©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Management Control in Decentralized Organizations Chapter 10

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 1 Define decentralization and identify its expected benefits and costs.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decentralization The delegation of freedom to make decisions is called decentralization. The delegation of freedom to make decisions is called decentralization. The lower in the organization that this freedom exists, the greater the decentralization. The lower in the organization that this freedom exists, the greater the decentralization.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Costs and Benefits Benefits of decentralization: Lower-level managers have the best information concerning local conditions. Lower-level managers have the best information concerning local conditions. It promotes management skills which, in turn, helps ensure leadership continuity. It promotes management skills which, in turn, helps ensure leadership continuity. Managers enjoy higher status from being independent and thus are better motivated. Managers enjoy higher status from being independent and thus are better motivated.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Costs and Benefits Costs of decentralization: Managers may make decisions that are not in the organization’s best interests. Managers may make decisions that are not in the organization’s best interests. Managers also tend to duplicate services that might be less expensive if centralized. Managers also tend to duplicate services that might be less expensive if centralized. Costs of accumulating and processing information frequently rise. Costs of accumulating and processing information frequently rise.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Costs and Benefits Managers in decentralized units may waste time negotiating with other units about goods or services one unit provides to the other. Managers in decentralized units may waste time negotiating with other units about goods or services one unit provides to the other.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Middle Ground Many companies find that decentralization works best in part of the company, while centralization works better in other parts. Many companies find that decentralization works best in part of the company, while centralization works better in other parts. Decentralization is most successful when an organization’s segments are relatively independent of one another. Decentralization is most successful when an organization’s segments are relatively independent of one another.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Segment Autonomy If management has decided in favor of heavy decentralization, segment autonomy, the delegation of decision- making power to managers of segments of an organization, is also crucial. If management has decided in favor of heavy decentralization, segment autonomy, the delegation of decision- making power to managers of segments of an organization, is also crucial.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 2 Distinguish between profit centers and decentralization.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Responsibility Centers and Decentralization Design of a management control system should consider two separate dimensions of control: Design of a management control system should consider two separate dimensions of control: Responsibilities 1 Autonomy 2

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Responsibility Centers and Decentralization Profit centers DecentralizationDecentralization These are entirely separate concepts and one can exist without the other. These are entirely separate concepts and one can exist without the other.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Responsibility Centers and Decentralization All control systems are imperfect. The choice among systems should be based on which one will bring more of the actions top management seeks. The choice among systems should be based on which one will bring more of the actions top management seeks.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 3 Explain how the linking of rewards to responsibility center results affects incentives and risk.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Motivation, Performance, and Rewards Criteria and Choices when Designing a Management Control System Motivational criteria: Goal congruence and managerial effort Motivational criteria: Goal congruence and managerial effort ManagementactionsManagementactionsPerformancemeasuresPerformancemeasuresRewardsRewards Feedback

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Motivation, Performance, and Rewards You get what you measure! Therefore, accounting measures, which provide relatively objective evaluations of performance, are important. Therefore, accounting measures, which provide relatively objective evaluations of performance, are important.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Agency Theory, Performance, Rewards, and Risks Agency theory deals with contracting between an organization and the managers that it hires. Agency theory deals with contracting between an organization and the managers that it hires. IncentiveIncentiveRiskRisk Cost of measuring performance performance

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 4 Compute ROI, residual income, and economic value added (EVA) and contrast them as criteria for judging the performance of organization segments.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Measures of Profitability Profitability does not mean the same thing to all people. Profitability does not mean the same thing to all people. Is it net income? Income before taxes? Net income percentage based on revenue? Is it an absolute amount? A percentage? Is it net income? Income before taxes? Net income percentage based on revenue? Is it an absolute amount? A percentage?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Return on Investment ROI = Income ÷ Investment ROIROI=IncomeRevenueIncomeRevenue×RevenueInvestmentRevenueInvestment

