Notes 1 The term cost center also has a cost accounting meaning that is different from its meaning here inthe context of responsibility center management. Most firms are com: prised of many cost centers setup for cost accounting pur poses to collect like-type costs and assign them to products and services, but these are not responsibility ‘centers because they focus on cost categorizations rather than lines of authority over expenses by managers in charge of organizational entities with accountability fora ‘cost budget. Firms typically use many more cost centers for cost accounting purposes than for responsibility center control purposes. 2 See, for exemple, “Study Finds Companies Profit When ‘They Track Product Pars," Forbes (December 20, 2013), online a onforb.es/18WTVsT. 13 "Cisco india’ New Marketing Initiatives Ramp Up Lead Gen- craton," CRN January 15, 2015), online at wwrw.crn.com. 4 “RBS Finds Itself Back in Hot Water,” The Wal StretJour- nal (Novernber 25, 2013), online at on:ws}.com/IekyZ04. 5 "Who Says the Music Industry Is Kaput,” Business Week (May 27, 2010), online at wwww.businessweek.com. 6 R. Cooper and R. Slagmulder, “Micro Profit Centers” ‘Management Accounting, 79, 00.12 (1998), pp. 16-18. 7 For a further discussion of return measures and their ‘effects, which we also treatin more detail in Chapter 10, see W. A. Van der Stede, “Discussion of The Role of Per formance Measures in the Intertemporal Decisions of Business Unie Managers," Contemporary Accounting ‘Research, 30,n0.3 (2013), pp. 962-9. 8 thi. ‘9 “Why Energy Management Matters to ClOs,” Forbes (September 15, 2010), online at www:forbes.com. ‘Transfer pricing also applies to transfers involving cost centers, Transfers can be made, for example, at actual or u 2 13 4 15 16 ” 8 standard cost or at full or variable cost berween cost cens- fers. However, since most transfer pricing problems {involve profit (or investment) centers, for reasons of sim plicty, this chapter refers to both the supplying and buy- ing entities as profiecenters. ‘See, fr example, Global Transfer Pricing Survey (Ernst & Young, 2016). ‘Examples are numerous, but for some recent cases, see “Brussels Opens Tax Probe into Apple, Starbucks and Fiat," The Financial Times (June 11, 2014), online at on. f.com/IhJ2NE7. M. Cools and R. Slegmulder, “Tax-Compliant Transfer Pricing and Responsibility Accounting” Journal of Man agement Aecounting Research, 21 (2006), pp. 151-78. See, for example, C. X. Chen, S. Chen, F. Pan, and Y. ‘Wang, “Determinants and Consequences of Transfer Pic {ing Autonomy: An Empirical Investigation," Journal of Management Accounting Research, 27, no. 2 (2015), pp. 225-59, Global Transfer Pricing Survey, op it “The Nobel Prize for Economics: The Bigger Picture,” The Economist (ctober 12, 2009), online at econ.st/ JwMiwM; “The Man Who Showed Why Firms Exist,” The Economist (September 7, 2013), online at econ. sv/161DLgM. For a recent academic treatment of dual transfer prices, see E, Johnson, N. B. Johnson, and T. Pfeiffer, “Dual ‘Transfer Pricing with Internal and External Trade,” Review of Accounting Studies, 21, no, 1 (March 2016), Pp. 140-64, See, fore smple, §. Anderson, B. Zhou, R. Ghayad, and IM, Gragg, “The Interaction of Managerial and Tax Trans: fer Pricing." Tax Management Transfer Pricing Report, 24, no, 17 January 2016) In July 2003, Kevin Wentworth, CEO of Kranworth Chair Corporation (KCC), was considering a major reorganization ~ a divisionalization — of his company's organization structure: Like many entrepreneurs, | have always been focused on top-line sales growth, and I have con- ‘tantly been impressing on my managers to drive alos. My beliot was that if you do that, everything ‘else takos caro of itso. Up until recently, | think our approach made sense. We had very tle competi tion, and our margins were huge. Now things are changing. We've got some major ‘competitors who are making headway. I think we needed to take a fresh management approach to 275‘PPortunities to do things better. Our new div sionalized organization structure should help us ‘serve our customers better and maybe force us to eliminate certain markets or products that are not producing results. But I'm not sure it's working very well. We're ‘seeing some finger pointing between the managers of the newly created divisions and the managers in charge of corporate departments, There is alot of Politics involved in defining the roles, responsibili- ties, ... and rights, of each of the responsibility Centers, and i's not clear to me yet exactly where ‘0 draw the lines. The company In the early 1980s, Weston Krantz, an avid outdoors per- son, developed a new design for a lightweight, portable chair that could be stored ina bag and carried anywhere Convinced that his design had commercial value, in 1987 Weston cofounded Kranworth Chair Corporation (KCC) with his longtime friend, Kevin Wentworth, who