16-1 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Financial Performance Evaluation and Transfer Pricing in the Decentralized Firm.

Slides:



Advertisements
Similar presentations
MANAGEMENT ACCOUNTING
Advertisements

Investment Centers and Transfer Pricing n Top managers of large companies evaluate their divisions as investment centers. The manager of an investment.
Performance Evaluation, Variable Costing, and Decentralization
Chapter 15: Performance Evaluation and Compensation
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Investment Centers and Transfer Pricing Investment Centers and.
Investment Centers and Transfer Pricing
© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Decision Making is pushed down. Delegation of Decision Making (Decentralization) Decentralization.
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Investment Centers and Transfer Pricing Investment Centers and.
CHAPTER 8 PRICING Study Objectives
DECENTRALIZATION AND PERFORMANCE EVALUATION © itaesem/iStockphoto CHAPTER 10.
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 18 Organizational Design, Responsibility Accounting, and Evaluation.
© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 25-1 REWARDING BUSINESS PERFORMANCE Chapter 25.
Chapter 22 Performance Evaluation for Decentralized Operations
Chapter 10 Decentralization: Responsibility Accounting,
Performance Evaluation in the Decentralized Firm
Chapter 13 Business Unit Performance Measurement.
24 Performance Evaluation for Decentralized Operations Accounting 26e
Chapter Twelve Performance Evaluation and Decentralization COPYRIGHT © 2012 Nelson Education Ltd.
Chapter 15 Chapter 15 Performance Evaluation and Compensation Key Topics: –Agency theory –Knowledge and assigning decision-making authority –Performance.
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 13
Business Unit Performance Measurement Chapter 14 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.
ROI, Residual Income, and Economic Value Added
ADVANCED MANAGEMENT ACCOUNTING
Managerial Accounting:
Financial performance measures and transfer pricing
1 Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under.
Segment Reporting and Transfer Pricing
EMBA Presentation November 15,2012. Internal Performance Measurement  Responsibility Centers  Residual Income  Return on Investment  EVA.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.
Decentralized Performance Evaluation
Management and Cost Accounting, 6 th edition, ISBN © 2004 Colin Drury Management and Cost Accounting, 6 th edition, ISBN ©
AC239 Unit 8 Chapter 24 Performance Evaluation for Decentralized Operations.
Copyright © 2003 Pearson Education Canada Inc. Slide Chapter 24 Performance Measurement, Compensation, and Multinational Considerations.
© 2008 by Nelson, a division of Thomson Canada Limited Transparency 8.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron.
Accounting 3020 Chapter 12 – Segment Reporting, Decentralization, and Balanced Scorecard.
Chapter 24 Responsibility Accounting and Performance Evaluation
Performance Evaluation for Decentralized Operations 24.
Accounting 4310 Chapter 14 Business Unit Performance.
RESPONSIBILITY ACCOUNTING CHAPTER 22 & Decentralization  Decentralization is the freedom for managers at lower levels of the organization to make.
Contemporary accounting problems The first topic THE PART 2 Responsibility Accounting.
© John Wiley & Sons, 2005 Chapter 15: Performance Evaluation and Compensation Eldenburg & Wolcott’s Cost Management, 1eSlide # 1 Cost Management Measuring,
Performance Evaluation for Decentralized Operations Student Version.
9-1 Fundamental Managerial Accounting Concepts Thomas P. Edmonds Bor-Yi Tsay Philip R. Olds Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights.
Performance Evaluation Return on Investment EBIT / Operating Assets Problems with formula EBIT Why not net income? Operating Assets Book value versus fair.
10-1 Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing 10.
PPT 10-1 ADVANCED MANAGEMENT ACCOUNTING. PPT 10-2 Decentralization and Transfer Pricing.
© 2007 Pearson Education Canada Slide 14-1 Decentralized Organizations, Transfer Pricing, and Measures of Profitability 14.
1 PowerPointPresentation by PowerPoint Presentation by Gail B. Wright Professor Emeritus of Accounting Bryant University MANAGERIAL ACCOUNTING 10 TH EDITION.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.
Introduction The dilemma for companies is to find tools that allow the evaluation of managers at all levels in the organization. How would the evaluation.
Investment Centers and Transfer Pricing CHAPTER 13 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without.
Performance Evaluation Chapter 15 Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
1 PowerPointPresentation by PowerPoint Presentation by Gail B. Wright Professor Emeritus of Accounting Bryant University © Copyright 2007 Thomson South-Western,
CHAPTER FIVE Responsibility Accounting and Transfer Pricing.
10-1 Division Performance Measurement Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 10.
Responsibility Accounting and Transfer Pricing Chapter Five Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.
10-1 Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing.
CORNERSTONES of Managerial Accounting, 5e. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part,
CHAPTER 15: PERFORMANCE EVALUATION AND COMPENSATION Cost Management, Canadian Edition © John Wiley & Sons, 2009 Chapter 15: Performance Evaluation and.
Internal Performance Measurement and Transfer Pricing
Chapter 13 Financial performance measures for investment centres and reward systems.
Performance Measurement and Transfer Pricing
Division Performance Measurement
Performance Evaluation for Decentralized Operations
Decentralization and Performance Evaluation
Electronic Presentation by Douglas Cloud Pepperdine University
Decentralization and Performance Evaluation
Performance Evaluation for Decentralized Operations
Financial and Managerial Accounting:
Presentation transcript:

