Decentralization:
Responsibility
Accounting,
Performance
Evaluation, and
Transfer Pricing
Prepared by
Douglas Cloud
Pepperdine University
10-1
Objectives
1. Define responsibility
accounting
After studying
this and describe
the four types
of
responsibility
centers.
chapter, you should
2. Explain why firms
to decentralize.
be chose
able to:
3. Compute and explain return on investment
(ROI), residual income (RI), and economic
value added (EVA).
4. Discuss the methods of evaluating and
rewarding managerial performance.
Continued
10-2
Objectives
5. Explain the role of transfer pricing in a
decentralized firm.
6. Discuss the methods of setting transfer
pricing.
10-3
Responsibility Accounting
Responsibility accounting is a system that measures the
results of each responsibility center and compares those
results with some measure of expected or budgeted
outcome.
There are four major types of responsibility centers:
 Cost center
 Revenue center
 Profit center
 Investment center
10-4
Reasons for Decentralization
1. Better access to local information
2. Cognitive limitations
3. More timely response
4. Focusing of central management
5. Training and evaluation
6. Motivation
7. Enhanced competition
10-5
Measuring the Performance of
Investment Centers
Return on Investment (ROI)
Residual Income (RI)
Economic Value Added (EVA)
10-6
Components of ROI
Operating income
ROI =
Average operating assets
Sales
Operating
income
=
X
Average operating
Sales
assets
Operating income
=
X
margin
Operating asset
turnover
10-7
Components of ROI
Margin expresses the portion of sales that is
available for interest, income taxes, and profit.
Turnover shows how productively assets are
being used to generate sales.
10-8
Advantages of the ROI Measure

It encourages managers to pay careful
attention to the relationships among sales,
expenses, and investments, as should be the
case for a manager of an investment center.

It encourages cost efficiency.

It discourages excessive investment in
operating assets.
10-9
Comparison of ROI
Snack Foods
Division
Appliance
Division
Year 1:
Sales
Operating income
Average operating assets
ROI
$30,000,000
1,800,000
10,000,000
18 %
$117,000,000
3,510,000
19,500,000
18 %
Year 2:
Sales
Operating income
Average operating assets
ROI
$40,000,000
2,000,000
10,000,000
20 %
$117,000,000
2,925,000
19,500,000
15 %
10-10
Margin and Turnover Comparison
Snack Foods
Division
Margin
Turnover
ROI
Appliance
Division
Year 1
Year 2
Year 1
Year 2
6.0 %
x3.0
18.0 %
5.0 %
x4.0
20.0 %
3.0 %
x6.0
18.0 %
7.5 %
x6.0
15.0 %
10-11
Disadvantages of the ROI Measure

It discourages managers from investing in
projects that would decrease the divisional
ROI but would increase the profitability of
the company as a whole.