shad an MBA degree and financial expertise. (The corpo- Fation’s name was a contraction of the founders’ names: Krantz and Wentworth.) KCC was headquartered in Denver, Colorado, in the foothills of the Rocky Moun- tains. KCC produced a broad line of high-quality and fashionable portable, folding chairs, which were branded «as various models ofthe Fold-t! brand. In ts early years, KCC sold its products exclusively to distributors. Since its inception, KCC had been organized func- tionally, In 2003, reporting to the cofounders were vice presidents in charge of sales, supply chain, and finance ‘and administration, plus staff managers responsible for advertising and research and development (Exhibit 1), Over the years, KCC expanded its product offerings, In 2003, it offered an extensive line of folding chairs, ‘The chairs were produced in various sizes and models, including both adult and child chairs, single chairs and oveseats, and full- and beach-height chairs, Some chairs had additional features, such as cup holders, storage pockets, and trays. The chairs were produced at several price points, with varying fabrics, designs (eg. single vs. double layer), and frame materials. KCC also offered some related products, such as folding tripod stools, ottomans, cots, and stadium seats. KCC also pro- duced custom-designed products. It employed screen- printing artists and seamstresses who applied custom logos, graphics, and lettering to the nylon. KCC products were often seen at corporate trade shows and 276 tailgate parties at sporting events. The company kept track of approximately 1,500 stock keeping units (SKUs) ~ finished products and various piece parts that the company sold ~although about 85-90% of the sales stemmed from only about 40 of the SKUs, Gradually, KCC built sales by investing in more ‘advertising and by adding other distribution channels, By 2003, it sold some products directly to major retail chains (Wal-Mart, K-Mart, Target), as well as other retailers (eg. sporting goods stores) of various sizes, It sold to retailers using the KCC sales force, outside reps, and distributors. It also sold custom products directly to corporations and high school or university book: stores and athletic departments. The retail channels Provided the highest sales volumes, but those sales were made at lower margins. In the 1990s, KCC moved its core manufacturing facilites to Mexico and China to take advantage oflower labor rates. Only some assembly (“kitting”) and custom- ‘ning facilities were retained in the Denver location, In the company’s first decade of existence, KCC had litle competition. Its chair designs were protected by ‘more than 20 patents. Sales grew rapidly, and average ‘margins were high, in the range of 40-50%, although some margins were sacrificed in later years in order to senerate sales from large retail chains. In 1999, KCC borrowed $30 million because the founders, particularly Kevin, wanted to take a signifi- cant amount of cash out of the company. Kevin had become interested in ranching, and he wanted to buy a significantly larger ranch. Ranching had become his passion, and he was spending less and less time at KCC. (For years Weston had spent only a small portion of his ‘ime at KCC as he traveled and pursued his various avo- cations.) The debt service on the loan reduced KCC man. ‘agers! margin for error. Cash flow was tight, particularly at the slow time ofthe year - October to January. Starting in the late 1990s, some significant competi- tors, mostly from Asian countries, entered the market with comparable chair designs. Despite the fact that ‘most customers perceived KCC as having superior designs and higher quality, and customer satisfaction was high, the higher competition and the worldwide recession of the early 2000s caused sales to flatten and profits to drop. The company’s management incentive plan did not pay out in either 2001 or 2002. in 2003, performance was slightly improved. KCC’s total reve. ‘ues were projected to be approximately $70 million, ‘up from $68 million in 2002, and profits were expected 10 be slightly positive,Motivation for divisionalization In 2002, Kevin began to think about changes that, right stem from a change in organization structure. He thought that the KCC managers needed to focus ‘more on the quality, and not just the quantity, of sales. To illustrate the point, he described an example in ‘which KCC personnel had aggressively sought business from Target, the large retail chain. In order to develop this retail account, KCC designed a special chair model for Target and offered a special price with a lower gross margin. While Target did sell some Fold-it! chairs, they did not sell many. Part of the reason for the poor sales was that many of Target's outlets did not display the Fold-it! chairs effectively. Instead of dis playing them in the sporting goods department, they