Cost Management ACCOUNTING AND CONTROL

1. Cost ManagementACCOUNTING AND CONTROL HANSEN & MOWEN

2. 10 CHAPTER Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing

3. 1 OBJECTIVE Responsibility Accounting Responsibility accounting is 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

4. 2 OBJECTIVE 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

5. 3 OBJECTIVE 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 = (Operating income / Sales)  (Sales / Average operating assets) = Operating income margin  Operating asset turnover Margin: portion of sales available for interest, taxes and profit Turnover: how productively assets are being used to generate sales

6. 3 OBJECTIVE Measuring the Performance of Investment Centers Comparison of Divisional Performance

7. 3 OBJECTIVE Measuring the Performance of Investment Centers Comparison of Divisional Performance (cont’d) aOperating income divided by average operating assets. bOperating income divided by sales. cSales divided by average operating assets.

8. 3 OBJECTIVE 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.

9. 3 OBJECTIVE Measuring the Performance of Investment Centers Residual incomeis the difference between operating income and the minimum dollar return required on a company’s operating assets:

10. 3 OBJECTIVE Measuring the Performance of Investment Centers Advantages of Residual Income Project I Residual income = $1,300,000 - (0.10  $10,000,000) = $1,300,000 - $1,000,000 = $300,000 Project II Residual income = $640,000 - (0.10  $4,000,000) = $640,000 $400,000 = $240,000

11. 3 OBJECTIVE Measuring the Performance of Investment Centers Advantages of Residual Income (continued) Add Add Add Both Maintain Project I Project II Projects Status Quo Operating assets $60,000,000 $54,000,000 $64,000,000 $50,000,000 Operating income $ 8,800,000 $ 8,140,000 $ 9,440,000 $ 7,500,000 Minimum return* 6,000,0005,400,0006,400,0005,000,000 Residual income $ 2,800,000 $ 2,740,000 $ 3,040,000 $ 2,500,000 *0.10 Operating assets. Preferred alternative

12. 3 OBJECTIVE Measuring the Performance of Investment Centers Disadvantages of Residual Income Division A Division B Average operating assets $15,000,000 $2,500,000 Operating income $ 1,500,000 $ 300,000 Minimum returna 1,200,000 200,000 Residual income $ 300,000 $ 100,000 Residual returnb 2% 4% a0.08 Operating assets. bResidual income divided by operating assets.

13. 3 OBJECTIVE Measuring the Performance of Investment Centers Disadvantages of Residual Income (continued) • It is an absolute measure of return which make it difficult to directly compare the performance of divisions. • It does not discourage myopic behavior.

14. 3 OBJECTIVE Measuring the Performance of Investment Centers Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

15. 3 OBJECTIVE Measuring the Performance of Investment Centers EVA Example After-Tax Weighted Amount Percent x Cost = Cost Mortgage bonds $ 2,000,000 0.133 0.048 0.006 Unsecured bonds 3,000,000 0.200 0.060 0.012 Common stock 10,000,000 0.667 0.120 0.080 Total $15,000,000 Weighted average cost of capital 0.098 $15,000,000 x .098 = $1,470,000

16. 3 OBJECTIVE Measuring the Performance of Investment Centers EVA Example (continued) Furman’s EVA is calculated as follows: After-tax profit $1,583,000 Less: Weighted average cost of capital 1,470,000 EVA $ 113,000 The positive EVA means that Furman, Inc., earned operating profit over and above the cost of the capital used.

17. 3 OBJECTIVE Measuring the Performance of Investment Centers Behavioral Aspects of EVA Hardware Software Division Division Sales $5,000,000 $2,000,000 Cost of goods sold 2,000,000 1,100,000 Gross profit $3,000,000 $ 900,000 Divisional selling and administrative expenses 2,000,000 400,000 Operating income $1,000,000 $ 500,000

18. 3 OBJECTIVE Measuring the Performance of Investment Centers The EVA for each division can be calculated as follows: Hardware Software Division Division Operating income $1,000,000 $500,000 Less: Cost of capital 1,100,000 220,000 EVA $ (100,000) $280,000

19. 3 OBJECTIVE Measuring the Performance of Investment Centers Behavioral Aspects of EVA • Tends to focus on long-run • Discourages myopic behavior

20. 4 OBJECTIVE Measuring and Rewarding the Performance of 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. Incentive Pay for Managers

21. 4 OBJECTIVE 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.

22. 4 OBJECTIVE 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 bonus to reward performance by keeping salaries fairly level and allow bonuses to fluctuate with reported income.

23. 4 OBJECTIVE Measuring and Rewarding the Performance of Managers Stock-Based Compensation Stock options frequently are offered to manager to make them part owners of the company—thus encourage goal congruence. A stock option is is the right to buy a certain number of shares of the company’s stock, at a particular price and 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.

24. 5 OBJECTIVE Transfer Pricing 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.

25. 5 OBJECTIVE Transfer Pricing Impact of Transfer Price on Transferring Divisions and the Company as a Whole

26. 6 OBJECTIVE Setting Transfer Prices A transfer pricing system should satisfy three objectives: • Accurate performance evaluation • Goal congruence • Preservation on divisional autonomy The opportunity cost approach identifies the minimum transfer price and the maximum transfer price.

27. 6 OBJECTIVE Setting Transfer Prices • Market price • Negotiated transfer prices • Cost-based transfer prices • Variable cost • Full (absorption cost)

28. 6 OBJECTIVE Setting Transfer Prices Example 1: Avoidable Distribution Costs Summary of Sales and Production Data

29. 6 OBJECTIVE Setting Transfer Prices Example 1: Avoidable Distribution Costs Comparative Income Statements

30. 6 OBJECTIVE Setting Transfer Prices Example 1: Avoidable Distribution Costs Comparative Income Statements (continued)

31. 6 OBJECTIVE Setting Transfer Prices Example 2: Excess Capacity Comparative Statements

32. 6 OBJECTIVE Setting Transfer Prices Example 2: Excess Capacity Comparative Statements (continued)

33. 6 OBJECTIVE Setting Transfer Prices Disadvantages of Negotiated Transfer Prices • One division manager, possessing 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.

34. 6 OBJECTIVE Setting Transfer Prices Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and accurate performance evaluation.

35. 6 OBJECTIVE Setting Transfer Prices Disadvantages of Negotiated Transfer Prices • Full-cost transfer pricing • Full cost plus markup • Variable cost per fixed fee • Propriety of use

36. 6 OBJECTIVE Setting Transfer Prices Use of Transfer Pricing to Affect Income Taxes Paid

37. End of Chapter 10