DECENTRALIZATION

Issues Related to Decentralization
o performance evaluation
o Mgmt. compensation
o Transfer Pricing
RESPONSIBILITY ACCOUNTING
 a system that measures the results of each
responsibility center
 compares those results w/ expected or
budgeted outcomes
There is a strong link between an organization’s
structure and its responsibility actg. system.
TYPES OF RESPONSIBILITY CENTERS
 a responsibility center is a part of the
business whose manager is accountable for
specified activities
1. Cost Center
- a manager is only responsible for costs
- e.g. Production dept.
2. Revenue Center
- manager is only responsible for revenue
- e.g. Mktg. dept.
3. Profit Center
- manager is responsible for both cost and
revenue
- e.g. Plant managers are responsible for
pricing and selling
4. Investment Center – manager is responsible for
revenues, cost and investments
- e.g. divisions
6. The accountant shall also be familiar with the
THE ROLE OF INFORMATION AND ACCOUNTABILITY financial actg. rules of the countries in which the firm
A manager is responsible for a responsibility center operates
because of
1. He/she has the ability to control the subject of his Responsibility Accounting
or her responsibility (cost/rev/investment/profit) -the system of responsibility, accountability and
2. He or she is best informed regarding them (the performance evaluation where accounting measures
subject) and reports play a key role in the process
- responsibility entails accountability and
What are needed to help managers make decisions? accountability implies performance measurement
1. Knowledge where actual outcomes are compared w/ expected
2. Creativity or budgeted outcomes.
3. Flexibility
DECENTRALIZATION
What are important to an accountant?  practice of delegating decision-making
-calcu. and worksheet authority to the lower levels
WRONG !! 2 Approaches to manage diverse and complex
1. Good training activities
2. Good education a.) Centralized decision making –
3. Staying up to date w/ one’s field 1. decisions are made at the top
level
What does staying up to date mean? (context: global 2. lower level managers implement
business) the decisions
- it requires reading in a Variety of business areas b.) Decentralized decision making –
such as 1. Allows managers at lower levels to
1. Information systems make and implement decisions
2. Mktg.
3. Management Multinational Corporation (MNC)
4. Politics  a special case of the decentralized firm
5. Economics

 a corporation that does business in more
than one country in such a volume that its
well-being and growth rest in more than one
country
REASONS FOR DECENTRALIZATION
1. Better Access to local info.
- decision quality is affected by information
available. Lower managers are in contact with
immediate operating conditions
2. Cognitive Limitations – no longer are middle
managers individuals w/ “people skills” and
organization skills only but they must have specific
field of expertise
3. More Timely Response – it takes time to transmit
local info. to headquarters and transmit decision
back to the local unit.
Related Prob: Different languages native to managers
of divisions in MNC.
2 Ways to Address this
a.) Decentralized structure pushes decision
making down to the local manager level eliminating
the need to interpret instructions from above.
b.) incorporate technology that overrides
the language barrier and eases cross-border data
transfer
DECENTRALIZATION
4. Focusing of Central Management
- by decentralizing operating decisions, TOP
MGMT. is free to focus on strategic planning and
decision making.
- They can concentrate on the long-run survival of the
org.
5. Training and Evaluation of Segment Managers
- to prepare future generation of higher-level
managers by giving them the chance to make
significant decisions
6. Motivation of Segment Managers
- by giving them freedom to make decisions (local
managers), some of their higher level needs are met
a.) Self-esteem and
b.) Self- actualization
7. Enhanced Competition
- decentralization allows the company to determine
each division’s contribution to profit and to expose
each division to market forces
THE UNITS OF DECENTRALIZATION
- decentralization is usually achieved by segmenting
the company into divisions
- in a decentralized setting, some interdependencies
usually exist which creates the need for transfer
pricing
DIVISIONS ARE DIFFERENTIATED BY
1. Type of good/ services
2. Type of Customer served
HOW DO COMPANIES MAINTAIN CONTROL OF
RESPONSIBILITY CENTERS?
1. By developing performance measures for
each center
 provides direction to managers
 used to evaluate performance
Performance measures should encourage
goal congruence
Goal Congruence – goals of the manager are
closely aligned with the firm’s goals
2. Basing rewards on a manager’s ability to
control the responsibility center
CONTROL OF COST CENTERS
- through evaluation of:
1. Efficiency – how well the activities are performed
2. Effectiveness – whether the manager has
performed the right activities
-#whether the objective was achieved
CONTROL OF PROFIT CENTERS
1. Profit contribution ( from performance report,
contribution income statement)
 DECENTRALIZATION

