Performance Evaluation of Business Units PERTEMUAN XIII
KEMAMPUAN AKHIR YANG DIHARAPKAN
Agenda
•
Decentralization
– Proft centers and proft computations – Transfer pricing
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National Youth Association
•
HCC Industries
Decentralization and
performance evaluation
Performance evaluation
becomes necessary when
decision rights are delegated.
Do owners evaluate
Decentralization: Why?
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Environment
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Information specialization
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Timeliness of response
•
Conservation of central management
time
•
Computational complexity
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Training of local managers
Responsibility centers:
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Standard cost centers - production
variances
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Revenue centers - revenue variances
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Discretionary expense centers
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Proft centers - some measure of proft
•
Investment centers - some proftability
Problems associated with
decentralization:
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Goal congruence
•
Externalities
Responsibility accounting:
This refers to the various concepts
and tools used by managerial
accountants to measure the
performance of people and
Key concepts in responsibility
accounting:
•
Controllability
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The controllability principle
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Controllability problems
Designing an accounting-based
performance measure:
•
Representing fnancial (and other)
goals
•
Choosing income and investment
numbers
•
Choosing measures for income and
investment numbers
•
Choosing a target
Proft centers:
Proft center: A proft center is a unit for
which the manager has the authority to make decisions on sources of supply and choices of markets.
Proft measurement:
Variable contribution margin Controllable contribution
Divisional contribution
John Daly
Suppose that a year or more ago, John Daly, who owned the rights to produce a nifty new product, believed the product, Nifty, would be quite proftable if economical production facilities could be located. After much
investigation, John located a small building on the edge of town that was reasonably cheap, even though it was actually
John Daly continued:
The building contained 150,000 square feet of usable space and cost $100,000 per year to rent. John’s manufacturing operation required about 75% of this space.
In his frst year of operation, the company
earned about $100,000 in operating income. John paid his manager a salary, but rewarded exceptional efort by sharing profts.
John Daly continued
A friend of John’s had an idea for using the excess space in the facility and he asked John to fnance the operation. Once the
friend had explained his idea, John agreed. New equipment was purchased, and the new product, New, was manufactured and sold, along with Nifty, during the second year of operation. There was no incremental
John Daly continued
Once the costs that could be directly associated with the new product were deducted, operating profts had increased by $25,000. Nifty’s
results were the same as in year one.
Investment centers: ROI and
Residual Income
Investment centers: The manager has been given maximum discretion for making short-run operating decisions on product mix, pricing and production
methods, as well as the level and type of assets to be used.
Investment
Sales
*
Sales
Income
Investment
Income
Simple example: ROI
The Division A manager earns $50,000 on his controllable investment of $350,000. His ROI is:
% 3 . 14 %
100 *
$350,000 $50,000
ROI
What income number?
Residual income
Residual income is as close as an accountant comes to computing economic profit. It is operating income after paying all providers of capital.
Residual income =
Operating income - the cost of capital
Simple example: Residual
income
Division A:
Operating income $50,000
Cost of capital (42,000)
Residual income $ 8,000
The cost of capital in dollars is just the per dollar opportunity cost of investors’ capital times the size of their investment.
Which performance
measure is better?
Simple example: The investors’ cost of capital remains 12% throughout.
Division A:Assets = $350,000 Income = $50,000
ROI = 14.3%
Suppose the division manager is considering investing $15,000 in an asset that will earn $2,000 in income.
Decision 1: Will she take the
investment?
% 3 . 13 $15,000 $2,000 ROI than less is return l Incrementa % 3 . 14 % 2 . 14 $365,000 $52,000 after ROI DivisionDecision 2: Simple example
Suppose the division manager is considering disposing of an asset with a book value of $20,000 which earns $2,500 in income during any accounting period. Will he dispose of the asset?
%
5
.
12
$20,000
$2,500
ROI
s
Asset'
% 3 . 14 % 4 . 14 $330,000 $47,500 after ROI
Division
Residual income: Decision
1
Suppose now that the division manager’s performance evaluation measure is residual income. Will the manager choose to invest in a new assets that makes $2,000 per year and costs $15,000?
