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Transfer pricing implementation effects

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Title:
Transfer pricing implementation effects F-16 maintenance efficiency and effectiveness at the Ogden Air Logistics Center, 1988-1993
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F-16 maintenance efficiency and effectiveness at the Ogden Air Logistics Center, 1988-1993
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D'Amico, Robert Joseph
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Denver, CO
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University of Colorado Denver
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English
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xiii, 325 leaves : forms ; 29 cm

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Airplanes -- Maintenance and repair ( lcsh )
Transfer pricing ( lcsh )
Airplanes -- Maintenance and repair ( fast )
Transfer pricing ( fast )
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bibliography ( marcgt )
theses ( marcgt )
non-fiction ( marcgt )

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Bibliography:
Includes bibliographical references (leaves 307-325).
Thesis:
Submitted in partial fulfillment of the requirements for the degree, Doctor of Philosophy, Public Administration
General Note:
School of Public Affairs
Statement of Responsibility:
by Robert Joseph D'Amico.

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ocm37296301
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Full Text
TRANSFER PRICING IMPLEMENTATION EFFECTS: F-16
MAINTENANCE EFFICIENCY AND EFFECTIVENESS AT THE OGDEN
AIR LOGISTICS CENTER,
1988-1993
by
Robert Joseph DAmico
B.S.B.A., University of Denver, 1982
M.G.A., University of Maryland, 1988
A dissertation submitted to the
University of Colorado at Denver
in partial fulfillment
of the requirements for the degree of
Doctor of Philosophy
Public Administration
1996


1996 by Robert Joseph DAmico
All rights reserved


This dissertation for the Doctor of Philosophy
degree by
Robert Joseph D'Amico
has been approved
C. Terry Grant


DAmico, Robert Joseph (Ph.D., Public Administration)
Transfer Pricing Implementation Effects: F-16 Maintenance Efficiency And
Effectiveness At The Ogden Air Logistics Center, 1988-1993
Thesis directed by Professor Franklin James
ABSTRACT
With the current debate about the utility of post-bureaucratic theory, this
dissertation examines whether a post-bureaucratic initiative improved efficiency
by fostering a competitive environment within a public organization. The
problem statement is clear: Will transfer pricing theory help some public
organizations become more efficient without reducing output effectiveness?
This study is significant to the public administration literature because it
offers an analysis of a post-bureaucratic question involving transfer pricing theory
in the public sector which has never before been conducted. Many theory-
building ideas are prevalent in the literature for transfer pricing (Hirshleifer, 1956;
Coe & OSullivan, 1993), competition (Donahue, 1989; Savas, 1992), and the
post-bureaucratic paradigm (Barzelay, 1992; Dilulio, Garvey, & Kettl, 1993).
This dissertation offers insight into some of these ideas.
IV


The study is organized using post-bureaucratic theory as an evaluation of
market-like arrangements within a public organization. It moves toward transfer
pricing theory within the setting of a principal-agent relationship, then the public
adoption of transfer pricing is discussed. A model to help understand the transfer
pricing problem is offered called the Competitive Fiscal Model that is
contrasted with the Non-Competitive Fiscal Model.
The research methodology includes a triangulated strategy of data
collection from financial archives, published sources, and interviews. Data were
analyzed using various financial ratios, regression equations, and content analyses
that rely upon both Yins (1994) and Eisenhardts (1989) case study frameworks.
In general, the findings show that the implementation of transfer pricing
theory contributed toward developing a competitive environment at the test site;
however, control of the transfer pricing process was not developed. While output
effectiveness remained relatively constant, financial analysis shows efficiency
improvements due, in part, to competition generated from implementing inter-
divisional transfer pricing.
The study concludes with a discussion of the implication of transfer
pricing and post-bureaucratic theories to public administration. Implementing
these theories into public organizations is characterized by highly complex,
v


interconnected relationships. Forthrightly acknowledging these complexities is
important for organizations that are considering the adoption of post-bureaucratic
initiatives. Significant organizational changes are required to fully implement
them.
vi
!


CONTENTS
CHAPTER PAGE NUMBER
1. INTRODUCTION................................................1
Background.............................................3
Significance of Study..................................6
Definition of Terms....................................8
Organization of Paper..................................9
2. LITERATURE REVIEW..........................................11
The Post-Bureaucratic Paradigm........................11
Market Failure....................................16
Self-Interested Behavior Motivates an Agent...........17
Transfer Pricing Theory...............................21
The Beginning of Transfer Pricing Theory..........22
Movement Towards Decentralization and
Divisional Structures.............................24
Market Price or Some Cost Derivative..............25
Pricing Policies..................................28
Economic Theory...................................32
vu


Accounting Theory..................................34
Transfer Pricing Applied to Public Organizations.......37
Revolving and Internal Service Funds...............38
Revolving Funds Since 1952.........................41
Special Issues for Transfer Pricing in Public Sector
Organizations..........................................43
Imperfect and Non-Market Situations................44
Calculating Total Cost Is Problematic..............46
Transfer Pricing in the DoD............................48
The Defense Business Operations Fund...............49
Other Factors......................................51
Chapter Summary........................................57
PROBLEM STATEMENT..........................................59
Two Operating Levels of Transfer Pricing...............59
Descriptive Framework..................................60
The Non-Competitive Fiscal Model (NCFM)................61
Role of Transfer Pricing ..........................64


The Competitive Fiscal Model (CFM)
65
I
Role of Transfer Pricing ..........................73
Competitive Fiscal Model and Efficiency............76
Chapter Summary........................................86
4. RESEARCH DESIGN.............................................87
Site Selection.........................................87
Yins Type 2 Case Study................................89
Research Hypotheses....................................92
Research Methodology and Data Analysis.................96
Data Collection....................................97
Variables.........................................103
Establishing Causality............................105
Data Manipulation.................................107
Validity..........................................108
Problems and Constraints..............................110
Chapter Summary.......................................114
i
I
I
ix


5. ANALYSIS
115
Overview of Depot Business.............................115
Overview of Ogdens Business.......................122
Ogden Has Downsized................................124
The Budget Structure at Ogden -
Descriptive Financial Data.............................139
1991 Ogdens First Year of Competition..........140
Chapter Summary........................................163
6. FINDINGS AND CONCLUSIONS....................................165
TP Implementation Efficiency Trends....................166
Implementation of the Competitive Fiscal
Model and Transfer Pricing at Ogden................167
Implementation of the Competitive Fiscal
Model was a One Way Street.........................169
The Policy Change in 1994 Was No Surprise.........172
The End of Public/Private Competition..............178
Inter-Divisional Transfer Pricing..................179
The Transfer Pricing Process and DBOF..............183
Procedures for Devising Cost Data Need Work........189
Lack of Internal Cost Controls.....................193
x


i
I
Efficiency Indicators and Trends at Ogden..........197
Analysis of Ogdens Efficiency Financial Factors...198
Analysis of Other Efficiency Factors at Ogden......209
Output Trends at Ogden.................................233
Professionalism....................................234
Depth of Coverage..................................236
Quality and Timeliness.............................242
F-16 Quality Variables.............................245
Summary of Findings by Hypotheses......................256
Conclusions............................................264
7. IMPLICATIONS FOR PUBLIC ADMINISTRATION......................278
Summary of Findings....................................279
Implementation of Transfer Pricing and the
Competitive Fiscal Model...........................281
Relevance of Findings to Post-Bureaucratic Theory......285
Implications of Findings for the Ogden ALC.............291
Priorities for Future Research.........................297
In Retrospect..........................................299
I
XI


APPENDIX.
300
A. Sample Interview Tracking Sheet.........................300
B. Return on Sales Regression Results......................302
C. Return on Assets Regression Results.....................303
D. Attrition Regression Results............................304
E. Glossary................................................305
BIBLIOGRAPHY................................................307


ACKNOWLEDGMENTS
The author would like to acknowledge several important organizational
and individual contributions to this manuscript. The US Air Force Academy
Department of Management provided both money and other resources, time, and
advice, particularly during the formulation stages of this research. The Defense
Systems Management College also provided funding for part of this study.
Additionally, the US Naval War College provided time and resources during the
concluding stages. All of these organizational contributions were invaluable to
the author.
There were many individual contributions that had major impacts on the
final product. My dissertation committee was especially helpful in directing this
manuscript. The author wishes to thank Professor Franklin James for accepting
the task of directing this research project and Professor Peter deLeon for
providing sage guidance and advice while developing the final version.
Finally, the author offers a warm thanks to the many personnel at the
Ogden Air Logistics Center who spent their valuable time on interviews and a site
visit. Without their support this study would not have been possible.
xm


CHAPTER 1
INTRODUCTION
Competition within the public sector is often postulated as a way to
improve public organizational performance (Savas, 1992a & 1992b; Donahue,
1989). This off-the-cuff assumption that competition can improve efficiency,
however, remains untested. Many popular publications report anecdotal evidence
that supports the contention that competition is the panacea for inefficient
bureaucracy (Shine & Amy, 1993; Hough, 1992). This case study offers an
analysis of this question through transfer pricing (TP) theory.
The purpose of this study is to examine whether the adoption of TP theory
and practices promoted efficiency within the Ogden Air Logistics Center (ALC).
The study of this theory and these practices include the combined effects of
several post-bureaucratic proposals that include: competition within the public
sector; competition between the public and private sectors; intra and inter-
divisional TP; and revolving funds.
This case study offers a descriptive model to evaluate the hypothesis that
one aspect of market-like efficiency within some public organizations can be
accomplished with TP practices. This model is called the Competitive Fiscal
1


Model (CFM) and is developed using a principal-agent framework.1 While TP
has received little attention in the traditional public administration literature, the
movement toward a market-oriented government is encouraging for the adoption
of this innovative fiscal change.
This dissertation uses case study research to develop a framework for
assessing efficiency results related to TP implementation within a large public
organization. The research design is a single case study of TP implementation
that spans over half a decade (1988-1993) and includes multiple perspectives and
units of analyses. The search for factors that influence efficiency was guided by
public administration literature and other evidence. Data sources include personal
and telephone interviews, a site visit, archival records and documentation. The
primary method of analysis is within case comparisons of data sources.
Studying transfer pricing implementation effects is important to help
understand how one aspect of a post-bureaucratic initiative within a public
organization influences overall productive efficiency. Implementation effects
may have integrated impacts on both efficiency and effectiveness within
organizations adopting this innovation. The Ogden ALC was chosen as the study
1 Transfer pricing theory and practices can be viewed as an incentive system among principals and
agents. Principal-agent theory can be used to evaluate the performance gap between principals
and agents caused from information asymmetry. One way to close this performance gap is
through transfer pricing mechanisms.
2


site because it is a large public organization that has implemented TP and uses TP
data for decision making. While post-bureaucratic theory includes many other
organizational initiatives, a case study of Ogdens implementation status and
impacts of TP will provide insight into this theory for academicians.
Background
Within the Congress and Department of Defense (DoD), there has often
been complaints of inefficiency, particularly in the weapons procurement process.
Examples of extraordinary prices paid for ordinary goods are abundant. A toilet
seat that cost $640 and a 4 cent diode that costs $ 110 are both examples that
received Congressional attention in the 1980s (Brown, 1984). Overpricing,
overcharging, and poor management have contributed toward wasted resources.
Excess costs permeate the organization (Gansler, 1980; Kelman, 1990). This
problem has been present for many years, but with the post-Gulf War military
absorbing large budget reductions and the Clinton Administration encouraging
market-oriented government through its National Performance Review (Gore,
1993), now is an important time for the DoD and particularly the United States
Air Force (USAF) to reduce inefficiency to maintain combat effectiveness in the
face of widespread budget reallocations.
3


