Horngren Ima16 Inppt10

Copyright © 2014 Pearson Education, Inc.
publishing as Prentice Hall 10 - 1

Chapter 10
Management Control
in Decentralized Organizations
Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 2

Chapter 10 Learning Objectives
1. Define decentralization and identify its expected

benefits and costs.
2. Distinguish between responsibility centers and

decentralization.
3. Explain how the linking of rewards to responsibility-

center performance metrics affects incentives and risk.
4. Compute return on investment (ROI), economic profit,

and economic value added (EVA).

Chapter 10 Learning Objectives
5. Compare the incentives created by income, ROI, and

economic profit (or EVA) performance measures.
6. Define transfer prices and identify their purpose.
7. State the general rule for transfer pricing and use it to

assess transfer prices based on total costs, variable costs,
and market prices.
8. Identify the factors affecting multinational transfer

prices.
9. Explain how controllability and management by

objectives (MBO) aid the implementation of management
control systems.

Learning
Objective 1 Decentralization
The delegation of freedom to make

decisions is called decentralization.
The delegation of decision making authority

to lower levels of the organization.
The lower in the organization that authority
is delegated, the greater the decentralization.

Learning
Objective 1 Centralization
The process by which decision making is

concentrated within a particular location
or group is called centralization.
Concentration of decision making authority only at the

highest levels of an organization is called Centralization

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.

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.

Middle Ground
Many companies find that decentralization

works best in part of the company, while
centralization works better in other parts.
Decentralization is most successful

when an organization’s segments are
relatively independent of one another.

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.
For decentralization to work, autonomy must be

real, not just “lip service.” Top managers must
be willing to abide (comply)by decisions made by
segment managers in most circumstances.

Learning Responsibility Centers
Objective 2
and Decentralization
Design of a management control system should

consider two separate dimensions of control:

Responsibility Centers
Profit centers Cost Centers
Will a profit center or a cost center better

solve the problems of goal congruence and
management effort?
In designing accounting control systems, top

managers must consider the system’s impact
on behavior desired by the organization.

Responsibility Centers
The management control system should

be designed to achieve the best possible
alignment between local manager decisions
and the actions central management seeks.
For example, a plant may seem to be a

“natural” cost center because the plant manager
has no influence over decisions
concerning the marketing of its products.

Learning Performance Metrics and
Objective 3
Management Controls
Linking rewards to responsibility-

center performance metrics affects
incentives and risk.
Incentives are the rewards, both

implicit and explicit, for managerial
effort and actions.
A performance metric is a specific

measure of management
accomplishment.

Motivation, Performance, and Rewards
Incentives. . .
Performance-based rewards that

enhance managerial effort toward
organizational goals.
Motivational Rewards
Criteria
Motivation, Performance, and Rewards
You get what you measure!
Therefore, accounting measures,

which provide relatively objective
evaluations of performance,
are important.

Performance Metrics and
Management Controls
The design of a management control system

affects the actions of managers. It specifies
how outcomes translate into unit performance
metrics and into both explicit and implicit
rewards.
Performance Metrics and
Management Controls
Agency theory provides a model to analyze

relationships where one party (the principal)
delegates decision-making authority to another
party (the agent).
Agency theory is useful to analyze situations

where there is imperfect alignment between
the principal’s and agent’s
1)Information and
2)Objectives.

Agency Theory, Performance,
Rewards, and Risks
Agency theory deals with contracting between

an organization and the managers that it hires
to make decisions on its behalf.
Cost of measuring
Incentive Risk
performance

Learning
Objective 4 Measures of Profitability
Measures of income are readily available from

the financial reporting system at any level of
the organization for which a company can
identify revenues and expenses.
Accountants can easily customize income

measures such as income before interest and
taxes (EBIT) or earnings before interest,
taxes, depreciation, and amortization (EBITDA).

Return on Investment
A more comprehensive measure of profitability

that takes into account the investment required
to generate income is the return on investment
(ROI).
ROI is the product of two items:

Return on Capital
sales AND turnover
ROI

Valuation of Assets
Should values be based on gross book value

(original cost) or net book value (original
cost less accumulated depreciation).
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.

Valuation of Assets
Asset values: beginning, ending, or average
If investment does not change throughout

the year, it will not matter whether assets
are measured at the beginning, the end,
or average for the year.
If investment changes throughout the year,

we should measure invested capital
as an average for the period.

Valuation of Assets
Because income is a flow of resources over

a period of time, and a company should
measure the effect of the flow on the
average amount invested.
The most accurate measures of average

investment take into account the amount
invested month-by-month, or even
day-by-day.
Economic Profit (Residual Income)
RI is defined as after-tax net operating

income less a capital charge.
Capital charge is the cost of capital

multiplied by the amount of investment.
RI tells you how much a company’s

after-tax operating income exceeds
what it is paying for capital.

Economic Value Added
Net operating profit after-tax (NOPAT)

is income before interest expense but
after tax.
Economic value added (EVA) =

adjusted NOPAT – (weighted average cost of
capital × adjusted average invested capital)

Learning Incentives from Income,
Objective 5
ROI, or Economic Profit
Why do some companies prefer

economic profit (or EVA) to ROI?
ROI can motivate segment managers to make

investment decisions that are not in the best
interests of the company as a whole.
Economic profit (or EVA) motivate managers to

invest only in projects earning more than the
cost of capital because only those projects
increase the division’s economic profit.

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

Learning
Objective 6 Transfer Prices
The price that one segment charges another

segment of the same organization for a
product or service is a transfer price.
When one segment of a company produces

and sells an item to another segment,
a transfer price is required.
The transfer price is revenue to the producing

company and cost to the acquiring segment.