What is the current residual income? $8,000
Residual income: Decision
2
Will the Division A manager who is evaluated using
residual income dispose of an asset with annual earnings of $2,500 and a book value of $20,000?
New residual income$47,500 controllable cont. (39,600) new cost of capital
Compare divisons: ROI and
residual income
Division A
Assets: $350,000 Contrib: $50,000 ROI: 14.3%
Division B
Assets: $250,000 Contrib: $37,500 ROI: 15%
Which division is more profitable?
What rate of return does the larger division make on its additional assets?
Proft centers: HCC
Industries
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Participatory budgeting
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Setting budget performance targets
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Risk sharing and risk setting
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Communicating using the budget
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There are no actual calculations to
do for
HCC Industries
Proft centers and transfer
pricing:
TRANSFER PRICE
Objectives of transfer pricing schemes:
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Encourage managers to make decisions
that are in the organization’s best
interest.
•
Provide information for evaluation of
business units and managers.
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Minimize tax obligations (we will ignore)
Constraint: The scheme chosen should
require little intervention by top
The unifying principle is opportunity
cost:
The general transfer pricing rule: T = VC + OC
VC = OUTLAY COSTS INCURRED TO THE POINT OF TRANSFER;
USUALLY APPROXIMATED BY STANDARD VARIABLE COST
OC = OPPORTUNITY COST TO THE FIRM (I.E., CONTRIBUTION
FOREGONE = CM)
Transfer pricing: Crossville Company
At practical capacity, the Fabricating Division of Crossville Company has facilities to produce 8,000 units per month. Each unit requires five direct labor hours. The Assembly Division has forwarded a requisition for 8,000 units to the Fabricating Division. Since Crossville uses a market-based transfer pricing system,
contribution margin using a $50 market price would be $168,000.
Georges, Inc., a competitor, also sells the units for $50. The receipt of this requisition from Assembly upset the Fabricating manager as he had just been approached by an outside buyer with a rush order for 5,000 units at a $56 unit selling price.
Crossville Company
A. Does top management have a transfer pricing policy?
B. What is the minimum transfer price required by the selling division, Fabricating?
$53.75, the immediate average market price
C. What is the maximum transfer price required by the buying division?
Crossville Company
D. Will the two division managers agree to the transfer?
Buying
Division Selling Division
Crossvillle Company
Which of the following circumstances will lead
to goal congruence between the managers and the overall firm? Why?
1. The policy enforced is market price transfers.
Will the managers agree to transfer?
Is the transfer in the best interest of the company?
Crossville Company
Is the transfer in the best interest of the company? Minimize costs:
Internal transfer: Relevant cost of product = $53.75
External transfer: Fab: ($53.75) - 29 = ($24.75) Assy: $50.00
Relevant cost of product = $25.25 Note: $168,000 / 8,000 = $21 = CM/unit
Therefore, VC = $29 per unit
Crossville Company
2. Fabricating has adequate idle capacity.
This means that there is no meaningful market price for the items that would be transferred.
Internal transfer: Fab’s outlay cost = $29 Assy’s outlay cost = $0
External transfer Fab’s outlay cost = $0 Assy’s outlay cost = $50
What price will the Fabrication manager ask?
Crossville Company
3. Fabricating is forced to transfer product in lieu of selling 5,000 units outside.
Fabrication manager gets $50 Assembly manager pays $50
Internal transfer: $53.75 relevant cost
External transfer: $24.25 relevant cost
Negotiated market-based
prices:
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Some form of outside market for the
intermediate product.
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Sharing of all market information
among the negotiators.
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Freedom to buy or sell outside. This
provides the necessary discipline to
the bargaining process.
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Support and occasional involvement
Its limitations:
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Time consuming
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Leads to confict within frms
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It makes the measurement of
divisional proftability sensitive to the
negotiating skills of managers.
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It requires the time of top
management to oversee and mediate.
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It may lead to a suboptimal level of
NYA
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Transfer pricing.
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Reward functions are as follows:
– Total points = 300
– Your fraction of the 300 points:
Your team’s margin/Overall corporate margin
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