Improving efficiency within the USAF and other military services is
important to maintain national defense at the least cost to the taxpaying public.
DoD policy has always been directed at getting the most goods and services for
the least amount of money. Minimizing overall costs while maintaining national
defense is an important goal to many perspectives. Finding new and innovative
ways to reduce costs throughout the various functions of the USAF while
maintaining effectiveness is particularly important during downsizing periods.
While this goal of improved efficiency is important, there are impediments
to reaching it. Some of these impediments include: lack of political will (Prager,
1994); lack of competition, autonomous choice, and profit motivation; and the
lack of timely procurement source selection decisions (Kelman, 1990). One
should note, however, that values like an equitable distribution of government
purchases among various disadvantaged groups (like minority-owned businesses)
are relevant governmental goals as well. Prager says the public sector is
inefficient because of ...a lack of political will to establish efficiency as a high-
level priority of government operations (p. 180). He goes on to say that policy
makers de-emphasize efficiency as a goal by not providing management with the
flexibility to pursue efficiency goals and because ...the incentive structure of the
public sector either is neutral toward or even discourages cost savings (p. 180).
4


Meier (1993) claims that efficiency within many public organizations is not even
a relevant goal. However, there are some government activities where efficiency
may be relevant goals, such as government enterprise and internal service funds2
or government corporations3 such as Amtrak, the US Postal Service Corporation,
or the Federal Deposit Insurance Corporation.
The problem facing USAF cost-reduction strategies is two-fold:
increasing efficiency while maintaining combat effectiveness. It is important that
one views these two strategies in tandem, as intertwined and not separate. In
pursuit of the most efficient alternative, combat effectiveness may be
significantly affected. For example, when deciding to buy a new weapon system
rather than upgrading an older one, there may be conflict between a perceived
effectiveness increase and economic efficiency. The way to decrease costs may
be to simply upgrade an older system, but this may not be appropriate, depending
on the perceived enemys threat level, state of technology, and other exogenous
factors.
2 An enterprise fund is a financial structure established to Finance and account for ...the
acquisition, operation, and maintenance of governmental facilities and services that are entirely or
predominantly self-supporting by user charges (Hay & Wilson, 1995, p. 755). An internal
service fund is established to account for ...services and commodities furnished by a designated
department or agency to other departments and agencies within a single governmental unit, or
other governmental unit (Hay & Wilson, 1995, p. 760).
3 Government corporations are federally chartered institutions that serve public functions that are
of a business nature.
5


The focus of this case study will be on efficiency results related to the
implementation of TP and competition; however, combat effectiveness factors
will also be analyzed.
Significance of Study
The implementation effects of TP theory and practices has significance to
the field of public administration. With the important movement occurring from
Webers (1925) classic bureaucratic theory toward a post-bureaucratic paradigm,
theories that help analyze the market-like characteristics of public organizations
are significant contributions to the public administration literature. These
contributions can take many forms. Efficiency improvements attributed to TP
practices fit within the literature as described by Barzelay and Armajani (1992)
and Osborne and Gaebler (1992). Others have entered this growing branch of
public administration (DeWitt et al., 1994; Dilulio, Garvey, & Kettl, 1993; Lan &
Rosenbloom, 1992; Rubin, 1992) as well. Most academic attention has been at
the theory-building level with some testing of hypotheses. For example, Overman
and Loraine (1994) recently tested a post-bureaucratic question relating
information and control within organizations and Coe and OSullivan (1993)
tested the use of revolving funds to uncover indirect costs.
6


Transfer pricing practices within a principal-agent framework are
associated with revolving funds like the Defense Business Operations Fund
(DBOF).4 The usefulness of these theories, and the implementation of market-
like incentives to help improve efficiency in public organizations is attractive and
is receiving increased professional and academic attention as the federal
government encourages market-like behavior (Clinton, 1993; Gore, 1993 & 1994;
Thompson & Jones, 1994).
In short, the case study makes four contributions to the literature. First, it
is the first account of TP implementation effects within a public organization that
spans many years and includes perspectives of decision makers from many
functional areas and hierarchical levels. Second, it offers a descriptive framework
to view efficiency, effectiveness, competitiveness and autonomous choice factors.
Third, it provides behavioral and contextual factors that influence TP. Finally, it
offers a test of part of post-bureaucratic theory the part involving quasi-
marketplace arrangements. Therefore, the unit of analysis, time period under
consideration, linkage to established theory, and development of a descriptive
framework distinguishes this research from previous studies.
4 The DBOF is a DoD revolving fund worth over $80 billion (DoD Comptroller, 1994).
7


The Ogden ALC offers a special case to evaluate TP implementation
because it is a unique organization that has a business orientation and tangible
output -- both are important prerequisites to study post-bureaucratic theory and
the CFM.
Definition of Terms
Before continuing, some definitions are offered. First, a revolving fund
is a public adaptation of TP theory in which an organization provides a service or
good on a cost reimbursement basis. The reimbursed cost is transferred into the
public sellers revolving fund. The service or good can be provided to either a
public or private buyer. Second, transfer pricing theory describes an intra-
organizational arrangement where internal units of a good or service are provided
on a cost-reimbursement basis. The action of an internal organization affects not
only its own performance but also the performance of other internal organizations.
In this analysis, TP implementation means the implementation of competition
within and between public and private sectors using revolving funds. It includes
the CFM, TP and the DBOF as an integrated package.
Third, principal-agent theory describes a relationship between two
parties where a performance gap is caused by information asymmetry on the part
8


of an agent. An agents information advantage may introduce an extra cost to a
principal. The goal of the principal is to minimize this potential cost gap; the goal
of the agent is to maximize self-interested behavior. Fourth, the term cost is
used throughout the paper. Cost, in this analysis, is the sacrifice incurred in
economic activity -- that which is given up or forgone to consume, to save, to
exchange, to produce and so forth. It is the expiration of future benefits used to
produce a unit of output and includes direct labor, direct material and
manufacturing overhead costs. Finally, the terms efficiency and effectiveness
have many meanings. Oftentimes, they are described in terms of inputs and
outputs. In this dissertation, efficiency will be analyzed by looking at multiple
factors such as the ratios of net income to assets (called return on assets) and net
income to sales (called return on sales), overall cost reductions, inventory
management, autonomous decision making and social equity considerations.
Effectiveness will also be analyzed by examining output timeliness and reliability
factors such as aircraft component failures and aircraft mission readiness rates.
Organization of Paper
The remainder of the case study proceeds as follows. The relevant theories
will be briefly examined in Chapter Two. In Chapter Three, the CFM will be
9


introduced as an alternative framework to the Non-Competitive Fiscal Model.
The CFM is an adaptation of TP theory within a principal-agent framework. It
attempts to explain a way to minimize costs between principals and agents within
market-oriented public organizations. Chapter Four describes the case study
research design and methodology used to examine the hypotheses. Chapter 5
provides an analysis and in-depth background of the collected data. Chapter Six
discusses findings and conclusions, while Chapter Seven makes concluding
comments regarding the implications of this study for public administration.
10


CHAPTER 2
LITERATURE REVIEW
This chapter reviews the theoretic literature that is relevant to the central
research question. It includes sections on post-bureaucratic, principal-agent, and
TP theories. The post-bureaucratic theory literatures are centered mainly in the
field of public administration with emphasis on market-like relationships within
public organizations. Both principal-agent and TP theories are pan-disciplinary
with many literature sources in the fields of economics, accounting, public
administration and others.
The Post-Bureaucratic Paradigm
Some modem public administration scholars argue that government
bureaucracy in the 1990s is shifting away from centrally controlled, hierarchical
bureaucratic structures. These classic bureaucratic structures, like Max Weber
(1925) described in "The Theory of Social and Economic Organization," permeate
public organizations. Barzelay and Armajani (1992) argue that government
bureaucracy is moving toward a post-bureaucratic paradigm that is market-
oriented. This shift from classic Weberian bureaucracy toward a post-
11


bureaucratic or market-oriented government organization may be an
organizational shift similar in scope to American cottage industries evolving
toward complex corporations that occurred during the Industrial Revolution
(Johnson, 1975, 1981).
In this new model, they argue that customer satisfaction, quality, service,
and value are key components of government service and that government
competition for work is crucial for providing incentives to public organizations to
become efficient. Barzelay and Armajani outline the shifting paradigm as
including a movement from public interest towards valued results, from efficiency
to quality and value, from administration to production, from control to voluntary
compliance, from enforcing responsibility toward building accountability, and
more.
The post-bureaucratic movement toward market-oriented government is
fueling various innovations within the public sector. For example, Osborne and
Gaebler (1992) discuss the innovative uses of revolving funds in government as a
means for government services to be market-driven, generating profits from their
services, and financing capital expenditures through these stand-alone funds (p.
213-214).
12


The momentum to remodel government organizations with market-like
efficiency is growing. For example, the National Performance Review (NPR),
headed by Vice President Al Gore (1993), made many recommendations to help
government organizations become more market-like. The implementation
successes of these recommendations remain to be seen.5 However, the orientation
toward market-oriented government is observed throughout them. These
recommendations are broken into four chapters. Most relevant to this analysis are
the recommendations in Chapter Two entitled Putting Customers First (p. 8).
The steps for putting customers first, according to NPR, include: giving
customers a voice and a choice; making service organizations compete; creating
market dynamics; and using market mechanisms to solve problems. These goals
that are designed to put customers first are targeted toward specific government
agency recommendations.
Jones and Thompson (1994) discuss market-oriented government
specifically in the Pentagon and DoD. Their book introduces various change
agents to use in improving the efficiency and effectiveness of the DoD. These
change agents are centered on organizational structure relationships between the
5 The GAO estimates that no recommendations from the NPR have been implemented
(GAO/GGD-94-203R).
13


military services and Secretary of Defense, and accounting and budget changes to
help reform and streamline operations. According to Kronenberg (1995), Jones
and Thompsons book
...is more about the nature of public administration and the way
long-term institutional processes and complex systems of
incentives, affecting both public and private sectors, have produced
a deep structure of decision making that resists both reform and
understanding (p. 251).
The last chapter of their book calls for quasi-market and quasi-investment center
operations to improve efficiency within the DoD. Creating incentives to
maximize cost-effectiveness with competition and private sector capital budgeting
is the crux of their argument. Kronenberg critiques Jones and Thompson for
...neglect(ing) any intellectual obligation to consider that the
quality of combat forces may be affected-some say contaminated-if
the motivating logic of organized action is profit seeking and
resource optimization (p. 257).
By way of contrast, classic bureaucratic theory involves rigid bureaucracy
characterized as having division of labor, work specialization, distinct rules and
regulations, and formalized administration (Weber, 1925). This bureaucratic
structure does not encourage optimal incentives to produce market-like efficiency.
Some of the sub-optimal incentives include: customers required to use specific
government suppliers of goods and services; revenues earned through politically
14


established budgets rather than voluntary market activities; little inter-
organizational competition for business; and workers jobs and fixed salaries
protection regardless of output.
There are surely many different definitions of the terms and debates about
the utility of efficiency and efficiency analysis when examining government
activities. Stone (1988) critiques the usage of efficiency in policy analysis saying
...[tjrying to measure efficiency is like trying to pull oneself out of quicksand
without a rope. There is no firm ground (p. 53). Meier (1993) defines it as
...delivering goods and services at the least possible cost (p. 4) and concludes
that efficiency ...is essentially an untestable proposition (p. 4).
Fischer (1995) discusses the debate between efficiency and equity saying:
This debate ... has proven to be anything but academic....America
is often said to face a crisis of values. The very solutions to these
deeply entrenched problems often raise questions more about the
configuration of social and political values underlying
contemporary society than they do about technical matters
regarding policy design and program implementation.
Thus...policy evaluation can be seen as addressing only part of the
problem.... (p. 9)
However, Fischer (1995) caveats his argument about efficiency by cautiously
acknowledging its utility in policy analysis:
The fact that efficiency has often been misused to further the
interests of particular groups over others does not vitiate its
fundamental importance in the realms of organization and policy.
15