shelved them wherever they had room. Kevin ‘explained, “I walked into a Target store in a suburb of Denver and found that our products were siting on the bottom shelf horizontally in the back corner of the ‘Automotive Department, where nobody could ever see them!” Because of the “growth at all costs” philosophy, KCC incurred significant product development and marketing costs and ended up carrying a large amount of inventory; so, overall, the Target account, and some others like it, were very unprofitable. But to develop ‘more focus on the quality of sales, KCC had to develop ‘a stronger customer focus, to understand better cus- tomers’ needs and wants, and to improve customer service levels. Kevin also thought that divisionalization, if imple- ‘mented properly, could help KCC improve its efficiency and asset utilization. He thought that with an improved ‘customer focus, it was almos ble that the com- pany could reduce its SKUs, possibly outsource more functions, and generally learn to serve customer needs better while tying up less capital. Divisionalization alternatives What kind of divisionalization would be best? Kevin ‘thought first about the relatively conservative approach ‘of merely making the sales function a profit center. This approach would involve charging Sales for the full costs (or, perhaps, full costs plus a markup) ofthe prod- ucts they sold, Sales would have to pay for the costs of customizing products and holding inventory. This approach would make Sales more aware of the cost implications of their decisions and, hence, more moti- vated to generate profitable sales. ‘Kranworth Chair Corporation But Kevin concluded that KCC should probably so further to create true product divisions. The KCC man- agers had frequent debates about what products and sales channels were most profitable, but those debates ‘were not informed with hard data, A divisionalization ‘would require some disaggregation of total costs and ‘would facilitate profitability analyses. If this was done, however, the KCC managers would. have to consider how self-contained the new operating ‘entities should be. Kevin wondered, “Should [the prod- uct divisions] each have their own supply chain man- agement, sales force, R&D, and human resources functions, or should those resources be shared?” ‘The obvious product split in KCC was between Retail Produets and Custom Products. The Retail Division would focus on the higher volume, standard product sales to retail outlets. The Custom Products Division, ‘would focus on the smaller-volume custom sales. In the approach that Kevin was planning to present to his management team, the two product divisions were to become profit centers. Each entity would be dedicated to its focused core business, but their manag- ers would be free to choose how they did business and what they incorporated into their business model. Reporting to each of the division managers would be managers responsible for sales and marketing, pur- chasing and inventory control, and finance and accounting. Supply chain, R&D, human resources, and advertising would still be centralized, although these functions would clearly have to work closely with divi sion managers. Kevin hoped that this new structure would allow the Retail and Custom Products divisions to make some bold, new decisions. The new company focus would also be on creating value, rather than merely growing, For the divisions, creating value could easily mean con- tracting sales to eliminate unprofitable or marginally profitable products and customers. The best customers, for example, were probably those that bought the most profitable products, placed inventory requirements on, KCC that were reasonable and predictable, had a strong, credit standing and payment history, and were rela- tively easy to serve. The divisions might also decide that they should outsource some functions, such as warehousing, which might allow KCC to provide better customer service during the busy seasons and to ‘employ fewer people and assets in the low seasons. (On July 28, 2003, Kevin presented his divisionaliza- tion ideas to his management team. Figure 1 shows an ‘excerpt from the presentation he gave. 27——_——————_e, ee ‘Chapter 7 «Financial Responsibility Centers Figure 1 Excerpt from presentation given by Kevin Wentworth ‘The new product divisions will be lean, mean fighting machines witha direct purpose and the vision to carry ‘that purpose out. With our [corporate managers'] help, they will look at how they do business now and hat they can do better. They will have the ‘opportunity to dream. If we were to start a new produet-line business, think ofthe questions that ‘would have to be answered: 41. How should we staf? 22. How should we source? 8, How should we warehouse? 