16-1 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Financial Performance Evaluation and Transfer Pricing in the Decentralized Firm 16 PowerPresentation® prepared by David J. McConomy, Queen’s University

16-2 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives l Define responsibility accounting and describe four types of responsibility centres. l Explain why companies decentralize.

16-3 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives l Compute and interpret return on investment (ROI), residual income (RI) and economic value added (EVA). l Explain the role of transfer pricing in decentralized companies.

16-4 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Responsibility Accounting Responsibility accounting is a system that measures the results of each responsibility centre according to the information managers need to operate their centres. There are four major types of responsibility centres: Cost centre Revenue centre Profit centre Investment centre

16-5 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Decentralization: The Major Issues l The degree of decentralization l Performance measurement l Management compensation l The setting of transfer prices

16-6 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Reasons for Decentralization There are many reasons to explain why firms decide to decentralize, including: 1.Utilization of local information 2.Strategic focus of central management 3.Training and motivational opportunities for managers 4.Enhanced competition among divisions

16-7 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Measuring the Performance of Investment Centres l Return on Investment (ROI) l Residual Income (RI) l Economic Value Added (EVA)

16-8 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Components of ROI Decomposition of the ROI formula: ROI = Operating income/Average operating assets = (Operating income/Sales) x (Sales/Average operating assets) = Operating income margin x Operating asset turnover

16-9 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. An ROI Example 2004Electronics Div. Medical Supplies Div. Sales$30,000,000$117,000,000 Operating income1,800,0003,510,000 Average operating assets10,000,00019,500, Sales$40,000,000$117,000,000 Operating income2,500,0002,925,000 Average operating assets10,000,00019,500,000 Minimum return of 10%

16-10 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Margin and Turnover Comparisons Electronics Medical Products Margin6.0%5.0%3.0%2.5% Turnoverx 3.0 x 4.0 x 6.0 x 6.0 ROI18.0%20.0%18.0%15.0%

16-11 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Advantages of ROI l Relationships among sales, expenses, and investments. l Cost efficiency. l Operating asset efficiency.

16-12 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Disadvantages of the ROI Measure l Focus on divisional profitability at the expense of overall company profitability l Focus on the short term at the expense of the long term

16-13 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Components of RI Decomposition of the RI formula: RI = Operating income- (Minimum rate of return x Operating assets) = Operating income – Minimum return on Assets

16-14 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. An RI Example Project 1 Project 2 Operating Income$1,300,000$640,000 Average Operating Assets 10,000,0004,000,000 Minimum Return10%10% Residual Income$300,000$240,000 Both projects have a positive residual income, take them both if funds are available.

