Decentralised

8/10/2019 Decentralised

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Agenda

DecentralizationProfit centers and profit computations

Transfer pricing National Youth Association

HCC Industries

Group problem solving


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Decentralization andperformance evaluation

Performance evaluation becomes

necessary when decision rights are

delegated. Do owners evaluate

managerial inputs or outputs?


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Decentralization: Why?

Environment

Information specialization

Timeliness of response

Conservation of central management time

Computational complexity Training of local managers

Motivation of local managers


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Responsibility centers:

Standard cost centers - production variances

Revenue centers - revenue variances

Discretionary expense centers

Profit centers - some measure of profit

Investment centers - some profitabilitymeasure (e.g., ROI or residual income)


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Problems associated with

decentralization:

Goal congruence

Externalities

Over-consumption of perquisites


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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.


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Key concepts in responsibility

accounting:

Controllability

The controllability principle

Controllability problems

Traceability


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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


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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


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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 profitableif 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 largerthan he needed.


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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?


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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 sameas in year one.

Required: Suppose John wants to define each

product line as a profit center and split profits withhis managers fifty-fifty. What operating profit

would you compute for the two product lines? How

much bonus would each manager receive?


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Simple example: ROI

The Division A manager earns $50,000 on his

controllable investment of $350,000. His ROI is:

%3.14%100* $350,000

$50,000ROI

What income number?

What investment number?


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Residual income

Residual income is as close as an accountant comes

to computing economic profit. It is operating incomeafter 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


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Simple example: Residual

income

Division A:

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.

Providers of capital demand 12% on average.

This is the opportunity cost of their capital.


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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?


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Decision 1: Will she take the

investment?

%3.13$15,000$2,000ROIthanlessisreturnlIncrementa

%3.14%2.14 $365,000$52,000afterROIDivision

Would the providers of capital want her to take it?


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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 peryear and costs $15,000?

What is the current residual income? $8,000

New residual income: $52,000 controllable cont.

(43,800) new cost of capital

$ 8,200 new residual income


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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


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Compare divisons: ROI and

residual income

Division A

Assets: $350,000

Contrib: $50,000ROI: 14.3%

Division B

Assets: $250,000

Contrib: $37,500ROI: 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?


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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 forHCC Industries

Pay attention to the probabilities that are

tossed about.


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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.


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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.


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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 THEFIRM (I.E., CONTRIBUTION

FOREGONE = CM)

Note that CM = SP - VC, so VC + OC = SP - the market price

when OC > 0, less adjustments.


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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 ashe 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.


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Crossville Company

Is the transfer in the best interest of the company?

Minimize costs:

Internal transfer: Relevant cost of product = $53.75

External transfer: Fab: ($53.75) - 29 = ($24.75)Assy: $50.00

Relevant cost of product = $25.25

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

Therefore, VC = $29 per unit

The company does not want an internal transfer.


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Crossville Company

2. Fabricating has adequate idle capacity.

This means that there is no meaningful market pricefor 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?


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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.


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Negotiated market-based prices:

Some form of outside market for the

intermediate product.

Sharing of all market information among thenegotiators.

Freedom to buy or sell outside. This provides

the necessary discipline to the bargainingprocess.

Support and occasional involvement of top

management.


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Its limitations:

Time consuming

Leads to conflict within firms

It makes the measurement of divisionalprofitability sensitive to the negotiating

skills of managers.

It requires the time of top management tooversee and mediate.

It may lead to a suboptimal level of output.


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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.


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Group work:

Work

Europa, Inc handout.

Documents

Decentralised