Decentralizing Cross-Functional Decisions: Coordination Through Internal Markets

A firm faces many problems that are inherently cross-functional. To solve them successfully requires the coordinated actions of many functional representatives acting in a decentralized setting. Functional managers, however, respond to their own individual incentives and may consequently fail to maximize the overall profits of the firm. We examine this issue in a setting in which the output of early actions limits the range of later actions, and we propose an incentive scheme that allows the system to be successfully decentralized. Our mechanism is based on linear transfer prices for the intermediate output that are implemented through an internal market; a market maker buys the output from one function and sells it to another. She is not obliged to sell at the same price at which she bought and may set prices solely to provide incentives. We illustrate the flexibility of the scheme by applying it to several models in the operations management literature.