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Return on Investment Division A ROI: = Income ÷ Investment $200,000 ÷ $500,000 = 40% $200,000 ÷ $500,000 = 40% Division A ROI: = Income ÷ Investment $200,000 ÷ $500,000 = 40% $200,000 ÷ $500,000 = 40% Division B ROI: = Income ÷ Investment $150,000 ÷ $250,000 = 60% $150,000 ÷ $250,000 = 60% Division B ROI: = Income ÷ Investment $150,000 ÷ $250,000 = 60% $150,000 ÷ $250,000 = 60%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Residual Income RI is defined as after-tax net operating income less a capital charge. RI is defined as after-tax net operating income less a capital charge. Capital charge is the cost of capital multiplied by the amount of investment. Capital charge is the cost of capital multiplied by the amount of investment. RI tells you how much a company’s after-tax operating income exceeds what it is paying for capital. RI tells you how much a company’s after-tax operating income exceeds what it is paying for capital.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Economic Value Added Economic value added Economic value added = Adjusted after-tax operating income – Cost of invested capital (%) × Adjusted average invested capital Economic value added Economic value added = Adjusted after-tax operating income – Cost of invested capital (%) × Adjusted average invested capital

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 5 Compare the advantages and disadvantages of various bases for measuring the invested capital used by organization segments.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton ROI or Residual Income? Why do some companies prefer residual income (or EVA) to ROI? Why do some companies prefer residual income (or EVA) to ROI? Under ROI, the message is go forth and maximize your rate of return, a percentage. Under ROI, the message is go forth and maximize your rate of return, a percentage. Under RI, the message is go forth and maximize residual income, an absolute amount. Under RI, the message is go forth and maximize residual income, an absolute amount.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Invested Capital To apply either ROI or residual income, both income and invested capital must be measured and defined. To apply either ROI or residual income, both income and invested capital must be measured and defined.  Total assets  Total assets employed  Total assets less current liabilities  Stockholders’ equity  Total assets  Total assets employed  Total assets less current liabilities  Stockholders’ equity

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Asset Allocation to Divisions Commonly used bases for allocation, when assets are not directly identifiable with a specific division, include: Commonly used bases for allocation, when assets are not directly identifiable with a specific division, include: Asset Class Corporate cash ReceivablesInventories Plant and equipment Asset Class Corporate cash ReceivablesInventories Plant and equipment Possible Allocation Base Budgeted cash needs Sales weighted by terms Budgeted sales or usage Usage of services Possible Allocation Base Budgeted cash needs Sales weighted by terms Budgeted sales or usage Usage of services

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Valuation of Assets Should values be based on historical cost or some version of current value? Should values be based on historical cost or some version of current value? Practice is overwhelmingly in favor of using net book value based on historical cost. Practice is overwhelmingly in favor of using net book value based on historical cost. Most companies use net book value in calculating their investment base. Most companies use net book value in calculating their investment base.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 6 Define transfer prices and identify their purpose.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Transfer Prices The price that one segment charges another segment of the same organization for a product or service is a transfer price. The price that one segment charges another segment of the same organization for a product or service is a transfer price.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Purpose of Transfer Pricing Why do transfer-pricing systems exist? Management wants to create performance measurement systems. Management wants to create performance measurement systems. Decisions that maximize a segment’s profit should also maximize the profits of the entire company. Decisions that maximize a segment’s profit should also maximize the profits of the entire company.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Purpose of Transfer Pricing Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs. Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 7 State the general rule for transfer pricing and use it to assess transfer prices based on total costs, variable costs, and market prices.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton General Rule Transfer price = Outlay cost + Opportunity cost Selling division outlay cost = $6; Opportunity cost = $4 Buying division cost = Transfer price + Other costs $10 + $12 = $22; Selling price = $25 Buying division cost = Transfer price + Other costs $10 + $12 = $22; Selling price = $25 Subcomponent transfer price = $10