Instead of rejecting technical knowledge as an ideological ploy in
the struggle for control, as is often the case in literature of the
political left, the critical task is to restrict such instrumental
knowledge to its proper role in the organization and evaluation of
action (p. 225).
Efficiency in the context of this manuscript will be used to describe an improved
allocation of resources through minimizing the total cost of a unit of output
(Brewer and deLeon, 1983). It will, however, always attempt to balance its
limited instrumentality with other perspectives.
Market Failure
Any movement toward post-bureaucratic theory underscores the purpose
of government activities and their relationships with markets. The reasons that
citizens demand government services and a sizable government revolve around
market failures. Citizens demand government services for goods they cannot
provide for themselves or purchase in other markets. Government growth since
the early 1900s reflect an increased demand for services that markets fail to
provide (Hyman, 1990). The relative mix between government provided services
and those provided by the private sector is a delicate balance.
16


The introduction of post-bureaucratic initiatives with an orientation toward
quasi-markets within government environments opens possibilities for evaluating
market failures. Specifically, one of the rationales for government activities,
according to Hyman (1990), is the ...effects of market transactions on third
parties other than buyers and sellers (p. 72). In other words, government should
intervene in producing goods or services in those activities that affect a third party
to the transactions. Some government transactions between and among public
and private buyers and sellers may influence third parties. Third parties that may
be affected by such transactions include principals and agents within public
organizations, or citizens, who are sometimes considered the principals within
government activities.
Self-Interested Behavior Motivates An Agent
The crux of principal-agent theory as it relates to government
organizations is, as Arrow (1964) shows, the notion of agents acting in their own
self-interest. This self-interested behavior occurs because principalis cannot fully
monitor agents' behavior and because of information asymmetries. The Founding
17


Fathers acknowledged the potential impacts of self-interested behavior on our
system of government.6
According to Kaplan and Atkinson (1989), principal-agent theory is a
"theory of the firm and of economic equilibrium with private information" (p. 11).
Principal-agent theory primarily addresses the contractual relationships between
principals and agents that exist within an organizational framework where the
principal is an actor who plays a role as internal customer, buyer, or superior in
some way. The agent is an actor who plays the role of internal supplier, seller, or
subordinate in organizational interactions. It is a theory of optimal organizational
design.7
Principal-agent theory tries to determine the optimal method to motivate
agents to act in the best interest of the principal, despite strong self-interested
behavior. Because principals do not have full information about agents'
performance, principals often institute control mechanisms to monitor them.
6 James Madison understood the importance of controlling self-interested behavior: If men were
angels, no government would be necessary. If angels were to govern men, neither external nor
internal controls on government would be necessary. In framing a government which is to be
administered by men over men, the great difficulty lies in this: you must first enable the
government to control the governed; and in the next place oblige it to control itself. A
dependence on the people is, no doubt, the primary control on the government; but experience has
taught mankind the necessity of auxiliary precautions. (Madison. Federalist Paper No. 51, circa
1787. in The Federalist Papers. New York: New American Library, 1961, p. 332.)
7 In post-bureaucratic theory, the principal can also be viewed as citizens because they are the
superior stakeholders within government activities. The agents can be considered those people
who are implementing various government policies.
18


Arrow (1964) addresses principal-agent theory and TP usage within large
organizations as control mechanisms he offers TP as an incentive system to
solve the problem of control.
Although Arrow (1959, 1964), Jensen and Meckling (1976), and Lynn
(1994) do not directly discuss principal-agent theory within government
organizations, one can envision how a principals or agent's self-interested
behavior can adversely affect performance in these organizations. In classic
bureaucratic theory, principals do not always (indeed, do not always want to) have
full information and cannot always observe their agents perform public duties.
Incentive systems within government organizations may not be adequate to
minimize an agent's self-interested behavior. For example, fixed salaries and job
security based more on seniority rather than performance quality may not
encourage behavior that maximizes a principal's interests. According to Jensen &
Meckling (1976), organizations should develop incentives or implement operating
rules to minimize self-interested behavior because the divergence of interests
between principals and agents is, theoretically, an avoidable cost.
Donahue (1989) argues that the public is the principal for government
when privatizing various government functions. He discusses the agency
relationship as:
19


...[consisting of] the reliance of a principal upon an agent with an
agenda of his own. The agency problem is the difficulty, in all but
the simplest such relationships, of ensuring that the principal is
faithfully served and that the agent is fairly compensated (p. 38).
He describes two relevant dimensions when considering establishing
principal/agent relationships with the private sector. These dimensions are
financial and performance. The financial dimension refers to the choice of paying
for a good or service individually or collectively through a form of taxation. The
performance dimension refers to the question of whether goods or services should
be produced by a government or private organization.
Much of the literature on principal-agent theory is difficult to directly
apply to either public or private organizations because few perfectly competitive
markets exist and marginal cost is extremely difficult to measure. Marginal cost
is relevant in this discussion because it is the extra cost incurred from making a
business decision. The performance gap between principals and agents has a cost
associated with it. This cost is theoretically marginal cost in a perfect market
setting. Lynn (1994) concludes his discussion of principal-agent theory by
heralding it as a credible framework for thinking about organizations despite its
quixotic nature:
The use of conceptual frameworks delineating agency problems to
study the incentive effects of goals is surely a better basis for
20


advising practitioners than ideologically-justified advocacy of
performance measurement (p. 32).
Dilulio (1994) redefined principal agent theory during the closing plenary
session at the Berkeley Symposium on Public Management Research. In short, he
described several instances where agents performed with outstanding results
despite incentives not to do so within federal bureaucracies. He argued that public
agents do not necessarily try to maximize their own self interest. Instead, many
agents give much of themselves in pursuit of public service. He calls this
relationship between principals and agents principled agents. Within the CFM,
principled agents may be able to reduce production costs simply by making these
costs known to decision makers and workers. However, all public organizations
may not have principled agents. Therefore, organizational incentives may be
required to improve efficiency. Of course, this is an endless debate; not all public
agencies have self-serving principals and agents; not all public agencies have self-
sacrificing ones either.
Transfer Pricing Theory
Much of the literature on principal-agent theory discusses incentive
compensation systems between principals and agents. As Arrow (1964) shows,
21


there are many formal and informal contractual relationships between principals
and agents on many organizational levels. This framework need not be limited to
"operating" rules that attempt to monitor and control agent behavior. Promoting
organizational efficiency by reducing the divergence in self-interested behavior
between principals and agents is the crux of this theory. One principal-agent
relationship that may help government organizations become more efficient is TP
theory. Just as the theoretic nature of markets deals with an equilibrium level of
supply and demand caused by external buyers and sellers, Arrow (1964) argues
that these same invisible forces occur within organizations. It is within these
internal markets that TP plays a role between principals and agents. These
internal markets exist in both private and public organizations.
The Beginning of Transfer Pricing Theory
Kaplan and Atkinson (1989) describe the importance of TP:
...the actions of an individual unit affect not only its own measure
of performance but also the measures of other units. For example,
when goods or services are transferred from one unit to another,
these goods or services are frequently priced in order to recognize
revenue for the supplying unit and an input-factor cost to the
purchasing unit (p. 538).
22


Because some organizational units affect the performance of other units, the
methods used to determine prices for transferring intra-organizational goods and
services is important. Transfer prices can be used to "regulate transactions within
firms" (Arrow, 1964, p. 404) just like in exogenous markets.
Eccles (1985) offers a comprehensive study of TP theory. He discusses
TP and traces the beginning to approximately 100 years ago. In 1901, Henry
Sidgwick published his theory of the exchange value of material products. He
suggested that TP within organizations be treated like any other market
transaction and that the price charged for internal transfers of products be at
market price. When Sidgwick developed his theory, most firms were
manufacturers of a single or very narrow product line. Because of this narrow
product focus during the late nineteenth and early twentieth centuries, Sidgwick
concluded that TP had insignificant consequences to most firms (cited in Eccles,
1985). During this same time period, many large industrial firms were already
using inter-divisional TP policies designed to evaluate the efficiency of
decentralized divisions (Kaplan, 1984; Johnson, 1975, 1981).
23


Movement Towards Decentralization and Divisional Structures
During the late nineteenth and early twentieth centuries, the simple,
narrowly-focused manufacturing firms were evolving from simple to functional to
modem, divisionally structured corporations as part of the Industrial Revolution.
These divisionally structured organizations could generate higher profits because
of greater productivity and lower costs associated with "administrative
coordination" (Chandler, 1977, p. 6) and economies of scale. As manufacturing
organizations increased in complexity with different product lines, these firms
began vertically integrating with their suppliers and distributors to increase
profitability (Johnson, 1975).
This vertical integration and product diversity encouraged centralized
control through a functional organizational structure (Chandler, 1962).
Organizations were also integrating and diversifying into new product and market
areas. Despite this increasing complexity of organizational operations, centralized
control of the firm kept owners focused on overall organizational profits.
Transfer pricing in this period was simply accomplished by tracking material and
labor costs of producing goods (Kaplan, 1984). As organizations became
increasingly more complex, the centrally controlled, functionally structured
organizations started to become more cumbersome and organizations began
24


moving into more decentralized structures (Chandler, 1962). The manufacturing
divisions of multi-product organizations were formed as stand-alone organizations
with a manager responsible for daily control of output. These stand-alone
divisions, often called profit centers, reported directly to corporate headquarters.
This early decentralization of running the daily operation allowed corporate
managers to concentrate on overall strategic planning and integrative activities
between divisions rather than be distracted by the daily operations of the business.
Organizations continued to increase in complexity throughout the twentieth
century which prompted top management to decentralize even more control in
divisional managers. Because of this ever-increasing complexity caused by the
expansion of business enterprises through mergers and consolidations, the
significance of internal transfers began to increase (Johnson, 1981).
Market Price or Some Cost Derivative
Transfer pricing theory as developed by economic and accounting
scholars, centers around two general pricing policies: market price or some cost
derivative. The argument for using market price as a pricing policy within
organizations parallels Arrow's (1964) discussion on organizations having their
own internal markets. Arrow and others recognized that perfectly competitive
25


internal markets were difficult to find and devised alternative pricing policies for
non-market conditions caused by information asymmetry, uncertainty, and more.
Chandler (1962) shows that the DuPont Powder Company, General
Motors Corporation, Standard Oil Company, and Sears, Roebuck, and Company
created multi-division organizational structures in the early 1900s. In 1921, the
DuPont Powder Company decided to use market price for inter-divisional
transfers because market price helped managers to evaluate divisional return on
investments. This company was one of the first organizations to recognize the
importance of TP in increasingly complex organizations.
In 1927, Donaldson Brown addressed the significance of using market
pricing as a TP policy. He advocated this policy because it allowed corporate
managers to assess divisional performance through measurements of return on
investment. He discussed the importance of being able to measure the return on
investment between divisions because he was concerned that non-market pricing
for internal transfers would conceal inefficiencies. Brown was the first to offer a
formula for measuring return on investment that is still widely used today and is
commonly referred to as the "DuPont method" (Homgren & Foster, 1991, p. 884).
Brown also evaluated the difficulties that arose from using market price as a
method to evaluate internal TP. Furthermore, Brown thought that most divisions
26


had few external customers. This oligopsony market is not perfectly competitive.
In this case, Brown argues that the buyer determines the market price. Because
market pricing is dependent on a equilibrium level of supply and demand, the
amount of autonomy that each selling and buying division has is an important
aspect of TP policy (Eccles, 1985, p. 18).
Camman (1929) discusses the differences between using actual production
cost and market price in TP theory. But Camman's discussion clearly showed his
preference for using production cost in TP within organizations. In short, the
advantages of using market price, according to Camman, are its usefulness in
judging managerial performance, calculating make or buy decisions, and
measuring the return on investments within a division. But the disadvantages of
using market price were not viewed as inconsequential. These problem areas
include bickering between management on determining market price, inadequate
incentives for the selling division when market price does not provide enough
profit margin, the bias caused by divisional profits competing with overall
corporate profits, and the buying division's lack of knowledge of transferring costs
(p. 37). In these early theories, the debate on which method to use when
transferring goods within a corporation was bipolar: market price or actual
production cost. Cammans article, one should note, does not discuss the
27


