Performance Evaluation for Decentralized Operations & TRANSFER PRICING

Performance Evaluation for Performance Evaluation for Decentralized Operations & Decentralized Operations &

TRANSFER PRICINGTRANSFER PRICING

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1. List and explain the advantages and disadvantages of decentralized operations.

2. Prepare a responsibility accounting report for a cost center.3. Prepare responsibility accounting reports for a profit center.4. Compute and interpret the rate of return on investment, the

residual income, and the balanced scorecard for an investment center.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

5. Explain how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business.

ObjectivesObjectivesObjectivesObjectives

Centralized and Decentralized

Operations

Advantages of Advantages of DecentralizationDecentralizationAdvantages of Advantages of

DecentralizationDecentralization It allows managers to focus on acquiring expertise in their areas of

responsibility. Decentralizing decision making provides excellent training for managers. Delegation improves employee morale. Decentralization helps managers create good customer relations by

responding quickly to customers’ needs. Managers become more creative in suggesting operating and product

improvement.

Decisions made by one manager may negatively affect the profitability of the entire organization.

Assets and operating costs are duplicated (e.g., each division has its own administrative office staff).

Disadvantages of Disadvantages of Decentralized OperationsDecentralized Operations

Disadvantages of Disadvantages of Decentralized OperationsDecentralized Operations

Responsibility CentersResponsibility CentersResponsibility CentersResponsibility Centers

Managers are held accountable for controlling costs.

Cost CentersCost Centers

Profit CentersProfit CentersManagers are held accountable for costs and making decisions that impact revenues favorably.

Investment CentersInvestment CentersManagers are held accountable for costs and revenues and are also held accountable for the efficient use of assets.

Responsibility CentersResponsibility CentersResponsibility CentersResponsibility Centers

COLLEGE

Responsibility Accounting Responsibility Accounting for Cost Centersfor Cost Centers


College of College of EngineeringEngineering

College of Arts College of Arts and Sciencesand Sciences

College of College of BusinessBusiness

UNIVERSITY

Dept. of Management

Dept. of Marketing

Dept. of Accounting

COST CENTERS IN A UNIVERSITY



DEPARTMENT

COST CENTERS IN A UNIVERSITY

Department of

Accounting

Over Under Budget Actual Budget Budget

Budget Performance ReportSupervisor, Department 1—Plant A

For the Month Ended October 31, 2006

Factory wages $ 58,100 $ 58,000 $100Materials 32,500 34,225 $1,725Supervisory salaries 6,400 6,400 Power and light 5,750 5,690 60Depreciation 4,000 4,000 Maintenance 2,000 1,990 10Insurance, taxes 975 975

$109,725 $111,280 $1,725 $170


These totals are shown on the Manager, Plant A’s budget performance report (Slide 13).

These totals are shown on the Manager, Plant A’s budget performance report (Slide 13).

$109,725$109,725 $111,280$111,280 $1,725$1,725 $170$170


Administration $ 17,500 $ 17,350 $150

Department 1 109,725 111,280 $1,555

Department 2 190,500 192,600 2,100

Department 3 149,750 149,100 650

$467,475 $470,330 $3,655 $800

From the Supervisor—Department 1, Plant A budget performance report (Slide 12).

From the Supervisor—Department 1, Plant A budget performance report (Slide 12).

Budget Performance ReportManager, Plant A



Department 1 109,725 111,280 $1,555 Department 1 109,725 111,280 $1,555

Administration $ 17,500 $ 17,350 $150

Department 1 109,725 111,280 $1,555

Department 2 190,500 192,600 2,100

Department 3 149,750 149,100 650

$467,475 $470,330 $3,655 $800


This is shown on the Vice-President’s budget production report (Slide 15).

This is shown on the Vice-President’s budget production report (Slide 15).

$467,475 $470,330 $3,655 $800$467,475 $470,330 $3,655 $800

Budget Performance ReportManager, Plant A



Budget Performance ReportVice-President, Production

For the Month Ended October 31, 2006Over Under

Budget Actual Budget Budget

Administration $ 19,500 $ 19,700 $ 200

Plant A 467,475 470,330 2,855

Plant B 395,225 394,300 $925

$882,200 $884,330 $3,055 $925


Note that “Over Budget” is a net figure.Note that “Over Budget” is a net figure.

