1. 2 decentralization lo1: explain costs and benefits of decentralization practice of delegating...

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Decentralization

LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization

Practice of delegating decisions to lower-level managers

Practice of delegating decisions to lower-level managers

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a) it forces top levels of management to focus on

individual units.

b) it empowers more employees at lower levels of

management.

c) it allows for better and more timely decision making.

d) it trains future managers.

Test Your Knowledge!The benefits of decentralization include all of the following except:

Decentralization does not force top levels of management to focus on individual units.

Decentralization does not force top levels of management to focus on individual units.

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Organization Structure

• A responsibility center is the smallest unit of analysis Almost like a mini-business Clearly defined goals and authority

• We need to put in control systems Induce “right” use of local knowledge Induce coordination & cooperation with other

responsibility centers Ideally, a mix of financial (profit, sales) and non-financial

(yield, customer satisfaction) measures

• Incentive structure depends on unit being considered Non-trivial to link performance measures to incentives


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Typical Organization Structure


Aaron Knight,CEO

Manager,New Jersey

Region

Manager,New York

Region

Manager,Westchester

Region

Branches BranchesStaff Assistant

BranchManagers

Supervisor(Copies)

Supervisor (PC)

Copy CenterStaff

PC Center Staff

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Kinds of Responsibility Centers


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Cost Center

• Goal: minimize the cost of producing a specified level of output or the cost of delivering a specified level of service Efficiency of operations is the focus

• Examples Machining, assembly, the entire plant Human resources, advertising, general

administration


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Cost Center: Duties And Measures

• What can a cost center manager control? Mix of inputs for a given level of output Not responsible for final products and service

• How should we evaluate them? Budget-based comparison for financials Center specific non-financial measures


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Kinds Of Cost Centers• Engineered cost center

Clear relation between resources consumed and output

Machining or Assembly department

Flexible budget makes sense here Quality, service, response time are all important

Critical Success Factors (CSF)

• Discretionary cost center No clear relation between resources consumed and

output Legal, Accounting, R & D

Does not make sense to flex the budget Non-financial measures gain more importance


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Profit Centers

• Profit centers aim to both minimize costs and to maximize revenues. Regional centers Product line managers

• What can these managers control? Input mix, product mix, selling prices Profit center typical contains revenue and cost

centers


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Profit Centers: Evaluation

• How should we evaluate a profit center? Budgeted vs. actual profits

Baseline is master budget as manager responsible for output as well

Non-financials are more strategic in nature

• Issues to consider include: If system encourages local profit maximization as

opposed to firm-wide profit maximization? How to price transfers across profit centers?


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Investment Centers

• Aim to maximize the returns from invested capital, or to put the capital invested by owners and shareholders of their organizations to the most profitable use. Large independent divisions in organizations such as Sony,

Siemens, Microsoft, and Proctor and Gamble. Decision rights

• What decisions can managers make? Input mix, product mix, selling prices, capital expenditures

• How should we evaluate them? Financials focus on Investment performance

Return on Investment, Residual Income, Economic Value Added

Non-financial measures less important Focus on strategy implementation and long-term potential


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Performance Evaluation

• The controllability principle Focus on costs and benefits that reflect the

consequences of the actions taken by the decision maker.

Sales for marketing manager Costs and quality for production manager

• The informativeness condition A performance measure is informative if it provides

information about a manager’s effort, even if the manager does not have control over it

Helps to filter out the noise between effort and the outcome measure

Leads to relative performance evaluation Grading on a curve (you cannot control the class average!)

LO2: Apply the principles of performance measurementLO2: Apply the principles of performance measurement

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Choosing A Performance Measure

• Involves many related decisions How to reflect decision rights assigned to the

responsibility center being evaluated? What is right time horizon to consider?

How do define the measure?

Is investment measured at gross or net book value, at replacement cost?

• Implementation requires more choices What is the target level of performance?

What is the timing of feedback?


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Effective Measures

• An effective measure Aligns employee and organizational goals. Yields maximum information about the decisions or

actions of the individual or organizational unit. Is easy to measure. Is easy to understand and communicate

• No single measure has all of these characteristics Rely on multiple measures Financial and non-financial Portfolio approach


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Evaluating Cost Centers

• Short term measures Focus is on efficiency Non-financial measures for operational control

Real time, actionable, disaggregate Variances

Financial impact Trends and patterns

• Long term measures Focus is on effectiveness Trend in efficiency

Kaizen Investments in future

Training

LO3: Rate the performance of cost and profit centersLO3: Rate the performance of cost and profit centers

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Measuring Profit Centers

• Short-term Less reliance on non-financial measures Budget- actual comparison

More macro than cost center comparison Variances for spotting trends and patterns

• Long-term Growth measures

Sales, profit and efficiency Drivers of future profitability

Non-financial measures

LO3: Rate the performance of cost and profit centersLO3: Rate the performance of cost and profit centers

