Managerial economics and organizational architecture 5e ch017

Cost Centers• Manufacturing • Assigned decision rights to produce a stipulated level of output... Cost Centers• Economic efficiency minimize costs for given output • Technical efficiency

Managerial Economics and Organizational Architecture, 5e

Chapter 17: Divisional

Performance Evaluation

Measuring Divisional Performance

• Rewards are based on performance

evaluations

• Must be consistent with decision rights

granted to the unit manager

• Units can be characterized into five

groups

Cost Centers

• Manufacturing

• Assigned decision rights to produce a

stipulated level of output

Cost Centers

• Economic efficiency (minimize costs for

given output)

• Technical efficiency (maximize output for

given budget)

• Note: minimizing average cost does not

yield profit-maximizing sales level

Expense Centers

• Personnel, accounting

• Managers are given fixed budget and

asked to maximize service/output

• Output is more subjectively measured than

in a cost center

• Budgets may be benchmarked with those

of other firms

• Lack of charge back leads to overuse

• Risk of “empire building”

Revenue Centers

• Sales, distribution

• Managers compensated for selling a set of products

• Objective to maximize revenue for a given

price or quantity and budget

• May not be consistent with value

maximization

• Revenue maximized when MR=0

• But MC may be greater than 0

Profit Centers

• Combined cost and revenue centers

• Managers are given a fixed capital budget

and allocated decision rights for input mix,

product mix and selling prices

• Evaluated on difference between actual

and budgeted accounting profits

Profit Centers

• Firms must be wary of individual units

maximizing profits at the expense of

maximizing value of the whole firm

Complications

• Selection of transfer price

• Overhead allocation

Investment Centers

• Profit centers with decision rights over

capital expenditures

• Evaluated on basis of return on capital

• Return on assets

• For the investment center – the ratio of accounting net income to the total assets invested in the

center

• Economic value added

Transfer Pricing

• Price paid for intra-organizational transfers

of goods and services

• Choice determines both distribution of

profits among units and overall profits

• If transfer prices are mis-measured,

managers in various divisions will make

inappropriate decisions

Transfer Pricing

• The optimal transfer price for a product or

service is its opportunity cost

• Often difficult to measure

• Measurement

– Costless information

• Opportunity cost is the marginal cost

– Asymmetric information

• Managers may have incentives to hide true costs and may charge monopoly price instead of price equal to MC

Profit-Maximizing Product Price

110

60

$

Firm profit = $500

MR

MC = $10

D

Q

Decentralized Firm

transfer price 110

60

10

Quantity

D

$

Profits = $250

$ 110 85 60

Quantity

D

MR

Q

MC Profits = $125

Transfer-Pricing Methods

• Market base

• Marginal cost

• Full cost

• Negotiated

Internal Accounting

• The accounting system

– Decision management requires estimates of

future benefits and costs

– Backward-looking accounting systems

support decision control

Internal Accounting

• Tradeoffs between decision management

and control

– Accounting measures are not under the

control of those being monitored

– Managers with decision making rights are

often dissatisfied with financial measures for

making operating decisions