MANAGEMENT ACCOUNTING

MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

Management Accounting Decentralized organizations (Control) Chapter 7

Objectives • Use the controllability principle to choose performance measures for managers • Identify responsibility centres based on the extent of each manager’s responsibilities • Choose performance measures for cost, profit and investment centres • Identify the strengths and weaknesses of using ROI and residual income as performance measures for investment centres • Choose transfer prices to create performance measures that reflect the activities controlled by each manager • Use opportunity costs to choose transfer prices that will lead to decentralized decision making that is best for the organization • Choose transfer prices to minimize taxes and overcome international obstacles

The Controllability Principle Controllable costs are costs that are affected by a manager’s decisions Holding managers responsible fordecisions where they have authority

The Controllability Principle Some costs are affected by the organization’s environment A single manager does not have control over all costs The manager’s responsibilities are limited by the job description

The Controllability Principle Managers onlypartially control costs Management actions Performance measures Costs Rewards Uncontrollable environmental effects Performance measures based on controllable costs lead to more predictable rewards for managers

The Controllability Principle Management Actions Performance Measures Costs Rewards Uncontrollable Environmental Effects Performance measures andrewards will influence managementto focus on controllable costs

The Controllability Principle When performance measures are affected by uncontrollable environmental effects Management Actions Performance Measures Costs Rewards Uncontrollable Environmental Effects management may try tocontrol performance measures rather than the underlying costs

The Controllability Principle Relative performance measurement attempts to remove uncontrollable factors by comparing performance measures of different managers facing similar circumstances

Responsibility Centres A Cost Center manager has control over the incurrence of costs, but no control over revenues or investment funds A Profit Center manager has control over both costs and revenues, but no control over investment funds An Investment Center manager has control over costs, revenues, and investment funds

Responsibility Accounting Responsibility Accounting is the process of recognizing sub-units within the organization assigning responsibilities to managers evaluating the performance of those managers

Hierarchy of Responsibility Centres

Hierarchy of Responsibility Centers Chief Executive Officer Division Division A B Product 1 Product 2 Product 3 Cost Centers Mfg. Sales Mfg. Sales Mfg. Sales

Hierarchy of Responsibility Centers Chief Executive Officer Division Division A B { Product 1 Product 2 Product 3 Profit Centers Mfg. Sales Mfg. Sales Mfg. Sales

Hierarchy of Responsibility Centers Chief Executive { Officer Division Division A B Investment Centers Product 1 Product 2 Product 3 Mfg. Sales Mfg. Sales Mfg. Sales

Responsibility CentersNumerical Example The television division requests €100 million to develop, manufacture and sell a new flat-screen model Central administration borrows €100 million at a 10% interest rate to provide the cash. The television department invests the €100 million to generate profits of €6 million The net effect: Interest expense €10 million annually less profit on the new model €6 million The investment resulted in a €4 million loss

Return on Investment (ROI) An evaluation of profit as measured against the size of the investment centre Return on = Earnings before / Total assets of Investment Interest the Investment Can be compared against the opportunity cost of capital

Sales ÷ Sales Turnover Total Investment × Return on Investment Earnings Return on Sales ÷ Sales ROI

ROI Numerical Example An organization’s investment centre has a number of investment opportunities. The opportunity cost of capital of the organization is 8%. What is the ROI of these investment opportunities and which would add value to the organization Project A and C would add value as their ROI is greater than the opportunity cost of capital. Project B would not add value

Problems with ROI ROI does not necessarily recognize the risk of projects and incentives to under- or over-invest ROI does not recognize the risk of the investment centre • Higher returns imply higher risk ROI may lead to an under- or over-investment in assets • Only assets with high returns will be purchased

Return on Investment (ROI) Increase Sales Ways to improve ROI Reduce Expenses Reduce Assets

Residual Income Residual income is the difference between and investment centre’s profits and the opportunity cost of using the assets Residual = Profits – (Opportunity cost of capital x Total assets) Income = (Profits/Total assets x Total assets) – (Opportunity cost of capital x Total Assets) =(ROI x Total assets) – (Opportunity cost of capital x Total Assets) = ROI – Opportunity cost of capital x Total Assets It encourages managers to make profitable investments that would be rejected by managers using ROI

Residual IncomeNumerical Example A tractor division has profits (not including interest expense) of £20 Million and investment (Total assets) of £100 million. The division has an opportunity cost of capital of 15%. What is the residual income of the division £20 Million – (15% x £100 Million) = £5 Million

Problems with Residual Income • Changes in market value are not measured • The historical cost of assets is used • Managers will try to increase residual income, while the stockholders would like to see market value increase Comparisons across investment centres of different sizes are difficult

Multiple Performance Measures The manager of an investment centre should not be evaluated by a single performance measure In order to protect the firm’s reputation investment centre managers are usually constrained in terms of the quality of products they can sell and the market niches that they can enter

Transfer Pricing The amount charged when one division sells goods or services to another division The transfer price affects the profit measure for the selling division and the buying division

The External and Internal Transfer of Products ExternalSupplier Raw Materials Division A IntermediateProduct Division B Finished Product ExternalCustomer

Reasons for Transfer Pricing • Control (incentives and performance measures) • Decentralized planning decisions • International/tax reasons

Summary of Transfer Pricing Methods

Control Issues Transfer prices can be used as inputs to the performance measurement system Transfer pricing assigns costs to managers who are responsible for the costs

Transfer PricingNumerical Example The Parts division manufactures parts that it sells to the Assembly division The cost to the Parts division is £10 per unit. The Assembly division assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit. What is the profit per unit if the transfer price is £12 each What is the profit per unit if the transfer price is £10 each

Transfer Pricing for Decentralized Planning Purposes • Some divisions are required to buy internally produced items • The internal producer may not have an incentive to keep costs down • When managers have the decision right to buy “outside,” the internal producer must stay competitive on both quality and cost

Transfer Prices for Decentralized Planning Decisions

Choosing Transfer Prices A transfer price that maximizes firm value (a planning issue) may not maximize a manager’s performance measure (a control issue) Negotiated transfer prices are more effective when there is an external market alternative

Globalization and Transfer Pricing Tax Minimization – if a multinational transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countries Political Considerations can affect the transfer-pricing decision, if there is a risk of expropriation of assets the company may use high transfer prices to reduce the apparent profitability of their foreign subsidiaries

Management Accounting Decentralized organizations (Control) End of Chapter 7

MANAGEMENT ACCOUNTING