Coordinating replenishment and pricing in a firm

Replenishment and pricing strategies are traditionally determined by entirely separate units of a firm, the former by production and the latter by marketing. In a large organization production and marketing are traditionally measured in terms of performance criteria appropriate and relevant within the world in which they operate, rather than in terms of overall company performance. We consider a situation where the headquarters uses a simple linear transfer price between the two functions to govern the transactions. The misaligned incentives among these functional managers are caused by a transfer price between them that distorts the marginal production cost and revenue, as well as by a misallocation of cost: Marketing's pricing strategy influences expected leftover inventory, but only production incurs the cost. The misalignment can be mitigated through the following two ways. First, if production commits to a service level instead of an inventory level, both production and marketing, and hence the firm as a whole, are better off. Second, the same improvement can be achieved through organizational changes so that marketing becomes the dominant function. We also propose a mechanism that aligns the functional managers' incentives to be compatible to the firm.