Decentralization in Organizations: Benefits, Costs & Control Systems

1. Chapter 16 Management Control In Decentralized Organizations

2. Define decentralization and identify its expected benefits and costs. Learning Objective 1

3. Decentralization The delegation of freedom to make decisions is called decentralization. The lower in the organization that this freedom exists, the greater the decentralization.

4. Centralization versus Decentralization Centralization Decentralization Minimum Constraints Maximum Freedom Maximum Constraints Minimum Freedom

5. Costs and Benefits Benefits of decentralization: Lower-level managers have the best information concerning local conditions. It promotes management skills which, in turn, helps ensure leadership continuity. Managers enjoy higher status from being independent and thus are better motivated.

6. Costs and Benefits Costs of decentralization: Managers may make decisions that are not in the organization’s best interests. Managers also tend to duplicate services that might be less expensive if centralized. Costs of accumulating and processing information frequently rise.

7. Costs and Benefits Managers in decentralized units may waste time negotiating with other units about goods or services one unit provides to the other.

8. Middle Ground • Cost-benefit considerations usually require that some management decisions be highly decentralized and others centralized. • Decentralization is most successful when an organization’s segments are relatively independent of one another.

9. Segment Autonomy If management has decided in favor of heavy decentralization, segment autonomy, the delegation of decision-making power to managers of segments of an organization, is also crucial.

10. Distinguish between profit centers and decentralization. Learning Objective 2

11. Profit Centers and Decentralization Accountability for revenue and expenses Profit centers Freedom to make decisions Decentralization These are entirely separate concepts and one can exist without the other.

12. Profit Centers and Decentralization All control systems are imperfect. Judgments about their merits should concentrate on which alternative system will bring more of the actions top management seeks.

13. Define transfer prices and identify their purpose. Learning Objective 3

14. Transfer Prices • Transfer prices are the amounts charged by one segment of an organization for a product or service that it supplies to another segment of the same organization.

15. Purpose of Transfer Pricing Why do transfer-pricing systems exist? – to communicate data that will lead to goal-congruent decisions – to evaluate segment performance and thus motivate managers toward goal-congruent decisions

16. Purpose of Transfer Pricing Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

17. Identify the relative advantages and disadvantages of basing transfer prices on total costs, variable costs, and market prices. Learning Objective 4

18. Transfers at Cost • About half of the major companies in the world transfer items at cost.

19. Transfers at Cost What are some examples? Full cost plus a profit markup Variable costs Standard costs Actual costs Full cost

20. Market-Based Transfer Prices If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort.

21. Market-Based Transfer Prices • The major drawback to market-based prices is that market prices are not always available for items transferred internally.

22. Variable-Cost Pricing • When market prices cannot be used, versions of “cost-plus-a-profit” are often used as a fair substitute.

23. Variable-Cost Pricing In situations where idle capacity exists, variable cost would generally be the better basis for transfer pricing and would lead to the optimum decision for the firm as a whole.

24. Negotiated Transfer Prices • Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.

25. Dysfunctional Behavior Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals.

26. The Need for Many Transfer Prices • The “correct” transfer price depends on the economic and legal circumstances and the decision at hand. • Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort.

27. Identify the factors affecting multinational transfer prices. Learning Objective 5

28. Multinational Transfer Pricing Example • An item is produced by Division A in a country with a 25% income tax rate. • It is transferred to Division B in a country with a 50% income tax rate. • An import duty equal to 20% of the price of the item is assessed. • Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen).

29. Multinational Transfer Pricing Example Which transfer price should be chosen? $100 Why?

30. Multinational Transfer Pricing Example Income of A is $40 higher: 25% × $40 = ($10) higher taxes Income of B is $40 lower: 50% × $40 = $20 lower taxes Import duty paid by B: 20% × $40 = ($8) Net savings = $2

31. Explain how the linking of rewards to responsibility center results affects incentives and risk. Learning Objective 6

32. Link Rewards to Results Choices of Responsibility Motivational Criteria Centers and Incentives Goal Congruence Managerial Effort Performance Measures Rewards Feedback Feedback

33. Link Rewards to Results • Research shows that the more objective the measures of performance, the more likely the manager will provide effort. • Thus accounting measures, which provide relatively objective evaluations of performance, are important.

34. Agency Theory Economists describe the formal choices of performance measures and rewards as agency theory. Employment contracts will trade off three factors: 1 – Cost of measuring performance 2 – Incentive 3 – Risk

35. Compute ROI, residual income, and economic value added (EVA) and contrast them as criteria for judging the performance of organization segments. Learning Objective 7

36. Measures of Profitability • Segment managers in decentralized organizations are often evaluated based on their segment’s profitability. • Is it net income? • Income before taxes? • Net income percentage based on revenue? • Is it an absolute amount? • A percentage?

37. Return on Investment ROI = Income ÷ Investment ROI Income Revenue Revenue Investment = ×

38. Return on Investment Project A: Operating income ÷ Investment required $200,000 ÷ $500,000 = 40% Project B: Operating income ÷ Investment required $150,000 ÷ $250,000 = 60%

39. Residual Income RI = Net operating income – Imputed interest Imputed interest refers to the cost of capital. RI tells you how much your company’s operating income exceeds what it is paying for capital.

40. Economic Value Added Economic value added = Income – After-tax cost of capital × (Long-term liabilities + Stockholders’ equity)

41. Compare the advantages and disadvantages of various bases for measuring the invested capital used by organization segments. Learning Objective 8

42. ROI or Residual Income? Why do some companies prefer residual income (or EVA) to ROI? Under ROI, the message is go forth and maximize your rate of return, a percentage. Under RI, the message is go forth and maximize residual income, an absolute amount.

43. Invested Capital To apply either ROI or residual income, both income and invested capital must be measured and defined. Total assets Total assets employed Total assets less current liabilities Stockholders’ equity

44. Asset Allocation to Divisions • Commonly used bases for allocation, when assets are not directly identifiable with a specific division, include: Asset Class Corporate cash Receivables Inventories Plant and equipment Possible Allocation Base Budgeted cash needs Sales weighted by terms Budgeted sales or usage Usage of services

45. Valuation of Assets Should values be based on historical cost or some version of current value? Practice is overwhelmingly in favor of using net book value based on historical cost. Most companies use net book value in calculating their investment base.

46. Understand the role of management control systems in decentralized organizations. Learning Objective 9

47. Keys to SuccessfulManagement Control Systems Successful management control systems have several key factors in addition to appropriate measures of profitability. Controllability Management by objectives Tailoring budgets for managers

48. Focus on Controllability • A distinction should be made between the performance of the division manager and the performance of the division as an investment by the corporation. • Managers should be evaluated on the basis of their controllable performance.

49. Management by Objectives MBO describes the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period. The manager’s performance is then evaluated in relation to these agreed-upon budgeted objectives.

50. Tailoring Budgets for Managers • Many of the troublesome motivational effects of performance evaluation systems can be minimized by the astute use of budgets. • The desirability of tailoring a budget to particular managers cannot be overemphasized.