DECENTRALIZATION: RESPONSIBILITY
ACCOUNTING, PERFORMANCE
EVALUATION, AND TRANSFER PRICING
CHAPTER 10
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CHAPTER 10 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
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
CHAPTER 10 OBJECTIVES
4. Explain the role of transfer pricing in a
decentralized firm
5. Discuss the methods of setting transfer
prices
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
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
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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
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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
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DECENTRALIZATION
• Decentralization: practice of delegating
decision making authority to the lower levels
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DECENTRALIZATION
Reasons for Decentralization
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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
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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
• Efficiency means how well activities are performed
• Effectiveness can be defined as whether the manager
has performed the right activities
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
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
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MEASURING THE PERFORMANCE OF
INVESTMENT CENTERS
Return on Investment
• Operating income refers to earnings before interest
and income taxes
• Operating assets includes all assets used to
generate operating income
Average
operating = (Beginning net book value + Ending net book value)/2
assets
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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
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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
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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
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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]
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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
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
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]
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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
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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
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
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
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© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use.
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
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MEASURING AND REWARDING THE
PERFORMANCE OF MANAGERS
Issues to Consider in Structuring IncomeBased 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
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MEASURING AND REWARDING THE
PERFORMANCE OF MANAGERS
Noncash Compensation Noncash
• Compensation is an important part of the
management reward structure
• Perquisites are also important
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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
• Profitability, return on investment, and
managerial performance evaluation of both
divisions are affected by transfer pricing
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EXHIBIT 10.1—IMPACT OF TRANSFER PRICE ON
TRANSFERRING DIVISIONS AND THE COMPANY AS A
WHOLE
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SETTING TRANSFER PRICES
• A transfer pricing system should satisfy three
objectives
• Accurate performance evaluation
• Goal congruence
• Preservation
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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
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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
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SETTING TRANSFER PRICES
Negotiated Transfer Prices
• Advantages
1. Comply with the three criteria of goal congruence,
autonomy, and accurate performance evaluation
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SETTING TRANSFER PRICES
Negotiated Transfer Prices
• Disadvantages
1. One divisional manager with 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
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EXHIBIT 10.2—SUMMARY OF SALES AND
PRODUCTION DATA
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EXHIBIT 10.3—COMPARATIVE INCOME
STATEMENTS
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EXHIBIT 10.4—COMPARATIVE STATEMENTS
LO-6
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SETTING TRANSFER PRICES
Cost Based Transfer Prices
• Full-cost transfer pricing
• Full cost plus markup
• Variable cost plus fixed fee
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SETTING TRANSFER PRICES
• The IRS accepts four transfer pricing policies
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Comparable uncontrolled price method
Resale price method
Cost-plus method
Advanced pricing agreements (APAs)
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EXHIBIT 10.5—USE OF TRANSFER PRICING
TO AFFECT INCOME TAXES PAID
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END OF CHAPTER 10
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