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Measuring Investment Centers

• Three widely used metrics Return on Investment (and variants)

Residual Income

Economic Value Added

LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters

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Return on Investment (ROI)

• ROI = Income/Investment

• We find many variations of the above formula Income definitions typically used

Operating income, Net Income

Investment definitions typically used Total assets, total assets - current liabilities

We will use total assets and operating income

• The best metric depends on the purpose at hand Operating income best suited for performance

evaluation


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Sample ROI Calculations


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ROI: Evaluation

• Advantages Effective summary measure Size independent (can compare across divisions) Can decompose ROI into smaller pieces

• Criticism Can foster underinvestment Favors older divisions because of their smaller asset

base


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ROI: Measurement

• We can measure assets at several levels

• In general, Match the definition in the numerator and denominator Use the measure best suited for decision at hand

Use exit cost for whether to stay in business!


Net book value Most popular

Gross book value Removes effects of age

Replacement value

Conceptually sound, hard to measure

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$7,000,000

($7,150,000 + $6,850,000) / 2 = $7,000,00011

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($1,100,000 + $1,300,000) / 2 = $1,200,000

$7,000,000 + $1,200,000 = $8,200,000

$7,150,000 + $250,000 - $6,850,000 = $550,000

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$7,000,00022$8,200,00033

44 $550,000

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ROI: Decomposition• DuPont Method

• ROI = Investment turnover * Return on sales Investment turnover = Revenues/Investment Return on sales = Income/Revenues

• This analysis helps to identify the source of the profit Must be in line with business strategy Suggests corrective action


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$6,400,000 / $8,000,000 = 0.8011

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$800,000 / $6,400,000 = .125

Profit margin x asset turnover = 0.80 x .125 = 10%

112233

0.80.12510%

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Managing ROI


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a) decrease sales.

b) decrease profits.

c) increase costs.

d) decrease operating assets.

Test Your Knowledge!When a company is attempting to increase return on investment (ROI) it should work to:

Decreasing operating assets will cause return on investment to improve if other relevant

factors remain constant.

Decreasing operating assets will cause return on investment to improve if other relevant

factors remain constant.

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Residual Income (RI)• Residual Income (RI)

RI = Income - (Required rate of return * Investment)

Definition of income and investment same as under ROI

Required rate of return is the opportunity cost of capital to the company

• RI is a measure of “additional” value of the project than what is expected

• RI is a size sensitive measure -- bigger projects with the same ROI may show a greater RI than smaller projects


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Calculating RI

• RI has similar measurement issues Still have to define income and investment Still have to pick measurement basis (gross / net)

for assets


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Residual Income: Evaluation• Advantages

Avoids underinvestment problem present with ROI (Will explore in a few slides)

Intuitive economic interpretation

• Disadvantages Size dependent (larger divisions have larger RI) Depends on rate used

Income Investment RI (at 14%) RI (at 16%)

Division A $18,000 $100,000 $4,000 $2,000

Division B $160,000 $1,000,000 $20,000 $0


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Comparing ROI and RI

• RI is size dependent but ROI is not Can lead to conflicting rankings

• But, RI is conceptually superior because it is claimed to lead to better project selection

Income Investment ROI RI (at 14%)

Division A $18,000 $100,000 18% $4,000

Division B $160,000 $1,000,000 16% $20,000


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Project Evaluation: ROI Vs. Ri


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Economic Value Added (EVA)• A variation of the residual income concept involving

more “careful” calculations

• EVA = NOPAT - (WACC [Total assets - NIBCL]) NOPAT = Net operating income after taxes WACC = Weighted average cost of capital NIBCL = Non-interest bearing current liabilities

• Various adjustments to GAAP to derive economic income GAAP requires treatment of some items such as R&D

expenditures, failed exploration attempts, goodwill that are “inconsistent” with these items being “investments”

Detailed EVA calculations will be covered in an elective class


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EVA Evaluation

• Advantages Presents true economic picture

Provides managers with information about cost of capital used in their business

Specifies what to measure and how to measure

• Disadvantages More complex calculations as it requires numerous

adjustments to GAAP income statements While used by many firms, not as popular as ROI


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Choosing Time Horizons• ROI, RI, and EVA calculations are for a single time

period (one year) Many companies use annual bonus plans based on

such measures

• Could promote investment myopia Investments may hurt these measures in the short

run because benefits realize only in the future years

• Using NPV analysis to make investment decisions is consistent with using multi-year RI to evaluate managers’ performances


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What Is A Transfer Price?

