Managerial Economics and Organizational Architecture, 5e Chapter 17: Divisional Performance Evaluation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Measuring Divisional Performance Rewards are based on performance evaluations Must be consistent with decision rights granted to the unit manager Units can be characterized into five groups 17-2

Cost Centers Manufacturing Assigned decision rights to produce a stipulated level of output 17-3

Cost Centers Economic efficiency (minimize costs for given output) Technical efficiency (maximize output for given budget) Note: minimizing average cost does not yield profit-maximizing sales level 17-4

Expense Centers Personnel, accounting Managers are given fixed budget and asked to maximize service/output Output is more subjectively measured than in a cost center Budgets may be benchmarked with those of other firms Lack of charge back leads to overuse Risk of “empire building” 17-5

Revenue Centers Sales, distribution Managers compensated for selling a set of products Objective to maximize revenue for a given price or quantity and budget May not be consistent with value maximization Revenue maximized when MR=0 But MC may be greater than 0 17-6

Profit Centers Combined cost and revenue centers Managers are given a fixed capital budget and allocated decision rights for input mix, product mix and selling prices Evaluated on difference between actual and budgeted accounting profits 17-7

Profit Centers Firms must be wary of individual units maximizing profits at the expense of maximizing value of the whole firm. Complications Selection of transfer price Overhead allocation 17-8

Investment Centers Profit centers with decision rights over capital expenditures Evaluated on basis of return on capital Return on assets For the investment center – the ratio of accounting net income to the total assets invested in the center Economic value added 17-9

Transfer Pricing Price paid for intra-organizational transfers of goods and services Choice determines both distribution of profits among units and overall profits If transfer prices are mis-measured, managers in various divisions will make inappropriate decisions 17-10

Transfer Pricing The optimal transfer price for a product or service is its opportunity cost Often difficult to measure Measurement Costless information Opportunity cost is the marginal cost Asymmetric information Managers may have incentives to hide true costs and may charge monopoly price instead of price equal to MC 17-11

Profit-Maximizing Product Price $ 110 Firm profit = $500 Price (in dollars) 60 MC = $10 MR D Q 10 22 Quantity 17-12

Decentralized Firm transfer price $ $ Profits = $125 110 Profits = $250 110 85 60 60 MC Costs (in dollars) 10 MC MR D MR D Q Q 5 11 5 11 22 Quantity Quantity Manufacturing division Distribution division 17-13

Transfer-Pricing Methods Market base Marginal cost Full cost Negotiated 17-14

Internal Accounting The accounting system Decision management requires estimates of future benefits and costs Backward-looking accounting systems support decision control 17-15

Internal Accounting Tradeoffs between decision management and control Accounting measures are not under the control of those being monitored Managers with decision making rights are often dissatisfied with financial measures for making operating decisions 17-16