advantages and disadvantages of using market price in the context of perfectly
competitive markets. Instead, he uses alternative pricing policies as an integral
part of an internal management information system.
Pricing Policies
Zimmerman (1995) says there are currently four general pricing policies
used in establishing a TP: market price, negotiated price, variable cost, and full
cost. The advantages and disadvantages of these strategies will be briefly
described below. In short, there is no single best TP policy. Rather, a TP policy
is situationally dependent and opportunity-based (Zimmerman, 1995; Homgren
and Foster, 1991; Kaplan and Atkinson, 1989).
First, given a competitive external market for a good, the product should
be transferred at the external market price. If the supplying subunit cannot make a
profit at the external price, then the organization would be better off not producing
internally and should instead purchase in the external market. Market price
presumably permits the correct make or buy decision, but market price is not
necessarily the right price. There are other factors to consider. For example,
internal transactions occur within firms because internal supplying is cheaper than
buying in external markets where there are interdependencies among costs, profits
28


or products. As interdependencies become more pivotal, they reinforce the need
for internal production and at the same time reduce the ability of the external
market price to reflect accurately the opportunity cost of producing inside.
Alternatively, it is often the case that a good or service purchased from an external
supplier is not identical to the good produced internally. This situation reduces
the ability of market price to serve as an accurate TP. Additionally, even when
there are less costly goods or services in the external market, producing internally
may still make sense if the timeliness of supply, quality control and proprietary
nature of the good or service are relevant factors.
Second, negotiated TP is a fairly common practice for internally produced
goods and services. However, it has significant drawbacks such as being time
consuming and resulting in conflicts among subunits when trying to establish a
TP. In public organizations, negotiated TP are legislatively established and
stabilized to be consistent with the annual budget process. Additionally, the
process may be politicized to suit various agendas. Negotiated TP can have either
positive or negative impacts on efficiency, depending on how closely the price
covers opportunity cost and who is burdened with paying unrecovered costs.
Third, if no external market exists or there are large interdependencies that
distort the value of a market price-based TP, then variable (or marginal) cost may
29


be used. Oftentimes, the optimum TP for decision making is opportunity cost
(whether that is market price or variable cost). The TP is measured by what the
producing division forgoes when it produces the last unit and transfers it to the
buying division. The cost of making the decision to produce this extra unit is
referred to as opportunity cost. When an external market exists, the opportunity
cost to the seller of transferring one more unit is the market price forgone by not
selling externally. The sellers fixed costs will not be covered and are not part of
the opportunity cost of selling to a buyer. In short, when there are no external
markets the only relevant cost for decision making when at idle capacity is
variable cost. As in the other TP strategies, variable cost also presents problems.
For example, if all of a selling subunits output is internally consumed, then
revenues will only cover variable costs and will not cover fixed expenses. Thus,
the seller would appear to be losing money. Another problem has to do with
production volume. Establishing the variable cost of producing extra units may
not be constant throughout production. That is, as production increases, variable
costs may similarly increase because of paid overtime, having to rent extra
equipment, and more. Transferring a non-standard TP based on variable
production levels complicates decision making. Furthermore, any TP policy that
involves calculating variable cost creates an incentive for the selling managers to
30


classify costs as variable. Since variable cost analysis tends to be discretionary,
resources are dissipated as managers arbitrate over the various cost terms and their
application. To avoid these sorts of disputes, more objective TP policies, such as
full costs, are often used.
The last TP policy, full costs, is popular among many firms because it is
simple and seemingly objective. It results in better control because it does not
provide managerial incentive to reclassify fixed expenses as variable. But
decision making is worsened by using this strategy because the buying unit may
purchase fewer units at the full cost price. Additionally, full cost distorts decision
making because it does not represent the opportunity cost to the firm of producing
and transferring one more unit internally. Furthermore, full cost allows the
producing unit to transfer all of its inefficiencies to other subunits that purchase its
goods or services. With a full cost TP, the selling subunit has no incentive to be
efficient because it can recover all of its costs. This problem can be reduced if the
buying unit can purchase externally as well, thereby forcing the selling subunit to
remain competitive.
31


Economic .Theory
The idea of evaluating TP policy using an economic framework, with the
goal of optimal resource allocation, is useful when assessing TP theory in
government organizations. While most private organizations consider the optimal
transfer price as being the one that maximizes overall corporate profitability,
government organizations do not have that same goal. Rather, governmental
organizations do concern themselves with optimal resource allocation. Selecting
the best pricing policy varies with an organizations overall goals and ability to
track internal costs accurately. The internal markets within government
organizations are often oligopolies and oligopsonies, rather than perfectly
competitive.
The efficient allocation of resources in markets is the general focus of
economic theory. Therefore, when one considers intra-organizational activities as
having some market-like characteristics that regulate supply and demand, price
and quantity, and buyers and sellers, economic theory has a place in academic
literature for TP. Transfer pricing can be viewed in terms of the allocation of
intra-organizational resources across organizational divisions with the goal of
maximizing profits.
32


Arrow (1959, 1964) discusses TP theories in environmentally uncertain
organizational settings. Hirshleifer (1956), however, was the first economist to
evaluate TP with economic theory. He essentially approached TP as a marginal
analysis problem. Hirshleifer showed that market pricing was the optimal method
of allocating resources when the transferred good was traded in a perfectly
competitive market. Perfectly competitive markets can be characterized as
having, according to microeconomics:
1. A large number of buyers and sellers, each acting independently and
having little influence on supply and demand
2. Identical goods and services
3. Full information about alternatives and prices
4. Unrestricted entry and exit (Thompson, 1988, p. 235)
In non-market transactions, however, Hirshleifer says the optimal TP policy is
marginal cost. For example, a non-market transaction could be government
supplied national defense. There is no market to regulate supply and demand,
therefore market price cannot be used as a method of transferring the price of this
service from the federal government to the general public. In this case, the cost of
producing one more unit of defense, if it could be measured, should be the price
charged to the general public.
33


More recently, Besanko and Sibley (1991) conclude that TP should be set
to minimize total cost because of the effects of information asymmetry (p. 56).
Hirshleifefs theoretical framework provided much academic discussion on TP;
but applying his ideas proved idealistic because in actual practice there are few
perfectly competitive markets and calculating marginal cost is extremely
problematic within organizational settings.
i
Accounting Theory
Economic theory used to describe TP was focused on optimal allocation of
resources through intra-organizational pricing policies. Optimal resource
allocation within government organizations is an important notion. Accounting
theory, on the other hand, used to describe TP is focused on maximizing overall
corporate profitability through pricing policies. In other words, the goal of
I
improving resource allocations is to increase profitability. In classic bureaucratic
theory, profitability is unimportant to government organizations; instead,
i
t
efficiency and effectiveness are important measures of success. But in market-
| oriented government, profitability can be important when organizations act like
! independent, stand-alone units, like profit centers, that "earn" their revenues and
i
34


make capital investment decisions similar to private organizations (Osborne &
Gaebler, 1992).
Transfer pricing research conducted by accounting scholars has diversified
well beyond simple market price and actual production costs as pricing policies.
Alternative TP policies include market price, marginal cost, incremental cost plus
fixed fee, full cost, dual rate transfer prices, and negotiated market-based prices
(Kaplan & Atkinson, 1989). These TP policies have various advantages and
disadvantages. Choosing the optimal pricing policy varies with the nature of an
organization's internal and external markets. Kaplan and Atkinson (1989) use
Solomons' (1965) framework as a guide to select the optimal TP policy.
Solomons (1965) was among the first researchers to adapt accounting theory to
Hirshleifer's economic theory. Solomons developed a grid to help determine
which TP policy to use in five different situations (pp. 198-205). The situations
he described varied from perfectly competitive markets to varying degrees of
imperfect internal and external markets. Benke and Edwards (1980) also
developed different TP policies to use in different market situations. These
authors, however, thought profit maximization was not a golden rule to drive all
decisions. Instead, as long as profit was maximized in most situations,
35


performance measurement was important to consider when establishing TP
policy.
Other accounting scholars also recognized the potential profitability
effects of TP policies in imperfect market and non-market transactions. For
example, Anthony and Dearden (1980) advocated using market price when those
prices are available and, like Brown (1927), advocated the position that selling
divisions must have the autonomy to trade internally or externally. The notion of
intra-organizational sellers having the autonomy to choose internal or external
buyers is important to counter oligopsony markets.
Keegan and Howard (1988), Kaplan and Atkinson (1989) and other
present day academicians write about issues important to consider in TP. Transfer
pricing policies often are used to charge the cost of goods consumed within an
organization to manufacture a finished product. However, charging the cost for
services within private or public organizations has received relatively little
attention in the literature. Keegan and Howard discuss modem TP that involves
services rather than tangible products. They point out that TP for services
involves a number of challenges and principles, detail the problems and offer
several process changes to help improve TP within service areas. Keegan and
Howard also include survey results gathered from half of the top 148
36


manufacturing companies in the US. The survey results showed that TP was used
widely throughout those manufacturing firms, that most firms used some
negotiated price between buyers and sellers, and that the idea of transferring the
cost of services was new to them. The application of transferring the cost for
services has good potential in government organizations because they have a large
service orientation. Internally transferring the cost for government services has
already occurred in some organizations.
Transfer Pricing Applied to Public Organizations
Transfer pricing theory normally applies to private firms and helps
organizations make internal resource allocation and profitability decisions. The
public adaptation of TP theory is through publicly created fund accounts called
"internal transfer funds" or "revolving funds." Barzelay and Armajani (1992) say
there are two kinds of revolving funds: internal service funds and enterprise
funds. These two types of funds differ in one pivotal area ~ the customer.
Enterprise funds sell their government products and services to external customers
while internal service funds sell their products or services to internal customers (p.
141). Like Anthony and Dearden (1980) and Brown (1927), Barzelay and
Armajani (1992) advocate the importance of sellers to supply both internal and
37


external customers to reduce oligopsonistic effects in public organizations using
revolving funds. This expanded customer base may improve the competitive
framework in markets and reduce the ability of the public buyer to control prices.
Revolving and Internal Service Funds
Revolving funds are public adaptations of TP theory and represent efforts
to promote market-like efficiency within government agencies. Ideally, buyers of
a publicly produced good or service may be both internal government
organizations or external private customers; however, many principal-agent
relationships within government are limited to intra-government activities.
According to Hay and Wilson (1995), Internal Service Funds (ISFs) are
activities that produce goods or services to be provided to departments or
agencies of a governmental unit, or other governmental units, on a cost-
reimbursement basis ... (p. 295). Barzelay and Armajani (1992) describe
revolving funds more generally as being established when the public can benefit
by providing a statewide service from a centralized agency. With revolving
funds, the buying public unit is charged for the use of a centralized service. These
charges, Barzelay and Armajani argue, are based on pre-established rates; rates
should be sufficient to cover all operating costs and generate enough revenue for
38
I


future capital investments and reduced rates. The act of establishing rates,
though, may seriously impede theoretical equilibrium within markets. When
revenues earned through collecting rates do not cover total costs, then costs must
be reduced, rates increased, or deficits covered by a third party. Operating losses
are allowed to be carried into follow-on years.
Barzelay and Armajani (1992) include a discussion of the advantages and
disadvantages with revolving funds. They show that market-like pressures should
encourage efficiency and the success of organizations designed under this concept
should be evaluated by their ability to "sell" products and services to other
government agencies through voluntary actions. Barzelay and Armajani go on to
offer a comprehensive explanation of the advantages and disadvantages of
revolving funds summarized below.
The principle advantage is that revolving funds provide efficient allocation
of scarce public resources (as Hirshleifer and others pointed out). Other
advantages include:
- marketplace factors encourage self-interested behavior that is
compatible with public organizational goals of maximizing
scarce resources
- use or avoidance of publicly produced goods or services provide
officials with information about the need for government
activities
39


