1
Decentralization
Practice of delegating decisions to
lower-level managers
2
LO1: Explain costs and benefits of decentralization
Test Your Knowledge!
The benefits of decentralization include all of the
following except:
a) it forces top levels of management to focus on
individual units.
b) it empowers more employees at lower levels of
management.
c) it allows for better and more timely decision making.
d) it trains future managers.
Decentralization does not force top levels of
management to focus on individual units.
3
Organization Structure
• A responsibility center is the smallest unit of
analysis
 Almost like a mini-business
 Clearly defined goals and authority
• We need to put in control systems
 Induce “right” use of local knowledge
 Induce coordination & cooperation with other
responsibility centers
 Ideally, a mix of financial (profit, sales) and non-financial
(yield, customer satisfaction) measures
• Incentive structure depends on unit being
considered
 Non-trivial to link performance measures to incentives
4
LO1: Explain costs and benefits of decentralization
Typical Organization Structure
Aaron Knight,
CEO
Manager,
New Jersey
Region
Staff Assistant
Manager,
New York
Region
Manager,
Westchester
Region
Branches
Branches
Branch
Managers
Supervisor
(Copies)
Copy Center
Staff
5
Supervisor (PC)
PC Center Staff
LO1: Explain costs and benefits of decentralization
Kinds of Responsibility Centers
6
LO1: Explain costs and benefits of decentralization
Cost Center
• Goal:
minimize the cost of producing a
specified level of output or the cost of
delivering a specified level of service
 Efficiency of operations is the focus
• Examples
 Machining, assembly, the entire plant
 Human resources, advertising, general
administration
7
LO1: Explain costs and benefits of decentralization
Cost Center: Duties And Measures
• What can a cost center manager control?
 Mix of inputs for a given level of output
 Not responsible for final products and service
• How should we evaluate them?
 Budget-based comparison for financials
 Center specific non-financial measures
8
LO1: Explain costs and benefits of decentralization
Kinds Of Cost Centers
• Engineered cost center
 Clear relation between resources consumed and
output
 Machining or Assembly department
 Flexible budget makes sense here
 Quality, service, response time are all important
Critical Success Factors (CSF)
• Discretionary cost center
 No clear relation between resources consumed and
output
 Legal, Accounting, R & D
 Does not make sense to flex the budget
 Non-financial measures gain more importance
9
LO1: Explain costs and benefits of decentralization
Profit Centers
• Profit centers aim to both minimize costs and
to maximize revenues.
 Regional centers
 Product line managers
• What can these managers control?
 Input mix, product mix, selling prices
 Profit center typical contains revenue and cost
centers
10
LO1: Explain costs and benefits of decentralization
Profit Centers: Evaluation
• How should we evaluate a profit center?
 Budgeted vs. actual profits
 Baseline is master budget as manager responsible for
output as well
 Non-financials are more strategic in nature
• Issues to consider include:
 If system encourages local profit maximization as
opposed to firm-wide profit maximization?
 How to price transfers across profit centers?
11
LO1: Explain costs and benefits of decentralization
Investment Centers
•
Aim to maximize the returns from invested capital, or
to put the capital invested by owners and
shareholders of their organizations to the most
profitable use.
 Large independent divisions in organizations such as Sony,
Siemens, Microsoft, and Proctor and Gamble. Decision rights
•
What decisions can managers make?
 Input mix, product mix, selling prices, capital expenditures
•
How should we evaluate them?
 Financials focus on Investment performance
 Return on Investment, Residual Income, Economic Value Added
 Non-financial measures less important
 Focus on strategy implementation and long-term potential
12
LO1: Explain costs and benefits of decentralization
Performance Evaluation
• The controllability principle
 Focus on costs and benefits that reflect the
consequences of the actions taken by the decision
maker.
 Sales for marketing manager
 Costs and quality for production manager
• The informativeness condition
 A performance measure is informative if it provides
information about a manager’s effort, even if the
manager does not have control over it
 Helps to filter out the noise between effort and the outcome
measure
 Leads to relative performance evaluation
 Grading on a curve (you cannot control the class average!)
