Agenda

1
Agenda

• Decentralization
• Profit centers and profit computations
• Transfer pricing
• National Youth Association
• HCC Industries
• Group problem solving

2
Decentralization and performance evaluation

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

3
Decentralization Why?

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

4
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)

5
Problems associated with decentralization

• Goal congruence
• Externalities
• Over-consumption of perquisites

6
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.

7
Key concepts in responsibility accounting

• Controllability
• The controllability principle
• Controllability problems
• Traceability

8
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

9
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

10
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.

11
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?

12
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.

13
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?

14
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.
15
Simple example ROI
The Division A manager earns 50,000 on
hiscontrollable investment of 350,000. His ROI
is
What income number?
What investment number?
16
Residual income
Residual income is as close as an accountant
comesto 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 returnon
invested capital size of investment
17
Simple example Residual income
Providers of capital demand 12 on average.
This is the opportunity cost of their capital.
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 opportunitycost of investors capital
times the size of their investment.
18
Which performance measure is better?
Simple example The investors cost of capital
remains12 throughout.
Division A
Assets 350,000
Income 50,000
ROI 14.3
Suppose the division manager is considering
investing15,000 in an asset that will earn
2,000 in income. Will she take the investment?
19
Decision 1 Will she take the investment?
Would the providers of capital want her to take
it?
20
Decision 2 Simple example
Suppose the division manager is considering
disposingof an asset with a book value of
20,000 which earns2,500 in income during any
accounting period. Willhe dispose of the asset?
What do providers of capital want him to do?
21
Residual income Decision 1
Suppose now that the division managers
performanceevaluation measure is residual
income. Will the managerchoose to invest in a
new assets that makes 2,000 per year 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
22
Residual income Decision 2
Will the Division A manager who is evaluated
usingresidual 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
23
Compare divisons ROI and residual income
Division BAssets 250,000Contrib
37,500ROI 15
Division AAssets 350,000Contrib
50,000ROI 14.3
Which division is more profitable?
What rate of return does the larger division make
onits additional assets?
Is it more than the cost of capital?
24
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.

25
Profit centers and transfer pricing
TRANSFER PRICE
A PRICE CHARGED BY ONE SEGMENT OF ANORGANIZATION
FOR A PRODUCT OR SERVICETHAT IT SUPPLIES TO
ANOTHER SEGMENT OFTHE ORGANIZATION.
26
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.

27
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 pricewhen OC gt 0, less adjustments.
28
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.
29
Crossville Company
A. Does top management have a transfer pricing
policy?
B. What is the minimum transfer price required
by theselling division, Fabricating?
53.75, the immediate average market price
C. What is the maximum transfer price required
by thebuying division?
50, the price it would pay to Georges
30
Crossville Company
D. Will the two division managers agree to the
transfer?
31
Crossvillle Company
Which of the following circumstances will leadto
goal congruence between the managers and
theoverall 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?
32
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.
33
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?
34
Crossville Company
3. Fabricating is forced to transfer product in
lieu ofselling 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.
35
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.

36
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.

37
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.

38
Group work

• Work
• Europa, Inc handout.