- these funds are responsive to changes in customer needs
- customers become more cost-conscious
- public organizations can make return on investment and other
efficiency related decisions based on market conditions (Barzelay
and Armajani, 1992)
Revolving funds, however, do not come into government usage without some
drawbacks. Among the drawbacks include:
- political misuse of revolving funds in government activities not
appropriate for these funds
- less legislative control (as Hay points out)
- cash flow needs must be monitored because activities need to be
funded from the revolving fund (Barzelay and Armajani, 1992).
Overman and Boyd (1994) critique Barzelay and Armajanis post-
bureaucratic recommendations as essentially being best practices research, and
not possessing enough academic rigor. Frederickson (1996) also critiques
Barzelay and Armajanis work for omitting ...[ijssues of replication, verification,
and peer review (p. 268).
Revolving funds incorporate some of the features of a government
corporation and some of the features of conventional public production. Like a
government corporation, the producer operating through a revolving fund prices
its outputs and relies primarily on revenues from sales to cover production costs.
40


But despite that business-like feature, revolving funds resemble conventional
public production because they rely on labor employed directly by the
government and are unable to borrow in private credit markets (Mikesell, 1995).
Revolving Funds Since 1952
The use of revolving funds is not new. Instead, it is an idea that is
receiving increased public attention. The Office of Personnel Management
(OPM) established a revolving fund in 1952 to manage the costs of security
background investigations for various government agencies. As the central
government agency to control background security investigations for granting and
periodically updating security clearances for government officials, OPM receives
funding on a cost reimbursement basis for background checks from government
agencies requesting the service. In establishing the fund, Congress required the
General Accounting Office (GAO) to provide a report of OPM activities every
three years. In a report of revolving fund activities from 1983 through 1986, the
GAO discussed some of the operating principles of OPM's revolving fund.
Authors of this report said that if profits are generated from OPM's background
investigation service, then these profits should be returned to their customers, that
prices should be "...based on the estimated cost of these services" (GAO/GGD-87-
41


81, 1987, p. 2), and that three years (at the GAO urging) was the amount of time
that the revolving fund could operate at a loss. Additionally, financial limits on
the amount of surplus and deficits in the revolving funds were bounded.
For example, ...retained earnings for the investigations activity
should range from a surplus of $2.5 million to a deficit of $1.0
million. If retained earnings deviate from these standards, OPM
now requires that plans be developed in writing for bringing
retained earnings back within the standards (GAO/GGD-87-81,
1987, p. 2).
Clearly, the tone of the GAO's report is centered about legislative control.
According to Steiss (1982), too much organizational control limits initiative and
encourages self-interested behavior. OPMs revolving fund as established
through 1986 is not allowed to work with market-like efficiency. Neither profit
nor competitive incentives exist within this internal market and prices are not
market-driven. OPM is the sole supplier of security background investigations
and most customers are from other government organizations. OPM's managers
are restrained by the surplus and deficit controls as well as their inability to retain
any surplus revenues to make other investments that would improve their service
or reduce their costs. More recently, President Clinton has planned to privatize
OPMs role. In short, this revolving fund appears to provide little incentive for
improved allocation of resources.
42


Special Issues for Transfer Pricing in Public Sector Organizations
Transfer pricing theory as viewed by economic and accounting scholars
investigates optimal resource allocations and profitability in private organizations.
Alternative TP policies vary with the nature of an organization's internal and
external markets. These markets can be perfectly competitive, imperfect, or
involve non-market activities. Governmental organizations face the same market
conditions and pricing dilemmas. However, TP policies used within government
organizations do not vary with market conditions. Instead, legislators often
establish transfer prices with fixed rates between government units in an effort to
control expenditures more carefully. Sometimes government organizations use a
cost method to transfer prices. For example, the DoD uses its revolving fund to
encourage market-like efficiency in some support organizations. This revolving
fund uses transfer prices based on an actual cost per unit of output (The Defense
Business Operations Fund. 1993). However, calculating an accurate unit cost per
output is difficult.
Not all academic scholars advocate using market price or the actual cost of
producing a good or service as a TP policy. Hay and Wilson (1995) argue that the
prices charged by revolving funds should be less than market price to justify their
43


existence. But at the same time they say the revolving fund managers must be
able to finance plant and equipment upgrades from the fund (p. 298). Revolving
funds should also pay for labor, material, and all overhead costs. Raising money
for capital investments requires some surplus charges over full cost and retained
earnings. This implies that some price inflation over cost, but less than market
price is warranted. When government organizations can compete in perfectly
competitive markets and without their profit incentive, there may be a bias in this
market that favors the government supplier. In other words, government
organizations must sell enough of an appropriately priced good or service to
ensure that total revenues minus total costs equal zero. Private organizations,
however, must sell their goods or services to ensure that total revenues minus total
costs are greater than zero to earn a profit. Additionally, government suppliers
may be able to gain advantages by mixing productive assets between market and
non-market activities, thereby receiving additional advantages.
Imperfect and Non-market Situations
Cook (1955), Gould (1964), Abdel-Khalik and Lusk (1974) and others
applied Hirshleifer's economic theory to TP. These theorists concluded that
problems using marginal cost as a basis for TP in imperfect markets, like in the
44


public sector, existed. They also point to the inherent pricing problems that cause
markets to be less than perfectly competitive because of informational
discrepancies influencing market price.
Besanko and Sibley (1991) wrote about modem TP and applied economic
modeling to non-market settings. This modem theoretical economic look at TP
specifically addressed the issue of improving resource allocation in non-market
settings. They conclude, like Ronen and McKinney (1970), that organizations
should create an internal market for the transferred good and charge the selling
division a tax or subsidy to make the transferred price equal market price.
Hof and Rideout (1993) take the discussion of TP toward a quantitative
analysis of cost allocations among joint projects in an environment where cost
information is uncertain. Joint projects include multiple organizational units
supplying resources or participating in the output of some other unit. They use
the framework of defining core limits in assessing joint cost allocations. These
"core limits" (p. 402) are defined as alternative costs and separable costs; they
represent the functions maximized in quadratic program equations. Hof and
Rideout conclude that alternative and separable cost considerations are necessary
to prevent inefficient and inequitable rewards between buyers and sellers.
45


Calculating Total Cost Is Problematic
The total cost of producing a unit of output is often difficult to measure in
public organizations. Total cost includes the direct costs of labor and material as
well as the indirect costs of overhead expenses. The direct cost of labor and
material is easy to count when compared with a unit of output. Overhead costs,
on the other hand, are difficult to allocate to a unit of output. These costs include
supervision, utility bills, depreciation expense, health and retirement costs, and
more. In private organizations, these expenses are allocated to a unit of output or
distributed based on a cost driver such as labor hours per unit. In classic
bureaucratic theory, however, measuring total costs is particularly troublesome.
Many government organizations have difficulty identifying a meaningful unit of
production. For example, how does one evaluate a single unit of output for a
police officer? Is it by measuring arrest rates? Crime rates? Mean time to
respond to a complaint? Or, is there some other meaningful indicator?
Additionally, capital assets are not normally depreciated, and manpower and other
personnel benefits are centrally managed. Many of these overhead costs are
transparent to public managers.
Coe and O'Sullivan (1993) studied the use of TP in municipal
governments. Their study focuses directly on internal service funds used to
46


account for indirect costs within government organizations. These indirect costs
include, for example, the number of miles driven on government vehicles, central
stores charges based on the actual cost of goods taken out of inventory stocks,
data processing based on usage time, and more. Their study shows much of the
difficulty with utilizing TP within government organizations -- like establishing
actual cost that captures many indirect expenses. They proposed that cost
accounting data, as captured through TP, be used to make production efficiency
comparisons. Additionally, they state that a cost accounting system is necessary
to track the costs of maintaining, repairing, and replacing equipment. Coe and
OSullivan conclude that ...more effort should be made ... to understand the
mechanics and value of indirect costing (p. 63). Government organizations often
are service oriented. Much of the difficulty shown by Keegan and Howard (1988)
in establishing TP within service companies can be observed in Coe and
O'Sullivan's study because many indirect costs are for services, rather than goods.
These services are provided by one subunit of an organization to another subunit.
Out of 237 respondent cities with populations between 25,000 and 499,000 only 2
had used TP to account for services. Coe and OSullivan also plea for more
research on indirect costs: ...scant research exists on the practices of accounting
for indirect costs (p. 59).
47


Transfer Pricing in DoD
Templin (1994) examined three theoretical approaches to understanding
the buyer-seller relationship within the DoD. Specifically, he looked at economic
ffee-market theory, transaction cost economics and systems theory. He critiqued
the economic free market theory because it ignores legal, political, socio-
economic and other relevant aspects that enter the ffee-market environment.
Transaction cost economics explains optimum cost-effective contracts for
transactions and is considered useful in understanding the nature of various
contractual relationships involving the DoD. Templin spends a large amount of
his research discussing the applicability of systems theory because it explains the
degree of interdependence between buyers and sellers systems. His study is a
descriptive analysis of these three theoretical approaches to buyer-seller
relationships and he builds upon Ganslers (1980 & 1989) studies. The buyer-
seller relationship most applicable to this study, however, is manipulated and
controlled within the DoD revolving fund.
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The Defense Business Operations Fund
The Defense Business Operations Fund (DBOF) is a large revolving fund
used by the DoD to encourage market-like efficiencies within DoD organizations.
In Fiscal Year 1993, this revolving fund was worth about $81 billion and included
such diverse support functions as supply management, distribution, depots, depot
maintenance, transportation, base support, and much more. The operational
forces in the DoD are typically the buyers of support activities available in the
DoD. Like markets, the customers are important in determining the quantity of a
good or service demanded. Unlike markets, however, internal prices of these
goods and services are not market driven. Instead prices are set to ensure that
DoD organizations break-even without making any profit (The Defense Business
Operations Fund. 1993).
Calculating total costs to help establish transfer prices in the DoD is
enhanced by a budget innovation called "Unit Cost Resourcing" (UCR). UCR
represents an organizations total cost of producing one unit of output. Transfer
prices are set at calculated unit costs and prices are adjusted yearly based on the
amount of cost shortfall or surplus generated from producing its good or service
(Unit Cost Resourcing. 1993).
49


Calculating unit cost requires organizations to identify the total costs for
producing a good or service. Total cost includes:
...the direct costs, indirect costs, and allocated G & A [general and
administrative] costs. Total costs will eventually include
depreciation expenses, amortization, depletion of natural resources,
and prepaid expenses fUnit Cost Resources. 1992, p. 12).
Once total costs are quantified, units of production must be measured to calculate
the cost per unit of output. Devising unit costs through total production cost
calculations is an ideal goal, but problematic in practice. Calculating costs for
material, labor, and other indirect costs like overhead requires accurate estimates
of these variables. Estimating the value of indirect variables like overhead is
complex because many of these costs cannot easily be traced to a unit of output.
Additionally, the DoD presently has no cost accounting system to track these
costs. The accounting system now in use within the DoD was devised to track
government expenditures. According to the Secretary of the Air Force's Financial
Management Office"... there is a real limitation in the ability of the Air Force
accounting system to measure total cost" fUnit Cost Resources. 1992, p. 27).
Academic literature on revolving funds is scarce and shows little research.
A study of DBOF that would assess its ability to promote market-like efficiencies
could test Hirshleifer's model within government organizations. Barzelay and
50


