Decentralizing cross-functional decisions: Coordination through internal markets

A firm faces many problems that are inherently cross-functional. To solve t hem successfully requires the coordinated actions of many functional repres entatives acting in a decentralized setting. Functional managers, however, respond to their own individual incentives and may consequently fail to max imize the overall profits of the firm. We examine this issue in a setting i n 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 de centralized. Our mechanism is based on linear transfer prices for the inter mediate output that are implemented through an internal market; a market ma ker buys the output from one function and sells it to another. She is not o bliged to sell at the same price at which she bought and may set prices sol ely to provide incentives. We illustrate the flexibility of the scheme by a pplying it to several models in the operations management literature.