Responsibility accounting

Responsibility AccountingTypes of Responsibility Centers – Cost center: only responsible for costs – Revenue center: only responsible for revenues – Profit center: responsible for both r

COST MANAGEMENT

Accounting & Control

Hansen▪Mowen▪Guan

Chapter 10 Decentralization:

Responsibility Accounting, Performance Evaluation, and Transfer Pricing

Study Objectives

1 Define responsibility accounting, and describe the four

types of responsibility centers

2 Explain why firms choose to decentralize

3 Compute and explain return on investment (ROI),

residual income (RI), and economic value added (EVA)

4 Discuss methods of evaluating and rewarding

managerial performance

5 Explain the role of transfer pricing in a decentralized

firm

Responsibility Accounting

Responsibility accounting

– measures the results of each responsibility center

– compares those results with some measure of

expected or budgeted outcome

Responsibility Accounting

Types of Responsibility Centers

– Cost center: only responsible for costs

– Revenue center: only responsible for revenues

– Profit center: responsible for both revenues and costs– Investment center: responsible for revenues, costs, and investments

Reasons for Decentralization

– Better access to local information

– More timely response

– Focusing of central management

– Training and evaluation of segment managers

– Motivation of segment managers

– Enhanced competition

Return on investment (ROI)

the most common measure of performance for

an investment center

ROI = Operating income ÷ Average operating assets

= (Operating income ÷ Sales) × (Sales ÷ Average operating assets)

= Operating income margin × Operating asset turnover

Measuring the Performance of

Investment Centers

available for interest, taxes

assets are being used to

generate sales

Sales Average operating assets

Measuring the Performance of

Investment Centers

Measuring the Performance of

Investment Centers

Measuring the Performance of

Investment Centers

Advantages of the ROI measure

– Helps managers focus on the relationship between

sales, expenses and investment

– Encourages cost efficiency

– Discourages excessive investment in operating assets

Disadvantages of the ROI measure

– Discourages managers from investing in projects

decreasing divisional ROI but increasing profitability of the company overall

– Encourages managers to focus on the short-term at the expense of the long-term

Residual income

the difference between operating income and the

minimum dollar return required on a company’s

operating assets

Measuring the Performance of

Investment Centers

Residual = Operating - Minimum rate of return

Income Income × Operating assets

Advantages of Residual Income

Measuring the Performance of

b Residual income divided by operating assets.

Disadvantages of Residual Income

Measuring the Performance of

Investment Centers

ROI is an absolute measure of return; it

does not discourage myopic behavior

Economic value added (EVA)

after-tax operating profit minus the total annual cost of capital.

Measuring the Performance of

Investment Centers

Total capital employed = capital assets

plus other expenditures meant to have

a long-term payoff

EVA Example

Measuring the Performance of

Investment Centers

EVA Example (continued)

Furman’s EVA is:

Less: Weighted average cost of capital (1,470,000)

The positive EVA means that Furman, Inc., earned operating

profit over and above the cost of the capital used.

Measuring the Performance of

Investment Centers

Behavioral Aspects of EVA

 Tends to focus on long-run

 Discourages myopic behavior

Behavioral Aspects of EVA

Positive EVA = wealth is being created

Negative EVA = capital is being destroyed

Measuring and Rewarding the

Performance of Mangers

• Measuring performance in the MNC

– Evaluate the division

– Evaluate the manger

• Base on factors where control exists

• Do not evaluate on factors over which there is no

control (currency fluctuations, income taxes, etc.)

Measuring and Rewarding the

Performance of Mangers

• MNC divisional ROIs impacted by

– International vs domestic environmental conditions

(economic, legal, political, social, etc.)

• Multiple measures of performance for

MNC divisions

– Consider market potential and market share

– Residual income and ROI should not be the sole

measures for MNC divisions

Measuring and Rewarding the

Performance of Mangers

• Managerial rewards

– Separation of ownership and management creates the possibility that managers may not operate the

business in the best interest of the shareholders

• Managers do not exert the most productive effort for the company

• Managers may spend company resources on perquisites

– A well-structured incentive compensation system

encourages goal congruence

Measuring and Rewarding the

Performance of Mangers

• Cash compensation

– Reward good management performance by granting periodic raises

• Become a permanent part of the compensation package

– Bonuses provide more flexibility

• Income-based compensation may encourage dysfunctional behavior.

– A combination of salary and bonus keeps salaries

fairly level and allows bonuses to fluctuate with

reported income

Measuring and Rewarding the

Performance of Mangers

• Stock-based compensation

– A stock option is the right to buy a certain number of shares of the company’s stock, at a particular price and after a set length of time

– Stock options are offered to managers

• They become owners (shareholders) of the company

• Ownership encourages goal congruence

– The price of the stock is usually set to approximate market price at the time of issue

• If the stock price rises in the future, the manager may exercise the option.

Measuring and Rewarding the

Performance of Mangers

• Issues to consider

– Single-measure outcomes encourage gaming

behavior

– The Big Bath

– Cash bonuses and stock options encourage

short-term orientation by management

• Noncash compensation

– Autonomy

– Perquisites

Transfer Pricing

Transfer prices are the prices charged for

goods produced by one division and

transferred to another.

The price charged affects the revenues of

the transferring division and the costs of the receiving division.

Transfer Pricing

Opportunity cost approach identifies

– The minimum price that a selling division would be

will to accept

Floor: leaves the selling division no worse off for

having sold to an internal division– The maximum price that the buying division would be willing to pay

Ceiling: leaves the buying division no worse off for

having purchased from an internal division

Transfer Pricing

Setting Transfer Prices

A good should be transferred internally

whenever the opportunity cost (minimum price)

of the selling division

is less than the opportunity cost (maximum price)

of the buying division.

Setting Transfer Prices

• Commonly used policies

• Variable cost

• Full (absorption cost)

Negotiated transfer prices

Example 1: Avoidable Distribution Costs

Setting Transfer Prices

Negotiated transfer prices

Example 1: Avoidable Distribution Costs

Setting Transfer Prices

Negotiated transfer prices

Example 1: Avoidable Distribution Costs

Setting Transfer Prices

Negotiated transfer prices

Example 2: Excess Capacity

Setting Transfer Prices

Negotiated transfer prices

Example 2: Excess Capacity

Setting Transfer Prices

Setting Transfer Prices

• Negotiated Transfer Prices

– Disadvantages

• Time consuming– Advantages

• Negotiation helps ensure goal congruence

• Comparable negotiating skills support motivation and accurate performance measures

Setting Transfer Prices

• Cost-Based Transfer Prices

– Forms

• Full-cost transfer pricing

• Full cost plus markup

• Variable cost plus fixed fee– Propriety of use

• Impact on divisional profit is negligible

• Ease of cost measurement is beneficial

• Result of negotiations

Setting Transfer Prices

• Transfer Pricing and the MNC

– Performance evaluation

– Optimal determination of income taxes

• Shift costs to high-tax countries

• Shift revenues to low-tax countries

Setting Transfer Prices

Setting Transfer Prices

• IRS Code §482

– Requires arms’-length transactions

– Allowable pricing methods

• Comparable uncontrolled price method

• Resale price method

• Cost-plus method

• Negotiated between the company and the IRS

• Income taxes are universal

– Market-based transfer prices

COST MANAGEMENT

Accounting & Control

Hansen▪Mowen▪Guan

End Chapter 10