Armajani (1992) describe the optimum use of revolving funds where the sellers
and buyers act as private parties with the ability to buy from or sell to private or
public organizations. The DBOF, although promoted to encourage market
efficiencies, is not really organized like a private sector TP system. Instead,
legislative controls on rates, revenue and loss limitations, and even potential
buyers and sellers may introduce biases into this market. These biases may result
in less efficient government organizations because the incentives of competition,
market based prices, and profit motivations are not present.
Other Factors
There are many factors and incentives that may influence the efficiency of
o
public organizations. Post-bureaucratic market initiatives within government
may be one factor. However, there are other factors that enter into the efficiency
equation. These other factors include, but are not limited to, changes in
production technology, privatization, legal constraints, social equity
considerations, and impacts on effectiveness. For example, values like an
equitable distribution of government contracts for procured goods are relevant 8
8 Indeed, finding any one factor or incentive that greatly contributes to efficiency improvements
may be impossible to isolate in real social settings.
51


goals and make a purposeful trade-off with efficiency decisions. This subsection
will briefly highlight some of the most common factors and incentives, such as
privatization, social equity, and effectiveness.
Privatization: Privatization is ...enlisting private energies to improve the
performance of tasks that would remain in some sense public (Donahue, 1989, p.
7). There are many tasks that public organizations, and the DoD in particular,
perform in house including vehicle and aircraft maintenance, financial
management, medical care, fire fighting, and security. Many of these tasks, while
still essential to overall output, could be performed by the private sector. For
example, [0]ne study conducted by the Center for Naval Analyses examined the
percentage of time that ships were free from mission-degrading failures in
equipment. It found no difference between ships maintained in the public and
private sectors (Keenan, 1994, p. 7). One way to reduce costs would be to
outsource those activities that could be performed by the private sector more
cheaply than by making the goods or services in house. Not all functions could be
privatized, but many functions could be privatized to reduce infrastructure costs.
Privatization is already occurring within many DoD functions. For example,
janitorial functions are often performed by private contracts rather than military or
52


civilian defense employees, and some maintenance functions of newly acquired
defense hardware are privatized.
Caveats about mission critical functions must be considered in making
privatization decisions. Kettl (1993) argues for more privatization, but cautions
against the privatization of core functions. The goal of reducing costs has
evolved toward providing the best service for the best price. At the same time, the
DoD must guard its ability to maintain critical core skills and resources required
in times of national emergencies. The DoD is moving towards purchasing private
sector products and processes where possible. This shift from militarily unique
products and services will both increase military access to the national industrial
base and support the growing trend towards privatization of public sector services,
both in this country and abroad as the political, military and industrial worlds
change (Savas, 1992b).
Social Equity: There is truly a rich literature base discussing the
relationship between equity and efficiency spawned by the new public
administration movement. This relationship has been studied and debated by
Marini (1971), Waldo (1971), Frederickson (1971), Stone (1988), and many
others. According to Brewer and deLeon (1983), equity ... measure[s] how fairly
53


a service is distributed among various target groups ...unmet needs (p. 337).
They go on to say that ...equity involves two types of measurable criteria: the
percentage of a group needing service that actually receives it and the variance
among groups in the quantity of services received (p. 337). Equity, according to
Hyman (1990), is judgment about the fairness of an outcome (p. 67). Denhardt
(1993) discusses the efficiency versus equity trade-off. Equity, he says,
...involves a sense of fairness or justicespecifically, the correction of existing
imbalances in the distribution of social and political values (p. 130). Denhardt
sums up the new public administrations goal of ...at least [a] complementary
basis for the study of public administration (p. 130) including values of social
equity in addition to rational efficiency.
Effectiveness: Light (1993) defines effectiveness as ...what is best for
government (p. 204). In his book Monitoring Government, effectiveness is
discussed in both organizational and dollar terms. In organizational terms, he
discusses effectiveness as including organizational independence, staff size
increases, and gains in stability and certainty within dynamic political
environments. In terms of dollars, he discusses effectiveness criteria such as
financial waste. Effectiveness, according to Meier (1993), ...is determined by
54


whether or not the bureau achieved the policy goals stated for it by other policy
decision makers (p. 132). Meier discusses effectiveness in the context of
organizational competence. Effectiveness, along with timeliness, efficiency and
reliability are major organizational competency factors to be considered within
public organizational structures. Brewer and deLeon (1983) describe
effectiveness as ...a ratio measure relating observed output to the planned output
over some time period (p. 338). They counterbalance this definition with the
interplay of effectiveness and efficiency. In general, Brewer and deLeon caution
about evaluating efficiency without also looking at organizational effectiveness,
and vice versa. They also make a special distinction between outcome and
effect when evaluating policies. In short, the time horizon between an outcome
and its effect occurs over a given period. Effectiveness evaluation should include
the effects of the changes over this time period and, they say, it complicates policy
evaluation.
Light (1993) offers several measures of effectiveness. These measures
include: professionalism, depth of coverage, and quality. Light defines
professionalism as to ... set minimum standards of performance against which to
measure compliance (p. 204). Measurement of standards compliance, in Lights
model, represents the extent of professionalism. Gordon (1992) discusses several
55


elements of professionalism in public service. These include a common entrance
examination, systematic recruitment efforts and a career emphasis. This trend in
professionalism has led to the requirement for more objective personnel rules and
regulations, direct and indirect connections with institutions of higher education in
local communities, and the development of a system of administrative positions
over the last four decades.
Depth of coverage is another variable used by Light to assess
effectiveness. In this sense, he used depth of coverage as a ratio of inspector
generals to overall employees as an effectiveness criteria. Specifically, Light used
ratio analysis to measure effectiveness with ratios including total inspector staff to
total employees and total inspector staff to total agency budgets. He then
compared the ratios between various federal agencies and assessed their impacts
on inspector general manning policies across federal agencies.
Light also used quality as an effectiveness variable to measure output. His
measurements are designed to look at the characteristics of selective outputs
within various government agencies. Specifically, he looked at the rate of
indictments to convictions within inspector general audits in the federal
government. For example, approximately 250 of the 300 indictments for fraud,
56


waste and abuse within the DoD resulted in convictions in 1989 (Light, 1993, p.
211).
Chapter Summary
The review of literature that helps examine whether the adoption of TP
theory will promote efficiency within government organizations shows two
distinctly different TP purposes: use as a regulator of internal market transactions
or as part of a management information system. Most of the literature analyzed
for this paper discusses the purpose of TP theory as a regulator of internal
markets. One of the goals of TP theory is to improve resource allocation within
organizations. In other words, will the use of TP theory help government
organizations become more efficient in terms of decreasing costs, increasing
output, or both is the question?
The central question that this study analyzes, will the implementation of
TP and competition within government organizations promote efficiency, still
needs to be answered. Very little academic attention is given to TP theory within
government organizations. With the movement toward market-oriented
government, the answer to this question is both timely and relevant.
57


Transfer pricing theory within a principal-agent framework describes a
market-like arrangement within private organizations and in some public
organizations. RevoIving funds are a public adaptation of TP theory. The
Competitive Fiscal Model (explained in Chapter 3) using TP theory as a way to
regulate operations within an Air Logistics Center may help to understand the
relationship among public and private buyers and sellers. Much research has been
conducted on principal-agent and TP theories in the private sector. However,
comparatively little research has been conducted in the public sector. Studies that
test hypotheses related to TP and efficiency would be significant contributions to
the public administration literature.
58


CHAPTER 3
PROBLEM STATEMENT
Two Operating Levels of Transfer Pricing
Transfer pricing, in this case study, has two organizational levels in
operation: intra- and inter-divisional. Intra-divisional TP refers to a cost
reimbursement system instituted within an organization that transfers the cost of
internally produced goods or services. Costs are transferred between various
functions within an organization in order to provide incentive for the subunits to
identify inefficiencies. Inefficiencies may be revealed by comparing internal
transfer prices with external market prices for equivalent goods or gauging
internal customers willingness to purchase such goods.
On the other hand, TP can operate on another organizational level. This
other level will be referred to as inter-divisional TP. As Arrow (1964) suggested,
organizations can be viewed as sub-organizations within themselves. TP has a
role between these sub-organizations. These sub-organizations can be considered
as separate organizational divisions that produce goods or services, and are often
financially independent from their parent organization. Intra-divisional TP occurs
within divisions. Inter-divisional TP refers to the cost transfers of goods or
59


services between divisions of a parent organization. Inter-divisional TP can occur
at a sales prices that replicates market price, total cost or some negotiated transfer
price. For example, inter-divisional TP may occur within the DBOF between the
DoD parent organization and its divisions or individual military services.
However, to get an accurate sales price for inter-divisional TP, internal cost
knowledge is required. Accurate internal cost information can come from an
intra-divisional TP system.
Competition within public organizations can be initiated when an inter-
divisional TP is used. Competitive relationships can be established by attaching a
sales price to publicly produced goods or services and selling them to other
organizations. An intra-divisional TP would make pricing goods more accurate
and provide managerial decision makers with important cost information about
production that may otherwise not be available. Knowledge of this cost
information may then be used to create incentives to improve efficiency within a
given division.
A Descriptive Framework
A competitive model for the public sector may help public organizations
minimize costs and become more efficient. For public sector employees to have
60


proper incentives to minimize costs, a framework is needed to encourage this
behavior. This framework can be called the Competitive Fiscal Model (CFM).
This model will be contrasted with the more typical, non-competitive, classically
budgeted public organization.
Figure 3.1: Non-Competitive Fiscal Model
S: Private Seller(s)
Pa: Public Agent
Ps: Public Seller
Pg: Public Good
Pb: Public Buyer
The Non-Competitive Fiscal Model fNCFMI
Before discussing the CFM, a model that describes classic government
fiscal actions will be discussed. The Non-Competitive Fiscal Model (NCFM)
Internal Government Market
61


consists of a public organization with a public buyer (Pb), public seller (Ps),
private seller (S), public agent (PJ, and public good (Pg). In the NCFM, the Pb,
having a need for a good or service, submits a request for the needed product or
service to a government public agent (PJ. The Pa could be a contracting officer,
procurement specialist, source selection representative, or other resource advisor
depending on the nature of the Pg. The Pa arranges for the purchase of the product
through Ps or S. The Pb in many instances pays nothing. In other instances, Pb
pays Ps or S whatever price is negotiated by Pa. In these other instances, the Pbs
budget is reduced during the fiscal year by the amount of the purchase. For
example, in the DoD, office equipment is normally purchased from a
commanders annual budget in this way. However, if a commander needs
transportation service from the centralized transportation organization, he or she is
provided the service at no charge. The Ps receives funding for the provided
service from its budget. In this case, the Pb never knows the cost associated with
the transportation request. The level of service provided (supply) by Ps is driven
by Pss budget rather than Pbs requirements (demand).
In the NCFM, there are few incentives to minimize cost by the Pb or the
Ps. The Pb has little control over expenditures because of a legislatively
established budget authority that must be obligated by the end of the fiscal year
62


and stringent legislative controls. In many cases, the Pb neither knows the full
cost of a product or service nor fully captures the total cost of operating his or her
organization. This model, however, does offer strong checks on expending public
resources since the budget authority does not involve hard cash, the products or
services undergo various reviews during the Pa selection process, and there is
always a form of rationing resources. The NCFM places a high social value on
control and accountability of decision makers. In the USAF, for example, if a
major Pb like Air Combat Command (ACC)9 has a need to upgrade F-16 aircraft
avionics packages, there are both competitive and non-competitive aspects to this
transaction. The avionics upgrade, in terms of hardware or software, will be put
out for bids from private sellers (S) in the defense industry. During the source
selection process, a contractor will be selected to manufacture the upgrade. Once
the avionics products are ready for installation, the F-16s would normally be
modified with the new avionics package at another USAF organization like the
Air Logistics Center (ALC) in Ogden, Utah (Ps) which is funded from a
centralized USAF source. The amount of money that the ALC charges to modify
the F-16s is unknown to the Commander of ACC because the job order is
9 Air Combat Command (ACC) is a USAF Major Command with 133,232 military and civilian
personnel and over 2000 aircraft (Mehuron, 1995).
63


