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Week 12 - Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing, Chapter 17

Week 12 - Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing, Chapter 17. Learning Objectives. 1. Define responsibility accounting and describe four types of responsibility centres. 2. Explain why firms choose to decentralize.

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Week 12 - Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing, Chapter 17

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  1. Week 12 - Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing, Chapter 17

  2. Learning Objectives 1. Define responsibility accounting and describe four types of responsibility centres. 2. Explain why firms choose to decentralize. 3. Compute and explain return on investment (ROI) and residual income (RI). 4. Discuss methods of evaluating and rewarding managerial performance. 5. Explain the role of transfer pricing in a decentralized firm.

  3. Responsibility Accounting Responsibility Accounting-A process that involves creating areas of responsibility, which are known as responsibility centres, and assigning subordinate managers to those areas. 1. Cost centre 2. Revenue centre 3. Profit centre 4. Investment centre Types of responsibility centres:

  4. Decentralization: The Major Issues 1. The degree of decentralization 2. Performance measurement 3. Management compensation 4. The setting of transfer prices

  5. Reasons for Decentralization 1. Access to local information 2. Cognitive limitations (control of information, etc.) 3. More timely response 4. Focusing of central management 5. Training and evaluation 6. Motivation 7. Enhanced competition

  6. Measuring the Performance of Investment Centres 1. Return on Investment (ROI) 2. Residual Income (RI)

  7. Components of ROI • Decomposition of the ROI formula: • ROI = (Operating income/Average operating assets) • = Operating income/Sales x Sales/Average operating assets • = Operating income margin x Operating asset turnover

  8. An ROI Example ABC Division XYZ Division 1995 Sales $20,000,000 $120,000,000 Operating income 2,000,000 5,000,000 Average operating assets 12,000,000 35,000,000 1996 Sales $35,000,000 $120,000,000 Operating income 2,500,000 5,500,000 Average operating assets 12,000,000 35,000,000 Minimum return of 10%

  9. Margin and Turnover Comparisons ABC XYZ 1995 1996 1995 1996 Margin 10% 7.1% 4.2% 4.6% Turnover x 1.667 x 2.917 x 3.429 x 3.429 ROI 16.67% 20.71% 14.40% 15.77%

  10. Advantages of ROI 1. It encourages managers to focus on sales, expenses, and investments. 2. It encourages cost efficiency. 3. It discourages excessive investment in operating assets.

  11. Disadvantages of the ROI Measure 1. It discourages managers from investing in projects that would decrease the divisional ROI but increase the profitability for the company as a whole. 2. It encourages managers to focus on the short run at the expense of the long run.

  12. A Residual Income Example Residual Income = Operating income - (r x Operating assets) where r = The minimum rate of return Refer to data in transparency 12-8: ABC XYZ 1995 1996 1995 1996 Operating assets $12,000,000 $12,000,000 $35,000,000 $35,000,000 Operating income 2,000,000 2,500,000 5,000,000 5,500,000 Minimum return 1,200,000 1,200,000 3,500,000 3,500,000 Residual income $800,000 $1,300,000 $1,500,000 $2,000,000

  13. Comparison of ROI and Residual Income Measures ABC XYZ 1995 1996 1995 1996 Return on Investment 16.67% 20.71% 14.40% 15.77% Residual income $800,000 $1,300,000 $1,500,000 $2,000,000 Which measure is best?

  14. Features of the Residual Income Measure 1. Like ROI, residual income encourages short run orientation. 2. Residual income uses an absolute measure of profitability making direct comparison of profitability of divisions with different investment bases unfair since the level of investment may differ.

  15. 1. Tends to Focus on Long-run 2. Discourages Myopic Behaviour Why have Multiple Performance Measures? Multiple Performance Measurements

  16. Management Compensation Salary Incentives tied to profits and/or performance What Method? Cash-based methods Noncash-based methods

  17. Transfer Pricing: General Concerns Some Major Issues 1. Impact on performance measures 2. Impact on firm-wide profits 3. Impact on autonomy

  18. Transfer Pricing Approaches 1. Cost-based approach • Variable cost • Full (absorption cost) 2. Market price 3. Negotiated market price Transfer price = Variable cost per unit + Lost contribution per unit on outside sales This relationship identifies the minimum and maximum transfer prices

  19. A Transfer Pricing Problem Assume the following data for division A: Capacity in units 50,000 Selling price to outside $15 Variable cost per unit 8 Fixed costs per unit (based on capacity) 5 Division B would like to purchase units for division A. Division B is currently purchasing 5,000 units per year from an outside source at a cost of $14.

  20. A Transfer Problem Example (Continued) 1. Assume division A has idle capacity in excess of 10,000 units: Minimum transfer price = Variable cost + Lost contribution margin = $8 + $0 = $8 2. Assume division A is working at capacity: Transfer Price = Variable cost + Lost contribution margin = $8 + $7 = $15 (market price) 3. Assume division A is working at capacity, but a negotiated $2 in variable costs can be avoided on intercompany sales: Transfer Price = Variable cost + Lost contribution margin = $6 + $7 = $13 (negotiated price)

  21. In-Class Assignment -1 Direct Market Price Boardfeet Manufacturing Boardfeet (000) Costs (000) (000) 1995 11.67 $2,625 $336 1996 12.04 3,010 291 1997 11.27 3,100 310 1998 12.00 3,600 326

  22. Suggested Solution (1) (2) (3) (4) (5) (6) Transfer Price Market Difference Market Thousands Excess Manufacturing Price for of Pre-tax Costs (000) Large Boardfeet Profits Direct With Markup Orders Transferred (3 x 4) (2 - 5) 1995 $2,625 $3,281 $319 11.67 $3,723 ($442) 1996 3,010 3,763 276 12.04 3,323 440 1997 3,100 3,875 295 11.27 3,325 550 1998 3,600 4,500 310 12.00 3,720 780

  23. In-Class Assignment - 2 Division Competition 1990 2.47 2.43 1991 2.51 2.53 1992 2.34 2.49 1993 2.30 2.55 1994 2.36 2.61 1995 1.98 2.64 1996 1.96 2.71 1997 1.90 2.81 1998 1.95 2.77 1999 1.81 2.73

  24. ROI = (Operating income/Average operating assets) = Operating income/Sales x Sales/Average operating assets = Operating income margin x Operating asset turnover

  25. In-Class Assignment - 3 Customer Satisfaction Survey, 1996 to 1999 (% score on a 100% scale) 1999 1998 1997 1996 Product quality 60.5 84.5 83.7 84.9 Recommend to friends 57.3 92.3 91.7 92.2 Good value 47.6 74.1 76.5 75.6 Features 89.6 54.8 57.3 56.8

  26. Numerical Questions from the Back of Chapter 17 E17-1 E17-7 E17-9 E17-15

  27. Question E17-7 Please turn to your textbook to read the question.

  28. Question E17-9 Please turn to your textbook to read the question.

  29. Question E17-15 Please turn to your textbook to read the question.

  30. The End

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