Decentralization in Organizations

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Chapter 11
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Decentralization in Organizations
Benefits of Decentralization
Top management freed to concentrate on strategy.
Lower-level managers gain experience
in decision-making.
Decision-making authority leads to job
satisfaction.
Lower-level decisions often based on better
information.
Lower level managers can respond quickly to
customers.
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Decentralization in Organizations
May be a lack of coordination among autonomous man
agers.
Lower-level managers may make decisions without
seeing the big picture.
Disadvantages of Decentralization
Lower-level managers objectives may not be those
of the organization.
May be difficult to spread innovative ideas in
the organization.
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Decentralization and Segment Reporting
An Individual Store

• A segment is any part or activity of an
  organization about which a manager seeks cost,
  revenue, or profit data. A segment can be . . .

Quick Mart
A Sales Territory
A Service Center
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Cost, Profit, and Investments Centers

• Cost Center
• A segment whose manager has control over
  costs,
• but not over revenues or investment funds.

Cost
Cost
Cost
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Cost, Profit, and Investments Centers
Revenues

• Profit Center
• A segment whose manager has control over both
  costs and revenues,
• but no control over investment funds.

Sales Interest Other
Costs
Mfg. costs Commissions Salaries Other
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Cost, Profit, and Investments Centers
Corporate Headquarters

• Investment Center
• A segment whose manager has control over
  costs, revenues, and investments in operating
  assets.

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Return on Investment (ROI) Formula
Income before interest and taxes (EBIT)
Cash, accounts receivable, inventory, plant and
equipment, and other productive assets.
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Return on Investment (ROI) Formula
We can modify our original formula slightly
Margin
Turnover

Net operating income Sales
Sales Average operating assets

ROI


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Controlling the Rate of Return

• Three ways to improve ROI . . .

• Reduce
• Expenses

• Increase
• Sales

• Reduce
• Assets

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Residual Income - Another Measure of Performance
Net operating income above some minimum return on
operating assets
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Residual Income
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Motivation and Residual Income
Residual income encourages managers to make
profitable investments that would be rejected by
managers using ROI.
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Delivery Performance Measures
Process Time Inspection Time Move Time
Queue Time
Wait Time
Process time is the only value-added time.
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Delivery Performance Measures
Process Time Inspection Time Move Time
Queue Time
Wait Time
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The Balanced Scorecard
Management translates its strategy into
performance measures that employees understand
and influence.
Performancemeasures
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The Balanced Scorecard
A balanced scorecard should have measuresthat
are linked together on a cause-and-effect basis.
If we improveone performancemeasure . . .
Another desiredperformance measurewill improve.
The balanced scorecard lays out concrete actions
to attain desired outcomes.
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The Balanced Scorecard FromStrategy to
Performance Measures
Performance Measures
Financial Has our financialperformance improved?
What are ourfinancial goals?
Customer Do customers recognize thatwe are
delivering more value?
What customers dowe want to serve andhow are we
going towin and retain them?
Vision and Strategy
Internal Business Processes Have we improved key
business processes so that we can deliver more
value to customers?
What internal busi-ness processes arecritical
to providingvalue to customers?
Learning and Growth Are we maintaining our
abilityto change and improve?
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The Balanced Scorecard Non-financial Measures
The balanced scorecard relies on non-financial
measures in addition to financial measures for
two reasons
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The Balanced Scorecard - Jaguar Example
Profit
Contribution per car
Number of cars sold
Customer satisfactionwith options
Number ofoptions available
Time toinstall option
Employee skills in installing options
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The Balanced Scorecard and Compensation

• Incentive compensation should be linked to
  balanced scorecard performance measures.

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The Balanced Scorecard for Individuals
The entire organization should have an overall
balanced scorecard.
Each individual should have a personal balanced
scorecard.
A personal scorecard should contain measures that
can beinfluenced by the individual being
evaluated and thatsupport the measures in the
overall balanced scorecard.
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Transfer Pricing

• Appendix 11A

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Key Concepts/Definitions
A transfer price is the price charged when one
segment of a company provides goods or services
to another segment of the company.
The fundamental objective in setting transfer
prices is to motivate managers to act in the best
interests of the overall company.
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Three Primary Approaches

• There are three primary approaches to setting
  transfer prices
• Negotiated transfer prices
• Transfers at the cost to the selling division
• Transfers at market price
• And if all else fails Dictated

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Negotiated Transfer Prices
A negotiated transfer price results from
discussions between the selling and buying
divisions.