4. How should we sot? '5. How should wa ship? {8 How should we finance? ‘These are just some ofthe many questions that a new ‘company has to address. ‘We have a certain advantage since we already have «a baseline. But we also carry along a disadvantage. We have become entrenched in our ways and are the ‘costest product in the market. I we forced ourselves to completely reevaluate the business, could we significant reduce costs, provide better customer service, ad yield higher operating profits? That ‘answer must be “yes" in order to stay In business in ‘the future. Think ofthe fabulous business opportunity in front of ust Some of the KCC managers were enthusiastic about the proposed change, Others thought that the ideas ‘were radical. A few managers were bewildered, as they hhad never worked in an organization with a divisional structure and had trouble visualizing how it would work. In the ensuing discussion, many questions arose, such as relating to the specifics as to who would be responsible for what and how performance would be measured and rewarded. It was decided that the idea needed more specifics. A follow-up meeting was held two weeks later. By then most of the managers realized that top manage- ‘ment had already made this decision; the company was going to be divisionalized. They then became highly interested in shaping the details of the change. The focus of the second meeting was on defining division management responsibilities. Alter considerable discussion, there was general ‘agreement regarding the following general division of responsibilities: 278 2. Financing and other high-level financial matters 8. Engineering, design, and R&D 4. Facilities 65. Legal and intellectual property 6. Supply chain and quality 7. Corporate identity (eg. public relations, some gen- eral advertising) 8, Human resources 9. Information technology 410. Acquisitions and joint ventures Responsibilities of division management: 1. Overall vision and strategy for their respective markets 2, Development and implementation of divisional annual budgets 3. Staffing 4. Operations, including purchasing of parts and mate- rials specific to respective markets, receiving, ware- housing, shipping, and inventory management 5. Controllership and accounting. 6. Product-specific advertising and collateral material 7. Information technology support With this general understanding of the distribu- tion of responsibilities in the company in place, the next task was the development of ideas regarding performance measurement and incentives. This task ‘was assigned to Robert Chang, VP — Finance and Administration, Performance measurement and incentives Robert developed a measure that he called controllable returns, which was defined as operating income (before tax) divided by controllable assets. To get to operating income, all the division direct expenses were sub- tracted from division revenues, as were as many of the ¥ ifthe division (corporate plan was me, bathe corporat (vision) lan was no, division management would stl eeivethe divisional {corporate portion ofthe bons.‘corporate expenses that could be reasonably allocated to the divisions. The assets deemed controllable by the divisions included their receivables, inventories, and an assigned costo facilities they used. Robert proposed an incentive plan that provided 22 managers, down to the director level (one level below division manager), with a cash award based on achieve- ‘ment of annual targets set for controllable return at the divisional and corporate levels. For corporate manag- ers, the bonuses would be based solely on corporate performance. For managers assigned to a division, the bonuses would be based 75% on division performance ‘and 25% on corporate performance. Robert proposed that the expected payouts be set initially a relatively modest levels. If the annual per- formance targets were achieved, Kevin and Weston would be paid an award of 40% of salary, division managers would be paid 30%, and managers lower in the hierarchy would be paid 15-20%. No payouts ‘would be made if actual performance was below plan. If actual performance exceeded plan, the pay- ‘outs could be increased by up to 50%, at the discre- tion of top management and the company’s board of directors. Robert explained that he proposed the relatively modest awards because the costs of this plan would probably be in excess of $500,000, a significant addi- tional expense for the company. Maintaining competi- tive total compensation levels was not an issue because KCC managers were currently not accustomed to earn- {ng a bonus, since the old sales grovth-based incentive plan had not paid out anything in either 2001 or 2002. Plus, Robert thought the company needed to get some experience with setting division-level performance targets and measuring and evaluating performance in ‘anew way before ratcheting the performance-depend- ‘ent rewards upward while probably reducing the pro- portion of total compensation paid as fixed base salaries. ‘These suggestions