Budget Performance ReportVice-President, Production

For the Month Ended October 31, 2006Over Under

Budget Actual Budget Budget

Administration $ 19,500 $ 19,700 $ 200

Plant A 467,475 470,330 2,855

Plant B 395,225 394,300 $925

$882,200 $884,330 $3,055 $925

Each of the line items above is supported by a cost center report.Each of the line items above is

supported by a cost center report.


Responsibility Accounting for Profit Centers

Responsibility Accounting for Profit Centers

In a profit center, the unit manager has the responsibility and the authority to make

decisions that affect both costs and revenues.

Profit centers may be divisions, departments,

or products.

Profit centers may be divisions, departments,

or products.

Profit CentersProfit Centers

NEG, a diversified entertainment company, has two profit centers: the Theme Park

Division and the Movie Production Division.

NEG, a diversified entertainment company, has two profit centers: the Theme Park

Division and the Movie Production Division.

Theme Park Division

Movie Production Division

Revenues $6,000,000 $2,500,000Operating expenses 2,495,000 405,000

Charging Service Department Costs to Production Divisions


Purchasing Department: $400,000(Activity base: number of purchase requisitions)

Theme Park Division 25,000 purchase requisitions

Movie Production Division: 15,000 purchase requisitions

Total 40,000

$400,000

40,000 purchase requisitions$10 per purchase requisition

=




Payroll Accounting: $255,000(Activity base: number of payroll checks)

$255,000

15,000 payroll checks= $17 per payroll check

Theme Park Division 12,000 payroll checks

Movie Production Division: 3,000 payroll checks

Total 15,000




Legal Department: $250,000(Activity base: number of payroll checks)

$250,000

1,000 hours= $250 per hour

Theme Park Division 100 billed hours

Movie Production Division: 900 billed hours

Total 1,000


Nova Entertainment GroupService Department Charges to NEG Divisions

For the Year Ended December 31, 2006

Theme Movie Park Production

Service Department Division Division


Purchasing $250,000 $150,000

25,000 purchase 25,000 purchase requisitions x $10 requisitions x $10

per purchase per purchase requisitionrequisition







Purchasing $250,000 $150,000Payroll accounting 204,000 51,000

12,000 payroll 12,000 payroll checks x $17 per checks x $17 per

payroll checkpayroll check












Purchasing $250,000 $150,000Payroll accounting 204,000 51,000Legal 25,000 225,000






100 hours x $250 100 hours x $250 per hourper hour




Purchasing $250,000 $150,000Payroll accounting 204,000 51,000Legal 25,000 225,000Total service department charges $479,000 $426,000






Nova Entertainment GroupDivisional Income Statements


Theme Park Division Movie Production Division

Income from operations before service department charges.

Income from operations before service department charges.

Revenues $6,000,000 $2,500,000Operating expenses 2,495,000 405,000Income from operations $3,505,000 $2,095,000

Nova Entertainment GroupDivisional Income Statements


Theme Park Division Movie Production Division

Revenues $6,000,000 $2,500,000Operating expenses 2,495,000 405,000Income from operations $3,505,000 $2,095,000

Less service dept. charges:Purchasing $ 250,000 $ 150,000Payroll accounting 204,000 51,000Legal 25,000 225,000 Total service department charges $ 479,000 $ 426,000

Income from operations $3,026,000 $1,669,000

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Responsibility Accounting for

Investment Centers

Responsibility Accounting for

Investment Centers

In an investment center, the unit manager has the responsibility and the authority to make decisions

that affect not only costs and revenues but also the assets invested in the center.