MEASURING THE PERFORMANCE OF INVESTMENT Operating income – earnings before interest and 3. It discourages excessive investment in operating
CENTERS income tax assets
o Return on Investment - typically used for the ROI of divisions
o Residual Income DISADVANTAGES OF ROI
o Economic Value Added Net Income – used in the calculation of ROI for the 1. Discourages managers from investing in projects
company as a whole that would decrease the divisional ROI but would
RETURN ON INVESTMENT increase the profitability of the company as a whole
- profit earned per dollar of investment Operating Assets – include all assets used to 2. It can encourage myopic behavior in that
- most common measure of performance for an generate operating income. Include: managers may focus on the short run at the expense
investment center. It’s used o Cash of the long run. E.g.
a.) Internally – used to measure the relative o Receivables a. laying off highly paid employees
performance of divisions o Inventories b. cutting advertising budge
b.) Externally - used by stockholders to o Land c. delaying promotions
indicate the health of a company o Bldg. d. delaying employee training
o Equipment e. reducing preventive maintenance
ROI = f. using cheaper materials
2 Component Ratios of ROI
a.) Margin – ratio of operating income to sales. It RESIDUAL INCOME
shows the portion of sales available for interest,  `the difference between operating income
or income tax and profit and the minimum dollar return required on a
company’s operating assets
X b.) Turnover – found by dividing sales by average
operating assets. It shows how productively assets Residual Income =
are being used to generate sales
or
Operating Income – (Min. Rate of Return * Operating Assets)
X
ADVANTAGES OF ROI
Average Operating Assets = 1. Encourages investment center manager to pay ADVANTAGES OF RESIDUAL INCOME
careful attention to the relationships among sales, 1. Refocuses the managers on dollar profit
expenses, and investment 2. Encourage managers to move beyond a focus on
2. It encourages cost efficiency the percentage return
 DECENTRALIZATION

DISADVANTAGES OF RESIDUAL INCOME EVA = BEHAVIORAL ASPECTS OF EVA

1. It is an absolute measure of return 1. Eva encourages the right kind of behavior from
- it is tempting to claim that the division with After-tax Operating Income – (WACC* Total Capital Employed) divisions in a way that operating income alone
the highest residual income outperforms all cannot. The reason is EVA’s reliance on the true cost
Computing Cost of Capital Employed
the others but what if it used too much of capital
1. Determine the WACC
assets? 2. For investments to not seem free to divisions, EVA
2. Determine the total dollar amount of capital
To solve the problem, either should be measured for subsets of the company.
employed
a.) divide residual income by average
operating asset (residual return on Amount Percent x After-Tax Cost = Weighted Cost NONFINANCIAL MEASURES OF PERFORMANCE
investment) or Bonds 2,000,000 0.25 .09(1-0.35) = .0585 0.0146 o Market Share
b.) Compute both ROI & Residual income. o Customer Complaints
Equity 6,000,000 0.75 .06+.03= .09 6.75%
ROI could be used for interdivisional o Personnel turnover ratios
comparisons 8,000,000 0.0821 o Personnel development
2. It does not discourage myopic behavior Balanced Scorecard – developed to measure a firm’s
WACC = 8.21% performance in multiple areas