Purpose of Transfer Pricing
A company wants profitability metrics that

reward the segment manager for decisions
that increase both a segment’s profitability
and the profitability of the entire company.
Transfer prices should guide managers

to make the best possible decisions
regarding whether to buy or sell products
inside or outside of the company.

Learning
Objective 7 General Rule
Transfer price = Outlay cost + Opportunity cost
Outlay costs require a cash disbursement.

They are essentially the additional amount the
producing segment must pay to produce the
product or service.
Opportunity cost is the contribution to profit

that the producing segment forgoes by
transferring the item internally.

Transfer-Pricing Systems
Transfer-pricing systems have multiple

goals. The general rule provides a good
benchmark by which to judge transfer
pricing systems.
Popular transfer-pricing systems:

1. Market-based transfer prices
2. Cost-based transfer prices
a. Variable cost
b. Full cost (possibly plus profit)
3. Negotiated transfer prices
Market-Based Transfer Prices
If a market price exists, use it.
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 goal congruence . . .
. . . because the market price equals the

variable cost plus opportunity cost.
Sometimes market prices are not always

available for items transferred internally.

Market-Based Transfer Prices -
Drawbacks
When market prices don’t exist, companies

resort to cost-based transfer prices.
Cost-based transfer prices are

easy to understand and use.
Cost-based transfer prices lead to

dysfunctional decisions - decisions in
conflict with the company’s goals.

Full-Cost Pricing
This transfer pricing system includes not only

variable cost but also an allocation of fixed
costs (and, if included, the profit mark-up.)
It is implicitly assumed that the allocation
is a good approximation of the opportunity cost.
Dysfunctional decisions arise with full-cost

transfer prices when the selling segment has
opportunity costs that differ significantly from
the allocation of fixed costs and profit.

Variable-Cost Pricing
This transfer pricing system is

most appropriate when the
selling division forgoes no
opportunity when it transfers
the item internally.
Variable-cost transfer prices cause

dysfunctional decisions when the
selling segment has significant
opportunity costs.

Negotiated Transfer Prices
Companies heavily committed to segment

autonomy often allow managers
to negotiate transfer prices.
Open negotiation allows the managers to

make optimal decisions.
Critics of negotiated prices focus on the

time and effort spent negotiating, an activity
that adds nothing directly to the profits
of the company.
Learning
Objective 8 Multinational Transfer Pricing
Multinational companies use transfer

pricing to minimize their worldwide
taxes, duties, and tariffs.
Divisions in a high-income-tax-rate country

produce components for another division in a
low-income-tax-rate country. A low transfer
price would allow the company to recognize
most of the profit in the low-income-tax-rate
country, thereby minimizing taxes.
Multinational Transfer Pricing Example
Tax authorities also recognize the incentive

to set transfer prices to minimize taxes and
import duties. Therefore, most countries
have restrictions on allowable transfer prices.
U.S. multinationals must follow an Internal

Revenue Code rule specifying that transfers
be priced at “arm’s-length” market values,
or at the price one division would pay another
if they were independent companies.

A high-end running shoe produced by an Irish

Nike division with a 12% income tax rate.
It is transferred to a division in
Germany with a 40% income tax rate.
An import duty equal to 20% of the

price of the item is imposed by Germany.
Full unit cost is $100, and variable cost is

$60 (either transfer price could be chosen).

Income of the Irish division is $40 higher:

12% × $40 = ($4.80) higher taxes
Income of the German division is $40 lower:

40% × $40 = $16 lower taxes
Import duty paid by German division:

20% × $40 = ($8)
Net savings = $3.20

Learning
Objective 9 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.

Budgets, Performance Targets, and Ethics
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.

Budgets, Performance Targets, and Ethics
Using budgets as performance

targets also has its danger.
Companies that make meeting

a budget too important can
motivate unethical behavior.

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Copyright © 2014 Pearson Education, Inc.

publishing as Prentice Hall 10 - 1

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 2

1. Define decentralization and identify its expected

2. Distinguish between responsibility centers and

3. Explain how the linking of rewards to responsibility-

4. Compute return on investment (ROI), economic profit,

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 3

5. Compare the incentives created by income, ROI, and

6. Define transfer prices and identify their purpose.

7. State the general rule for transfer pricing and use it to

8. Identify the factors affecting multinational transfer

9. Explain how controllability and management by

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 4

The delegation of freedom to make

The delegation of decision making authority

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 5

The process by which decision making is

Concentration of decision making authority only at the

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 6

Lower-level managers have the best

It promotes management skills which,

Managers enjoy higher status from being

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 7

Managers may make decisions that are

Managers also tend to duplicate services

Costs of accumulating and processing

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 8

Many companies find that decentralization

Decentralization is most successful

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 9

If management has decided in favor of heavy

For decentralization to work, autonomy must be

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 10

Design of a management control system should

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 11

Profit centers Cost Centers

Will a profit center or a cost center better

In designing accounting control systems, top

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 12

The management control system should

For example, a plant may seem to be a

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 13

Linking rewards to responsibility-

Incentives are the rewards, both

A performance metric is a specific

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 14

Performance-based rewards that

You get what you measure!

Therefore, accounting measures,

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 16

The design of a management control system

Agency theory provides a model to analyze

Agency theory is useful to analyze situations

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 18

Agency theory deals with contracting between

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 19

Measures of income are readily available from

Accountants can easily customize income

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 20

A more comprehensive measure of profitability

ROI is the product of two items:

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 10 - 21