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Chapter 16

Management Control In
Decentralized
Organizations

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 1
Learning Objective 1

Define decentralization and


identify its expected
benefits and costs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 2
Decentralization

The delegation of freedom to make decisions


is called decentralization.

The lower in the organization that this freedom


exists, the greater the decentralization.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 3
Centralization versus
Decentralization

Centralization Decentralization

Maximum Constraints Minimum Constraints


Minimum Freedom Maximum Freedom

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 4
Costs and Benefits

Benefits of decentralization:
Lower-level managers have the best
information concerning local conditions.
It promotes management skills which,
in turn, helps ensure leadership continuity.
Managers enjoy higher status from being
independent and thus are better motivated.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 5
Costs and Benefits

Costs of decentralization:
Managers may make decisions that are not
in the organization’s best interests.
Managers also tend to duplicate services
that might be less expensive if centralized.
Costs of accumulating and processing
information frequently rise.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 6
Costs and Benefits

Managers in decentralized units may waste


time negotiating with other units about goods
or services one unit provides to the other.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 7
Middle Ground
 Cost-benefit considerations usually require
that some management decisions be highly
decentralized and others centralized.
 Decentralization is most successful when an
organization’s segments are relatively
independent of one another.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 8
Segment Autonomy

If management has decided in favor of heavy


decentralization, segment autonomy, the delegation
of decision-making power to managers of segments
of an organization, is also crucial.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 9
Learning Objective 2

Distinguish between profit


centers and decentralization.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 10
Profit Centers and
Decentralization

Accountability for
Profit centers
revenue and expenses

Freedom to make
Decentralization
decisions

These are entirely separate concepts


and one can exist without the other.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 11
Profit Centers and
Decentralization

All control systems are imperfect.

Judgments about their merits should


concentrate on which alternative
system will bring more of the
actions top management seeks.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 12
Learning Objective 3

Define transfer prices and


identify their purpose.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 13
Transfer Prices
 Transfer prices are the amounts charged by
one segment of an organization for a
product or service that it supplies to another
segment of the same organization.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 14
Purpose of Transfer Pricing

Why do transfer-pricing systems exist?

– to communicate data that will lead to


goal-congruent decisions

– to evaluate segment performance and


thus motivate managers toward
goal-congruent decisions

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 15
Purpose of Transfer Pricing

Multinational companies use transfer


pricing to minimize their worldwide
taxes, duties, and tariffs.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 16
Learning Objective 4

Identify the relative advantages


and disadvantages of basing
transfer prices on total
costs, variable costs,
and market prices.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 17
Transfers at Cost
 About half of the major companies in the
world transfer items at cost.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 18
Transfers at Cost

What are some examples?


Full cost plus a profit markup
Variable costs
Standard costs
Actual costs
Full cost

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 19
Market-Based Transfer Prices

If there is a competitive market for the product


or service being transferred internally, using
the market price as a transfer price will
generally lead to the desired goal
congruence and managerial effort.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 20
Market-Based Transfer Prices
 The major drawback to market-based prices
is that market prices are not always
available for items transferred internally.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 21
Variable-Cost Pricing
 When market prices cannot be used,
versions of “cost-plus-a-profit” are often
used as a fair substitute.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 22
Variable-Cost Pricing

In situations where idle capacity exists,


variable cost would generally be the
better basis for transfer pricing and
would lead to the optimum decision
for the firm as a whole.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 23
Negotiated Transfer Prices
 Companies heavily
committed to segment
autonomy often allow
managers to negotiate
transfer prices.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 24
Dysfunctional Behavior

Virtually any type of transfer pricing policy


can lead to dysfunctional behavior – actions
taken in conflict with organizational goals.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 25
The Need for Many Transfer
Prices
 The “correct” transfer price depends on the
economic and legal circumstances and the
decision at hand.
 Organizations may have to make trade-offs
between pricing for congruence and pricing
to spur managerial effort.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 26
Learning Objective 5

Identify the factors affecting


multinational transfer prices.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 27
Multinational Transfer Pricing
Example
 An item is produced by Division A in a
country with a 25% income tax rate.
 It is transferred to Division B in a country
with a 50% income tax rate.
 An import duty equal to 20% of the price of
the item is assessed.
 Full unit cost is $100, and variable cost is
$60 (either transfer price could be chosen).