centrally funded at the Pentagon. The jets are modified, the ALC receives its
funding through its budget authority and ACC receives the aircraft when
completed.
In this example, in theory, there exists little organizational incentive for
the ALC to deliver a high quality product or to minimize cost. In fact, it is
conceivable that cost minimization may be undesirable at the ALC because
savings may result in lower budget authority next year if funds are not spent in
other places. Weimer (1992) says:
...public executives have an incentive to spend appropriated funds
rather than return them to central budget agencies. Why return
surpluses when doing so conveys information about costs that may
result in lower budgets during the next fiscal year? (p. 142).
The customer is primarily concerned with the effectiveness of the avionics
upgrade because that affects ACCs combat readiness. Therefore, service quality
is an issue; however, cost per F-16 modification is irrelevant to ACC and is not
normally disclosed.
Role of Transfer Pricing
There is a role for TP in the NCFM as an information system. Two
situations in the NCFM warrant discussion. First, in classically organized public
64


organizations, there exists no mechanism to foster competition between public
and private producers. In these classic organizations, budgets are appropriated
through political processes and funds are allocated based on the priorities of Ps
rather than from the demands of Pb. In this situation, inter-divisional TP often has
no role within classically budgeted public organizations. Second, in some public
organizations, intra-divisional TP could be used without a competitive
environment as a way to increase information to decision makers to make better
choices. In this situation, increased information could lead to better decision
making.
There are potential benefits of implementing intra-divisional TP within
organizations described in the second situation. TP information and incentives in
the NCFM could both be valuable. Better information about the cost of
alternatives may help organizations make more efficient choices. Oftentimes,
decision making occurs with less than full information. TP could help decision
makers with choices by providing relevant cost information about production
processes. Moreover, more information may help narrow the information
asymmetry between principals and agents. Furthermore, if an organization using
the services of another unit must pay or transfer funds to the other unit, an
incentive to conserve resources may be created naturally that is not present
65


without TP incentives. These potential benefits exist whether or not there is
competition. Furthermore, other incentives such as bonuses, job performance
accountability, and revolving fund arrangements between other public
organizations may intensify efficiency improvement endeavors.
Figure 3.2 Competitive Fiscal Model
Autonomous Choice
B: Private Buyer
S: Private Seller
The Competitive Fiscal Model fCFfvD
An alternative model of fiscal management in parts of the public sector
may be designed to encourage more market-like efficiency by focusing on cost
66


minimization10 while still maintaining output effectiveness. Remember,
efficiency in this model is generally defined as the ratio of inputs to outputs
(Brewer and deLeon, 1983, p. 335).11 The model consists of an internal and
external marketplace including public buyers (Pb), public sellers (Ps), private
buyers (B), private sellers (S), a public good (Pg), and autonomous choice.
In the CFM, the internal marketplace consists of few Pb and Ps. As long as
decision makers choose to make purchases through their internal marketplace with
few Ps, there is little fiscal incentive for Ps or Pb to minimize costs because some
costs are out of their control. In many public organizations, managers neither
know nor account for the costs of their operations. However, if we broaden the
options to Pb and Ps by allowing them both the autonomous choices of finding
other Bs and Ss in the external marketplace, that is tempered by reasonable levels
of oversight to suppress individual corruption, in combination with other
incentives, efficiency may be enhanced. When Pb has a need for goods or
services, having the choice to buy from one of many Pss or Ss will help Pb see the
decision costs. Simply making decision makers aware of unit costs may decrease
overall costs (Eldenburg, 1994). However, other incentives may be required.
10 Specifically, cost minimization refers to decreasing the cost of goods sold (COGS) or services
provided for a constant level of output.
11 Inputs and outputs can be measured in widely differing ways. For example, financial or
production data, labor factors, timely job completion and other factors can be used.
67


Proper incentives to reduce costs by Pb might include paying bonuses based on
overall profits12 or allowing Pb flexibility in how the savings are spent in terms of
personnel or capital assets. Revolving funds may be excellent financial tools to
facilitate these incentives. Money could be spent on producing a good, surpluses
or deficits at the end of the year would be known, and if managers were allowed
flexibility in how surpluses were allocated or held accountable for the deficits,
efficiencies might be realized. Methods to implement this idea have been
proposed by various researchers. For example, Biller (1976) proposed the use of
savings banks to allow managers to keep some proportion of cost savings.
Weimer (1992) suggested the use of a Swiss bank approach as a way of keeping
savings invisible to legislators and others who control budgets. This approach
would allow, Weimer said ...[public executives to] have an incentive to secure
discretionary funds and contribute to deficit reduction because they could do so
without immediately revealing exploitable information to the central budgeting
agency (p. 142).13
For Ps to become more efficient and cost conscious, introducing
competition into its life may be an important incentive. However, this simple
Where PROFIT x(p v) f and x = the number of units produced and sold, p = the sales
price per unit, v = the unit variable cost and/ = total fixed costs (TFC).
13 Alternatively, Painter (1994) argued that strong constitutional checks and balances on public
agents outweigh any concern for efficiency or profitability.
68


model introduces many biases. For example, as long as a Ps has a guaranteed Pb,
regardless of the quality or cost of its product and a guaranteed revenue level in
the form of an annual budget, then a Ps may not be properly encouraged to be
efficient. Additionally, if a Ps has only one Pb as its customer, then the Pb may
force down the price charged by a Ps when using a revolving fund arrangement.
Furthermore, a Ps can minimize costs at various levels of output when there are
14
economies of scale because total unit cost decreases as units of output increase.
Without the ability to find other Pbs or Bs to maximize production capacity, cost
minimization may never occur. Because of this, a Ps may also need the autonomy
to find other Pbs and Bs. By having the autonomy to find other customers, a Ps is
encouraged to minimize costs to compete with other S.14 15
Using the same example as above, one can look at the CFM. Once again,
if the ACC Commander wants to modify the avionics packages on F-16s, the
modification request is submitted. But instead of empowering Pa to make his
selection decision, the ACC Commander would keep that decision close to him or
her. The contracting official would solicit bids from private contractors in the
14 This occurs because the Total Unit Cost (TUC) is lowest when TFC is spread over the largest x.
TUC=(uvc+ufc) where wvc=unit variable cost and u/c=unit fixed cost.
15 If a Ps is allowed flexibility in spending the money that remains after sales revenue minus total
costs is calculated, then even more incentive may be present to a Ps to be efficient than in the
NCFM.
69


defense industry just as before. The winner in this selection process would make
the modification to the avionics boxes. ACC would pay for the boxes from its
revolving fund by transferring the funds (as a function of sales price) to the
contractor. But the competition does not stop there. The ACC Commander
would then decide who should actually modify the airplanes with the new
avionics equipment. Under the NCFM, an ALC, if within its capability, would
automatically get the job, regardless of the price, quality, or timeliness of the
product. However, under the CFM, competition would occur again. ALCs could
bid for the F-16 job, but so could the Lockheed Martin Corporation that
manufactured the jets, a US Navy (USN) aircraft repair facility, or any other
public or private firm that so desired. Now the ACC Commander must once again
choose the best supplier for a given cost, quality level, timely completion and
more. He or she has a strong interest in the cost of this modification because it is
paid from a revolving fund. If the cost is too high for the increased capability
from the new avionics, the upgrade could be abandoned. Or, if it is important to
combat effectiveness and worth the price, the F-16s could be modified.
Prager (1994) points out that there are other non-financial incentives to
encourage efficiency. From the Ps side, cost minimization can be encouraged by
competing with the Ps or S. If the Ps cannot generate enough revenue to stay in
70


business because it is not cost competitive, then its incentive might simply be to
maintain jobs by decreasing costs and increasing output.16 But for the process to
be fair, the ALC also should be allowed to bid for work from other customers, like
Delta or Trans World Airlines. Within Ogdens landing gear function, for
example, the technical expertise and equipment are already in place to repair or
modify all military and civilian aircraft landing gear. Without this choice, ALCs
ability to compete would be limited. The ALC could not profitably use its excess
capacity to minimize costs. However, when a Pb can compete only for public
workloads, a competitive environment can still be established. In this case, cost
minimization, theoretically, can never be achieved; but, cost reductions (and
greater efficiency) can still occur.
Two key aspects of this model warrant explanation. The first is the
important use of a revolving fund and the second is the idea of autonomous
choice. First, notice in the examples that the use of a revolving fund was needed
as a financial tool to allow cost savings to accrue and be carried forward between
fiscal years.17 Also, revolving funds allow for the cost transfer between
16 Some public organizations may still receive contracts despite not being the best" suppliers. In
these cases, having internal suppliers available during war may outweigh efficiency concerns.
The DoD refers to these cases as core requirements. This will be fully discussed in Chapter 5.
17 Alternatively, funds could be allocated each year, as they are now, but with a different
allocation scheme.
71


organizations for goods or services. This application of TP in the public sector
may help organizations make efficiency decisions. Revolving funds already exist
in many public organizations. The DoDs revolving fund has existed since 1991
(DoD Comptroller, 1994). The CFM relies upon the use of revolving funds to
make full costs known and to transfer those costs between and within the public
and private sectors. Once costs are known, other incentives may be necessary to
encourage selecting the least cost product or service for a given level of output.
As Arrow (1964) pointed out, these incentives must minimize the gap between the
principals and agents caused by an agents self-interest and asymmetrical
information. For example, in this analysis the ACC Commander is the principal
and ALC workers are the agents. The ACC Commander wants the job completed
at the highest quality for the cheapest price. The ALC workers want to earn a
paycheck, but only they know if they are creating the best quality or cheapest
product given their private knowledge of individual outputs.
Second, the idea of autonomous choice is important for the model to
encourage efficiency. Both Pb and Ps need the power to make autonomous
choices. This will introduce competition into the internal marketplace and help
maximize productive capacity. Competition may help Ps become more cost-
efficient and Pb more aware of the cost of its products or services. However, the
72


best alternative may not always be the least cost or the most efficient. Social
equity considerations may be overriding values in some situations.
Kettl (1993) recently analyzed the public-private relationship. He issued a
warning about cooperative competition in government and said that markets are
not a substitute for governance. Instead, government needs to be a smart buyer
as the level of imperfections in the market increases. Uncertainty is a huge
problem within government and competition is not a panacea. Competition
...[could] not always tell the government just what to buy, could not prevent
conflicts of interest, and could not inform the government about just what it had
bought (Kettl, 1993, p. 202).
Role of Transfer Pricing
The role of TP in the CFM is important as both an information and
incentive system. As an information system, intra-divisional TP provides
organizational decision makers with information about output that is neither
known nor revealed within the NCFM. TP information highlights the cost of
internal sub-processes. Knowing these costs may help decision makers make
meaningful judgments about those sub-processes to improve efficiency by
reducing overall costs. These internal sub-processes may be eliminated, modified,
73


or expanded based on knowledge of their costs and contribution to end products
or services. Historical patterns of cost can be collected and analyzed to help
improve processes and various statistical measures of cost controls may be
recorded.
As an incentive system, intra-divisional TP may provide decision makers
meaningful incentives to improve efficiency that are not in place with the NCFM.
This incentive system revolves around an organizations ability to know costs of
sub-processes. Knowledge of internal sub-production costs can become useful
measurements of managerial effectiveness. Decision makers may be rewarded
based on their ability to control costs (rather than their ability to acquire a large
budget allocation). Alternatively, if they are held accountable for cost control
within their units, then incentives to maintain jobs and promotions may be
achieved. This new measurement methodology with the CFM and TP provides
another dimension in which managerial effectiveness can be evaluated. In short,
TP as an information system within the CFM centers on measuring and tracking
internal production cost data. TP as an incentive system centers on the usage of
that information to foster organizational improvements and for managerial
accountability.
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Inter-divisional TP requires the pricing of goods regardless of cost
information. This pricing activity allows goods to be bought and sold within
some type of quasi-market arrangement. Intra-divisional TP allows for better
pricing decisions because of specific production cost information. However, the
CFM can still be implemented with only an inter-divisional TP process by using a
market or negotiated price. Neither one of these pricing schemes require accurate
cost information. Inter-divisional TP can allow for competition between divisions
of organizations, such as competition between the military services as divisions of
a larger DoD parent organization. Within this competition between divisions, the
sales price of goods and services can be exchanged in quasi-market arrangements.
Additionally, as a market price or negotiated price is created for inter-divisional
transactions, this same price can be used to sell goods or services to private firms.
Implementing both the CFM and TP offers the opportunity for public
organizations to foster competitive relationships that may help improve
efficiency. In organizations with a developed cost tracking mechanism, intra-
divisional TP usage as both an information and incentive system may be useful to
reach market-like efficiency. In organizations without such a system, inter-
divisional TP usage alone may still provide strong competitive incentives that
help to improve production efficiency. Managerial information provided by TP,
75


