Agenda

1. Agenda • Decentralization • Profit centers and profit computations • Transfer pricing • National Youth Association • HCC Industries • Group problem solving

2. Decentralization and performance evaluation Performance evaluation becomes necessary when decision rights are delegated. Do owners evaluate managerial inputs or outputs?

3. Decentralization: Why? • Environment • Information specialization • Timeliness of response • Conservation of central management time • Computational complexity • Training of local managers • Motivation of local managers

4. Responsibility centers: • Standard cost centers - production variances • Revenue centers - revenue variances • Discretionary expense centers • Profit centers - some measure of profit • Investment centers - some profitability measure (e.g., ROI or residual income)

5. Problems associated with decentralization: • Goal congruence • Externalities • Over-consumption of perquisites

6. Responsibility accounting: This refers to the various concepts and tools used by managerial accountants to measure the performance of people and departments in order to foster goal congruence.

7. Key concepts in responsibility accounting: • Controllability • The controllability principle • Controllability problems • Traceability

8. Designing an accounting-based performance measure: • Representing financial (and other) goals • Choosing income and investment numbers • Choosing measures for income and investment numbers • Choosing a target • Choosing the timing of feedback

9. Profit centers: Profit center: A profit center is a unit for which the manager has the authority to make decisions on sources of supply and choices of markets. Profit measurement: Variable contribution margin Controllable contribution Divisional contribution Divisional profit before taxes

10. 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 profitable 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 somewhat larger than he needed.

11. 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 first year of operation, the company earned about $100,000 in operating income. John paid his manager a salary, but rewarded exceptional effort by sharing profits. What was operating income before facility costs?

12. John Daly continued A friend of John’s had an idea for using the excess space in the facility and he asked John to finance 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 increase in the cost of the facility or its maintenance.

13. John Daly continued Once the costs that could be directly associated with the new product were deducted, operating profits had increased by $25,000. Nifty’s results were the same as in year one. Required: Suppose John wants to define each product line as a profit center and split profits with his managers fifty-fifty. What operating profit would you compute for the two product lines? How much bonus would each manager receive?

14. 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.

15. Simple example: ROI The Division A manager earns $50,000 on hiscontrollable investment of $350,000. His ROI is: What income number? What investment number?

16. Residual income Residual income is as close as an accountant comesto computing economic profit. It is operating incomeafter paying all providers of capital. Residual income = Operating income - the cost of capital Cost of capital = demanded rate of returnon invested capital * size of investment

17. Simple example: Residual income Providers of capital demand 12% on average. This is the opportunity cost of their capital. 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 opportunitycost of investors’ capital times the size of their investment.

18. Which performance measure is better? Simple example: The investors’ cost of capital remains12% 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. Will she take the investment?

19. Decision 1: Will she take the investment? Would the providers of capital want her to take it?

20. Decision 2: Simple example Suppose the division manager is considering disposingof an asset with a book value of $20,000 which earns$2,500 in income during any accounting period. Willhe dispose of the asset? What do providers of capital want him to do?

21. Residual income: Decision 1 Suppose now that the division manager’s performanceevaluation measure is residual income. Will the managerchoose to invest in a new assets that makes $2,000 per year and costs $15,000? What is the current residual income? $8,000 New residual income: $52,000 controllable cont. (43,800) new cost of capital $ 8,200 new residual income

22. Residual income: Decision 2 Will the Division A manager who is evaluated usingresidual 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 $ 7,900 new residual income

23. Compare divisons: ROI and residual income Division BAssets: $250,000Contrib: $37,500ROI: 15% Division AAssets: $350,000Contrib: $50,000ROI: 14.3% Which division is more profitable? What rate of return does the larger division make onits additional assets? Is it more than the cost of capital?

24. Profit centers: HCC Industries • Participatory budgeting • Setting budget performance targets • Risk sharing and risk setting • Communicating using the budget • There are no actual calculations to do for HCC Industries • Pay attention to the probabilities that are tossed about.

25. Profit centers and transfer pricing: TRANSFER PRICE A PRICE CHARGED BY ONE SEGMENT OF ANORGANIZATION FOR A PRODUCT OR SERVICETHAT IT SUPPLIES TO ANOTHER SEGMENT OFTHE ORGANIZATION.

26. Objectives of transfer pricing schemes: • Encourage managers to make decisions that are in the organization’s best interest. • Provide information for evaluation of business units and managers. • Minimize tax obligations (we will ignore) Constraint: The scheme chosen should require little intervention by top management.

27. 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) Note that CM = SP - VC, so VC + OC = SP - the market pricewhen OC > 0, less adjustments.

28. 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. Top management’s initial reaction is to reject the offer.

29. Crossville Company A. Does top management have a transfer pricing policy? B. What is the minimum transfer price required by theselling division, Fabricating? $53.75, the immediate average market price C. What is the maximum transfer price required by thebuying division? $50, the price it would pay to Georges

30. Crossville Company D. Will the two division managers agree to the transfer?

31. Crossvillle Company Which of the following circumstances will leadto goal congruence between the managers and theoverall firm? Why? 1. The policy enforced is market price transfers. Will the managers agree to transfer? No, the Fabrication manager sells outside. Is the transfer in the best interest of the company?

32. Crossville Company Is the transfer in the best interest of the company? Minimize costs: Internal transfer: Relevant cost of product = $53.75 Note: $168,000 / 8,000 = $21 = CM/unit Therefore, VC = $29 per unit External transfer: Fab: ($53.75) - 29 = ($24.75) Assy: $50.00 Relevant cost of product = $25.25 The company does not want an internal transfer.

33. Crossville Company 2. Fabricating has adequate idle capacity. This means that there is no meaningful market pricefor 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? What price will the Assembly manager be willing to pay?

34. Crossville Company 3. Fabricating is forced to transfer product in lieu ofselling 5,000 units outside. Fabrication manager gets $50 Assembly manager pays $50 Internal transfer: $53.75 relevant cost External transfer: $24.25 relevant cost The managers will act against the company’s best interest.

35. Negotiated market-based prices: • Some form of outside market for the intermediate product. • Sharing of all market information among the negotiators. • Freedom to buy or sell outside. This provides the necessary discipline to the bargaining process. • Support and occasional involvement of top management.

36. Its limitations: • Time consuming • Leads to conflict within firms • It makes the measurement of divisional profitability sensitive to the negotiating skills of managers. • It requires the time of top management to oversee and mediate. • It may lead to a suboptimal level of output.

37. NYA • Transfer pricing. • Reward functions are as follows: • Total points = 300 • Your fraction of the 300 points: Your team’s margin/Overall corporate margin • These points will be used to award class participation credit.

38. Group work: • Work • Europa, Inc handout.