Chapter 16
Management Control In
Decentralized Organizations
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Learning Objective 1
Define decentralization and
identify its expected
benefits and costs.
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Decentralization
The delegation of freedom to make decisions
is called decentralization.
The lower in the organization that this freedom
exists, the greater the decentralization.
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Centralization versus
Decentralization
Centralization
Decentralization
Maximum Constraints
Minimum Freedom
Minimum Constraints
Maximum Freedom
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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.
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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.
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Costs and Benefits
Managers in decentralized units may waste
time negotiating with other units about goods
or services one unit provides to the other.
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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.

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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.
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Learning Objective 2
Distinguish between profit
centers and decentralization.
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Profit Centers and
Decentralization
Profit centers
Accountability for
revenue and expenses
Decentralization
Freedom to make
decisions
These are entirely separate concepts
and one can exist without the other.
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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.
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Learning Objective 3
Define transfer prices and
identify their purpose.
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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.
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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
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Purpose of Transfer Pricing
Multinational companies use transfer
pricing to minimize their worldwide
taxes, duties, and tariffs.
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Learning Objective 4
Identify the relative advantages
and disadvantages of basing
transfer prices on total
costs, variable costs,
and market prices.
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Transfers at Cost

About half of the major companies in the
world transfer items at cost.
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Transfers at Cost
What are some examples?
Full cost plus a profit markup
Variable costs
Standard costs
Actual costs
Full cost
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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.
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Market-Based Transfer Prices

The major drawback to market-based prices
is that market prices are not always
available for items transferred internally.
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Variable-Cost Pricing

When market prices cannot be used,
versions of “cost-plus-a-profit” are often
used as a fair substitute.
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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.
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Negotiated Transfer Prices

Companies heavily
committed to segment
autonomy often allow
managers to negotiate
transfer prices.
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Dysfunctional Behavior
Virtually any type of transfer pricing policy
can lead to dysfunctional behavior – actions
taken in conflict with organizational goals.
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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.

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Learning Objective 5
Identify the factors affecting
multinational transfer prices.
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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).

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Multinational Transfer Pricing
Example
Which transfer price should be chosen?
$100
Why?
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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
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Learning Objective 6
Explain how the linking of
rewards to responsibility
center results affects
incentives and risk.
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Link Rewards to Results
Choices of Responsibility
Centers and Incentives
Motivational Criteria
Goal
Congruence
Managerial
Effort
Performance
Measures
Rewards
Feedback
Feedback
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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.

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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
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Learning Objective 7
Compute ROI, residual income,
and economic value added (EVA)
and contrast them as criteria for
judging the performance of
organization segments.
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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?

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Return on Investment
ROI = Income ÷ Investment
ROI
=
Income
Revenue
Revenue
× Investment
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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%
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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.
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Economic Value Added
Economic value added
= Income
– After-tax cost of capital
× (Long-term liabilities + Stockholders’ equity)
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Learning Objective 8
Compare the advantages and
disadvantages of various bases
for measuring the invested
capital used by organization
segments.
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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.
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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
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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
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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.
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Learning Objective 9
Understand the role of
management control systems
in decentralized organizations.
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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
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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.

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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.
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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.

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End of Chapter 10
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