© 2007 Pearson Education Canada Slide 14-1 Decentralized Organizations, Transfer Pricing, and Measures of Profitability 14

© 2007 Pearson Education Canada Slide 14-1

Decentralized Organizations, Transfer Pricing, and Measures of

Profitability

14


Decentralization versus Centralization

Decentralization

• The delegation of decision making authority to managers throughout the organization

Centralization Decentralization Minimum freedom Maximum freedom


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



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



• 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 SingleProduct Line Multi-Product ProductNo Problems Common

Problems



• 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


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


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

FinalMarket

Transfer

Price

Intermediate Market

SellingDivision

BuyingDivision


Alternative Transfer Prices

• Cost-Based Transfer Price

• Variable cost plus a markup• Full cost plus a markup

• Market-Based Transfer Price

• Negotiated Transfer Price


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


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


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


Transfer Pricing in the Global Market

U.S.-Based LemmonMarketing Division

• profit centre

Israel-BasedMarketing Division

• profit centre

TransferPrice = ?

Third Marketing Division Sells

Worldwide on a Made-to-Order Basis

Headquarters andmanufacturing

division in Israel• 4 plants (cost centre)


Irving Oil versus Revenue Canada

Bermuda

New BrunswickRefinery


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


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 $275,000Invested capital $1,000,000 $500,000 $1,500,000ROI% 20% 15% 18.3%Capital charge (8%) $80,000 $40,000 $120,000Residual income $120,000 $35,000 $155,000


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 Y2006 Sales Revenue ($millions) $12 $82007 Sales revenue ($millions) $21 $19Invested capital ($millions) $20 $10


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


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

Documents

© 2007 Pearson Education Canada Slide 14-1 Decentralized Organizations, Transfer Pricing, and Measures of Profitability 14