrics came from
sales and marketing numbers. Horizon 3 covered
creating opportunities for new businesses; success
was measured through the attainment of preestab-
lished milestones. Multiple levels like those make
gaming far more complicated and far less likely to
succeed.

You can also vary the boundaries of your mea-
surement, by defi ning responsibility more narrowly
or by broadening it. To reduce delays in gate-closing
time, Southwest Airlines, which had traditionally
applied a metric only to gate agents, extended it
to include the whole ground team – ticketing staff ,
gate staff , and loaders – so that everyone had an
incentive to cooperate.

Finally, you should loosen the link between
meeting budgets and performance; far too many
bonuses are awarded on that basis. Managers may
either pad their budgets to make meeting them
easier or pare them down too far to impress their
bosses. Both practices can destroy value. Some com-

trap

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hbr.org | October 2009 | Harvard Business Review 101

panies get around the problem by giving manag-
ers leeway. The offi ce supplier Staples, for example,
lets them exceed their budgets if they can demon-
strate that doing so will lead to improved service for
customers. When I was a CFO, I off ered scope for
budget revisions during the year, usually in months
three and six. Another way of providing budget fl ex-
ibility is to set ranges rather than specifi c numbers
as targets.

Sticking to Your
Numbers Too Long
As the saying goes, you
manage what you mea-
sure. Unfortunately, per-
formance assessment
systems seldom evolve
as fast as businesses do.
Smaller and growing
companies are especially
likely to fall into this

trap. In the earliest stages, performance is all about
survival, cash resources, and growth. Comparisons
are to last week, last month, and last year. But as
the business matures, the focus has to
move to profi t and the comparisons to
competitors.

It’s easy to spot the need for change
aft er things have gone wrong, but how
can you evaluate your measures before
they fail you? The answer is to be very
precise about what you want to assess,
be explicit about what metrics are as-
sessing it, and make sure that everyone
is clear about both.

In looking for a measure of customer
satisfaction, the British law fi rm Addle-
shaw Booth (now Addleshaw Goddard) discovered
from a survey that its clients valued responsiveness
most, followed by proactiveness and commercial-
mindedness. Most fi rms would interpret this fi nd-
ing to mean they needed to be as quick as possible.
Addleshaw Booth’s managers dug deeper into the
data to understand more exactly what “responsive-
ness” meant. What they found was that they needed
to diff erentiate between clients. “One size does not
fi t all,” an employee told me. “Being responsive for
some clients means coming back to them in two
hours; for others, it’s 10 minutes.”

The point is that if you specify the indicator
precisely and loudly, everyone can more easily see
when it’s not fi t for the purpose. The credit-rating
agencies have come under attack because they gave

AAA ratings to so many borrowers who turned out
to be bad risks. The agencies have argued in their
own defense that lenders misunderstood what the
ratings meant. The AAA rating, they claim, was
awarded on the basis of borrowers’ credit records,
and it described the likelihood of default under
normal market conditions; it did not factor in what
might happen in the event of a massive shock to
the fi nancial system. Reasonable as this explanation
may be, it is no consolation to those who thought
they knew what the magic AAA represented.

• • •

Why do organizations that excel in so many other
ways fall into these traps? Because the people man-
aging performance frameworks are generally not
experts in performance measurement. Finance
managers are profi cient at tracking expenses, moni-
toring risks, and raising capital, but they seldom
have a grasp of how operating realities connect
with performance. They are precisely the people
who strive to reduce judgments to a single ROI
number. The people who understand performance
are line managers – who, of course, are crippled by
confl icts of interest.

A really good assessment system must bring fi –
nance and line managers into some kind of mean-
ingful dialogue that allows the company to benefi t
from both the relative independence of the former
and the expertise of the latter. This sounds straight-
forward enough, but as anyone who’s ever worked
in a real business knows, actually doing it is a rather
tall order. Then again, who says the CEO’s job is
supposed to be easy?

Andrew Likierman (alikierman@london.edu) is
the dean of London Business School, a nonexecutive
director of Barclays Bank, and the chairman of the
UK’s National Audit Offi ce.

Reprint R0910L To order, see page 143.

The moment you choose to manage
by a metric, you invite your managers
to manipulate it.

trap

1524 Oct09 Likierman layout.indd 1011524 Oct09 Likierman layout.indd 101 9/4/09 12:39:36 PM9/4/09 12:39:36 PM

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