To be discussed in class on Thursday 10/3. These notes will not help you do the Excel homework due Wednesday 10/2 at 11 PM. As long as you use cell references for the calculations, particularly in the case of an external competitive market, the transfer pricing part of the homework should not be too difficult.
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For the most part I'm going to use the U of I as model, circa 2004 since I had some awareness of how budgeting worked then, but before I do that, I want to begin with this hypothetical, meant to be humorous.
A spoiled brat kid whose parents are rich is starting college. The parents give the kid $10,000 as spending money during the freshmen year. During the first week in town, the kid manages to find a high stakes poker game, at which he loses the entire $10,000 on one all-in hand. The next day the kid asks the parents for more money since how else will he get through the school year without it. What should the parents do?
Sometimes budgeting makes you feel like a parent with a teenager who is a bit reckless. Other times it makes you feel like Yossarian in
Catch-22.
“Just because you're paranoid doesn't mean they aren't after you.”
Now we'll stop kidding and get into it. Budgeting is typically done on an annual basis. There are two basic types of funding model, and then there can be hybrids of these two. The first is called funding off the top. The second is called cost recovery. With funding off the top, the source of revenue for the unit is from another unit at least one rung up in the hierarchy and maybe several rungs up in the hierarchy. With cost recovery, the unit sells services of some sort to other units on campus. The revenues from sales of the service are the source of funding. Cost recovery is like transfer pricing, with the price at which the unit sells its service the transfer price. The only real difference is that when talking about transfer pricing we consider the transaction between an upstream division that produces an intermediate product and sells that to a downstream division which uses the intermediate product to produce final product for sale on the open market. Recall
this diagram, which we already showed in class. While it is true that cost recovery units are providing intermediate product of some sort, it is probably not right to consider the units that buy from them as downstream, selling their product on the open market. So the analogy only goes so far.
With off the top funding, the budget is typically divided into two pieces. The first is the total earnings of all people on salary in the unit. This is typically a large fraction of the unit's overall budget, roughly 70% or more. The other part of the budget is for everything else - wages for hourly workers, equipment purchases, expenditure on travel to conferences or for bringing in outside visitors or consultants, etc.
The critical thing is to understand how next year's budget depends on this year's budget. The typical approach is for for the campus to have some salary program, say 3%, so the revenues for paying salary are now 1.03 times what they were in the previous year. We will talk about how salary decisions are made in a moment. The non-salary part of the budget remains flat, it is the same as what it was last year. Among the bigger decisions that a unit manager decides is how to allocate salary among the members of the unit. (But not for himself or herself. The unit manager's salary is decided by the person the unit manager reports to.) One way to think of this is to break the salary increase into two components. The first is for cost of living. The second is for merit raises. Note that while often the staff expect a cost of living increase, that is not guaranteed. But it is not possible to lower a person's salary (in nominal terms. If there were high inflation then a salary increase less than the rate of inflation would lower the salary in real terms.) If an employee gets significant merit increases over several years, the person probably is in line for a promotion, which means a change of duties and a bigger bump up in salary. But those must be approved by the campus.
A cost recovery unit has the same approach to salaries, but now has to project future revenue to be able to cover paying staff and their salary increases.
A significant issue is what happens near the end of the fiscal year when: (a) the unit is carrying a positive balance and (b) if it is running a negative balance. Let's talk first about a unit that has no banking function itself. With a positive balance it's use it or lose it or the unit tries to park the money further up in the hierarchy so it can use it in the next fiscal year. If the unit can't park the money, then you'll occasionally observe some odd spending patterns at the end of the fiscal year, purchasing items that would have seemed extravagant earlier. Alternatively, if a budget surplus can be anticipated earlier in the fiscal year, then the money is "burning a whole in the manager's pocket." This enables some creative uses of the funds that are sensible but wouldn't be entertained if not for the budget surplus. Let's turn to the case of a negative balance. In this case the budget needs to be brought to balance somehow, probably out of the budget of the unit manager's boss or even one rung higher than that in organization. Closer to the top, the unit may have a banking function and/or have some accounts that enable banking, while other accounts zero out at the end of the fiscal year.
