© 2007 Pearson Education Canada Slide 14-1 Decentralized Organizations, Transfer Pricing, and Measures of Profitability 14

© 2007 Pearson Education Canada Slide 14-2 Decentralization versus Centralization Decentralization The delegation of decision making authority to managers throughout the organization CentralizationDecentralization Minimum freedom Maximum freedom

© 2007 Pearson Education Canada Slide 14-3 Decentralization (con’d) Benefits of Decentralization Lower-level managers are more informed about local conditions Managers acquire decision-making experience that trains them to assume leadership roles in organization Managerial independence leads to greater motivation

© 2007 Pearson Education Canada Slide 14-4 Decentralization (con’d) Costs of Decentralization Managers may make goal incongruent decisions Duplication of services (accounting and advertising) Increased cost of accumulating and processing information Managers may waste time arguing about shared services

© 2007 Pearson Education Canada Slide 14-5 Decentralization (con’d) Most companies adopt a blend of decentralized and centralized functions (decentralize marketing but centralize tax planning) Decentralization is most successful when organization's segments are relatively independent DiversifiedSingle IndustrySingle Product LineMulti-ProductProduct No ProblemsCommon Problems

© 2007 Pearson Education Canada Slide 14-6 Decentralization (con’d) Decentralization cannot work unless top management is willing to abide by its managers' decisions Stepping in and overriding managers' decisions will quickly result in motivational problems

© 2007 Pearson Education Canada Slide 14-7 Profit Centres and Decentralization Be careful to separate these two ideas Profit centres hold a manager accountable for revenues & expenses Decentralized manager has the freedom to make decisions Cost centre may be more decentralized than a profit centre if the cost centre manager has more authority

© 2007 Pearson Education Canada Slide 14-8 Transfer Pricing Transfer pricing deals with the valuation of goods and services traded between profit or investment centres in decentralized organizations Selling division wants the transfer price to be high Buying division wants the transfer price to be low Final Market Transfer Price Intermediate Market Selling Division Buying Division

© 2007 Pearson Education Canada Slide 14-9 Alternative Transfer Prices Cost-Based Transfer Price Variable cost plus a markup Full cost plus a markup Market-Based Transfer Price Negotiated Transfer Price

© 2007 Pearson Education Canada Slide Setting Transfer Prices Transfer Price = Cost Plus Used by half of the major companies in the world Consider using cost-based transfer price when market price is not available or too difficult to determine What may be variable and fixed to the selling division becomes completely variable to the buying division Should always transfer at standard cost

© 2007 Pearson Education Canada Slide Setting Transfer Prices (con’d) Transfer price = market price If the external market is competitive, using the market price as the transfer price will generally produce optimal results Adjustments may be made to reflect costs not incurred on internally transferred goods and services Market price forces divisional managers to be competitive

© 2007 Pearson Education Canada Slide Setting Transfer Prices (con’d) Negotiated transfer prices Common in organizations where managers have considerable autonomy Do not let negotiations take up too much time

© 2007 Pearson Education Canada Slide Transfer Pricing in the Global Market U.S.-Based Lemmon Marketing Division profit centre Israel-Based Marketing Division profit centre Transfer Price = ? Third Marketing Division Sells Worldwide on a Made-to-Order Basis Headquarters and manufacturing division in Israel 4 plants (cost centre)

© 2007 Pearson Education Canada Slide Irving Oil versus Revenue Canada Bermuda New Brunswick Refinery

© 2007 Pearson Education Canada Slide Return on Investment (ROI%) Top management's determination of the overall contribution of the division to corporate earnings Focus on long-run performance Are the dollars invested in the division generating an adequate return? Should more or less money be put into these activities? ROI%= income / invested capital =incomex revenue revenue invested capital Improve performance by Increasing income by reducing expenses Boost sales without increasing expenses Reduce investments in working capital and fixed assets without decreasing sales

© 2007 Pearson Education Canada Slide Residual Income (RI) Residual income is a variation of ROI% which focuses on an absolute dollar amount rather than a % Residual income = Divisional net income - (interest charge x invested capital) Imputed interest charge refers to the firm’s "cost of capital" Cost of capital is the minimum acceptable rate of return for investments in a project or a division If divisions have different levels of risk, they should have different imputed interest charges CurrentNew ProposalRevised Net income$200,000$75,000$275,000 Invested capital$1,000,000$500,000$1,500,000 ROI% 20% 15% 18.3% Capital charge (8%)$80,000$40,000$120,000 Residual income$120,000$35,000$155,000

© 2007 Pearson Education Canada Slide Economic Value Added (EVA) Variation of Residual Income Term coined and marketed by Stern Stewart & Co. Focuses on an absolute dollar amount rather than a % Economic Value Added (EVA) = Net operating income - [ Weighted-average cost of capital x (Long-term liabilities + Shareholders’ equity) ] Weighted-average cost of capital is the after-tax cost of long-term liabilities and shareholders’ equity weighted by their relative size for the company or the division XY 2006 Sales Revenue ($millions)$12$ Sales revenue ($millions)$21$19 Invested capital ($millions)$20$10

© 2007 Pearson Education Canada Slide Defining Invested Capital Possible alternative definitions of "invested capital" include total assets, total assets employed, total assets - current liabilities Best alternative depends on what the manager can influence Centrally administered assets are often allocated to divisions Allocations will not cause major problems if allocation base is deemed by managers to be reasonable

© 2007 Pearson Education Canada Slide Valuation of Plant & Equipment Assets Gross Book Value Original cost of assets Objective [no amortization (depreciation) allocations] Net Book Value Original cost less accumulated amortization (depreciation) Managers motivated to not invest in new assets Current Value Figures may be costly (and sometimes impossible) to determine