COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
Chapter 10
Decentralization:
Responsibility Accounting,
Performance Evaluation, and Transfer Pricing
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
1
Study Objectives
1. Define responsibility accounting, and describe the four
types of responsibility centers.
2. Explain why firms choose to decentralize.
3. Compute and explain return on investment (ROI),
residual income (RI), and economic value added (EVA).
4. Discuss methods of evaluating and rewarding
managerial performance.
5. Explain the role of transfer pricing in a decentralized
firm.
6. Discuss the methods of setting transfer prices.
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Responsibility Accounting
Responsibility accounting
– measures the results of each responsibility
center
– compares those results with some measure of
expected or budgeted outcome.
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Responsibility Accounting
Types of Responsibility Centers
– Cost center: only responsible for costs
– Revenue center: only responsible for
revenues
– Profit center: responsible for both revenues
and costs
– Investment center: responsible for revenues,
costs, and investments
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Decentralization
Reasons for Decentralization
– Better access to local information
– More timely response
– Focusing of central management
– Training and evaluation of segment managers
– Motivation of segment managers
– Enhanced competition
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Measuring the Performance of
Investment Centers
Return on investment (ROI)
the most common measure of performance for
an investment center
ROI = Operating income ÷ Average operating assets
= (Operating income ÷ Sales)  (Sales ÷ Average operating assets)
= Operating income margin  Operating asset turnover
Margin: portion of sales
available for interest, taxes
and profit
 Operating income 


Sales


Turnover: how productively
assets are being used to
generate sales


Sales


 Average operating assets 
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Measuring the Performance of
Investment Centers
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Measuring the Performance of
Investment Centers
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Measuring the Performance of
Investment Centers
Advantages of the ROI measure
– Helps managers focus on the relationship between
sales, expenses and investment.
– Encourages cost efficiency.
– Discourages excessive investment in operating
assets
Disadvantages of the ROI measure
– Discourages managers from investing in projects
decreasing divisional ROI but increasing profitability
of the company overall.
– Encourages managers to focus on the short-term at
the expense of the long-term.
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Measuring the Performance of
Investment Centers
Residual income
the difference between operating income and the
minimum dollar return required on a company’s
operating assets

Residual = Operating - Minimum rate of return
Income
Income
 Operating assets

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Measuring the Performance of
Investment Centers
Advantages of Residual Income
Project I
Residual income = $1,300,000 - (0.10  $10,000,000)
= $1,300,000 - $1,000,000
= $300,000
Project II
Residual income = $640,000 - (0.10  $4,000,000)
= $640,000 $400,000
= $240,000
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Measuring the Performance of
Investment Centers
Disadvantages of Residual Income
ROI is an absolute measure of return; it
does not discourage myopic behavior
Division A
Division B
Average operating assets
$15,000,000
$2,500,000
Operating income
$ 1,500,000
$ 300,000
1,200,000
200,000
300,000
$ 100,000
Minimum returna
Residual income
Residual returnb
a0.08
$
2%
4%
× Operating assets.
bResidual
income divided by operating assets.
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Measuring the Performance of
Investment Centers
Economic value added (EVA)
after-tax operating profit minus the total annual cost
of capital.

After-tax
EVA = operating - Weighted average cost of capital
 Total capital employed
income