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 28
Multinational Transfer Pricing
Example

Which transfer price should be chosen?

$100 Why?

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 29
Multinational Transfer Pricing
Example

Income of A is $40 higher:


25% × $40 = ($10) higher taxes
Income of B is $40 lower:
50% × $40 = $20 lower taxes
Import duty paid by B:
20% × $40 = ($8)
Net savings = $2

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 30
Learning Objective 6

Explain how the linking of


rewards to responsibility
center results affects
incentives and risk.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 31
Link Rewards to Results

Choices
ChoicesofofResponsibility
Responsibility
Motivational
MotivationalCriteria
Criteria Centers
Centersand
andIncentives
Incentives

Goal
Goal Managerial
Managerial Performance
Performance Rewards
Rewards
Congruence
Congruence Effort
Effort Measures
Measures

Feedback

Feedback

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 32
Link Rewards to Results
 Research shows that the more objective the
measures of performance, the more likely
the manager will provide effort.
 Thus accounting measures, which provide
relatively objective evaluations of
performance, are important.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 33
Agency Theory
Economists describe the formal
choices of performance measures
and rewards as agency theory.
Employment contracts will
trade off three factors:
1 – Cost of measuring performance
2 – Incentive 3 – Risk

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 34
Learning Objective 7

Compute ROI, residual income,


and economic value added (EVA)
and contrast them as criteria for
judging the performance of
organization segments.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 35
Measures of Profitability
 Segment managers in decentralized
organizations are often evaluated based on their
segment’s profitability.
 Is it net income?
 Income before taxes?
 Net income percentage based on revenue?
 Is it an absolute amount?
 A percentage?

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 36
Return on Investment

ROI = Income ÷ Investment

Income Revenue
ROI = Revenue × Investment

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 37
Return on Investment

Project A: Operating income ÷ Investment required


$200,000 ÷ $500,000 = 40%

Project B: Operating income ÷ Investment required


$150,000 ÷ $250,000 = 60%

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 38
Residual Income

RI = Net operating income – Imputed interest

Imputed interest refers to the cost of capital.


RI tells you how much your company’s
operating income exceeds what it is
paying for capital.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 39
Economic Value Added

Economic value added


= Income
– After-tax cost of capital
× (Long-term liabilities + Stockholders’ equity)

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 40
Learning Objective 8

Compare the advantages and


disadvantages of various bases
for measuring the invested
capital used by organization
segments.
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 41
ROI or Residual Income?

Why do some companies prefer


residual income (or EVA) to ROI?
Under ROI, the message is go forth and
maximize your rate of return, a percentage.
Under RI, the message is go forth and maximize
residual income, an absolute amount.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 42
Invested Capital

To apply either ROI or residual income,


both income and invested capital must
be measured and defined.
Total assets Total assets employed
Total assets less current liabilities
Stockholders’ equity

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 43
Asset Allocation to Divisions
 Commonly used bases for allocation, when
assets are not directly identifiable with a
specific division, include:
Asset Class Possible Allocation Base
Corporate cash Budgeted cash needs
Receivables Sales weighted by terms
Inventories Budgeted sales or usage
Plant and equipment Usage of services
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 44
Valuation of Assets

Should values be based on historical cost


or some version of current value?
Practice is overwhelmingly in favor of using
net book value based on historical cost.
Most companies use net book value in
calculating their investment base.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 45
Learning Objective 9

Understand the role of


management control systems
in decentralized organizations.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 46
Keys to Successful
Management Control Systems

Successful management control systems


have several key factors in addition to
appropriate measures of profitability.
Controllability Management by objectives
Tailoring budgets for managers

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 47
Focus on Controllability
 A distinction should be made between the
performance of the division manager and
the performance of the division as an
investment by the corporation.
 Managers should be evaluated on the basis
of their controllable performance.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 48
Management by Objectives

MBO describes the joint formulation by


a manager and his or her superior of a
set of goals and plans for achieving
the goals for a forthcoming period.

The manager’s performance is then


evaluated in relation to these
agreed-upon budgeted objectives.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 49
Tailoring Budgets for Managers
 Many of the troublesome motivational
effects of performance evaluation systems
can be minimized by the astute use of
budgets.
 The desirability of tailoring a budget to
particular managers cannot be
overemphasized.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 50
End of Chapter 10

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton 10 - 51

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