Cornerstones of cost management 3rd edition hansen mowen chapter 10

DECENTRALIZATION: RESPONSIBILITY ACCOUNTING, PERFORMANCE EVALUATION, AND TRANSFER PRICING CHAPTER 10... MEASURING THE PERFORMANCE OF INVESTMENT CENTERS Return on Investment • Return on I

DECENTRALIZATION: RESPONSIBILITY

ACCOUNTING, PERFORMANCE EVALUATION, AND TRANSFER PRICING

CHAPTER 10

CHAPTER 10 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

RESPONSIBILITY ACCOUNTING

• Responsibility accounting: a system

that measures the results of each

responsibility center and compares those

results with some measure of expected or

budgeted outcome

• Responsibility center: a part of the

business whose manager is accountable

for specified activities

RESPONSIBILITY ACCOUNTING

Types of Responsibility Centers

• Cost center: responsible only for costs

• Revenue center: responsible only for

revenues

• Profit center: responsible for both

revenues and costs

• Investment center: responsible for

revenues, costs, and investments

• Centralized decision making: decisions

are made at the very top level and lower

level managers are charged with

implementing those decisions

• Decentralized decision making: allows

managers at lower levels to make and

implement key decisions pertaining to

their areas of responsibility

• Decentralization: practice of delegating

decision making authority to the lower

levels

Reasons for Decentralization

• Better access to local information

• Cognitive limitations

• More timely response

• Focusing of central management

• Training and evaluation of segment managers

• Motivation of segment managers

• Enhanced competition

The Units of Decentralization

• Decentralization is usually achieved by

segmenting the company into divisions

• Control of cost centers is achieved by evaluating

the efficiency and the effectiveness of divisional

managers

• Efficiency means how well activities are performed

• Effectiveness can be defined as whether the

manager has performed the right activities

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Return on Investment

• Return on Investment (ROI) is the most

common measure of performance for an

investment center

ROI = Operating income / Average operating assets

ROI = (Operating income/ Sales) × (Sales / Average operating assets)

ROI = Operating income margin × Operating asset

turnover

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Return on Investment

• Operating income refers to earnings before

interest and income taxes

• Operating assets includes all assets used to

generate operating income

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Margin and Turnover

• ROI formula is broken into two component ratios:

margin and turnover

• Margin is the ratio of operating income to sales

• Turnover is found by dividing sales by average

operating assets

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Advantages of the ROI Measure

• Encourages investment center managers to

focus on the relationship between sales,

expenses and investment

• Encourages cost efficiency

• Discourages excessive investment in operating

assets

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Disadvantages of the ROI Measure

• Discourages managers from investing in projects

that would decrease divisional ROI but would

increase profitability of the company overall

• Encourages managers to focus on the short run at

the expense of the long run

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Residual Income

• Difference between operating income and

the minimum dollar return required on a

company’s operating assets

Residual Income = Operating Income – [Minimum rate of

return × Operating assets]

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Advantages of Residual Income

• Encourages managers to move beyond the focus

of the percentage return on investment

• Refocuses the manager on dollar profit

Disadvantages of Residual Income

• An absolute measure of return that makes it

difficult to directly compare the performance of

divisions

• does not discourage myopic behavior

MEASURING THE PERFORMANCE OF

INVESTMENT CENTERS

Economic Value Added (EVA)

• After-tax operating profit minus the total annual

cost of capital

• If positive, the company is creating wealth

• If negative, then the company is destroying wealth

• Key feature: focuses on after-tax operating

income and the actual cost of capital employed

EVA = After-tax operating income – [Weighted average

cost of capital × total capital employed]

MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

Incentive Pay for Managers—

Encouraging Goal Congruence

• Three reasons managers do not provide

good service

• They may have low ability

• They may prefer not to work hard

• They may prefer to spend company resources

on perquisites

MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

Managerial Rewards

• Include incentives tied to performance

• Objective is to encourage goal congruence, so that managers will act in the best interests of the firm

• Include salary increases, bonuses based on

reported income, stock options, and noncash

compensations

MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

Cash Compensation

• Includes salaries and bonuses

• Good management performance may be rewarded

by granting periodic raises

• Unlike periodic raises, bonuses are more flexible

• Many companies use a combination of salary and

bonuses to reward performance

MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

Stock-Based Compensation

• Stock is a share in the company

• Encourages goal congruence

• A stock option is the right to buy a certain number

of shares of the company’s stock, at a particular

price, after a set length of time

• The price of the stock is usually set approximately at market price at the time of issue

• If the stock price rises in the future, the manager

MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

Issues to Consider in Structuring

• Managers may increase short-term measures at the

expense of long-term measures

• Another issue to be considered in structuring

management compensation plans is that owners and

MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

Noncash Compensation Noncash

• Compensation is an important part of the

management reward structure

• Perquisites are also important

TRANSFER PRICING

goods produced by one division and

transferred to another

the transferring division and the costs of

the receiving division

managerial performance evaluation of both

divisions are affected by transfer pricing

EXHIBIT 10.1—IMPACT OF TRANSFER PRICE ON TRANSFERRING DIVISIONS AND THE COMPANY AS A

WHOLE

SETTING TRANSFER PRICES

• A transfer pricing system should satisfy

three objectives

• Accurate performance evaluation

• Goal congruence

• Preservation

SETTING TRANSFER PRICES

• The opportunity cost approach identifies the

minimum that a selling division would be

willing to accept and the maximum price that

the buying division would be willing to pay

• Minimum transfer price (floor): the transfer

price that would leave the selling division no

worse off if the good is sold to an internal

division

• Maximum transfer price (ceiling): the

transfer price that would leave the buying

SETTING TRANSFER PRICES

Market Price

If there is an outside market for the good to be

transferred and that outside market is perfectly

competitive, the correct transfer price is the

market price

SETTING TRANSFER PRICES

Negotiated Transfer Prices

• Advantages

1 Comply with the three criteria of goal congruence,

autonomy, and accurate performance evaluation

SETTING TRANSFER PRICES

Negotiated Transfer Prices

• Disadvantages

1 One divisional manager with private information

may take advantage of another divisional manager

2 Performance measures may be distorted by the

negotiating skills of managers

3 Negotiation can consume considerable time and

resources

EXHIBIT 10.2—SUMMARY OF SALES AND

PRODUCTION DATA

EXHIBIT 10.3—COMPARATIVE INCOME

STATEMENTS

EXHIBIT 10.4—COMPARATIVE STATEMENTS

SETTING TRANSFER PRICES

Cost Based Transfer Prices

• Full-cost transfer pricing

• Full cost plus markup

• Variable cost plus fixed fee

SETTING TRANSFER PRICES

• The IRS accepts four transfer pricing

policies

• Comparable uncontrolled price method

• Resale price method

• Cost-plus method

• Advanced pricing agreements (APAs)

EXHIBIT 10.5—USE OF TRANSFER PRICING

TO AFFECT INCOME TAXES PAID

END OF CHAPTER 10