If the overage is a small fraction of the overall budget, this is no big deal. But what is small or not is likely not specified ahead of time so, like beauty, it is in the eye of the beholder. The manager may be fearful that running a large negative balance will be treated as a black mark at performance review time. In my experience, units typically come in with a small positive balance, on these grounds. Where I've seen large negative balances, there was a structural issue with the budget. The unit had many more obligations than it could meet with available funding. This happens on occasion and is very uncomfortable, but not altogether surprising.
Let me make a little diversion here to illustrate. On our campus at the time I'm referring to the campus had a huge unfunded deferred maintenance obligation, somewhere between $500 million and $1 billion dollars. Performing deferred maintenance is necessary, just as replacing old equipment is necessary. But it is unglamorous so managers with budget authority would cheat on that and fund other things that would give them more credit. Eventually the campus "solved" the problem by having a fee that students pay to cover deferred maintenance. The funds raised with that fee can only be used on a deferred maintenance project. DKH was one of the first buildings to get an upgrade under the new approach. The air conditioning in the building is still not great (it is an old building) but it is much better than it was before they did the project. Getting back to the concluding point in the previous paragraph, if the unit has a large fraction of its expenditure to replace equipment, the funder of that unit may not have allocated the appropriate amount for that purpose. Instead, they will have allocated much less, or even nothing at all. This is passing the buck rather than assuming the obligation. It happens, more often than I care to explain further.
This brings up the next point, which is about sizing a unit's activities (and thus sizing its budget). If it is right sized and the activity level is stable over time, then the off the top funding approach I described above should work reasonably well, though it is possible that inflation on the expenditure items in the non-salary piece can be an issue. On the other hand that means falling prices on the expenditure items would produce a windfall for the unit.
What happens, however, if the unit's activity level is growing as there is more demand for the services that the unit provides? In the off the top model there will be scarcity and rationing of some sort. This gives one explanation why in certain departments students might not be able to get into the classes they want to register for. There simply isn't enough capacity to handle all the demand. If the unit were cost recovery, in contrast, then as the demand was increasing, revenues would be increasing as well, and the unit could afford to add capacity. There may still be near term bottlenecks, but it would be much easier to match the growth in demand to the growth in capacity, so that long term there wouldn't be excess demand. Indeed, the same argument suggest that cost recovery units can shrink when demand is falling off. In contrast, units funded off the top will start to appear as if they have idle capacity or underutilized capacity. Thus, in a dynamic environment where growth or shrinkage can't be forecasted perfectly, the cost recovery approach probably does a better job of matching capacity to demand.
That said, I want to note that in my work I preferred being in an off the top funded unit. To explain why, let's recall at the beginning of the semester we did the Akerlof Gift Exchange model. Gift exchange is how I'd like my units to operate, and it is hard if not impossible to do with a cost recovery approach. So we should note that the funding model does impact the nature of how work is done. Under cost recovery, the unit is more or less like a profit maximizing entity in the business world. That approach may have a place at the university, but the mainstay of what the university does shouldn't be driven by that model, in my opinion. Profit maximizing is anti-collegial.
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I briefly want to touch here on the other role that transfer pricing plays in the world outside the university, which is to impact division profitability and thereby serve as a performance measure of how the division is doing. Such performance measures are often linked to the compensation of the division's executive team. So division leadership may be more interested in division profitability than they are with overall organization profitability. This means that organizations have to balance incentives at the division level with maximizing overall organization profit. The Excel homework does consider this some.
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There is one other way that transfer pricing works for multinationals that is important in actuality, but we won't talk about it in our class. This is to move profit around geographically, from a high tax area to a low tax area. Transfer pricing re-sites the profit so the organization can retain a greater share of it. In other words, even if the economic activity of a company happens in one location, transfer pricing can then be use to "ship" profit to a different location. If this was done to make heavy investments in the destination location, that would be one thing. But if the profits are merely held as retained earnings, then there would seem to be no productivity argument in support of the transfer pricing. As such it looks like pure opportunism, from the point of view of the locality where the economic activity actually takes place and where tax revenues to fund public expenditures would be useful to the community overall. This begins to make the issue sound political. I don't want to bring politics into our class, as the last time I did that it blew up in my face. So I will close here, simply noting that the practice does exist.
