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Decentralization: Responsibility

Accounting, Performance
Evaluation, and Transfer Pricing
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, residual income,
and economic value added.
4. Discuss methods of evaluating and rewarding managerial
performance.
5. Explain the role of transfer pricing in a decentralized firm.
6. Discuss the methods of setting transfer prices.
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.

Types of Responsibility Centers:


1. Cost Center: only responsible for costs
2. Revenue Center: only responsible for revenues
3. Profit Center: responsible for both revenues and costs
4. Investment Center: responsible for revenues, costs, and
investments

Objective 1
10-3
Decentralization

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: the practice of delegating decision making


authority to the lower levels.

Objective 210-4
Decentralization
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

Objective 210-5
Decentralization

Control of cost centers is achieved by evaluating the


efficiency and the effectiveness of divisional managers.
• Efficiency: how well activities are performed
• Effectiveness: whether the manager has performed the
right activities

Objective 210-6
Measuring the Performance of
Investment Centers
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

Where:
Margin = portion of sales available for interest, taxes and profit
Turnover = how productively assets are being used to generate sales
Operating income = refers to earnings before interest and income
taxes
Operating assets = includes all assets used to generate operating
income

Objective 310-7
Measuring the Performance of
Investment Centers
Advantages of the ROI Measure:
1. Helps managers focus on the relationship between sales,
expenses and investment.
2. Encourages cost efficiency.
3. Discourages excessive investment in operating assets

Disadvantages of the ROI Measure:


1. Discourages managers from investing in projects decreasing
divisional ROI but increasing profitability of the company overall.
2. Encourages managers to focus on the short-term at the expense
of the long-term.

Objective 310-8
Measuring the Performance of
Investment Centers
Residual Income is the 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]

Residual income is a dollar measure of performance – encourages


managers to move beyond the focus of the percentage return on
investment to look at the absolute dollar value of the additional
profit.

However, the residual income is an absolute measure of return which


makes it difficult to directly compare the performance of
divisions. It also does not discourage myopic behavior

Objective 310-9
Measuring the Performance of
Investment Centers
Economic Value Added (EVA) is 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

EVA = After-tax operating income – [Weighted average cost of


capital × total capital employed]

Behavioral Aspects of EVA:


1. Tends to focus on long-run
2. Discourages myopic behavior

Objective 310-10
Measuring and Rewarding the
Performance of Managers
Incentive Pay for Managers
Why would managers not provide good service?
There are three reasons:
1. They may have low ability.
2. They may prefer not to work hard.
3. They may prefer to spend company resources on perquisites.

Objective 410-11
Measuring and Rewarding the
Performance of Managers
Managerial Rewards
• Frequently managerial rewards include incentives tied to
performance.
• The objective of managerial awards is to encourage goal
congruence, so that managers will act in the best interests of the
firm.
• Managerial rewards include salary increases, bonuses based on
reported income, stock options, and noncash compensations.

Objective 410-12
Measuring and Rewarding the
Performance of Managers
Cash Compensation
• 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 by keeping salaries fairly level and allowing
bonuses to fluctuate with reported income.

Objective 410-13
Measuring and Rewarding the
Performance of Managers
Stock-Based Compensation
• Stock options frequently are offered to managers to encourage
them to focus on the longer term.
• 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. Then, if the stock price rises in the future, the
manager may exercise the option.

Objective 410-14
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.

Profitability, return on investment, and managerial performance


evaluation of both divisions are affected by transfer pricing.

Objective 510-15
Transfer Pricing

Objective 510-16
Setting Transfer Prices
A transfer pricing system should satisfy three objectives:
• Accurate performance evaluation
• Goal congruence
• Preservation

The opportunity cost approach identifies the minimum transfer price


and the maximum transfer price.
• 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 division no worse off it an input is purchased from
an internal division.

Objective 610-17
Setting Transfer Prices
• Market price
• Negotiated transfer prices
• Cost based transfer prices
• Variable cost transfer pricing
• Full (absorption cost) cost transfer pricing

Objective 610-18
Setting Transfer Prices

Objective 610-19
Setting Transfer Prices

Objective 610-20
Setting Transfer Prices

Objective 610-21
Setting Transfer Prices
• Disadvantages of Negotiated Transfer Prices
• One divisional manager with private information may take
advantage of another divisional manager
• Performance measures may be distorted by the negotiating skills of
managers
• Negotiation can consume considerable time and resources
• Despite the disadvantages, negotiated price transfer prices offer some
hope of complying with the three criteria of goal congruence,
autonomy, and accurate performance evaluation

Objective 610-22
Setting Transfer Prices

• Cost-Based Transfer Prices


• Full-cost transfer pricing
• Full cost plus markup
• Variable cost per fixed fee
• Propriety of use

Objective 610-23
Setting Transfer Prices

Objective 610-24
End of Chapter 10