ECONOMIC VALUE ADDED (EVA) Determining the Amount of Capital Employed MEASURING AND REWARDING THE PERFORMANCE
 it is after tax operating income minus the - includes amount paid for OF MANAGERS
total annual cost of capital 1. Machinery Performance of Division ≠ Performance of Manager
 it is a dollar figure. However, it does bear a 2. Bldg.
resemblance to rate of return as it links the 3. Land Why wouldn’t manages provide good service?
net income to capital employed 4. R&D 1. They may be unable to perform the job
 Relates profit to resources needed to achieve 5. Employee training - requires owner to discover info about the
it 6. etc. manager before hiring them
2 Types of EVA 2. They may prefer not to work hard
a.) Positive – creating wealth #4 and #5 are classified by GAAP as expenses but EVA - require owner to monitor the manager or
b.) Negative – destroying wealth is an internal mgmt.. accounting measure and to arrange an incentive scheme
Over the long term, only those companies creating therefore these expenses can be thought of as the 3. They may prefer to spend company resources on
wealth can survive. investments that they truly are. perquisites
 DECENTRALIZATION

- require owner to monitor the manager or MEASURING PERFORMANCE IN THE c.) Educated workforce
to arrange an incentive scheme MULTINATIONAL FIRM d.) good/poor infrastructure
Perquisites – are a type of fringe benefit receved 1. Separate evaluation of the division from eval. of a e.) political and legal systems – accountant
over and above salary manager of MNC must also be aware of this
2. Manager’s evaluation should not include factors
MANAGERIAL REWARDS include over which he exercises no control .. the corporation must be aware of and control
o salary increases 3. Managers should be evaluated based on revenue these differing environmental factors
o bonuses based on reported income and cost incurred
o stock options 4. Once a manager is evaluated, then the subsidiary MULTIPLE MEASURES OF PERFORMANCE
o noncash compensation FS can be restated to the home currency and  The interconnectedness of the global
Cash Compensation uncontrollable costs can be allocated company weakens the independence or
- include stand-alone nature of any one segment
a.) Salaries – once raises take effect, it’s  rigid evaluation of performance of foreign
usually permanent ENVIRONMENTAL VARIABLES divisions IGNORES the OVERARCHING
b.) Bonus – give firms more flexibility 1. Economic STRATEGIC IMPORTANCE OF global presence
o inflation  Residual Income and ROI becomes less
Stock-Based compensation o foreign currency exchange rates important measures of managerial
1. Can encourage goal congruence o income taxes performance. In addition to these 2, top
2. Share price can fall for reasons beyond a o Transfer prices managers look at:
manager’s control 2. Legal – e.g. prohibition of import of certain items a.) Market potential
Stock Options – the right to buy a certain number of 3. Political b.) Market Share
shares of the company’s stock, at a certain price and 4. Social
after a set length of time 5. Educational factors TRANSFER PRICING
- Objective: encourage managers to focus on Transfer prices – the prices charged for goods
the longer term COMPARISON OF DIVISIONAL ROI produced by one division and transferred to another
- the existence of environmental factors makes  affects the revenues of the of the
Noncash Compensation interdivisional comparison of ROI misleading transferring division and the costs of the
include Examples include receiving division
1. Autonomy a.) Lack of consistency of internal reporting
2. Perquisites b.) Min. wage law

 profitability, ROI, and managerial
performance evaluation of both divisions are
affected
IMPACT OF TRANSFER PRICING ON INCOME
– Actual transfer price nets out for the company as a
whole
– Even so, it could still affect the level of profits
earned by the company as a whole if it affects
divisional behavior (e.g. is on p. 307 2nd paragraph)
SETTING TRANSFER PRICES
Transfer pricing system should satisfy 3 objectives:
1. Accurate performance Evaluation
2. Goal performance
3. Preservation of divisional autonomy
Accurate Performance Evaluation
– No one divisional manager benefits at the expense
of another.
Goal Congruence
– Divisional managers select actions that maximize
firm-wide profits
Autonomy
– Central mgmt. should not interfere with the
decision-making freedom of divisional managers
DECENTRALIZATION
Transfer pricing problem
 Concerns finding a system that satisfies all 3
objectives
Opportunity cost Approach
 identifies the minimum price that a selling
division would be willing to accept and the
maximum price that the buying division
would be willing to pay
Bargaining Range
 min. and max. price define this
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)
 transfer price that would leave the buying
division no worse off if an input is purchased
from an internal division
THE OPPORTUNITY COST APPROACH IS TELLING US
THAT A GOOD SHOULD BE TRANSFERRED
INTERNALLY WHENEVER
MinTP < MaxTP
COMMON POLICIES THAT DIVISIONS FOLLOW IN
TRANSFER PRICING
MARKET-BASED TRANSFER PRICING
– if there is an outside market for the good to be
transferred and that the outside market is perfectly
competitive , the correct transfer price is the market
price
NEGOTIATED TRANSFER PRICING
– Perfectly competitive market rarely exist. In most
cases, producers can influence price
– Opportunity cost help define the boundaries of the
negotiation set
– E.g. in the book, transfer price was somewhere
within the bargaining range to make both divisions
yield better profit
DISADVANTAGES OF NEGOTIATED TRANSFER PRICES
o One divisional manager with private
information may take advantage of another
divisional manager
o Performance measures may be distorted by
the negotiating skills of the manager
o Negotiation can consume considerable time
and resources
ADVANATAGES
- offers some hope of complying to the 3 criteris
1. Goal congruence – process of making sure that
actions of diff. divisions mesh together

