HANSEN

1
Cost ManagementACCOUNTING AND CONTROL

• HANSEN MOWEN

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Decentralization Responsibility Accounting,
Performance Evaluation, and Transfer Pricing

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Responsibility Accounting
Responsibility accounting is 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
• Cost center only responsible for costs
• Revenue center only responsible for revenues
• Profit center responsible for both revenues and
  costs
• Investment center responsible for revenues,
  costs, and investments

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Decentralization

• 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

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Measuring the Performance of Investment Centers
Return on investment (ROI) is the most common
measure of performance for an investment center.
ROI Operating income / Average operating
assets (Operating income / Sales) ? (Sales /
Average operating assets) Operating income
margin ? Operating asset turnover
Margin portion of sales available for interest,
taxes and profit
Turnover how productively assets are being used
to generate sales
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Measuring the Performance of Investment Centers
Comparison of Divisional Performance
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Measuring the Performance of Investment Centers
Comparison of Divisional Performance (contd)
aOperating income divided by average operating
assets. bOperating income divided by
sales. cSales divided by average operating assets.
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Measuring the Performance of Investment Centers

• Advantages of the ROI measure
• Helps managers focus on the relationship between
  sales, expenses and investment.
• Encourages cost efficiency.
• Discourages excessive investment in operating
  assets

• Disadvantages of the ROI measure
• Discourages managers from investing in projects
  decreasing divisional ROI but increasing
  profitability of the company overall.
• Encourages managers to focus on the short-term at
  the expense of the long-term.

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Measuring the Performance of Investment Centers
Residual income is the difference between
operating income and the minimum dollar return
required on a companys operating assets
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Measuring the Performance of Investment Centers
Advantages of Residual Income
Project I Residual income 1,300,000 - (0.10 ?
10,000,000) 1,300,000 - 1,000,000
300,000 Project II Residual income 640,000 -
(0.10 ? 4,000,000) 640,000 400,000
240,000
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Measuring the Performance of Investment Centers
Advantages of Residual Income (continued)
Add Add Add Both Maintain Project I
Project II Projects Status Quo Operating
assets 60,000,000 54,000,000 64,000,000
50,000,000 Operating income 8,800,000
8,140,000 9,440,000 7,500,000 Minimum
return 6,000,000 5,400,000 6,400,000
5,000,000 Residual income 2,800,000
2,740,000 3,040,000 2,500,000 0.10
Operating assets.
Preferred alternative
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Measuring the Performance of Investment Centers
Disadvantages of Residual Income
Division A Division B Average operating assets
15,000,000 2,500,000 Operating income
1,500,000 300,000 Minimum returna
1,200,000 200,000 Residual income
300,000 100,000 Residual returnb
2 4 a0.08 Operating
assets. bResidual income divided by operating
assets.
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Measuring the Performance of Investment Centers
Disadvantages of Residual Income (continued)

1. It is an absolute measure of return which make it
   difficult to directly compare the performance of
   divisions.
2. It does not discourage myopic behavior.

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Measuring the Performance of Investment Centers
Economic value added (EVA) is after-tax operating
profit minus the total annual cost of capital.
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Measuring the Performance of Investment Centers
EVA Example

After-Tax Weighted
Amount Percent x Cost Cost
Mortgage bonds 2,000,000 0.133 0.048 0.006 Unse
cured bonds 3,000,000 0.200 0.060 0.012 Common
stock 10,000,000 0.667 0.120 0.080
Total 15,000,000 Weighted average cost of
capital 0.098
15,000,000 x .098 1,470,000
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Measuring the Performance of Investment Centers
EVA Example (continued)
Furmans EVA is calculated as follows After-tax
profit 1,583,000 Less Weighted average cost of
capital 1,470,000 EVA
113,000 The positive EVA means that Furman,
Inc., earned operating profit over and above the
cost of the capital used.
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Measuring the Performance of Investment Centers
Behavioral Aspects of EVA
Hardware Software Division
Division
Sales 5,000,000 2,000,000 Cost of goods sold
2,000,000 1,100,000 Gross profit 3,000,000
900,000 Divisional selling and administrative
expenses 2,000,000 400,000 Operating
income 1,000,000 500,000
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Measuring the Performance of Investment Centers
The EVA for each division can be calculated as
follows
Hardware Software Division
Division
Operating income 1,000,000 500,000 Less
Cost of capital 1,100,000 220,000 EVA
(100,000) 280,000
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Measuring the Performance of Investment Centers
Behavioral Aspects of EVA

• Tends to focus on long-run
• Discourages myopic behavior

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Measuring and Rewarding the Performance of
Managers
Incentive Pay for Managers

• Why would managers not provide good service?
  There are three reasons
• They may have low ability.
• They may prefer not to work hard.
• They may prefer to spend company resources on
  perquisites.

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Measuring and Rewarding the Performance of
Managers
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.

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Measuring and Rewarding the Performance of
Managers
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
  bonus to reward performance by keeping salaries
  fairly level and allow bonuses to fluctuate with
  reported income.

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Measuring and Rewarding the Performance of
Managers
Stock-Based Compensation
Stock options frequently are offered to manager
to make them part owners of the companythus
encourage goal congruence.
A stock option is is the right to buy a certain
number of shares of the companys stock, at a
particular price and 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.
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Transfer Pricing
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.
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Transfer Pricing
Impact of Transfer Price on Transferring
Divisions and the Company as a Whole
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Setting Transfer Prices

• A transfer pricing system should satisfy three
  objectives
• Accurate performance evaluation
• Goal congruence
• Preservation on divisional autonomy

The opportunity cost approach identifies the
minimum transfer price and the maximum transfer
price.
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Setting Transfer Prices

• Market price
• Negotiated transfer prices
• Cost-based transfer prices
• Variable cost
• Full (absorption cost)

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Setting Transfer Prices
Example 1 Avoidable Distribution Costs
Summary of Sales and Production Data
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Setting Transfer Prices
Example 1 Avoidable Distribution Costs
Comparative Income Statements
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Setting Transfer Prices
Example 1 Avoidable Distribution Costs
Comparative Income Statements (continued)
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Setting Transfer Prices
Example 2 Excess Capacity
Comparative Statements
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Setting Transfer Prices
Example 2 Excess Capacity
Comparative Statements (continued)
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Setting Transfer Prices
Disadvantages of Negotiated Transfer Prices

• One division manager, possessing 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.

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Setting Transfer Prices
Despite the disadvantages, negotiated price
transfer prices offer some hope of complying with
the three criteria of goal congruence, autonomy,
and accurate performance evaluation.
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Setting Transfer Prices
Disadvantages of Negotiated Transfer Prices

• Full-cost transfer pricing
• Full cost plus markup
• Variable cost per fixed fee
• Propriety of use

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Setting Transfer Prices
Use of Transfer Pricing to Affect Income Taxes
Paid
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End of Chapter 10