Capacity Management, Decentralization, and Internal Pricing

Capacity Management, Decentralization, and Internal Pricing This paper studies the acquisition and subsequent utilization of production capacity in a decentralized firm comprised of multiple divisions. A central issue in our analysis is whether one or several of the divisions should be structured as investment centers with comprehensive responsibility for acquiring new capacity assets and maintaining existing ones. Ownership of capacity assets may alternatively be centralized, with the provision that the divisions rent capacity from a central unit on a period-by-period basis. The structure of responsibility centers is naturally related to the choice of internal pricing rules for capacity services. We find that an investment center arrangement combined with transfer prices set at full historical cost is efficient if in the short run there is effectively no flexibility in the divisional capacity assignments. In contrast, capacity may be fungible in the sense that even in the short-run the aggregate capacity available can be reassigned in response to fluctuations in the divisional revenues. When capacity is fungible, we identify the advantages of centralized capacity ownership. We also find that under certain conditions a system of negotiated transfer pricing is preferable to cost-based prices because negotiation leads to better coordination of the divisional capacity choices.