Chapter 10: Decentralization, Responsibility Accounting, Performance Evaluation and Transfer Pricing

Responsibility Accounting

refers to the measure of performance of managers, decentralized organizational units, and holding managers responsible for the results

when managers are held responsible for results, they should only be held responsible for costs and influences for which they have a significant influence

Reasons for Decentralizing Operations

decentralization = segments

- better decision making

- motivation of managers

- training of managers

- frees up time of central management to focus on strategic issues

Types of Decentralized Units

1. cost center (expenses)

2. revenue center (sales)

3. profit center (sales + expenses)

4. investment center (influence over profits, most responsibilities/divisions)

- increase of responsibility from 1-4

Cost Center

an organizational unit whose management is financially responsible only for costs

1. standard cost centers

2. discretionary cost centers

Standard Cost Centers

a cost center that has a clearly defined relationship between effort and accomplishment

- e.g. production departments in manufacturing organizations

- the performance of these centers is often evaluated using variances from flexible budgets (e.g. ch 9)

Discretionary Cost Center

a cost center that does not have clearly defined relationships between effort and accomplishment

- e.g. R&D depts, maintenance depts, administrative depts

- performance of these centers is often evaluated using non-financial measures (e.g. compare actual cost with budgeted costs, but this measure does not help one evaluate the effectiveness of the center)

Revenue Center

an organizational unit whose management is financially responsible for the units revenues

- not very common

- e.g. sales department (but if the dept is also given any responsibility for costs, it should be a profit center)

Profit Center

an organizational unit whose management is financially responsible for the difference between the units revenues and costs

- e.g. marketing functions because the manager has a responsibility for costs as well as for revenues

- a measure of profits is often used to evaluate the financial performance of the center

Investment Center

an organizational unit whose management is financially responsible for the relationship between the unit's profits and total assets

- e.g. divisions of companies

- traditional measures of performance: ROI, residual income, EVA

Return on Investment (ROI)

income / investment

- investment = average operating assets (avg of beg and end of year balances)

Sometimes broken down into 2 parts: (Sales / Investment) x (Income / Sales)

- sales / investment = investment turnover

- income / sales = return on sales (or margin)

Advantages of ROI Measure

1) encourages management to consider the relationship between income generated and dollars invested (will this investment increase income?)

2) encourages cost efficiency (reduce costs will increase ROI)

3) encourages efficient investment

Disadvantages of ROI Measure

1) could discourage managers from investing in a project that would decrease the divisons ROI, but might be an acceptable investment to the company as a whole

2) may encourage managers to focus on short term at the expense of the long term

Residual Income

RI = operating income - (minimum rate of return x operating assets)

- the rate is a minimum rate of return or the cost of capital

- operating assets also could be clarified as investment

Advantages of Residual Income Measure

1) encourages managers to accept investments that have a rate of return > cost of capital

2) managers might prefer that RI is expressed in $ rather than a %

Disadvantages of Residual Income Measure

1) RI can be improved by short term decisions that might not be best in the companies long term

2) because it is a $ measure, makes it difficult to compare divisions of different sizes (!)

Economic Value Added

EVA is like a residual income because a capital charge is deducted before the EVA amount is calculated. Basic Calculation:

Revenues

(- Operating costs and expenses)

= Operating profits before taxes

(- Taxes)

= After-tax operating profit

(- Capital charge (investment x WACC))

= EVA

When EVA is used to evaluate performance, the capital charge is calculated using the weighted-average cost of capital which is based on finance theory. The weighted-average cost of capital is the after-tax cost of debt + the cost of equity capital. The weighted-average cost of capital rate is then multiplied by the total capital (including debt) to arrive at the $ amount of the capital charge (look at examples)

Transfer Price

an amount charged for goods / services sold by on segment to another segment of the same organization (inter-company transfer)

- often there is a disagreement between the decentralized units relating to the transfer price

- sometimes managers will set transfer prices that improve their unit's performance measure but do not maximize profits of the firm

- decentralized unit (division) that sells the product records the transfer as a sale

- decentralized unit that buys the product records the transfer as a cost

Methods of Determining Transfer Price

Market based prices:

- market price

- adjusted market price

Negotiated transfer prices:

- upper limit set by buyer

- lower limit set by seller

Cost based transfer prices:

- marginal or variable costs

- variable cost-plus fixed fee

- full cost

- full cost-plus markup

Market Price

the price the intermediate product sells for in the outside market

- should be used as the transfer price if there is a competitive market for the intermediate product

- this price will encourage both departments to act in a manner that maximizes company profits, it is also the opportunity cost to the selling department

Adjusted Market Price

sometimes made because there are no selling costs or bad debts associated with intra-company transfers

- an adjustment for quantity discounts may also be included if the transfers are large enough to be affected by the discounts

Negotiated Price

- opportunity cost of each division should be used to establish the upper and lower limits

- transfer should only occur if the opportunity cost to the selling division is less than the opportunity cost to the buying division (range for negotiations to happen)

Disadvantages of Negotiated Transfer Prices

1. division managers with local info may take advantage of other managers

2. negotiating skills may determine who receives the most benefit from the negotiation (should negotiation skills affect performance evaluation measures?)

3. negotiating can consume lots of time and effort

Marginal or Variable Cost

if there is no market for the intermediate product (i.e. all transfers must be made internally), the marginal or variable costs may be an appropriate transfer price

- the problem is that the selling division will show a loss equal to its fixed costs, and the buying will show a profit

- marginal/variable cost is the best transfer price from the company's POV if there is no market for the product and the selling division is not operating at capacity (marginal cost is the opportunity cost)

Variable cost-plus Fixed Fee

this method attempts to overcome the limitation of the variable cost method by giving the selling division some contribution to fixed costs

- if the fixed fee is negotiated between the two divisions, then the method provides some of the benefits of the negotiated method

Full Cost

sometimes used as the transfer price because it may be the basis used to determine the market price

- however, it is not considered to be a theoretically sound basis for setting the transfer price because it is not the opportunity cost

Full cost-plus Markup

based on the idea that it approximates market price

- markup allows the selling division to show some profit on the sale

Optimal Transfer Price

the opportunity cost of the internal transfer to the supplying divison

Transfer Pricing in Multinational Enterprises

consider many factors:

- performance evaluation

- motivation of division managers

- minimization of income taxes

- import duties

- risks of inflation and exchange rate fluctuations

- transfer of funds across national boundaries