Eliminating Built-in Redundancies - Cost Allocation in Manufacturing-Remanufacturing Operations

Customers typically value a remanufactured product less than the original. And in many countries, remanufactured goods must legally be labelled as such, particularly in the EU. Associate Professor of Operations Management L. Beril Toktay and Assistant Professor of Accounting and Control Donna Wei expose the decision-making inefficiencies so often found in such operational procedures. They then consider the decisions made by individual division managers when divisional profits are computed without cost allocation. They show the resulting decisions to be sub-optimal.

by Beril Toktay,Donna Wei
Last Updated: 23 Jul 2013

For many industries, manufacturing and remanufacturing operations are carried out in different divisions, whose managers' performances are evaluated separately. Associate Professor of Operations Management L. Beril Toktay and Assistant Professor of Accounting and Control Donna Wei expose the inherent decision-making inefficiencies in such operational procedures. They also propose a mechanism to align incentives.

In a two-period model, the authors characterise the global profit-maximising prices of manufactured, versus re-manufactured products. Manufacturers and re-manufacturers need to make critical pricing decisions, based on two important factors for industries such as office machines, cell phones and vehicles. Customers typically value a remanufactured product less than the original. And in many countries, remanufactured goods must legally be labelled as such, particularly in the EU.

The ambiguities that tend to be present in the aforementioned operational procedures are detailed in the working paper. From both interviews and existing literature, Toktay and Wei identify a wide range of transfer pricing practices amongst the various divisions responsible for manufacturing or re-manufacturing.

These range from "essentially charging nothing, to full standard cost". The authors also point out a somewhat glaring inadequacy in current related academic literature: while extensive work has been produced relating to transfer pricing, none of it is specific to closed-loop supply chains.

To this end, Toktay and Wei consider a manufacturer who is also involved in re-manufacturing operations. They characterise the firm as having a distinct allocation of decision rights to individual managers, "in contrast to treating the firm as one black box that maximises profits centrally".

The authors' model is based of five characteristics:

· Firm structure: in the test firm, manufacturing and re-manufacturing are undertaken by two separate divisions.

· Market characteristics: An assumption is made that the new and the re-maufactured products are sold to different, non-overlapping market segments.

· Product lifecycle: An assumption is made that any new product can be used for a limited period. Subsequently, customers will return these.

· Consumer characteristics: The authors assume that consumer "willingness-to-pay is heterogeneous and uniformly distributed in the interval".

· Cost structure

The following section characterises the first-best decision that maximises profits for the entire firm. Toktay and Wei then consider the decisions made by individual division managers when divisional profits are computed without cost allocation. They show the resulting decisions to be sub-optimal.

They then consider a cost allocation mechanism, and determine the proportion of costs that need to be allocated across divisions, in order to provide respective managers the necessary incentives to make first-best decisions. The working paper concludes with a consideration of the managerial implications of the authors' findings.

INSEAD 2005

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