2. Accurate performance evaluation – concerns
about this can be eliminated if negotiating skills of
managers are comparable or if the firm views these
skills as an important managerial skill
3. Autonomy – if negotiation ensures goal
congruence, there is no need for central mgmt. to
intervene
COST-BASED TRANSFER PRICING (CBTP)
3 FORMS
o Full cost
o Full cost plus markup
o Variable cost plus fixed fee
… in all cases standard costs should be used to avoid
passing on the inefficiencies of one division to
another
ISSUE: PROPRIETY OF USE
FULL COST TRANSFER PRICING
– least desirable type of approach
– shuts down negotiations
FULL COST PLUS MARKUP
 Suffers from virtually the same problems as
full cost but is less perverse if the markup can
be negotiated
Case 1. If Full Cost Plus Markup formula may be the
outcome of negotiation
DECENTRALIZATION
– it is simply another example of negotiated
transfer pricing. Its use is fully justified.
Case 2. 2nd Example of the Book (Pharmaceutical
and Plastics Divisions)
– this approach could not represent all
negotiated prices (such as e.g. p. 310 par. 4) . Thus
superior approach is negotiation
VARIABLE COST PLUS FIXED FEE
 can be useful provided that the fixed fee is
negotiable
 has one advantage over full cost plus
markup: if the selling division is operating
below capacity, VC is its opportunity costs
 Negotiation w/ full consideration of
opportunity costs is preferred
PROPRIETY OF USE
 Many companies use cost-based despite its
disadvantages as they are simple and
objective (esp. when transfers between
divisions have small impact on the
profitability of either division)
 In some cases Full cost plus markup may just
be the formula agreed from NEGOTIATION.
But once established, this formula could be
used until original conditions change where
renegotiation would be necessary
TRANSFER PRICING AND THE MULTINATIONAL FIRM
For MNCs, transfer pricing must accomplish
1. Performance evaluation
2. Optimal determination of income taxes
Internal Revenue Code Section 482
 US-based multinationals are subject to this
on the pricing of intercompany transactions
 sales shall be made at “arm’s length” –
means transfer price match the price that
would be set if the transfer was made by
unrelated parties adjusted for differences
that have a measurable effect on the price:
a.) Landing cost (freight, insurance, duties,
special taxes)
b.) Marketing costs – (usually avoided in
internal transfers)
IRS 3 Pricing Methods approximating Arm’s Length
Pricing (in order of preference)
1. Comparable Price Method – essentially
the Market Price
2. Resale Price Method – (Sale Price received
by reseller – Appropriate Markup)
3. Cost-plus-Method – simply the CBTP
4. Transfer price negotiated between the
company and the IRS – if TP situation does
not fit into any of the 3 above
 DECENTRALIZATION

Advance Pricing Agreements (APAs) – assist tax

paying firms to determine whether a proposed
transfer price is acceptable to the IRS in advance of
income tax filing.
- an agreement between the IRS and a taxpayer

COUNTRIES THAT HAVE ISSUED TRANSFER PRICING

REGULATIONS w/in the past 20 yrs.
1. Japan
2. South Korea
3. Canada
4. EU

MANAGERS MAY LEGALLY AVOID INCOME TAXES

BUT NOT EVADE THEM!!