1. 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.

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

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

13. 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

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

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

16. 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