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Transfers at Cost What are some definitions of cost? Variable cost Full cost plus a profit markup Standard costs Full cost Actual costs

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Variable-Cost Pricing Companies that transfer items at variable cost assume that the selling division has no opportunity cost. Companies that transfer items at variable cost assume that the selling division has no opportunity cost. Because the outlay cost equals the variable cost. Because the outlay cost equals the variable cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Variable-Cost Pricing This transfer pricing system is most appropriate when the selling division forgoes no opportunity when it transfers the item internally. This transfer pricing system is most appropriate when the selling division forgoes no opportunity when it transfers the item internally.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Full-Cost Pricing This transfer pricing system includes not only variable cost but also an allocation of fixed costs (and, if included, the profit mark-up.) This transfer pricing system includes not only variable cost but also an allocation of fixed costs (and, if included, the profit mark-up.)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Market-Based Transfer Prices If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort. If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort. In this case, the market price is equal to the variable cost plus opportunity cost. In this case, the market price is equal to the variable cost plus opportunity cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Market-Based Transfer Prices Because the opportunity cost equals the market price less the variable cost. Because the opportunity cost equals the market price less the variable cost. Transfer price Transfer price = variable cost + opportunity cost = variable cost + (market price – variable cost) = market price Transfer price Transfer price = variable cost + opportunity cost = variable cost + (market price – variable cost) = market price

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Market-Based Transfer Prices Drawbacks 1. Market prices are not always available for items transferred internally. for items transferred internally. 1. Market prices are not always available for items transferred internally. for items transferred internally. 2. Imperfectly competitive markets exist.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Negotiated Transfer Prices Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices. Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices. Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals. Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton The Need for Many Transfer Prices The “correct” transfer price depends on the economic and legal circumstances and the decision at hand. The “correct” transfer price depends on the economic and legal circumstances and the decision at hand. Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort. Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort. State fair-trade laws and national antitrust acts can also influence transfer pricing. State fair-trade laws and national antitrust acts can also influence transfer pricing.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 8 Identify the factors affecting multinational transfer prices.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Multinational Transfer Pricing Example An item is produced by Division S in a country with a 8% income tax rate. An item is produced by Division S in a country with a 8% income tax rate. It is transferred to Division G in a country with a 40% income tax rate. It is transferred to Division G in a country with a 40% income tax rate. An import duty equal to 20% of the price of the item is assessed. An import duty equal to 20% of the price of the item is assessed. Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen). Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen).

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Multinational Transfer Pricing Example Which transfer price should be chosen?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Multinational Transfer Pricing Example Income of S is $40 higher: 8% × $40 = ($3.20) higher taxes Income of S is $40 higher: 8% × $40 = ($3.20) higher taxes Income of G is $40 lower: 40% × $40 = $16 lower taxes Income of G is $40 lower: 40% × $40 = $16 lower taxes Import duty paid by G: 20% × $40 = ($8) Import duty paid by G: 20% × $40 = ($8)  Net savings = $4.80

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 9 Explain how controllability and management by objectives (MBO) aid the implementation of management control systems.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Management by Objectives and Setting Expectations MBO describes the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period. MBO describes the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period. The manager’s performance is then evaluated in relation to these agreed-upon budgeted objectives. The manager’s performance is then evaluated in relation to these agreed-upon budgeted objectives.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Budgets, Performance Targets, and Ethics Many of the troublesome motivational effects of performance evaluation systems can be minimized by the astute use of budgets. Many of the troublesome motivational effects of performance evaluation systems can be minimized by the astute use of budgets. The desirability of tailoring a budget to particular managers cannot be overemphasized. The desirability of tailoring a budget to particular managers cannot be overemphasized.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Budgets, Performance Targets, and Ethics Using budgets as performance targets also has its danger. Using budgets as performance targets also has its danger. Companies that make meeting a budget too important can motivate unethical behavior. Companies that make meeting a budget too important can motivate unethical behavior.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton End of Chapter 10