13
LO2: Apply the principles of performance measurement
Choosing A Performance Measure
• Involves many related decisions
 How to reflect decision rights assigned to the
responsibility center being evaluated?
 What is right time horizon to consider?
 How do define the measure?
 Is investment measured at gross or net book
value, at replacement cost?
• Implementation requires more choices
 What is the target level of performance?
 What is the timing of feedback?
14
LO2: Apply the principles of performance measurement
Effective Measures
• An effective measure
 Aligns employee and organizational goals.
 Yields maximum information about the decisions or
actions of the individual or organizational unit.
 Is easy to measure.
 Is easy to understand and communicate
• No single measure has all of these
characteristics
 Rely on multiple measures
 Financial and non-financial
 Portfolio approach
15
LO2: Apply the principles of performance measurement
Evaluating Cost Centers
• Short term measures
 Focus is on efficiency
 Non-financial measures for operational control
 Real time, actionable, disaggregate
 Variances
 Financial impact
 Trends and patterns
• Long term measures
 Focus is on effectiveness
 Trend in efficiency
 Kaizen
 Investments in future
 Training
16
LO3: Rate the performance of cost and profit centers
Measuring Profit Centers
• Short-term
 Less reliance on non-financial measures
 Budget- actual comparison
 More macro than cost center comparison
 Variances for spotting trends and patterns
• Long-term
 Growth measures
 Sales, profit and efficiency
 Drivers of future profitability
 Non-financial measures
17
LO3: Rate the performance of cost and profit centers
Measuring Investment Centers
• Three widely used metrics
 Return on Investment (and variants)
 Residual Income
 Economic Value Added
18
LO4: Evaluate the performance of investment centers
Return on Investment (ROI)
• ROI = Income/Investment
• We find many variations of the above formula
 Income definitions typically used
 Operating income, Net Income
 Investment definitions typically used
 Total assets, total assets - current liabilities
 We will use total assets and operating income
• The best metric depends on the purpose at
hand
 Operating income best suited for performance
evaluation
19
LO4: Evaluate the performance of investment centers
Sample ROI Calculations
20
LO4: Evaluate the performance of investment centers
ROI: Evaluation
• Advantages
 Effective summary measure
 Size independent (can compare across divisions)
 Can decompose ROI into smaller pieces
• Criticism
 Can foster underinvestment
 Favors older divisions because of their smaller asset
base
21
LO4: Evaluate the performance of investment centers
ROI: Measurement
• We can measure assets at several levels
Net book value
Most popular
Gross book value
Removes effects of age
Replacement
value
Conceptually sound, hard to
measure
• In general,
 Match the definition in the numerator and
denominator
 Use the measure best suited for decision at hand
 Use exit cost for whether to stay in business!
22
LO4: Evaluate the performance of investment centers
1 $7,000,000
2 $7,000,000
3 $8,200,000
4 $550,000
1 ($7,150,000 + $6,850,000) / 2 = $7,000,000
2 ($1,100,000 + $1,300,000) / 2 = $1,200,000
3 $7,000,000 + $1,200,000 = $8,200,000
4 $7,150,000 + $250,000 - $6,850,000 = $550,000
23
ROI: Decomposition
•
•
DuPont Method
ROI = Investment turnover * Return on sales
 Investment turnover = Revenues/Investment
 Return on sales = Income/Revenues
•
This analysis helps to identify the source of the
profit
 Must be in line with business strategy
 Suggests corrective action
24
LO4: Evaluate the performance of investment centers
1
2
3
0.80
.125
10%
1 $6,400,000 / $8,000,000 = 0.80
2 $800,000 / $6,400,000 = .125
3 Profit margin x asset turnover = 0.80 x .125 = 10%
25
Managing ROI
26
LO4: Evaluate the performance of investment centers
Test Your Knowledge!
When a company is attempting to increase
return on investment (ROI) it should work to:
a) decrease sales.
b) decrease profits.
c) increase costs.
d) decrease operating assets.
Decreasing operating assets will cause return
on investment to improve if other relevant
factors remain constant.
