Chapter 15
Introduction to Accounting
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Accounting for Managers, 4th edition,
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Overview
• Decentralised profit responsibility
• Responsibility centres: cost, profit & investment
centres
• Divisional performance measurement
– Absolute profit, ROI & RI methods
•
•
•
•
Controllable profit
Transfer pricing
Transaction cost economics
Critical perspective
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Structure of organizations
• Structure follows strategy
– Chandler (1962)
• Diversification leads to multi-divisional forms
– Galbraith & Nathanson (1976)
• ‘the formal allocation of work roles and
the administrative mechanisms to control
and integrate work activities’
– Child (1972)
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Alternative business structures
Fig 15.1 Functional organization chart
Fig 15.2 Divisional organization chart
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Responsibility centres
• Cost centre
– No income generation responsibility
– Managed by ability to operate within cost budget
• Profit centre
– Responsible for ‘bottom line’ profits
– Cost budget may be exceeded if it results in higher profits
(higher sales, higher margin, etc.)
• Investment centre
– Responsible for ROI – contribution to corporate ROI
– Control of profits and level of investment
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Divisionalisation
• Decentralization
– devolution of authority to make decisions
• Divisionalization
– Decentralisation plus delegated profit responsibility
– Allows diversification with strategic direction & control
– Shareholder value is the criteria for overall business
success, but divisional performance is the criteria for
divisional success
– Managerial responsibility, linked to rewards
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Purposes of reporting divisional
performance
•
To guide divisional managers in making
decisions
To guide top management in making decisions
To enable top management to appraise the
performance of divisional management
•
•
–
Solomons (1965)
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Methods of divisional performance
measurement
• Absolute profit
• Return on Investment (ROI)
• Residual income (RI)
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Absolute profit
• Absolute profit: trend, comparison against target,
benchmark
• Comparing £ profits does not consider the
investment in the business and how long-term
profits can be affected by short-term decisions
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Return on investment (ROI)
• rate of return achieved on the capital
employed
Div A
Div B
Capital invested
€1,000,000
€2,000,000
Operating profit
€200,000
€300,000
Return on investment
20%
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15%
10
Residual income (RI)
• the profit remaining after deducting the
notional cost of capital from the investment in
the division
Div A
Div B
Capital invested
€1,000,000
€2,000,000
Operating profit
€200,000
€300,000
less cost of capital at 17.5%
€175,000
€350,000
Residual income
€25,000
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-€50,000
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Comparison of techniques
• ROI
– a decision cannot be made about relative
performance unless we know the cost of
capital
• Solomons (1965)
• RI
– the aim of managers should be to maximise
the residual income from the capital
investments in their divisions
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Comparison of techniques
• Residual income
– ‘overcame one of the dysfunctional aspects
of the ROI measure in which managers could
increase their reported ROI by rejecting
investments that yielded returns in excess of
their firm’s (or division’s) cost of capital, but
that were below their current average ROI’
– Johnson & Kaplan (1987)
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Illustration
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Illustration cont. - ROI
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Illustration cont. - ROI
• Division A may not want its project to be approved as its
overall ROI will fall from 25% to 24%
• Division B may want its project to be approved as its
overall RPI will increase from 10% to 10.1%
• Corporate view is to prefer Division A investment as it
earns a higher ROI
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Illustration cont. - RI
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Illustration cont. - RI
• Under the residual income method,
Division A’s project would be approved as
it contributes to shareholder value,
whereas Division B’s project erodes
shareholder value
– Compare the cost of capital of 15% to Division
B’s ROI (13% on new investment)
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Controllability
• One of the main problems in evaluating divisional
performance is the extent to which managers can
exercise control over investments and costs
charged to their responsibility centres
– ‘individuals should he held accountable only for
results they can control’
– Merchant (1987)
• Controllable profit
– The profit after deducting expenses that can be controlled
by the divisional manager, but ignoring those expenses
that are outside the divisional manager’s control
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Divisional profit report
& controllable profits – Solomons (1965)
Sales
Less
1,000,000
Variable cost of goods sold
200,000
Other variable expenses
100,000
300,000
Contribution margin
700,000
Less
250,000
Controllable divisional overhead
Controllable profit
450,000
Less
175,000
Non-controllable overhead
Operating Profit
275,000
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
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Manager
accountable for
Divisional
performance
20
Transfer pricing
• What price to charge for in-company transactions? affects the profitability of each business unit
– Market price to external customers, including a normal (or
lower) profit margin;
– Total cost of producing the goods or services, including
fixed and variable costs, but excluding any profit margin;
– Marginal cost of producing the goods or services, i.e.
including only variable costs, with or without a profit
margin;
– Negotiated price
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The transfer pricing problem
• Transfer prices that are suitable for evaluating
divisional performance may lead to divisions acting
contrary to the corporate interest
– Solomons (1965)
• Rewarding divisional performance which is not in the
best corporate interests
– What is good for a single division may not be the best for
the organisation as a whole.
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Transfer pricing illustration
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Accounting for Managers, 4th edition,
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Transfer pricing illustration
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Transaction cost economics
• Considers why some activities which require coordination occur within the organization’s
hierarchy (i.e. within the corporate structure)
while others take place through exchanges
outside the organization in the wider market (i.e.
between arms-length buyers and sellers)
• Whether markets or hierarchies are more
cost effective
– Outsourcing versus divisionalisation
Williamson (1975)
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Transaction costs
• Transactions incur costs over and above
the price for the commodity bought or sold
– Negotiation, monitoring, administration,
insurance
– Time commitments, obligations
– Legal, moral and power conditions
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Critical perspective
• Divisional or corporate perspective:
• ‘the image of an organisation which is given through
Accounts will be from a particular point of view, at a
particular point in time and will be selective in its
focus’
• Roberts & Scapens (1985)
• Managers are often critical that the corporate
head office fails to adequately distinguish
between controllable and non-controllable
overhead
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Critical perspective (cont.)
• Determining a risk-adjusted cost of capital for RI
purposes can be a subjective exercise
• Transfer pricing is subjective and affected by
power relations within an organization
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Accounting for Managers, 4th edition,
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Key points
• Decentralised profit responsibility through cost centres,
profit centres & investment centres
• Divisional performance measurement
– Absolute profit, ROI & RI methods
• Controllable profit
– Managerial accountability and divisional performance
• Transfer pricing
• Transaction cost economics: markets or hierarchy?
• Critical perspective
© 2012 John Wiley & Sons, Ltd,
Accounting for Managers, 4th edition,
9781119979678
29