1. Chapter 10 Decentralization: Responsibility Accounting,
Performance Evaluation, and Transfer Pricing
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license.

2. Study Objectives
Define responsibility accounting, and describe the four types of responsibility centers.
Explain why firms choose to decentralize.
Compute and explain return on investment (ROI), residual income (RI), and economic value added (EVA).
Discuss methods of evaluating and rewarding managerial performance.
Explain the role of transfer pricing in a decentralized firm.
Discuss the methods of setting transfer prices.

3. Responsibility Accounting1.
Responsibility accounting
measures the results of each responsibility center
compares those results with some measure of expected or budgeted outcome.

4. Responsibility Accounting
Types of Responsibility Centers
Cost center: only responsible for costs
Revenue center: only responsible for revenues
Profit center: responsible for both revenues and costs
Investment center: responsible for revenues, costs, and investments

5. Decentralization 2. Reasons for Decentralization
Better access to local information
More timely response
Focusing of central management
Training and evaluation of segment managers
Motivation of segment managers
Enhanced competition

6. Measuring the Performance of Investment Centers3.
Return on investment (ROI)
the most common measure of performance for an investment center
ROI = Operating income ÷ Average operating assets
= (Operating income ÷ Sales)  (Sales ÷ Average operating assets)
= Operating income margin  Operating asset turnover
Margin: portion of sales available for interest, taxes and profit
Turnover: how productively assets are being used to generate sales

7. Measuring the Performance of Investment Centers3.

8. Measuring the Performance of Investment Centers3.

9. Measuring the Performance of Investment Centers3.
Advantages of the ROI measure
Helps managers focus on the relationship between sales, expenses and investment.
Encourages cost efficiency.
Discourages excessive investment in operating assets
Disadvantages of the ROI measure
Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall.
Encourages managers to focus on the short-term at the expense of the long-term.

10. Measuring the Performance of Investment Centers3.
Residual income
the difference between operating income and the minimum dollar return required on a company’s operating assets

11. Measuring the Performance of Investment Centers3.
Advantages of Residual Income
Project I
Residual income = $1,300,000 - (0.10  $10,000,000)
= $1,300,000 - $1,000,000
= $300,000
Project II
Residual income = $640,000 - (0.10  $4,000,000)
= $640,000 $400,000
= $240,000

12. Measuring the Performance of Investment Centers3.
Disadvantages of Residual Income
ROI is an absolute measure of return; it does not discourage myopic behavior
Division A Division B
Average operating assets $15,000,000 $2,500,000
Operating income $ 1,500,000 $ 300,000
Minimum returna ,200, ,000
Residual income $ ,000 $ 100,000
Residual returnb % %
a0.08 × Operating assets.
bResidual income divided by operating assets.

13. Measuring the Performance of Investment Centers3.
Economic value added (EVA)
after-tax operating profit minus the total annual cost of capital.
Total capital employed = capital assets plus other expenditures meant to have a long-term payoff

14. Measuring the Performance of Investment Centers3.
EVA Example

15. Measuring the Performance of Investment Centers3.
EVA Example (continued)
Furman’s EVA is:
After-tax profit $1,583,000
Less: Weighted average cost of capital (1,470,000)
EVA $ 113,000
The positive EVA means that Furman, Inc., earned operating profit over and above the cost of the capital used.

16. Measuring the Performance of Investment Centers3.
Behavioral Aspects of EVA
Hardware Software
Division Division
Sales $5,000,000 $2,000,000
Cost of goods sold 2,000, ,100,000
Gross profit $3,000,000 $ 900,000
Divisional selling and
administrative expenses 2,000, ,000
Operating income $1,000,000 $ 500,000
Average cost of capital = 11%
Capital used $10,000,000 $2,000,000
Cost of capital $1,100,000 $220,000

17. Measuring the Performance of Investment Centers3.
Behavioral Aspects of EVA
Tends to focus on long-run
Discourages myopic behavior
Hardware Software
Division Division
Operating income $1,000, $500,000
Less: Cost of capital 1,100, ,000
EVA $ (100,000) $280,000
Positive EVA = wealth is being created
Negative EVA = capital is being destroyed

18. Measuring and Rewarding the Performance of Mangers4.
Measuring performance in the MNC
Evaluate the division
Evaluate the manger
Base on factors where control exists
Do not evaluate on factors over which there is no control (currency fluctuations, income taxes, etc.)

