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Decentralization:
Responsibility Accounting,
Performance Evaluation,
and Transfer Pricing
10
10-1
Responsibility Accounting
1
Responsibility Accounting: 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:
1. Cost Center: only responsible for costs
2. Revenue Center: only responsible for revenues
3. Profit Center: Responsible for both revenues and costs
4. Investment Center: responsible for revenues, costs, and
investments
10-2
Decentralization
2
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
10-3
Measuring the Performance of
Investment Centers
3
Return on Investment (ROI) is the most common measure of
performance for an investment center.
ROI = operating income / Average operating assets
ROI = (operating income/ sales) X (sales / average operating
assets)
ROI = Operating income margin X Operating asset turnover
Where:
Margin: portion of sales available for interest, taxes and profit
Turnover: how productively assets are being used to generate
sales
Operating income: refers to earnings before interest and income
taxes
Operating assets: includes all assets used to generate operating
income
10-4
Measuring the Performance of
Investment Centers
3
Advantages of the ROI Measure:
1. Helps managers focus on the relationship between sales,
expenses and investment.
2. Encourages cost efficiency.
3. Discourages excessive investment in operating assets
Disadvantages of the ROI Measure:
1. Discourages managers from investing in projects
decreasing divisional ROI but increasing profitability of the
company overall.
2. Encourages managers to focus on the short-term at the
expense of the long-term.
10-5
Measuring the Performance of
Investment Centers
3
Residual Income is the difference between operating income and the
minimum dollar return required on a company’s operating assets:
Residual Income = Operating Income – [Minimum rate of return X
Operating assets]
Residual income is a dollar measure of performance – encourages
managers to move beyond the focus of the percentage return on
investment to look at the absolute dollar value of the additional
profit.
However, the residual income is an absolute measure of return which
makes it difficult to directly compare the performance of divisions.
It also does not discourage myopic behavior
10-6
Measuring the Performance of
Investment Centers
3
Economic Value Added (EVA) is after-tax operating profit minus the
total annual cost of capital
if positive, the company is creating wealth
if negative, then the company is destroying wealth
key feature: focuses on after-tax operating income and the actual
cost of capital
EVA = After-tax operating income – [Weighted average cost of
capital X total capital employed]
Behavioral Aspects of EVA:
1.
Tends to focus on long-run
2.
Discourages myopic behavior
10-7
Measuring and Rewarding the
Performance of Managers
4
Incentive Pay for Managers
Why would managers not provide good service?
There are three reasons:
1. They may have low ability.
2. They may prefer not to work hard.
3. They may prefer to spend company resources on
perquisites.
10-8
Measuring and Rewarding the
Performance of Managers
4
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.
10-9
Measuring and Rewarding the
Performance of Managers
4
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
bonuses to reward performance by keeping salaries
fairly level and allowing bonuses to fluctuate with
reported income.
10-10
Measuring and Rewarding the
Performance of Managers
4
Stock-Based Compensation
Stock options frequently are offered to managers to
encourage them to focus on the longer term
A stock option is the right to buy a certain number of
shares of the company’s stock, at a particular price,
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
10-11
Transfer Pricing
5
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.
10-12
Setting Transfer Prices
6
A transfer pricing system should satisfy three
objectives:
• Accurate performance evaluation
• Goal congruence
• Preservation
The opportunity cost approach identifies the minimum
transfer price and the maximum transfer price.
10-13
Setting Transfer Prices
6
• Disadvantages of Negotiated Transfer Prices
One divisional manager with 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
• Despite the disadvantages, negotiated price transfer
prices offer some hope of complying with the three
criteria of goal congruence, autonomy, and accurate
performance evaluation
•
10-14