27
Residual Income (RI)
•
Residual Income (RI)
 RI = Income - (Required rate of return * Investment)
 Definition of income and investment same as under ROI
 Required rate of return is the opportunity cost of capital to
the company
28
•
RI is a measure of “additional” value of the project
than what is expected
•
RI is a size sensitive measure -- bigger projects with
the same ROI may show a greater RI than smaller
projects
LO4: Evaluate the performance of investment centers
Calculating RI
• RI has similar measurement issues
 Still have to define income and investment
 Still have to pick measurement basis (gross / net)
for assets
29
LO4: Evaluate the performance of investment centers
Residual Income: Evaluation
• Advantages
 Avoids underinvestment problem present with ROI
(Will explore in a few slides)
 Intuitive economic interpretation
• Disadvantages
 Size dependent (larger divisions have larger RI)
 Depends on rate used
Income
30
Investment RI (at 14%) RI (at 16%)
Division A
$18,000
$100,000
$4,000
$2,000
Division B
$160,000
$1,000,000
$20,000
$0
LO4: Evaluate the performance of investment centers
Comparing ROI and RI
• RI is size dependent but ROI is not
 Can lead to conflicting rankings
Income
Investment
ROI
RI (at 14%)
Division A
$18,000
$100,000
18%
$4,000
Division B
$160,000
$1,000,000
16%
$20,000
• But, RI is conceptually superior because it is
claimed to lead to better project selection
31
LO4: Evaluate the performance of investment centers
Project Evaluation: ROI Vs. Ri
32
LO4: Evaluate the performance of investment centers
Economic Value Added (EVA)
•
A variation of the residual income concept involving
more “careful” calculations
•
EVA = NOPAT - (WACC [Total assets - NIBCL])
 NOPAT = Net operating income after taxes
 WACC = Weighted average cost of capital
 NIBCL = Non-interest bearing current liabilities
•
Various adjustments to GAAP to derive economic
income
 GAAP requires treatment of some items such as R&D
expenditures, failed exploration attempts, goodwill that are
“inconsistent” with these items being “investments”
 Detailed EVA calculations will be covered in an elective class
33
LO4: Evaluate the performance of investment centers
EVA Evaluation
• Advantages
 Presents true economic picture
 Provides managers with information about cost of capital
used in their business
 Specifies what to measure and how to measure
• Disadvantages
 More complex calculations as it requires numerous
adjustments to GAAP income statements
 While used by many firms, not as popular as ROI
34
LO4: Evaluate the performance of investment centers
Choosing Time Horizons
35
•
ROI, RI, and EVA calculations are for a single time
period (one year)
 Many companies use annual bonus plans based on
such measures
•
Could promote investment myopia
 Investments may hurt these measures in the short
run because benefits realize only in the future years
•
Using NPV analysis to make investment decisions is
consistent with using multi-year RI to evaluate
managers’ performances
LO4: Evaluate the performance of investment centers
What Is A Transfer Price?
• Divisions transact with each other
 Vertical integration
 Synergy in operations
• Transfer price is a internal price for such
transactions
 No cash changes hands
36
LO5: Describe transfer pricing
Demand For Transfer Prices
• Computing product cost
• Determine divisional profit and provide
economic signal for
 Resource allocation
 Performance evaluation (support decentralization)
 Value due to minority shareholders
• Calculate taxes payable in different
jurisdictions
• Roles often conflict
37
LO5: Describe transfer pricing
1 ($431,300) 2 $243,000
1 $1,405,600 – [0.18 ($10,450,000 - $245,000)] = ($431,300)
2 $756,000 – [0.18 ($2,500,000 - $650,000)] = $243,000
38
Accounting Treatment
39
LO5: Describe transfer pricing
Conflict In Transfer Pricing
• Cooperation among divisions
 Increase “surplus”
 Maximize corporate profit
 Sum of divisional profits
• Competition among divisions
 Dividing surplus is “zero sum”
 Focus on divisional profit maximization
• Theoretical solution can be derived (see
appendix) but is not practically feasible
40
LO5: Describe transfer pricing
Practical Solutions
•
Market-based transfer pricing
 Price in the intermediate product market
•
Cost-based transfer pricing
 Variable cost-based transfer price

Unit variable cost plus a markup
 Full-cost based transfer price

•
41
Full cost plus a markup
Negotiated transfer price
LO5: Describe transfer pricing
Usage Patterns
• Market based prices
 Preferred when available
 30-50%
• Cost based prices
 Full cost is common
 25-50%
• Negotiated prices
 Usually market or cost is the starting point for
negotiations
42
LO5: Describe transfer pricing
International Transfer Prices
• Corporate tax planning affects where to
recognize income
• Incentives can also arise because of
 Competitive reasons
 Subsidies
 Regulatory reasons
 Restrictions on capital flow
• Tax planning incentives can override other
issues (e.g., providing best economic
signals) when setting transfer price
43
LO5: Describe transfer pricing
Rules & Regulations
• Governments recognize corporate
incentives\
• Impose extensive rules and regulations on
what is allowed
 Could impose sanctions
 Penalty for dumping
 Tariffs
• Setting transfer prices to optimize the
various tensions is a very difficult exercise
44
LO5: Describe transfer pricing
Intervention
• Game playing means profitable transfers
might not take place
 Sub-optimization
• Should HO intervene?
