Decentralized Organizations, Transfer Pricing, and Measures of Profitability

1. Decentralized Organizations, Transfer Pricing, and Measures of Profitability 14

2. Decentralization versus Centralization Decentralization • The delegation of decision making authority to managers throughout the organization Centralization Decentralization Minimum freedom Maximum freedom

3. Decentralization (con’d) Benefits of Decentralization • Lower-level managers are more informed about local conditions • Managers acquire decision-making experience that trains them to assume leadership roles in organization • Managerial independence leads to greater motivation

4. Decentralization (con’d) Costs of Decentralization • Managers may make goal incongruent decisions • Duplication of services (accounting and advertising) • Increased cost of accumulating and processing information • Managers may waste time arguing about shared services

5. Decentralization (con’d) • Most companies adopt a blend of decentralized and centralized functions (decentralize marketing but centralize tax planning) • Decentralization is most successful when organization's segments are relatively independent Diversified Single Industry Single Product Line Multi-Product Product No Problems Common Problems

6. Decentralization (con’d) • Decentralization cannot work unless top management is willing to abide by its managers' decisions • Stepping in and overriding managers' decisions will quickly result in motivational problems

7. Profit Centres and Decentralization • Be careful to separate these two ideas • Profit centres hold a manager accountable for revenues & expenses • Decentralized manager has the freedom to make decisions • Cost centre may be more decentralized than a profit centre if the cost centre manager has more authority

8. Transfer Pricing • Transfer pricing deals with the valuation of goods and services traded between profit or investment centres in decentralized organizations • Selling division wants the transfer price to be high • Buying division wants the transfer price to be low Transfer Price Selling Division Buying Division Final Market Intermediate Market

9. Alternative Transfer Prices • Cost-Based Transfer Price • Variable cost plus a markup • Full cost plus a markup • Market-Based Transfer Price • Negotiated Transfer Price

10. Setting Transfer Prices Transfer Price = Cost Plus • Used by half of the major companies in the world • Consider using cost-based transfer price when market price is not available or too difficult to determine • What may be variable and fixed to the selling division becomes completely variable to the buying division • Should always transfer at standard cost

11. Setting Transfer Prices (con’d) Transfer price = market price • If the external market is competitive, using the market price as the transfer price will generally produce optimal results • Adjustments may be made to reflect costs not incurred on internally transferred goods and services • Market price forces divisional managers to be competitive

12. Setting Transfer Prices (con’d) Negotiated transfer prices • Common in organizations where managers have considerable autonomy • Do not let negotiations take up too much time

13. Transfer Pricing in the Global Market • Headquarters and • manufacturing • division in Israel • 4 plants (cost centre) Transfer Price = ? • U.S.-Based Lemmon • Marketing Division • profit centre • Israel-Based • Marketing Division • profit centre Third Marketing Division Sells Worldwide on a Made-to-Order Basis

14. Irving Oil versus Revenue Canada New Brunswick Refinery Bermuda

15. Return on Investment (ROI%) • Top management's determination of the overall contribution of the division to corporate earnings • Focus on long-run performance • Are the dollars invested in the division generating an adequate return? • Should more or less money be put into these activities? ROI% = income / invested capital = income x revenue revenue invested capital • Improve performance by • Increasing income by reducing expenses • Boost sales without increasing expenses • Reduce investments in working capital and fixed assets without decreasing sales

16. Residual Income (RI) • Residual income is a variation of ROI% which focuses on an absolute dollar amount rather than a % Residual income = Divisional net income - (interest charge x invested capital) • Imputed interest charge refers to the firm’s "cost of capital" • Cost of capital is the minimum acceptable rate of return for investments in a project or a division • If divisions have different levels of risk, they should have different imputed interest charges Current New Proposal Revised Net income $200,000 $75,000 $275,000 Invested capital $1,000,000 $500,000 $1,500,000 ROI% 20% 15% 18.3% Capital charge (8%) $80,000 $40,000 $120,000 Residual income $120,000 $35,000 $155,000

17. Economic Value Added (EVA) • Variation of Residual Income • Term coined and marketed by Stern Stewart & Co. • Focuses on an absolute dollar amount rather than a % Economic Value Added (EVA) = Net operating income - [ Weighted-average cost of capital x (Long-term liabilities + Shareholders’ equity) ] • Weighted-average cost of capital is the after-tax cost of long-term liabilities and shareholders’ equity weighted by their relative size for the company or the division X Y 2006 Sales Revenue ($millions) $12 $8 2007 Sales revenue ($millions) $21 $19 Invested capital ($millions) $20 $10

18. Defining Invested Capital • Possible alternative definitions of "invested capital" include total assets, total assets employed, total assets - current liabilities • Best alternative depends on what the manager can influence • Centrally administered assets are often allocated to divisions • Allocations will not cause major problems if allocation base is deemed by managers to be reasonable

19. Valuation of Plant & Equipment Assets Gross Book Value • Original cost of assets • Objective [no amortization (depreciation) allocations] Net Book Value • Original cost less accumulated amortization (depreciation) • Managers motivated to not invest in new assets Current Value • Figures may be costly (and sometimes impossible) to determine