coupled with accountability incentives for decision makers to improve their
organizations, may help organizations price their goods and compete in market
transactions. However, existing public sector financial and budget systems are
frequently not prepared to face these tasks.
In short, the CFM can work, as a minimum, with inter-divisional TP and a
revolving fund. Prices must be charged for goods and services, and money must
change hands among organizations or parts of organizations. Intra-divisional TP
is not necessary for CFM but can facilitate it, by providing budget information
and discipline for the inter-divisional pricing and sale of goods and services.
Intra-divisional TP may also help make the organization more efficient and
competitive.
Competitive Fiscal Model and Efficiency
The relationship between and among Ps/S and P[/B in the pursuit of
creating a product requires incentives for improvement in production processes.
In the private sector, incentives might include an overall profitability increase
caused by reduced production costs. However, this classic incentive is
normally unavailable to public sector organizations. The CFM is one public
sector organizational relationship that attempts to use competition and TP to
76


provide incentive for improvement. The model relies upon pricing units of output
in order to bid for work with other public and private sector organizations. Unit
cost knowledge can also be used as an information and/or incentive system and is
important in estimating an accurate sales price for goods and services. Public
organizations do not customarily attach a sales price to goods or services they
produce. The CFM requires this information for meaningful competition within
markets. Intra-divisional TP as a means to track, transfer and account for sub-
process costs within a revolving fund is one way to understand this cost
information. It can also provide a meaningful incentive to hold decision makers
accountable for efficient production. Alternatively, the model could use sales
price as a mechanism (without cost knowledge) to foster competition between
sectors. However, this mechanism has other confounding effects. Estimating a
sales price based on managerial intuition eventually requires managers to account
for the cost of their output with policy makers. This accountability would be
difficult without cost information.
Maximizing productivity by charging the cost to produce a good to Pb or B
may also help lower costs and thereby increase efficiency because as production
output is increased, average unit cost declines. This is true because fixed costs are
allocated over more units of output. For example, if a company has the annual
77


productive capacity to make 100 widgets with a sales price of $5 each, but only
can sell 50 widgets in a year, then total revenue would be $250 at the end of the
year. With hypothetical fixed costs of $ 100 for utilities, building and equipment
expenses, and a variable cost of $2 for each widget produced (including the direct
cost of labor, materials and manufacturing overhead), the total cost to produce the
50 widgets would be $200 ($100 variable cost for the 50 widgets and $100 for the
fixed costs). The average cost per widget would therefore be $4. For each widget
sold, this hypothetical firm would earn $1 in profits. Now, if the managers of this
firm could innovatively sell their widget to any buyer they choose, then they may
be able to make and sell 100 widgets during the next year. When selling 100
widgets, the total cost of producing them is $300 ($200 variable cost for the 100
widgets and $100 for the fixed costs). The average cost per unit would now only
be $3. The firm could double its profit per unit (Sales price of $5 less $3 total unit
cost). Total revenues would be $500 with total profits increasing from $50 when
making only 50 widgets to $200 when making 100 widgets. As shown in this
simple example, maximizing productive capacity is a critical component in having
an efficient production process. 18
18 Productive capacity is an accounting term that describes the total amount of economic demand
that can be satisfied by an organization. Current production output is the amount of economic
demand satisfied by an organization at a given time.
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Other incentives, besides TP to bolster competition, may still be required
for production improvements. Some of these other incentives may include legal
changes, new budget systems, changes in production technology and more. For
example, legal incentives for production improvements could include regulatory
changes that standardize cost accounting and financial information systems within
public organizations. Currently, Generally Accepted Accounting Principles
(GAAP) and Cost Accounting Standards (CAS) do not discuss a standardized way
to transfer costs or trace indirect costs to individual job orders. Moreover, there
are no legal mandates for internal auditing within public organizations to ensure
that costs are accurately attributed to specific job orders. When TP is used as an
incentive system to hold decision makers accountable, a fair and objective
measurement standard must be established. Additionally, new budget systems
that allow public organizations to track revenues and expenses by job order may
also intensify the incentives for productivity improvements. Furthermore,
improved production techniques that eliminate non-value added processes and
incorporate new production equipment both could contribute toward efficiency
improvements.
79


Unit Cost Knowledge. In order for the CFM to be fully implemented,
public organizations must understand the cost of producing their goods or
services. This is necessary for meaningful competition between the sectors
because cost information should drive the sales price of a good or service. Cost
data include many facets of production inputs such as labor, material and
overhead costs. It also requires recognizing budget transfers as revenues
between Ps, Pb and B when a good or service is sold for the established price.
Furthermore, there are many meaningful activities that influence overhead and
general and administration costs, such as the management of funds owed to a Ps or
S (called accounts receivable) and holding costs associated with the management
of inventory required to produce a good or service. An organization that can
identify its costs can focus on those activities providing value added benefits to
the production processes and those which do not. Additionally, by truly
understanding ones cost structure, more competitive sales prices can be
established for goods and services.
Efficiency. Efficiency in this manuscript will be measured in many ways.
The CFM attempts to describe complex relationships between various
stakeholders in public and private organizations. An analysis of these
80


relationships will necessarily be complex. For this reason, various methods of
evaluating efficiency will be addressed. However, they will generally take the
form of input over output measurements. These measures will include financial,
accounting, and other variables which are briefly discussed below.
Financial and accounting measures of efficiency may include various costs
of production, balance sheet and income statement data, and ratio analyses.
Spending patterns for capital equipment used to produce goods and services, and
success in acquiring new job orders when operating under competitive guidelines
may all reveal insights into the effects of competition. Particularly, production
improvements can be analyzed with these financial data.
Other efficiency indicator variables connected to the model may include
autonomous decision making powers for public managers,19 maximizing
productive capacity, changes in production technology, and more. Internal cost
controls and management emphasis on cost reductions and cost milestones may
also provide insight into the relationship between public and private organizations
within a competitive environment. Analysis of external and internal quality
19 Autonomous decision making can be an incentive to improve efficiency because autonomy
could allow public managers to independently decide the source of various suppliers, for example,
without being encumbered with rules and regulations that force more costly alternatives upon
them. Autonomous decision making in selecting customers, such as from the private sector, to
maximize productive capacity could also increase efficiency as economies of scale are achieved.
81


control, product reliability, and maintenance and performance rates would help
evaluate the nature of Pg.
Conceptual Issues Affecting Efficiency. Analyzing efficiency within the
CFM with financial variables highlights two issues for concern. These issues
involve the difference between appropriated funds and budgetary revenue earned
through winning contracts, and asset level measurement. In the NCFM, budget
appropriations are referred to as revenues. They represent funds allocated to a
public organization to create output. In the CFM, budget appropriations still
represent revenues. However, within a competitive framework another source of
revenues can be added to appropriated funds. These other funds come from
successfully winning job orders from external organizations on a cost
reimbursement or fee basis. The combination of revenues from appropriated
funds and external organizations is still referred to as revenues or sales revenues
in this manuscript. These revenues will be used to analyze various aspects of an
organization. The merging of appropriated and other funding sources will be
necessarily combined in this case study in order that a comparison with overall
costs can be made. This merging is necessary because public sector financial
tracking systems are not sufficiently developed to compartmentalize total costs
82


based on job orders. Meaningful comparisons can be made between competitive
and non-competitive financial results by analyzing overall cost differences that
occur in each case. That is, within the CFM overall organizational revenues
(including both appropriated and non-appropriated funds) can be compared with
overall organizational expenses, and those results compared with the revenue and
expenses incurred during non-competitive years. These comparisons may yield a
revenue surplus (called net income) or revenue shortfall (called net loss). In this
case study, using net income and net loss as an efficiency indicator variable may
provide insight into overall organizational changes that occur when CFM is
implemented. This indicator variable can be used to assess how much budgetary
surplus or shortfall is created based on revenues and expenses. Comparisons
between years (when financial data is adjusted for inflation) and organizations can
be conducted by using different budget ratios analysis. Additionally, whether
appropriations are a major or minor component of revenue and the introduction of
competition (with TP) may provide substantial incentive for production
improvement in various aspects of an organizations output.
Asset utilization is another meaningful production aspect that must be
addressed. Many public organizations do not record, measure or track assets on
hand. For the CFM and TP to work, assets must be measured, recorded and
83


tracked. Assets represent a significant expense to organizations that must be
included in the cost for completing a job order. Not including asset costs, or the
expense of using assets, omits a large and important cost element. By ignoring
assets, full costs would not be recorded and public funds would be effectively
subsidizing public organizations trying to sell their goods and services in the
marketplace. Currently, federal funds are appropriated for major asset purchases
from Congressional appropriations, rather than from internal budgets.
Replacement assets are often funded in the same way. The CFM requires
knowledge of asset costs and depreciation.20 Within this model, budget surpluses
could be used to purchase assets, rather than Congressional appropriations.
Other Incentives. Calculating unit cost information and changing public
organizational cultures to emphasize costs may be significant hurdles that require
other incentives for short-term production improvements. The interaction
between a Ps, and Pb or B may require more incentive for improvement than
simply focusing on financial data. Other incentives for improvements may be
required between and among Ps/S and P(/B or within each stakeholders
organization. Incentives may be within the internal DoD marketplace or within
20 Depreciation is the expense of using an asset to make a product.
84


the environment external to DoD that has influence on its outcomes. Because
such a large culture shift rewarding cost identification and reductions will take
time, other incentives are likely to be required for improvements within a
competitive model for the public sector. Relevant incentives may include
encouraging an attitude that rewards risk, providing monetary encouragement for
cost reduction suggestions,21 or attaching individual promotions to financial
performance.
Output Effectiveness. In the CFM, the output produced by a Pb is shown
as Pg. When changing incentive structures in order to modify agents behavior, it
is critical to examine the characteristics of the good or service produced. It would
be reasonably easy for many public organizations to reduce costs and product
quality while labeling the changes as production improvements. Reduced costs
would make many policy stakeholders happy. However, if cost reductions
(marketed as resulting from production improvements) occur at the expense of a
modified output, then understanding the nature of the output becomes an
important aspect when analyzing the model.
21 The DoD currently has a program called value engineering. This program is designed to
reward both public and private producers of goods and services performing DoD contracts for cost
saving ideas that surface during the execution of a contract.
85


Chapter Summary
The purpose of this chapter was to introduce the research problem and
establish a descriptive framework to be used in the analysis. The CFM displays
the interaction among public and private buyers and sellers. The model relies on
the use of a revolving fund to establish the market-like arrangement between
buyers and sellers. The notion of competition and autonomous decision making
power among public managers are important aspects of the model.
86


CHAPTER 4
RESEARCH DESIGN
A triangulated research design was used to test hypotheses related to the
CFM. The triangulation involved a single case study of the Ogden Air Logistics
Center (ALC), with data collected from interviews, secondary publications and
financial archives that covered an extended time period and included multiple
units of analysis and perspectives.
Site Selection
The selection of cases in case study research depends more upon the
research question and resource limitations than upon statistical sampling
properties (Eisenhardt, 1989). The focus of this research assessing efficiency
results in the USAF F-16 aircraft maintenance program related to TP and CFM
implementation -- suggest these guidelines in selecting cases. First, to study
factors that influence success, F-16 maintenance firms with relatively mature
inter-divisional TP and CFM implementation are needed. Second, a setting in
Success is defined as the use of TP data in the manner intended by the firm prior to
implementation.
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