Datalink Inc.Divisional Income Statements


Northern Central SouthernDivision Division Division

Revenues $560,000 $672,000 $750,000Operating expenses 336,000 470,400 562,500Income from operations before service dept. charges $224,000 $201,600 $187,500Service department charges 154,000 117,600 112,500Income from operations $ 70,000 $ 84,000 $ 75,000

Invested assets $350,000 $700,000 $500,000Rate of return on investment 20% 12% 15%

Investment CentersInvestment Centers

20% 12% 15%20% 12% 15%

Revenues

Rate of Return on Investment (ROI)Rate of Return on Investment (ROI)Rate of Return on Investment (ROI)Rate of Return on Investment (ROI)

Investment Turnover

Profit Margin

Profit


The profit margin indicates the rate of profit

on each sales dollar.The

investment turnover indicates the rate of sales on

each dollar of invested

assets.

Profit Margin

Investment Turnover


Income from operation

Sales

Sales

Invested assetsxROI =

ROI =$ 70,000

$560,000x

$560,000

$350,000

ROI = 12.5% x 1.6 = 20%


Income from operation

Sales

Sales

Invested assetsxROI =


Profit Margin

Profit Margin

Inventory Turnover

Inventory Turnover

Northern Central SouthernDivision Division Division Profit MarginProfit Margin

Income from operations $ 70,000 $ 84,000 $ 75,000Revenues (Sales) $560,000 $672,000 $750,000

Profit margin 12.5% 12.5% 10.0%

Investment TurnoverInvestment Turnover

Revenues (Sales) $560,000 $672,000 $750,000Invested assets $350,000 $700,000 $500,000

Investment turnover 1.6 .96 1.5

Return on Investment (ROI)Return on Investment (ROI)Income from operations $ 70,000 $ 84,000 $ 75,000Invested assets $350,000 $700,000 $500,000

Rate of return on investment 20% 12% 15%

Income from

Operations

Minimum Acceptable

Rate of Return on

Assets

– =Residual Residual IncomeIncome

Northern Central SouthernDivision Division Division

Baldwin CompanyDivisional Income Statements


Income from operations $70,000 $84,000 $75,000Minimum acceptable incomefrom operations as a percent of invested assets:

$350,000 x 10% 35,000

$700,000 x 10% 70,000

$500,000 x 10% 50,000

Residual income $35,000 $14,000 $25,000

The balance scorecard is a set of financial and nonfinancial measures

that reflect multiple performance dimensions of a business.

The balance scorecard is a set of financial and nonfinancial measures

that reflect multiple performance dimensions of a business.

Innovation and Learning

• R&D investment• R&D pipeline• Skills and training• Time to market

Innovation and Learning

• R&D investment• R&D pipeline• Skills and training• Time to market

Customer• Satisfaction• Loyalty• Perception

Customer• Satisfaction• Loyalty• Perception

• Efficiency• Quality• Time

• Efficiency• Quality• Time

Financial• ROI• Residual income• Profit• Cost• Sales

Financial• ROI• Residual income• Profit• Cost• Sales

Internal Process

Transfer PricingTransfer Pricing

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing

When divisions transfer products or render services to each other, a

transfer pricing is used to charge for the products or services

When divisions transfer products or render services to each other, a

transfer pricing is used to charge for the products or services

Benefits of Transfer PricingBenefits of Transfer PricingBenefits of Transfer PricingBenefits of Transfer Pricing

1. Divisions can be evaluated as profit or investment centers.

2. Divisions are forced to control costs and operate competitively.

3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

1. Market price approach sets the price at which the product transferred could be sold to outside buyers.

2. Negotiated price approach allows decentralized managers to agree (negotiate) among themselves.

3. Cost price approach (variable or full) uses a variety of cost concepts for setting the transfer price.

Commonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer Prices

Variable Costper Unit $10

Market Priceper Unit $20

Full Costper Unit $13

Negotiated Price

Commonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer PricesCommonly Used Transfer Prices

Transfer Pricing—Negotiated Price ApproachTransfer Pricing—Negotiated Price Approach

1.Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity.

2.Division N purchases 20,000 units of the same product at $20 per unit from an outside source.

AssumptionsAssumptions

If the division managers agree on a price of $15 per unit, how much will each

division’s income increase?

If the division managers agree on a price of $15 per unit, how much will each

division’s income increase?

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Performance Evaluation for Decentralized Operations & TRANSFER PRICING