Management Control in Decentralized Organizations

1. Management Controlin Decentralized Organizations Chapter 10

2. Learning Objective 1 • Define decentralization • and identify its expected • benefits and costs.

3. Decentralization The delegation of freedom to make decisions is called decentralization. The lower in the organization that this freedom exists, the greater the decentralization.

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.

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.

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.

7. 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.

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.

9. Learning Objective 2 • Distinguish between profit • centers and decentralization.

10. 1 2 Responsibilities Autonomy Responsibility Centers and Decentralization Design of a management control system should consider two separate dimensions of control:

11. Responsibility Centers and Decentralization Profit centers Decentralization These are entirely separate concepts and one can exist without the other.

12. Responsibility Centers and Decentralization All control systems are imperfect. The choice among systems should be based on which one will bring more of the actions top management seeks.

13. Learning Objective 3 • Explain how the linking of rewards • to responsibility center results • affects incentives and risk.

14. Management actions Performance measures Rewards Motivation, Performance,and Rewards Criteria and Choices when Designing a Management Control System Motivational criteria: Goal congruence and managerial effort Feedback

15. Motivation, Performance,and Rewards You get what you measure! Therefore, accounting measures, which provide relatively objective evaluations of performance, are important.

16. Agency Theory, Performance, Rewards, and Risks Agency theory deals with contracting between an organization and the managers that it hires. 3 Factors: Incentive Risk Cost of measuring performance

17. Learning Objective 4 • Compute ROI, residual income, • and economic value added (EVA) • and contrast them as criteria for • judging the performance of • organization segments.

18. Measures of Profitability Profitability does not mean the same thing to all people. Is it net income? Income before taxes? Net income percentage based on revenue? Is it an absolute amount? A percentage?

19. = Income Revenue × Revenue Investment Return on Investment ROI = Income ÷ Investment ROI

20. Return on Investment Division A ROI: = Income ÷ Investment $200,000 ÷ $500,000 = 40% Division B ROI: = Income ÷ Investment $150,000 ÷ $250,000 = 60%

21. 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.

22. Economic Value Added Economic value added = Adjusted after-tax operating income – Cost of invested capital (%) ×Adjusted average invested capital

23. Learning Objective 5 • Compare the advantages and • disadvantages of various bases • for measuring the invested capital • used by organization segments.

24. 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.

25. 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

26. Asset Allocation to Divisions Commonly used bases for allocation, when assets are not directly identifiable with a specific division, include: Asset Class Corporate cash Receivables Inventories Plant and equipment Possible Allocation Base Budgeted cash needs Sales weighted by terms Budgeted sales or usage Usage of services

27. 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.

28. Learning Objective 6 • Define transfer prices and • identify their purpose.

29. Transfer Prices The price that one segment charges another segment of the same organization for a product or service is a transfer price.

30. Purpose of Transfer Pricing Why do transfer-pricing systems exist? Management wants to create performance measurement systems. Decisions that maximize a segment’s profit should also maximize the profits of the entire company.

31. Purpose of Transfer Pricing Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

32. Learning Objective 7 • State the general rule for transfer • pricing and use it to assess • transfer prices based on • total costs, variable costs, • and market prices.

33. Subcomponent transfer price = $10 General Rule Transfer price = Outlay cost + Opportunity cost Selling division outlay cost = $6; Opportunity cost = $4 Buying division cost = Transfer price + Other costs $10 + $12 = $22; Selling price = $25

34. Transfers at Cost What are some definitions of cost? Variable cost Full cost Full cost plus a profit markup Standard costs Actual costs

35. Variable-Cost Pricing Companies that transfer items at variable cost assume that the selling division has no opportunity cost. Why? Because the outlay cost equals the variable cost.

36. Variable-Cost Pricing This transfer pricing system is most appropriate when the selling division forgoes no opportunity when it transfers the item internally.

37. 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.)

38. 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. In this case, the market price is equal to the variable cost plus opportunity cost.

39. Market-Based Transfer Prices Why? Because the opportunity cost equals the market price less the variable cost. Transfer price = variable cost + opportunity cost = variable cost + (market price – variable cost) = market price

40. Market-Based Transfer Prices Drawbacks 1. Market prices are not always available for items transferred internally. 2. Imperfectly competitive markets exist.

41. Negotiated Transfer Prices Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices. Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals.

42. 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. State fair-trade laws and national antitrust acts can also influence transfer pricing.

43. Learning Objective 8 • Identify the factors affecting • multinational transfer prices.

44. Multinational Transfer Pricing Example An item is produced by Division S in a country with a 8% income tax rate. It is transferred to Division G in a country with a 40% 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).

45. Multinational Transfer Pricing Example Which transfer price should be chosen? $100 Why?

46. Multinational Transfer Pricing Example Income of S is $40 higher: 8% × $40 = ($3.20) higher taxes Income of G is $40 lower: 40% × $40 = $16 lower taxes Import duty paid by G: 20% × $40 = ($8) Net savings = $4.80

47. Learning Objective 9 • Explain how controllability and • management by objectives (MBO) • aid the implementation of • management control systems.

48. Management by Objectives and Setting Expectations 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.

49. 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.

50. 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.