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Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing

Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing. Prepared by Douglas Cloud Pepperdine University. Responsibility Accounting.

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Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing

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  1. Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing Prepared by Douglas Cloud Pepperdine University

  2. Responsibility Accounting Responsibility accountingis a system that measures the results of each responsibility center and compares those results with some measure of expected or budgeted outcome. There are four major types of responsibility centers: • Cost center • Revenue center • Profit center • Investment center

  3. Reasons for Decentralization 1. Better access to local information 2. Cognitive limitations 3. More timely response 4. Focusing of central management 5. Training and evaluation 6. Motivation 7. Enhanced competition

  4. Measuring the Performance of Investment Centers Return on Investment (ROI) Residual Income (RI) Economic Value Added (EVA)

  5. Components of ROI Operating income Average operating assets ROI = Sales Average operating assets Operating income Sales = X Operating income Operating asset margin turnover = X

  6. Components of ROI Marginexpresses the portion of sales that is available for interest, income taxes, and profit. Turnovershows how productively assets are being used to generate sales.

  7. Year 1: Sales $30,000,000 $117,000,000 Operating income 1,800,000 3,510,000 Average operating assets 10,000,000 19,500,000 ROI 18 % 18 % Year 2: Sales $40,000,000 $117,000,000 Operating income 2,000,000 2,925,000 Average operating assets 10,000,000 19,500,000 ROI 20 % 15 % Comparison of ROI Snack Foods Division Appliance Division

  8. Margin and Turnover Comparison Snack Foods Division Appliance Division Year 1 Year 2 Year 1 Year 2 Margin 6.0 % 5.0 % 3.0 % 7.5 % Turnover x3.0x4.0x6.0x6.0 ROI 18.0 % 20.0 % 18.0 % 15.0 %

  9. Residual Income Residual Income Operating income (Minimum rate of return x Operating assets) = - Project I: Project II: RI = $1,300,000 – (0.10 x $10,000,000) = $300,000 RI = $640,000 – (0.10 x $4,000,000) = $240,000 Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

  10. Residual Income--Example In thousands Add Add Add Both Maintain Project I Project II Projects Status Quo Operating assets $60,000 $54,000 $64,000 $50,000 Operating income $ 8,800 $ 8,140 $ 9,440 $ 7,500 Minimum return 6,000 5,400 6,400 5,000 Residual income $ 2,800 $ 2,740 $ 3,040 $ 2,500 Desired return = 10% Preferred alternative

  11. Minimum requirement is 8% Division A Division B Average operating assets $15,000,000 $2,500,000 Operating income $ 1,500,000 $ 300,000 Minimum return 1,200,000 200,000 Residual income $ 300,000 $ 100,000 Residual return 2 % 4 %

  12. Economic Value Added Economic value added (EVA)is after-tax operating profit minus the total annual cost of capital. EVA = After-tax operating income – (Weighted average cost of capital) x (Total capital employed)

  13. EVA Example Three sources of revenue were used by Furman, Inc.: $2 million of mortgage bonds paying 8 percent interest, $3 million of unsecured bonds paying 10 percent interest, and $10 million in common stock. Furman pays a tax rate of 40 percent. After tax cost = Interest – (tax rate x interest)

  14. EVA Example After-Tax Weighted Amount Percent x Cost = Cost Mortgage bonds $ 2,000,000 0.133 0.048 0.006 Unsecured bonds 3,000,000 0.200 0.060 0.012 Common stock 10,000,000 0.667 0.120 0.080 Total $15,000,000 Weighted average cost of capital 0.098 $15,000,000 x .098 = $1,470,000

  15. EVA Example Furman’s EVA is calculated as follows: 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. Behavioral Aspect of EVA Supertech, Inc., has two divisions. Operating income statements for the divisions are shown below: 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

  17. Behavioral Aspect of EVA • Supertech’s weighted average cost of capital is 11 percent. • Hardware, a buildup of inventories, use of warehouses, etc. uses capital amounting to $10 million. • The cost of capital is $1,100,000 (0.11 x $10,000,000). • The dollar cost of capital for the Software Division is $220,000 (0.11 x $2,000,000).

  18. Behavioral Aspect of EVA The EVA for each division can be calculated as follows: Hardware Software Division Division Operating income $1,000,000 $500,000 Less: Cost of capital 1,100,000 220,000 EVA -$ 100,000 $280,000 Hardware Division: COC > OI Software Division: COC < OI

  19. Transfer Pricing The transferred good is revenue to the selling division and cost to the buying division. This value is called transfer pricing.

  20. Transfer Pricing Some Major Issues • Impact on divisional performance measures • Impact on firm wide profits • Impact on divisional autonomy

  21. Transfer Pricing • Market price • Negotiated transfer prices • Cost-based transfer prices • Variable cost • Full (absorption cost)

  22. Direct materials $10 Transferred-in part 8 Direct labor 2 Variable overhead 1 Fixed overhead 10 Total cost $31 The Small Motors Division is operating at 70 percent capacity. A request is received for 100,000 units of a certain model at $30 per unit. Full manufacturing cost of the motor, broken down as follows: Should the Parts Division lower the transfer price to allow the Motor Division to accept the special order?

  23. $13 Direct materials $10 Transferred-in part 8 Direct labor 2 Variable overhead 1 Fixed overhead 10 Total cost $31 The division could pay as much as $17 for the component and still break even on the special order.

  24. When imperfection exists in competitive markets for the intermediate product, market price may no longer be suitable. Negotiated Transfer Prices

  25. Negotiated Transfer Prices In this case, negotiated transfer prices may be a practical alternative. Opportunity costs can be used to define the boundaries of the negotiation set.

  26. Disadvantages of Negotiated Transfer Prices • One division manager, possessing private information, may take advantage of another divisional manager. • Performance measures may be distorted by the negotiating skills of managers. • Negotiation can consume considerable time and resources.

  27. Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and accurate performance evaluation.

  28. Cost-Based Transfer Pricing • Full-cost transfer pricing • Full cost plus markup • Variable cost per fixed fee

  29. End of Chapter

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