 Feasibility is an issue
 Need detailed information about operations
 Gains surplus by forcing transaction
 Undercuts benefits due to decentralization
45
LO5: Describe transfer pricing
Appendix
TRANSFER PRICING
46
Acceptable Transfer Prices
• Selling Division
 Value = TP - Controllable cost
 Value ≥ Opportunity cost
 TPMIN = Controllable cost + Opportunity cost
• Buying division
 TPMAX = Opportunity cost
47
Appendix
Three Cases
• TPMAX = TPMIN
 No surplus from transfer
 Corporate does not care
 At the one agreeable price, divisional profit the same
with or without transfer
 Competitive market for transferred item
 Congruence between divisional and corporate
objectives
• TPMAX < TPMIN
 Negative surplus from transfer
 Corporate does not want transfer
 Divisions cannot agree on price
 Congruence between divisional and corporate
objectives!
48
Appendix
Three Cases
• TPMAX >TPMIN
 Surplus from transfer
 Surplus = TPMAX – TPMIN
• There is a price at which both divisions are
willing to voluntarily enter transaction
 Congruence between divisional and corporate
objectives
49
Appendix
For the chip division, the contribution margin from an external sale =
$18.00 per chip and the controllable cost = $12.50 per chip. Thus,
TPMIN = $12.50 + $18.00 = $30.50 per chip. For the phone division,
TPMAX is still $32 = $52 total variable cost of buying externally - $20
variable phone cost of buying internally. Thus, the range of
acceptable transfer prices is $30.50 to $32.00. If the transfer price is
set anywhere in this range, the company as a whole saves $1.50 for
every chip that is internally transferred.
50
Exercise 12.31
Responsibility accounting (LO1, LO2)
Karl Krader oversees a staff of over 200 persons and a budget
of close to a million dollars per year. He is responsible for the
upkeep of all buildings and equipment at a large university.
However, any reconstruction project is budgeted and
administered separately. Karl’s responsibilities include selection
and evaluation of personnel, negotiating with suppliers,
choosing the kinds of landscaping, and so on. Karl’s services,
however, are
Required:
a) Should Karl be evaluated as a profit center or a cost
center?
b) How should the university evaluate Karl’s performance?
51
Exercise 12.31 (Continued)
a) Should Karl be evaluated as a profit center or a cost
center?
We believe that Karl should be evaluated as a cost center. While he
provides a useful and visible service, there is no direct impact on
revenue. Further, he does not influence prices or determine the level
of output. His job is to keep up the buildings to specified quality
levels within allowed costs. This is a central characteristic of a cost
center.
52
Exercise 12.31 (Concluded)
b) How should the university evaluate Karl’s performance?
The university should use a mix of financial and non-financial
measures. Relying on financial measures alone is not advisable
because Karl can always postpone maintenance to come in below
budgeted expenditures. However, we do need to make sure that the
budget is not over-spent by a lot. Non-financial measures such as
time to respond to complaints and general score on upkeep seem
useful as a way to make sure that Karl is providing the desired service
quality.
53