16-15 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Advantages of Residual Income l Focus on accepting projects that are advantageous to the company

16-16 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Disadvantages of the RI Measure l Focus on the short term at the expense of the long term l An absolute measure of profitability makes it difficult to compare alternatives

16-17 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Economic Value Added Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital. EVA = After-tax operating income - (Weighted average cost of capital x total capital employed)

16-18 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Cost of Capital There are two steps involved in computing cost of capital: 1.determine the weighted average cost of capital (a percentage figure) 2.determine the total dollar amount of capital employed

16-19 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Weighted Average Cost of Capital Weighted Average Cost of Capital Suppose that a company has two sources of financing: $2 million of long- term bonds paying 9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average cost of capital is computed as follows: AmountPercentx After-tax cost= Weighted Cost Bonds $2,000, ( ) = Equity 6,000, = Total $8,000, =============

16-20 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. EVA Example Suppose that Mahalo, Inc., had after-tax operating income last year of $1,700,000. Mahalo, Inc. pays a marginal tax rate of 40 percent. Three sources of financing were used by the company: –$2 million of mortgage bonds paying 8 percent interest, –$3 million of unsecured bonds paying 10 percent interest, and –$10 million in common stock, which was considered to be no more or less risky than other stocks.

16-21 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Weighted Average Cost of Capital Weighted Average Cost of Capital The weighted average cost of capital for Mahalo, Inc. is computed as follows: AmountPercent x After-Tax Cost = Weighted Cost Mortgage bonds $ 2,000, Unsecured bonds 3,000, Common stock10,000, Total $15,000, =============

16-22 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. EVA Example Mahalo’s EVA is calculated as follows: After tax operating income$1,700,000 Less: Cost of capital 1,470,000 EVA$230,000 ======== The positive EVA means that Mahalo, Inc. earned operating profit over and above the cost of capital used.

16-23 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Behavioural Aspects of EVA l A number of companies have discovered that EVA helps to encourage the right kind of behaviour from their divisions in a way that emphasis on operating income alone cannot. The underlying reason is EVA’s reliance on the true cost of capital. l In many companies, the responsibility for investment decisions rests with corporate management. As a result, the cost of capital is considered a corporate expense. If a division builds inventories and investment, the cost of financing that investment is passed along to the overall (corporate) income statement and does not show up as a reduction from the division’s operating income.

16-24 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Features of EVA for Internal Performance Evaluation 1. A major advantage of EVA is that it discourages managers from using their current ROI as the effective hurdle rate to turn down investments. 2. Like ROI, EVA encourages short run orientation. 3. EVA uses an absolute measure of profitability, making direct comparison of profitability of divisions with different investment bases unfair since the level of investment may differ.

16-25 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Multiple Performance Measurements Why have Multiple Performance Measures? l Tends to Focus on Long-run l Discourages Myopic Behaviour

16-26 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Transfer Pricing The transferred good is revenue to the selling division and cost to the buying division. This value is called a transfer price.

16-27 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Some Major Issues Transfer Pricing: General Concerns l Impact on divisional performance measures l Impact on firm-wide profits l Impact on divisional autonomy

16-28 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Transfer Pricing Approaches l Market price l Negotiated transfer prices l Cost-based transfer prices –Variable cost –Full (absorption cost) Transfer price = Variable cost per unit + Lost contribution per unit on outside sales This relationship identifies the minimum and maximum transfer prices

16-29 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. A Transfer Pricing Problem A Transfer Pricing Problem Assume the following data for Division A: Capacity in units 50,000 Selling price to outside $15 Variable cost per unit 8 Fixed costs per unit (based on capacity) 5 Division B would like to purchase units for Division A. Division B is currently purchasing 5,000 units per year from and outside source at a cost of $14.

16-30 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. A Transfer Problem Example (continued) 1.Assume Division A has idle capacity in excess of 10,000 units: Minimum transfer price= Variable cost + Lost contribution margin = $8 + $0 = $8 2.Assume Division A is working at capacity: Transfer Price = Variable cost + Lost contribution margin = $8 + $7 = $15 (market price) 3. Assume Division A is working at capacity, but a negotiated $2 in variable costs can be avoided on intercompany sales. Transfer Price = Variable cost + Lost contribution margin = $6 + $7 = $13 (negotiated price)