Agenda

Decentralization
Profit centers and profit computations
Transfer pricing

National Youth Association

HCC Industries
Group problem solving

Decentralization and
performance evaluation
Performance evaluation becomes
necessary when decision rights are
delegated. Do owners evaluate
managerial inputs or outputs?

Decentralization: Why?

Environment
Information specialization
Timeliness of response
Conservation of central management time
Computational complexity
Training of local managers
Motivation of local managers

Responsibility centers:

Standard cost centers - production variances

Revenue centers - revenue variances
Discretionary expense centers
Profit centers - some measure of profit
Investment centers - some profitability
measure (e.g., ROI or residual income)

Problems associated with

decentralization:
Goal congruence

Externalities
Over-consumption of perquisites

Responsibility accounting:
This refers to the various concepts and tools
used by managerial accountants to measure the
performance of people and departments in
order to foster goal congruence.

Key concepts in responsibility

accounting:

Controllability
The controllability principle
Controllability problems
Traceability

Designing an accounting-based
performance measure:
Representing financial (and other) goals
Choosing income and investment numbers
Choosing measures for income and
investment numbers
Choosing a target
Choosing the timing of feedback

Profit centers:
Profit center: A profit center is a unit for which the
manager has the authority to make decisions on
sources of supply and choices of markets.
Profit measurement:
Variable contribution margin
Controllable contribution
Divisional contribution
Divisional profit before taxes

John Daly
Suppose that a year or more ago, John Daly, who
owned the rights to produce a nifty new product,
believed the product, Nifty, would be quite profitable
if economical production facilities could be located.
After much investigation, John located a small
building on the edge of town that was reasonably
cheap, even though it was actually somewhat larger
than he needed.

John Daly continued:

The building contained 150,000 square feet of usable
space and cost $100,000 per year to rent. Johns
manufacturing operation required about 75% of this
space.
In his first year of operation, the company earned
about $100,000 in operating income. John paid his
manager a salary, but rewarded exceptional effort by
sharing profits.
What was operating income before facility costs?

John Daly continued

A friend of Johns had an idea for using the excess
space in the facility and he asked John to finance the
operation. Once the friend had explained his idea,
John agreed. New equipment was purchased, and
the new product, New, was manufactured and sold,
along with Nifty, during the second year of
operation. There was no incremental increase in the
cost of the facility or its maintenance.

John Daly continued

Once the costs that could be directly associated with
the new product were deducted, operating profits had
increased by $25,000. Niftys results were the same
as in year one.
Required: Suppose John wants to define each
product line as a profit center and split profits with
his managers fifty-fifty. What operating profit
would you compute for the two product lines? How
much bonus would each manager receive?

Investment centers: ROI and

Residual Income
Investment centers: The manager has been given
maximum discretion for making short-run operating
decisions on product mix, pricing and production
methods, as well as the level and type of assets to be used.

Income
Income
Sales
ROI

*
Investment
Sales Investment

Simple example: ROI

The Division A manager earns $50,000 on his
controllable investment of $350,000. His ROI is:

$50,000
ROI
* 100% 14.3%
$350,000
What income number?
What investment number?

Residual income
Residual income is as close as an accountant comes
to computing economic profit. It is operating income
after paying all providers of capital.
Residual income =
Operating income - the cost of capital
Cost of capital = demanded rate of return
on invested capital * size of investment

Simple example: Residual

income
Division A: Providers of capital demand 12% on average.
This is the opportunity cost of their capital.
Operating income

$50,000

Cost of capital

(42,000)

Residual income

$ 8,000

The cost of capital in dollars is just the per dollar opportunity

cost of investors capital times the size of their investment.

Which performance measure is

better?
Simple example: The investors cost of capital remains
12% throughout.
Division A: Assets = $350,000
Income = $50,000
ROI = 14.3%
Suppose the division manager is considering investing
$15,000 in an asset that will earn $2,000 in income.
Will she take the investment?

Decision 1: Will she take the

investment?

$2,000
Incremental return is less than ROI
13.3%
$15,000
$52,000
Division ROI after
14.2% 14.3%
$365,000
Would the providers of capital want her to take it?

Decision 2: Simple example

Suppose the division manager is considering disposing
of an asset with a book value of $20,000 which earns
$2,500 in income during any accounting period. Will
he dispose of the asset?
$2,500
Asset's ROI
12.5%
$20,000
$47,500
Division ROI after
14.4% 14.3%
$330,000
What do providers of capital want him to do?

Residual income: Decision 1

Suppose now that the division managers performance
evaluation measure is residual income. Will the manager
choose to invest in a new assets that makes $2,000 per
year and costs $15,000?

What is the current residual income?

New residual income:

$8,000

$52,000 controllable cont.

