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Curriculum Center Browse Bibliography Build EPacket Pricing Structure Distribution Process Management Control in Nonprofit Organizations
Note on Transfer Pricing in Healthcare Organizations
Young, David W.
Functional Area(s):
   Management Control Systems
   Healthcare Management
Difficulty Level: Beginner
Pages: 5
Teaching Note: Not Available. 
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First Page and the Assignment Questions:

The idea of aligning the goals of managers of individual responsibility centers with the goals of the organization as a whole is called goal congruence. The term is borrowed from social psychology, and is an important consideration in designing a management control system. A lack of goal congruence ordinarily can be seen in the form of dysfunctional behavior on the part of responsibility center managers, i.e., behavior that is not in the best interests of the organization as a whole. Its presence ordinarily means that some changes are needed in the nature of the organization’s responsibility centers.

One of the most common areas of a lack of goal congruence is with transfer prices. Specifically, if a management control structure contains several responsibility centers that are not completely independent of each other, they almost certainly will engage in “buying and selling” transactions among themselves. As a result, the prices at which these transactions take place—the transfer prices— become important elements of the management control structure. To see how a lack of goal congruence can arise, consider the following problem:

Phyllis Martin is the director of the Ambulatory Care Division of Valley Hospital. The hospital has been organized into profit centers, and the Ambulatory Care Division is a profit center. Profit center managers and their key staff are paid annual bonuses based on their units’ profits.
Ms. Martin charges patients $11.00 for a urinalysis, which typically is required in conjunction with a diagnostic workup. The $11.00 charge covers the time spent by nurses in her division assisting the patient, the processing of paperwork by the division’s administrative staff, the supplies needed for the urinalysis, and the time spent by the nurse, the physician’s assistant, or the physician reporting the results to the patient. The lab work needed to actually analyze the patient’s urine sample is “purchased” by Ms. Martin from the hospital’s Laboratory Division.
The Laboratory Division, another profit center, charges all of the hospital’s divisions $6.00 for the analysis. The manager of the laboratory says that his price is based on variable costs of $2.00 per urinalysis (mainly supplies and labor), plus $3.00 of fixed costs, and $1.00 of profit. He believes this is reasonable.
Ms. Martin has found that she can purchase urinalyses of comparable quality for $4.50 each from a nearby free-standing laboratory. By doing so, she could improve her profit center’s performance considerably.
In the space on the next page, write out and complete the following table showing each profit center’s financial performance under the two options: You should do so before looking at the analysis that follows:
Amb Care Division Lab Division Hospital Overall
Option 1 - Ms. Martin buys
from Hospital Lab Division
Variable costs
Option 2 - Ms. Martin buys
from Free Standing Lab
Variable cost

Answer: The problem is that, although Ms. Martin could improve the performance of her division by having urinalyses prepared by the free-standing laboratory, the overall profit (or surplus) of Valley Hospital would decline if she were to do so. That is, the hospital pays $2.00 “out of pocket” for every urinalysis done by the Laboratory Division for Ms. Martin’s division. All other costs are fixed. Therefore each urinalysis done by the Laboratory Division reduces the hospital’s profit by $2.00.
If Ms. Martin buys urinalyses from the free-standing laboratory, the hospital incurs an incremental cost of $4.50 instead of $2.00, and its profit therefore is reduced by $4.50. This is because, when urinalyses are purchased from the free-standing laboratory, the price includes not just variable costs, but a portion of fixed costs of the free-standing laboratory, plus a profit margin. Clearly, the hospital would prefer to have Ms. Martin purchase urinalyses from its Laboratory Division rather than the free-standing laboratory.