were discussed in a staff meeting hheld on October 13, 2003.? The major point of dissen- sion was regarding the proposed assignment of some of the corporate expenses to the divisions. Some of the personnel who were slated for assignment toa division complained that they could not control the terms of ¥ Sales personnel were stil included in sessed commission plan, Artis meeting the ea came up chat ce sales commissions Thould be weighted based on product profitability, bur detailed ‘iscursion ofthis tea was deferred. Kranworth Chat Corporation deals that corporate staff negotiated for them, such es for insurance. Kevin headed off this discussion by explaining that these cost assignments would be built into the performance targets, o they would not affect the actual vs. targeted return comparison. Further, division managers would have near complete freedom ‘of sourcing. Ifthey did not like the services provided to ‘them by corporate staffs, they were free to purchase those services from outside the company. A follow-up meeting was scheduled for October 27, 2008. That meeting was intended to be used primarily to design the new organization - who would be assigned to what division and in what role (see Exhibit 2). It was hoped that the new divisionalized structure would be completely in place by January 1, 2004, and the first incentives based on controllable return would be paid based on 2004-performance. Hopes and concerns for the future Kevin was convinced that the new divisionalized organization structure would give KCC its best chance for future success: Most of us are now convinced that this is a good idea. Although it creates a more complex organiza- tion, it will make most of our managers feel more ‘empowered, It will also force us to be more focused (on returns, rather than revenues and cost control. Privately, however, Kevin expressed concern that this major turning point in the company's history was auite risky. I'm delegating considerable decision-making ower to the division managers. If they make mis~ takes, our business can go down the tubes. The ‘managers will make out all right; they can go find ‘another job. But the fortunes of my family and those of the other major owners would be devastated. He had a specific concern about one manager, Joe Yarmouth, the current VP-Sales who would be appointed as general manager of the Retail Division. Joe is in his early 508, and he has a lot of exper'- tence. But most of the experience isin sales, rather ‘than marketing and other functions, and all of his experience before KCC was in big compani Clorox, Hershey's. Culturally he does not have the ‘small company mindset. He has no experience in‘Chapter 7- Financial Responsibilty Centers understanding costs, cash flows, and returns. | think he should have been able to set up more deals that don't require any working capital invest- ‘ment, but he just doesn't think that way. So Kevin, and indeed most of the KCC managers, looked to the future with both eager anticipation and twepidation, Early experiences CC's early experiences with the divisionalized struc- ture created more concern. The first major initiative of Ed Sanchez, the manager of the new Custom Division, ‘was to propose the procurement of a more sophisti- cated fabric-cutting machine. This machine would allow the fabric to be cut more efficiently and lower both material and labor costs slightly. A discounted, cash flow analysis suggested that this machine was a ‘worthwhile investment. But, Kevin explained: In my opinion, this investment does not address the real issue in the Custom Division. Our real issue is ‘tumaround time. We have plenty of margin in cus ‘tom work, but we need to reduce our turnaround time to serve our customers better. | think Ed is ‘turing the wrong dials. Kevin also knew that in Retail, the newly installed division manager Joe Yarmouth, who had good con- tacts in the advertising world through his prior jabs, was talking with a new advertising agency about the possibility of a new campaign to advertise retail prod- ucts more aggressively. Kevin wondered whether this ‘was inthe best interest of the company. He commented: ''m worried about losing economies of scale from dealing with different ad agencies and about what this “go-tt-alone” advertising will do to our corpo- rate identity. And in any case, lack of advertising was not the problem we faced at Target; it wat product placement! Joe, in turn, had already been grumbling to Robert about late deliveries and missed sales as well as prod- uct returns due to quality problems, which were caused, in his opinion, by vendor problems that were under the purview of Carrie Jennings, the corporate head of Supply Chain and Quality In the new organiza- tion structure, Supply Chain was responsible for ‘obtaining and maintaining an adequate vendor group, primarily in Asia and Mexico, to secure both high-qual- ity