19. Measuring and Rewarding the Performance of Mangers4.
MNC divisional ROIs impacted by
International vs domestic environmental conditions (economic, legal, political, social, etc.)
Multiple measures of performance for MNC divisions
Consider market potential and market share
Residual income and ROI should not be the sole measures for MNC divisions

20. Measuring and Rewarding the Performance of Mangers4.
Managerial rewards
Separation of ownership and management creates the possibility that managers may not operate the business in the best interest of the shareholders
Managers do not exert the most productive effort for the company
Managers may spend company resources on perquisites
A well-structured incentive compensation system encourages goal congruence

21. Measuring and Rewarding the Performance of Mangers4.
Cash compensation
Reward good management performance by granting periodic raises
Become a permanent part of the compensation package
Bonuses provide more flexibility
Income-based compensation may encourage dysfunctional behavior.
A combination of salary and bonus keeps salaries fairly level and allows bonuses to fluctuate with reported income.

22. Measuring and Rewarding the Performance of Mangers4.
Stock-based compensation
A stock option is the right to buy a certain number of shares of the company’s stock, at a particular price and after a set length of time.
Stock options are offered to managers
They become owners (shareholders) of the company
Ownership encourages goal congruence
The price of the stock is usually set to approximate market price at the time of issue.
If the stock price rises in the future, the manager may exercise the option.

23. Measuring and Rewarding the Performance of Mangers4.
Issues to consider
Single-measure outcomes encourage gaming behavior
The Big Bath
Cash bonuses and stock options encourage short-term orientation by management
Noncash compensation
Autonomy
Perquisites

24. Transfer Pricing 5.
Transfer prices are the prices charged for goods produced by one division and transferred to another.
The price charged affects the revenues of the transferring division and the costs of the receiving division.

25. Transfer Pricing 5.
A transfer pricing system should satisfy three objectives:
Accurate performance evaluation
Goal congruence
Preservation on divisional autonomy

26. Transfer Pricing 5. Opportunity cost approach identifies
The minimum price that a selling division would be will to accept
Floor: leaves the selling division no worse off for having sold to an internal division
The maximum price that the buying division would be willing to pay
Ceiling: leaves the buying division no worse off for having purchased from an internal division

27. Transfer Pricing 5.

28. Setting Transfer Prices6.
A good should be transferred internally whenever the opportunity cost (minimum price) of the selling division is less than the opportunity cost (maximum price) of the buying division.

29. Setting Transfer Prices6.
Commonly used policies
Market price
Price in an outside, perfectly competitive, market
Negotiated transfer prices
Agreed to only if the opportunity cost of the selling division is less than the opportunity cost of the buying division
Cost-based transfer prices
Variable cost
Full (absorption cost)

30. Setting Transfer Prices6.
Negotiated transfer prices Example 1: Avoidable Distribution Costs

31. Setting Transfer Prices6.
Negotiated transfer prices Example 1: Avoidable Distribution Costs

32. Setting Transfer Prices6.
Negotiated transfer prices Example 1: Avoidable Distribution Costs

33. Setting Transfer Prices6.
Negotiated transfer prices Example 2: Excess Capacity

34. Setting Transfer Prices6.
Negotiated transfer prices Example 2: Excess Capacity

35. Setting Transfer Prices6.
Negotiated Transfer Prices
Disadvantages
Time consuming
Advantages
Negotiation helps ensure goal congruence
Comparable negotiating skills support motivation and accurate performance measures

36. Setting Transfer Prices6.
Cost-Based Transfer Prices
Forms
Full-cost transfer pricing
Full cost plus markup
Variable cost plus fixed fee
Propriety of use
Impact on divisional profit is negligible
Ease of cost measurement is beneficial
Result of negotiations

37. Setting Transfer Prices
Transfer Pricing and the MNC
Performance evaluation
Optimal determination of income taxes
Shift costs to high-tax countries
Shift revenues to low-tax countries

38. Setting Transfer Prices6.

39. Setting Transfer Prices
IRS Code §482
Requires arms’-length transactions
Allowable pricing methods
Comparable uncontrolled price method
Resale price method
Cost-plus method
Negotiated between the company and the IRS
Income taxes are universal
Market-based transfer prices

40. End Chapter 10
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license.