COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
Chapter 10
Decentralization:
Responsibility Accounting,
Study Objectives
1. Define responsibility accounting, and describe the four types of responsibility centers.
2. Explain why firms choose to decentralize.
3. Compute and explain return on investment (ROI),
residual income (RI), and economic value added (EVA). 4. Discuss methods of evaluating and rewarding
managerial performance.
5. Explain the role of transfer pricing in a decentralized firm.
Responsibility Accounting
Responsibility accounting
– measures the results of each responsibility
center
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
Decentralization
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
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
Measuring the Performance of
Investment Centers
Margin: portion of sales available for interest, taxes
and profit Operating income Sales � � � � � �
Turnover: how productively assets are being used to
generate sales
Sales
Average operating assets
� �
� �
Measuring the Performance of
Investment Centers
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.
Residual income
the difference between operating income and the minimum dollar return required on a company’s operating assets
Measuring the Performance of
Investment Centers
Advantages of Residual Income
Measuring the Performance of
Investment Centers
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
Division A Division B
Average operating assets $15,000,000 $2,500,000
Operating income $ 1,500,000 $ 300,000
Minimum returna 1,200,000 200,000
Residual income $ 300,000 $ 100,000
Residual returnb 2% 4%
a0.08 × Operating assets.
bResidual income divided by operating assets.
Disadvantages of Residual Income
Measuring the Performance of
Investment Centers
Economic value added (EVA)
after-tax operating profit minus the total annual cost of capital.
Measuring the Performance of
Investment Centers
After-tax
Weighted average cost of capital
EVA = operating -
Total capital employed
income
�
Total capital employed = capital assets plus other expenditures meant to have a
EVA Example
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.
Behavioral Aspects of EVA
Hardware Software Division Division
Sales $5,000,000 $2,000,000 Cost of goods sold 2,000,000 1,100,000 Gross profit $3,000,000 $ 900,000 Divisional selling and
administrative expenses 2,000,000 400,000 Operating income $1,000,000 $ 500,000
Measuring the Performance of
Investment Centers
Average cost of capital = 11%
Operating income $1,000,000 $500,000 Less: Cost of capital 1,100,000 220,000 EVA $ (100,000) $280,000
Hardware Software Division Division
Measuring the Performance of
Investment Centers
Tends to focus on long-run
Discourages myopic behavior
Behavioral Aspects of EVA
Measuring and Rewarding the
Performance of Mangers
• 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
Measuring and Rewarding the
Performance of Mangers
• 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
Measuring and Rewarding the
Performance of Mangers
•
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
Measuring and Rewarding the
Performance of Mangers
•
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.
Measuring and Rewarding the
Performance of Mangers
•
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.
Measuring and Rewarding the
Performance of Mangers
• 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
Transfer Pricing
Transfer prices
are the prices charged for
goods produced by one division and
transferred to another.
Transfer Pricing
• A transfer pricing system should satisfy
three objectives:
– Accurate performance evaluation
– Goal congruence
Transfer Pricing
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
Setting Transfer Prices
A good should be transferred internally
whenever
the opportunity cost (minimum price)
of the selling division
is less than
Setting Transfer Prices
• 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
Negotiated transfer prices
Example 1: Avoidable Distribution Costs
Negotiated transfer prices
Example 1: Avoidable Distribution Costs
Negotiated transfer prices
Example 1: Avoidable Distribution Costs
Negotiated transfer prices Example 2: Excess Capacity
Negotiated transfer prices Example 2: Excess Capacity
Setting Transfer Prices
• Negotiated Transfer Prices
– Disadvantages
• Time consuming
– Advantages
• Negotiation helps ensure goal congruence
Setting Transfer Prices
• Cost-Based Transfer Prices
– Forms
• Full-cost transfer pricing • Full cost plus markup
• Variable cost plus fixed fee
– Propriety of use
Setting Transfer Prices
• Transfer Pricing and the MNC
– Performance evaluation
– Optimal determination of income taxes
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
COST MANAGEMENT
Accounting & Control
Hansen▪Mowen▪Guan
