Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing

1. Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing Chapter 10

2. Chapter 10 Objectives • Define responsibility accounting, and describe the four types of responsibility centers • Explain why firms choose to decentralize • Compute and explain return on investment (ROI), residual income (RI), and economic value added (EVA) • Discuss methods of evaluating and rewarding managerial performance

3. Chapter 10 Objectives • Explain the role of transfer pricing in a decentralized firm • Discuss the methods of setting transfer prices

4. 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 LO-1

5. Responsibility Accounting Types of Responsibility Centers Cost center: responsible only for costs Revenue center: responsible only for revenues Profit center: responsible for both revenues and costs Investment center: responsible for revenues, costs, and investments LO-1

6. 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 LO-2

7. Decentralization Decentralization: practice of delegating decision making authority to the lower levels LO-2

8. 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 LO-2

9. Decentralization The Units of Decentralization Decentralization is usually achieved by segmenting the company into divisions Control of cost centers is achieved by evaluating the efficiency and the effectiveness of divisional managers • Efficiencymeans how well activities are performed • Effectiveness can be defined as whether the manager has performed the right activities LO-2

10. Measuring the Performance of Investment Centers Return on Investment 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 LO-3

11. Measuring the Performance of Investment Centers Average operating assets = (Beginning net book value + Ending net book value)/2 Return on Investment Operating income refers to earnings before interest and income taxes Operating assets includes all assets used to generate operating income LO-3

12. Measuring the Performance of Investment Centers Margin and Turnover ROI formula is broken into two component ratios: margin and turnover Margin is the ratio of operating income to sales Turnover is found by dividing sales by average operating assets LO-3

13. Measuring the Performance of Investment Centers Advantages of the ROI Measure • Encourages investment center managers to focus on the relationship between sales, expenses and investment • Encourages cost efficiency • Discourages excessive investment in operating assets LO-3

14. Measuring the Performance of Investment Centers Disadvantages of the ROI Measure Discourages managers from investing in projects that would decrease divisional ROI but would increase profitability of the company overall Encourages managers to focus on the short run at the expense of the long run LO-3

15. Measuring the Performance of Investment Centers Residual Income 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] LO-3

16. Measuring the Performance of Investment Centers Advantages of Residual Income Encourages managers to move beyond the focus of the percentage return on investment • Refocuses the manager on dollar profit Disadvantages of Residual Income An absolute measure of return that makes it difficult to directly compare the performance of divisions does not discourage myopic behavior LO-3

17. Measuring the Performance of Investment Centers Economic Value Added (EVA) 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 employed EVA = After-tax operating income – [Weighted average cost of capital × total capital employed] LO-3

18. Measuring and Rewarding the Performance of Managers Incentive Pay for Managers—Encouraging Goal Congruence Three reasons managers do not provide good service • They may have low ability • They may prefer not to work hard • They may prefer to spend company resources on perquisites LO-4

19. Measuring and Rewarding the Performance of Managers Managerial Rewards Include incentives tied to performance Objective is to encourage goal congruence, so that managers will act in the best interests of the firm Include salary increases, bonuses based on reported income, stock options, and noncash compensations LO-4

20. Measuring and Rewarding the Performance of Managers Cash Compensation Includes salaries and bonuses 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 LO-4

21. Measuring and Rewarding the Performance of Managers Stock-Based Compensation Stock is a share in the company Encourages goal congruence 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 • If the stock price rises in the future, the manager may exercise the option LO-4

22. Measuring and Rewarding the Performance of Managers Issues to Consider in Structuring Income-Based Compensation Objective is goal congruence between owner and manager Single measures of performance are subject to gaming behavior • Managers may increase short-term measures at the expense of long-term measures Another issue to be considered in structuring management compensation plans is that owners and managers may be affected differently by risk LO-4

23. Measuring and Rewarding the Performance of Managers Noncash Compensation Noncash Compensation is an important part of the management reward structure Perquisites are also important LO-4

24. 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 LO-5

25. EXHIBIT 10.1—Impact of Transfer Price on Transferring Divisions and the Company as a Whole LO-5

26. Setting Transfer Prices A transfer pricing system should satisfy three objectives • Accurate performance evaluation • Goal congruence • Preservation LO-6

27. Setting Transfer Prices The opportunity cost approach identifies the minimum that a selling division would be willing to accept and the maximum price that the buying division would be willing to pay • 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 LO-6

28. Setting Transfer Prices Market Price If there is an outside market for the good to be transferred and that outside market is perfectly competitive, the correct transfer price is the market price LO-6

29. Setting Transfer Prices Negotiated Transfer Prices Advantages • Comply with the three criteria of goal congruence, autonomy, and accurate performance evaluation LO-6

30. Setting Transfer Prices Negotiated Transfer Prices Disadvantages • 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 LO-6

31. EXHIBIT 10.2—Summary of Sales and Production Data LO-6

32. EXHIBIT 10.3—Comparative Income Statements LO-6

33. EXHIBIT 10.4—Comparative Statements LO-6

34. Setting Transfer Prices Cost Based Transfer Prices Full-cost transfer pricing Full cost plus markup Variable cost plus fixed fee LO-6

35. Setting Transfer Prices The IRS accepts four transfer pricing policies • Comparable uncontrolled price method • Resale price method • Cost-plus method • Advanced pricing agreements (APAs) LO-6

36. EXHIBIT 10.5—Use of Transfer Pricing to Affect Income Taxes Paid LO-6

37. End of Chapter 10