• Advantages of negotiated transfer prices
• They preserve the autonomy of the divisions,
  which is consistent with the spirit of
  decentralization.
• The managers negotiating the transfer price are
  likely to have much better information about the
  potential costs and benefits of the transfer than
  others in the company.

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Negotiated Transfer Prices
The buying divisions highest acceptable
transfer price is calculated as
If an outside supplier does not exist, the
highest acceptable transfer price is calculated
as
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Grocery Storehouse An Example
Assume the information as shown with respect to
West Coast Plantations and Grocery Mart (both
companies are owned by Grocery Storehouse).
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Grocery Storehouse An Example
If West Coast Plantations has sufficient idle
capacity (assume 3,000 crates) to satisfy Grocery
Marts demands (1,000 crates), without
sacrificing sales to other customers, then the
lowest and highest possible transfer prices are
computed as follows
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Grocery Storehouse An Example
If West Coast Plantations has some idle capacity
(assume 500 crates) and must sacrifice other
customer orders (500 crates) to meet Grocery
Marts demands (1,000 crates), then the lowest
and highest possible transfer prices are computed
as follows
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Grocery Storehouse An Example
If West Coast Plantations has no idle capacity (0
crates) and must sacrifice other customer orders
(1,000 crates) to meet Grocery Marts demands
(1,000 crates), then the lowest and highest
possible transfer prices are computed as follows
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Evaluation of Negotiated Transfer Prices
If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices within which
both the selling and buying divisions would have
higher profits if they agree to the transfer.
If managers are pitted against each other rather
than against their past performance or reasonable
benchmarks, a noncooperative atmosphere is almost
guaranteed.
Given the disputes that often accompany the
negotiation process, some companies rely on some
other means of setting transfer prices.
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Transfers at the Cost to the Selling Division
Many companies set transfer prices at either the
variable cost or full (absorption) cost incurred
by the selling division.

• Drawbacks of this approach include
• The selling division will never show a profit on
  any internal transfer.
• Cost-based transfer prices do not provide
  incentives to control costs.

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Transfers at Market Price
A market price (i.e., the price charged for an
item on the open market) is often regarded as the
best approach to the transfer pricing problem.

1. A market price approach works best when the
   product or service is sold in its present form to
   outside customers and the selling division has no
   idle capacity.
2. A market price approach does not work well when
   the selling division has idle capacity.

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Service Department Charges

• Appendix 11B

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The Need for Cost Allocations
OperatingDepartments
ServiceDepartments
Carry out the central purposesof an
organization
Provide supportthat facilitates theactivities
of operatingdepartments
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The Need for Cost Allocations
First Stage Allocations Service department costs
are allocated to operating departments.
Service Department (Cafeteria)
Operating Department (Molding)
Service Department (Accounting)
The Products
Operating Department (Assembly)
Service Department (Personnel)
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The Need for Cost Allocations
Second Stage Allocations Operating department
overhead costs and allocated service department
costs are applied to products.
Service Department (Cafeteria)
Operating Department (Molding)
Service Department (Accounting)
The Products
Operating Department (Assembly)
Service Department (Personnel)
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Selecting Allocation Bases
Personnel Number ofemployees
Custodial Squarefootage
Receiving Unitshandled
Cafeteria Number ofemployees
Individuals impacted
Security Squarefootage
Power Kilowatthours
Accounting Staffhours
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Selecting Allocation Bases
Personnel Number ofemployees
Custodial Squarefootage
Receiving Unitshandled
Cafeteria Number ofemployees
Amountof space orequipment
Security Squarefootage
Power Kilowatthours
Accounting Staffhours
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Selecting Allocation Bases
Personnel Number ofemployees
Custodial Squarefootage
Benefits receivedby the operatingdepartment
Ship/Receiv-ing Unitshandled
Cafeteria Number ofemployees
Security Squarefootage
Power Kilowatthours
Accounting Staffhours
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Allocating Costs by Behavior
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Allocation Pitfalls to Avoid
Pitfall 1 Using salesdollars as anallocation
base
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Allocation Pitfalls to Avoid
Pitfall 2 Allocating fixed costs using a
variableactivity allocationbase
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End of Chapter 11