Total capital employed = capital assets
plus other expenditures meant to have a
long-term payoff
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Measuring the Performance of
Investment Centers
EVA Example
Amount
Mortgage bonds
Unsecured bonds
Common Stock
Total Sources
Percent
After-Tax
Weighted
Cost
Cost
$
2,000,000
13.3%
0.0480
0.006
3,000,000
20.0%
0.0600
0.012
10,000,000
66.7%
0.1200
0.080
$ 15,000,000
Weighted average cost of capital
0.098
Capital employed $ 15,000,000
Cost of capital $ 1,476,000
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Measuring the Performance of
Investment Centers
EVA Example (continued)
Furman’s EVA is:
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.
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Measuring the Performance of
Investment Centers
Behavioral Aspects of EVA
Hardware
Division
Sales
Cost of goods sold
Gross profit
Divisional selling and
administrative expenses
Operating income
Average cost of capital = 11%
Capital used
Cost of capital
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
$10,000,000
$1,100,000
$2,000,000
$220,000
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Measuring the Performance of
Investment Centers
Behavioral Aspects of EVA
 Tends to focus on long-run
Hardware
 Discourages myopic behavior Division
Operating income
Less: Cost of capital
EVA
Software
Division
$1,000,000
$500,000
1,100,000
220,000
$ (100,000)
$280,000
Positive EVA = wealth is being created
Negative EVA = capital is being destroyed
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Measuring and Rewarding the
Performance of Mangers
• Measuring performance in the MNC
– Evaluate the division
– Evaluate the manger
• Base on factors where control exists
• Do not evaluate on factors over which there is no
control (currency fluctuations, income taxes, etc.)
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Measuring and Rewarding the
Performance of Mangers
• MNC divisional ROIs impacted by
– International vs domestic environmental
conditions (economic, legal, political, social,
etc.)
• Multiple measures of performance for
MNC divisions
– Consider market potential and market share
– Residual income and ROI should not be the
sole measures for MNC divisions
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Measuring and Rewarding the
Performance of Mangers
• Managerial rewards
– Separation of ownership and management
creates the possibility that managers may not
operate the business in the best interest of
the shareholders
• Managers do not exert the most productive effort
for the company
• Managers may spend company resources on
perquisites
– A well-structured incentive compensation
system encourages goal congruence
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Measuring and Rewarding the
Performance of Mangers
• Cash compensation
– Reward good management performance by granting
periodic raises
• Become a permanent part of the compensation package
– Bonuses provide more flexibility
• Income-based compensation may encourage dysfunctional
behavior.
– A combination of salary and bonus keeps salaries
fairly level and allows bonuses to fluctuate with
reported income.
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Measuring and Rewarding the
Performance of Mangers
• Stock-based compensation
– A stock option is the right to buy a certain number of
shares of the company’s stock, at a particular price
and after a set length of time.
– Stock options are offered to managers
• They become owners (shareholders) of the company
• Ownership encourages goal congruence
– The price of the stock is usually set to approximate
market price at the time of issue.
• If the stock price rises in the future, the manager may
exercise the option.
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Measuring and Rewarding the
Performance of Mangers
• Issues to consider
– Single-measure outcomes encourage gaming
behavior
– The Big Bath
– Cash bonuses and stock options encourage
short-term orientation by management
• Noncash compensation
– Autonomy
– Perquisites
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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.
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Transfer Pricing
• A transfer pricing system should satisfy
three objectives:
– Accurate performance evaluation
– Goal congruence
– Preservation on divisional autonomy
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Transfer Pricing
Opportunity cost approach identifies
– The minimum price that a selling division
would be will to accept
Floor: leaves the selling division no worse off for
having sold to an internal division
– The maximum price that the buying division
would be willing to pay
Ceiling: leaves the buying division no worse off for
having purchased from an internal division
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Transfer Pricing
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Setting Transfer Prices
A good should be transferred internally
whenever
the opportunity cost (minimum price)
of the selling division
is less than
the opportunity cost (maximum price)
of the buying division.
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Setting Transfer Prices
• Commonly used policies
– Market price
• Price in an outside, perfectly competitive, market
– Negotiated transfer prices
• Agreed to only if the opportunity cost of the selling
division is less than the opportunity cost of the
buying division
– Cost-based transfer prices
• Variable cost
• Full (absorption cost)
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Setting Transfer Prices
Negotiated transfer prices
Example 1: Avoidable Distribution Costs
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Setting Transfer Prices
Negotiated transfer prices
Example 1: Avoidable Distribution Costs
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Setting Transfer Prices
Negotiated transfer prices
Example 1: Avoidable Distribution Costs
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Setting Transfer Prices
Negotiated transfer prices
Example 2: Excess Capacity
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Setting Transfer Prices
Negotiated transfer prices
Example 2: Excess Capacity
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Setting Transfer Prices
• Negotiated Transfer Prices
– Disadvantages
• Time consuming
– Advantages
• Negotiation helps ensure goal congruence
• Comparable negotiating skills support motivation
and accurate performance measures
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Setting Transfer Prices
• Cost-Based Transfer Prices
– Forms
• Full-cost transfer pricing
• Full cost plus markup
• Variable cost plus fixed fee
– Propriety of use
• Impact on divisional profit is negligible
• Ease of cost measurement is beneficial
• Result of negotiations
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Setting Transfer Prices
• Transfer Pricing and the MNC
– Performance evaluation
– Optimal determination of income taxes
• Shift costs to high-tax countries
• Shift revenues to low-tax countries
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Setting Transfer Prices
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Setting Transfer Prices
• IRS Code §482
– Requires arms’-length transactions
– Allowable pricing methods
•
•
•
•
Comparable uncontrolled price method
Resale price method
Cost-plus method
Negotiated between the company and the IRS
• Income taxes are universal
– Market-based transfer prices
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COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
End Chapter 10
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
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