subassemblies and on-time delivery, while reducing 280 dependency on any given vendor. The divisions had responsibility only for placing the day-to-day purchas- ing orders (POs) with these vendors. Joe complained: It keep having delivery and quality Issues due to problems with our overseas vendors, over which | have no control, !'m sure going to miss my perfor. ‘mance target for the year. /am the one ~not Carrie ~ ‘who feols the pain of lower sales and higher costs ‘due to product returns, because It directly affects the numerator of my controllable retums measure, ‘and thus, my bonus that is totally based oni. have already lobbied corporate to let me have control ‘over vendor negotiations. if they won't do that, they should at least adjust my targets so that my evalu- ations aren't affected by others’ failures. But so far they don't seem to want to listen to me. Robert estimated that the divisions had about 85% control over their own P&L results. He believed that was significant enough: ‘Joe's arguments have some merit, but ne manager ever controls everything. Our managers need to work with others in the organization within the con- straints in which they are placed, to react to a lot of changing conditions, and to deliver the needed results. f Joe can't do this, then we'll ind someone: ‘else who can. Robert did not think that corporate managers should make any changes either to the assigned responsibilt- ties or the bonus plan. Joe had also proposed some other ideas for a leaner Retail business that could potentially affect the design of the Supply Chain function. He wanted to enter into arrangements with large retailers that would provide favorable pricing in return for commitments to take delivery of full containers of finished products right at the portof entry from either Asia or Mexico). This would climinate further kitting in the Denver plant and reduce inventory significantly. Kevin thought this could be a 00d idea, but he was not sure who should take responsi bility for working out the details. He was also worried about the politics involved in redrawing the lines of responsibility so early into the new divisionalization. ‘Another issue that had arisen involved the R&D function, Corporate R&D was responsible for new prod- ‘uct designs and refinements. Even though most ideas for new products or product improvements came from the division managers and their sales people in the field, division management did not have much control,KOT RO BR Oem agto on over which R&D initiatives received priority. Joe ‘Yarmouth commented: ‘There Is too much filtering by corporate RAD of the ideas that we feed them. We can’t get anything done without Ken Simmons’ [RAD manager] biess- ing, and Ken really takes his orders from Weston [Krantz]. We ought to have more influence. We know our markets better than anyone else in the ‘company, and we are paying for the function. We ‘Kramworth Cnsir Corporation they're doing for us area few tweaks on our stand ard products. Ed Sanches (Custom), in turn, was complaining that R&D was much to “reactive” to new product features already introduced by competitors, despite the fact that hae and his sales people has proposed many ideas for sore radical changes. Under this pressure from the division managers, Kevin was considering whether KCC should allow the {the divisions] each fund 50% of the corporate R&D divisions todo their own R&D. He knew doing so would budget. 'm about to take a $150,000 hit for corpo- solve the problems the divisions managers were com- rate R&D in my 2004 PAL, and what do I get for plaining about, but he wasn’t sure which new problems that? And why do we [the divisions] each have to it might create. Kevin did not like the whining. But he share the burden equally? I'm also annoyed that ‘Custom is getting a lot more R&D support than I do. also did not want to undercut the local initiative that ‘the new organization promised to bring to KCC. And in Certainly Retail is much larger than Custom, but _anty case, there were pressing issues to attend to on his we're not getting much support from R&D. All new ranch. Exhibit 1 Kranworth Chair Corporation: 2008 organization structure CChaleman, Weston Krantz President/OE‘ YP Finance & Administration ‘Robert \VP Supply Chain lL 1 rsa ay ae Niche | oma Assembly 8 omnes Mexico}bitadi ‘Chapter 7 - Financial Responsibility Conters ‘Exhibit 2 Kranworth Chair Corporation: 2004 organization structure Finance & Administration HA, Information Systems, and Legal (Robert Chang) tall Division Joseph Yarmouth (es }--}—[Seaa ‘Accounting & Administration 1 (eeen} Coe mae < amma ovroig —laonpratone =D funrnina ~ harensm ~emsroteire = earatemes® > SYgh Games” = Sea Sages at ere a oe ran “Soe “This cave was prepared by Professors Kenneth A. Merchant, Wim A. Van der Sede, and research assistant Clara CKiaoing) Chen. Copyright © by Kenneth Merchant and Wi A Van der Sede.