It can encourage myopic behavior, in that
managers may focus on the short run at the
expense of the long run.
10-12
Residual Income
Residual income is the difference between operating
income and the minimum dollar return required on a
company’s operating assets:
Residual
Operating (Minimum rate of return x
=
x
Income
income
Operating assets)
Project I:
RI = $1,300,000 – (0.10 x $10,000,000) = $300,000
Project II:
RI = $640,000 – (0.10 x $4,000,000) = $240,000
10-13
Residual Income--Example
In thousands
Operating assets
Add
Project I
$60,000
Add
Add Both
Project II
Projects
$54,000
$64,000
Maintain
Status Quo
$50,000
Operating income
$ 8,800
$ 8,140
$ 9,440
$ 7,500
Minimum return
6,000
5,400
6,400
5,000
Residual income
$ 2,800
$ 2,740
$ 3,040
$ 2,500
Desired return = 10%
Preferred
alternative
10-14
Disadvantages of Residual Income
1. It is an absolute measure of
return which make it
difficult to directly compare
the performance of
divisions.
2. It does not discourage
myopic behavior.
10-15
Disadvantages of Residual Income
Minimum requirement is 8%
Average operating assets
Operating income
Minimum return
Residual income
Residual return
Division A
$15,000,000
$ 1,500,000
1,200,000
$ 300,000
2%
Division B
$2,500,000
$ 300,000
200,000
$ 100,000
4%
10-16
Economic Value Added
Economic value added (EVA) is after-tax
operating profit minus the total annual cost of
capital.
EVA = After-tax operating income – (Weighted
average cost of capital) x (Total capital
employed)
10-17
EVA Example
Three sources of revenue were used by
Furman, Inc.: $2 million of mortgage
bonds paying 8 percent interest, $3 million
of unsecured bonds paying 10 percent
interest, and $10 million in common stock.
Furman pays a tax rate of 40 percent.
10-18
EVA Example
After-Tax
Weighted
Amount Percent x Cost
=
Cost
Mortgage bonds
Unsecured bonds
Common stock
Total
$ 2,000,000
0.133
0.048
0.006
3,000,000
0.200
0.060
0.012
10,000,000
0.667
0.120
0.080
$15,000,000
Weighted average cost of capital
0.098
$15,000,000 x .098 = $1,470,000
10-19
EVA Example
Furman’s EVA is calculated as follows:
After-tax profit
Less: Weighted average cost of capital
EVA
$1,583,000
1,470,000
$ 113,000
The positive EVA means that Furman, Inc., earned
operating profit over and above the cost of the
capital used.
10-20
Behavioral Aspect of EVA
Supertech, Inc., has two divisions. Operating income statements
for the divisions are shown below:
Sales
Cost of goods sold
Gross profit
Divisional selling and
administrative expenses
Operating income
Hardware
Division
Software
Division
$5,000,000
2,000,000
$3,000,000
$2,000,000
1,100,000
$ 900,000
2,000,000
$1,000,000
400,000
$ 500,000
10-21
Behavioral Aspect of EVA
 Supertech’s weighted average cost of capital is 11
percent.
 Hardware, a buildup of inventories, use of
warehouses, etc. uses capital amounting to $10
million.
 The cost of capital is $1,100,000 (0.11 x
$10,000,000).
 The dollar cost of capital for the Software Division
is $220,000 (0.11 x $2,000,000).
10-22
Behavioral Aspect of EVA
The EVA for each division can be calculated as
follows:
Operating income
Less: Cost of capital
EVA
Hardware
Division
Software
Division
$1,000,000
$500,000
1,100,000
220,000
-$ 100,000
$280,000
10-23
Multiple Performance
Measurements
Tends to focus on long-run
 Discourages myopic behavior

10-24
Incentive Pay for Managers
Why would managers not provide good service? There
are three reasons:

They may have low ability.

They may prefer not to work hard.

They may prefer to spend company resources
on perquisites.
10-25
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.
10-26
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 bonus to reward performance by keeping
salaries fairly level and allow bonuses to
fluctuate with reported income.
10-27
Stock-Based Compensation
Stock options frequently are
offered to manager to make
A stock
option
them part
owners
of theis is the right
to buy encourage
a certain number of
company—thus
The
price of the stock is
shares
of
the
company’s
goal congruence.
setprice
approximately at
stock, at a usually
particular
at the time of
and after a setmarket
lengthprice
of time.
issue. Then, if the stock price
rises in the future, the manager
may exercise the option.
10-28
Transfer Pricing
The transferred good is
revenue to the selling
division and cost to the
buying division. This
value is called transfer
pricing.
10-29
Transfer Pricing
Some Major Issues
 Impact on divisional performance
measures
 Impact on firm wide profits
 Impact on divisional autonomy
10-30
Transfer Pricing
 Market price
 Negotiated transfer prices
 Cost-based transfer prices
 Variable cost
 Full (absorption cost)
10-31
The Small Motors Division is
operating at 70 percent capacity. A
request is received for 100,000 units
of a certain model at $30 per unit.
Full manufacturing cost of the
motor, broken down as follows:
Direct materials
Transferred-in part
Direct labor
Variable overhead
Fixed overhead
Total cost
$10
8
2
1
10
$31
Should the Parts Division lower the transfer price to
allow the Motor Division to accept the special order?
10-32
Direct materials
Transferred-in part
Direct labor
Variable overhead
Fixed overhead
Total cost
$10
8
2
1
10
$13
$31
The division could pay as much as $17 for the
component and still break even on the special order.
10-33
Negotiated Transfer Prices
When imperfection exists in
competitive markets for the
intermediate product, market price
may no longer be suitable.
10-34
Negotiated Transfer Prices
In this case, negotiated transfer
prices may be a practical
alternative. Opportunity costs can
be used to define the boundaries of
the negotiation set.
10-35
Disadvantages of Negotiated
Transfer Prices
1. One division manager, possessing private
information, may take advantage of another
divisional manager.
2. Performance measures may be distorted by
the negotiating skills of managers.
3. Negotiation can consume considerable time
and resources.
10-36
Despite the disadvantages,
negotiated price transfer prices offer
some hope of complying with the
three criteria of goal congruence,
autonomy, and accurate
performance evaluation.
10-37
Cost-Based Transfer Pricing
 Full-cost transfer
pricing
 Full cost plus markup
 Variable cost per fixed
fee
10-38
End of
Chapter
10-39
10-40