Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing

1. Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing 10 CHAPTER

2. Responsibility Accounting OBJECTIVE 1 Responsibility Accounting: a system that measures the results of each responsibility center and compares those results with some measure of expected or budgeted outcome. Types of Responsibility Centers: • Cost Center: only responsible for costs • Revenue Center: only responsible for revenues • Profit Center: Responsible for both revenues and costs • Investment Center: responsible for revenues, costs, and investments

3. Decentralization Reasons for Decentralization: Better access to local information Cognitive limitations More timely response Focusing of central management Training and evaluation of segment managers Motivation of segment managers Enhanced competition OBJECTIVE 2 10-3

4. Measuring the Performance of Investment Centers Return on Investment (ROI) is the most common measure of performance for an investment center. ROI = operating income / Average operating assets ROI = (operating income/ sales) X (sales / average operating assets) ROI = Operating income margin X Operating asset turnover Where: Margin: portion of sales available for interest, taxes and profit Turnover: how productively assets are being used to generate sales Operating income: refers to earnings before interest and income taxes Operating assets: includes all assets used to generate operating income OBJECTIVE 3 10-4

5. Measuring the Performance of Investment Centers Advantages of the ROI Measure: Helps managers focus on the relationship between sales, expenses and investment. Encourages cost efficiency. Discourages excessive investment in operating assets Disadvantages of the ROI Measure: Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall. Encourages managers to focus on the short-term at the expense of the long-term. OBJECTIVE 3 10-5

6. Measuring the Performance of Investment Centers Residual Income is the difference between operating income and the minimum dollar return required on a company’s operating assets: Residual Income = Operating Income – [Minimum rate of return X Operating assets] Residual income is a dollar measure of performance – encourages managers to move beyond the focus of the percentage return on investment to look at the absolute dollar value of the additional profit. However, the residual income is an absolute measure of return which makes it difficult to directly compare the performance of divisions. It also does not discourage myopic behavior OBJECTIVE 3 10-6

7. Measuring the Performance of Investment Centers Economic Value Added (EVA) is after-tax operating profit minus the total annual cost of capital if positive, the company is creating wealth if negative, then the company is destroying wealth key feature: focuses on after-tax operating income and the actual cost of capital EVA = After-tax operating income – [Weighted average cost of capital X total capital employed] Behavioral Aspects of EVA: Tends to focus on long-run Discourages myopic behavior OBJECTIVE 3 10-7

8. Measuring and Rewarding the Performance of Managers Incentive Pay for Managers Why would managers not provide good service? There are three reasons: They may have low ability. They may prefer not to work hard. They may prefer to spend company resources on perquisites. OBJECTIVE 4 10-8

9. Measuring and Rewarding the Performance of Managers Managerial Rewards Frequently managerial rewards include incentives tied to performance. The objective of managerial awards is to encourage goal congruence, so that managers will act in the best interests of the firm. Managerial rewards include salary increases, bonuses based on reported income, stock options, and noncash compensations. OBJECTIVE 4 10-9

10. Measuring and Rewarding the Performance of Managers Cash Compensation Good management performance may be rewarded by granting periodic raises. Unlike periodic raises, bonuses are more flexible. Many companies use a combination of salary and bonuses to reward performance by keeping salaries fairly level and allowing bonuses to fluctuate with reported income. OBJECTIVE 4 10-10

11. Measuring and Rewarding the Performance of Managers Stock-Based Compensation Stock options frequently are offered to managers to encourage them to focus on the longer term A stock option is the right to buy a certain number of shares of the company’s stock, at a particular price, after a set length of time The price of the stock is usually set approximately at market price at the time of issue. Then, if the stock price rises in the future, the manager may exercise the option OBJECTIVE 4 10-11

12. Transfer Pricing OBJECTIVE 5 Transfer prices are the prices charged for goods produced by one division and transferred to another. The price charged affects the revenues of the transferring division and the costs of the receiving division. 10-12

13. Setting Transfer Prices OBJECTIVE 6 A transfer pricing system should satisfy three objectives: • Accurate performance evaluation • Goal congruence • Preservation The opportunity cost approach identifies the minimum transfer price and the maximum transfer price. 10-13

14. Setting Transfer Prices OBJECTIVE 6 • Disadvantages of Negotiated Transfer Prices • One divisional manager with private information may take advantage of another divisional manager • Performance measures may be distorted by the negotiating skills of managers • Negotiation can consume considerable time and resources • Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and accurate performance evaluation 10-14