(43,800) new cost of capital
$ 8,200

new residual income

Residual income: Decision 2

Will the Division A manager who is evaluated using
residual income dispose of an asset with annual earnings
of $2,500 and a book value of $20,000?
New residual income $47,500 controllable cont.
(39,600)

new cost of capital

$ 7,900

new residual income

Compare divisons: ROI and

residual income
Division A
Assets: $350,000
Contrib: $50,000
ROI: 14.3%

Division B
Assets: $250,000
Contrib: $37,500
ROI: 15%

Which division is more profitable?

What rate of return does the larger division make on

its additional assets?
Is it more than the cost of capital?

Profit centers: HCC Industries

Participatory budgeting
Setting budget performance targets
Risk sharing and risk setting
Communicating using the budget
There are no actual calculations to do for
HCC Industries
Pay attention to the probabilities that are
tossed about.

Profit centers and transfer

pricing:

TRANSFER PRICE

A PRICE CHARGED BY ONE SEGMENT OF AN

ORGANIZATION FOR A PRODUCT OR SERVICE
THAT IT SUPPLIES TO ANOTHER SEGMENT OF
THE ORGANIZATION.

Objectives of transfer pricing

schemes:
Encourage managers to make decisions that
are in the organizations best interest.
Provide information for evaluation of
business units and managers.
Minimize tax obligations (we will ignore)
Constraint: The scheme chosen should
require little intervention by top
management.

The unifying principle is

opportunity cost:
The general transfer pricing rule:
T = VC + OC
VC = OUTLAY COSTS INCURRED TO
THE POINT OF TRANSFER;
USUALLY APPROXIMATED BY
STANDARD VARIABLE COST
OC = OPPORTUNITY COST TO THE
FIRM (I.E., CONTRIBUTION
FOREGONE = CM)
Note that CM = SP - VC, so VC + OC = SP - the market price
when OC > 0, less adjustments.

Transfer pricing: Crossville

Company
At practical capacity, the Fabricating Division of Crossville
Company has facilities to produce 8,000 units per month. Each unit
requires five direct labor hours. The Assembly Division has
forwarded a requisition for 8,000 units to the Fabricating Division.
Since Crossville uses a market-based transfer pricing system,
contribution margin using a $50 market price would be $168,000.
Georges, Inc., a competitor, also sells the units for $50. The receipt
of this requisition from Assembly upset the Fabricating manager as
he had just been approached by an outside buyer with a rush order
for 5,000 units at a $56 unit selling price.
Top managements initial reaction is to reject the offer.

Crossville Company
A. Does top management have a transfer pricing policy?
B. What is the minimum transfer price required by the
selling division, Fabricating?
$53.75, the immediate average market price
C. What is the maximum transfer price required by the
buying division?
$50, the price it would pay to Georges

Crossville Company
D. Will the two division managers agree to the transfer?
Buying
Division

$50 or less

Selling
Division

$53.75 or more

Crossvillle Company
Which of the following circumstances will lead
to goal congruence between the managers and the
overall firm? Why?

1. The policy enforced is market price transfers.

Will the managers agree to transfer?
No, the Fabrication manager sells outside.

Is the transfer in the best interest of the company?

Crossville Company
Is the transfer in the best interest of the company?
Minimize costs:
Internal transfer:

Relevant cost of product = $53.75

Note:

$168,000 / 8,000 = $21 = CM/unit

Therefore, VC = $29 per unit

External transfer:

Fab:
($53.75) - 29 = ($24.75)
Assy:
$50.00
Relevant cost of product =
$25.25

The company does not want an internal transfer.

Crossville Company
2. Fabricating has adequate idle capacity.
This means that there is no meaningful market price
for the items that would be transferred.
Internal transfer:

Fabs outlay cost = $29

Assys outlay cost = $0

External transfer

Fabs outlay cost = $0

Assys outlay cost = $50
What price will the Fabrication manager ask?
What price will the Assembly manager be willing to pay?

Crossville Company
3. Fabricating is forced to transfer product in lieu of
selling 5,000 units outside.
Fabrication manager gets $50
Assembly manager pays $50

Internal transfer: $53.75 relevant cost

External transfer: $24.25 relevant cost

The managers will act against the companys best interest.

Negotiated market-based prices:

Some form of outside market for the
intermediate product.
Sharing of all market information among the
negotiators.
Freedom to buy or sell outside. This provides
the necessary discipline to the bargaining
process.
Support and occasional involvement of top
management.

Its limitations:
Time consuming
Leads to conflict within firms
It makes the measurement of divisional
profitability sensitive to the negotiating
skills of managers.
It requires the time of top management to
oversee and mediate.
It may lead to a suboptimal level of output.

NYA
Transfer pricing.
Reward functions are as follows:
Total points = 300
Your fraction of the 300 points:
Your teams margin/Overall corporate margin

These points will be used to award class

participation credit.

Group work:
Work
Europa, Inc handout.