• Divisions transact with each other Vertical integration Synergy in operations

• Transfer price is a internal price for such transactions No cash changes hands

LO5: Describe transfer pricingLO5: Describe transfer pricing

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Demand For Transfer Prices

• Computing product cost

• Determine divisional profit and provide economic signal for Resource allocation Performance evaluation (support decentralization) Value due to minority shareholders

• Calculate taxes payable in different jurisdictions

• Roles often conflict


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$1,405,600 – [0.18 ($10,450,000 - $245,000)] = ($431,300)11

22 $756,000 – [0.18 ($2,500,000 - $650,000)] = $243,000

11 22($431,300) $243,000

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Accounting Treatment


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Conflict In Transfer Pricing

• Cooperation among divisions Increase “surplus”

Maximize corporate profit Sum of divisional profits

• Competition among divisions Dividing surplus is “zero sum”

Focus on divisional profit maximization

• Theoretical solution can be derived (see appendix) but is not practically feasible


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Practical Solutions

• Market-based transfer pricing Price in the intermediate product market

• Cost-based transfer pricing Variable cost-based transfer price

Unit variable cost plus a markup

Full-cost based transfer price Full cost plus a markup

• Negotiated transfer price


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Usage Patterns

• Market based prices Preferred when available

30-50%

• Cost based prices Full cost is common

25-50%

• Negotiated prices Usually market or cost is the starting point for

negotiations


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International Transfer Prices

• Corporate tax planning affects where to recognize income

• Incentives can also arise because of Competitive reasons

Subsidies

Regulatory reasons

Restrictions on capital flow

• Tax planning incentives can override other issues (e.g., providing best economic signals) when setting transfer price


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Rules & Regulations

• Governments recognize corporate incentives\

• Impose extensive rules and regulations on what is allowed Could impose sanctions

Penalty for dumping Tariffs

• Setting transfer prices to optimize the various tensions is a very difficult exercise


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Intervention

• Game playing means profitable transfers might not take place Sub-optimization

• Should HO intervene? Feasibility is an issue

Need detailed information about operations

Gains surplus by forcing transaction Undercuts benefits due to decentralization


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TRANSFER PRICING

Appendix

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Acceptable Transfer Prices

• Selling Division Value = TP - Controllable cost

Value ≥ Opportunity cost TPMIN = Controllable cost + Opportunity cost

• Buying division TPMAX = Opportunity cost

AppendixAppendix

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Three Cases• TPMAX = TPMIN

No surplus from transfer Corporate does not care

At the one agreeable price, divisional profit the same with or without transfer

Competitive market for transferred item

Congruence between divisional and corporate objectives

• TPMAX < TPMIN

Negative surplus from transfer Corporate does not want transfer

Divisions cannot agree on price Congruence between divisional and corporate

objectives!

AppendixAppendix

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• TPMAX >TPMIN

Surplus from transfer Surplus = TPMAX – TPMIN

• There is a price at which both divisions are willing to voluntarily enter transaction Congruence between divisional and corporate

objectives

AppendixAppendix

Three Cases

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For the chip division, the contribution margin from an external sale =

$18.00 per chip and the controllable cost = $12.50 per chip. Thus,

TPMIN = $12.50 + $18.00 = $30.50 per chip. For the phone division,

TPMAX is still $32 = $52 total variable cost of buying externally - $20

variable phone cost of buying internally. Thus, the range of

acceptable transfer prices is $30.50 to $32.00. If the transfer price is

set anywhere in this range, the company as a whole saves $1.50 for

every chip that is internally transferred.

For the chip division, the contribution margin from an external sale =

$18.00 per chip and the controllable cost = $12.50 per chip. Thus,

TPMIN = $12.50 + $18.00 = $30.50 per chip. For the phone division,

TPMAX is still $32 = $52 total variable cost of buying externally - $20

variable phone cost of buying internally. Thus, the range of

acceptable transfer prices is $30.50 to $32.00. If the transfer price is

set anywhere in this range, the company as a whole saves $1.50 for

every chip that is internally transferred.

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Responsibility accounting (LO1, LO2)Karl Krader oversees a staff of over 200 persons and a budget of close to a million dollars per year. He is responsible for the upkeep of all buildings and equipment at a large university. However, any reconstruction project is budgeted and administered separately. Karl’s responsibilities include selection and evaluation of personnel, negotiating with suppliers, choosing the kinds of landscaping, and so on. Karl’s services, however, are

Required:a) Should Karl be evaluated as a profit center or a cost

center?

b) How should the university evaluate Karl’s performance?

Exercise 12.31

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Exercise 12.31 (Continued)a) Should Karl be evaluated as a profit center or a cost

center?

We believe that Karl should be evaluated as a cost center. While he provides a useful and visible service, there is no direct impact on revenue. Further, he does not influence prices or determine the level of output. His job is to keep up the buildings to specified

quality levels within allowed costs. This is a central characteristic of a cost center.

We believe that Karl should be evaluated as a cost center. While he provides a useful and visible service, there is no direct impact on revenue. Further, he does not influence prices or determine the level of output. His job is to keep up the buildings to specified

quality levels within allowed costs. This is a central characteristic of a cost center.

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Exercise 12.31 (Concluded)b) How should the university evaluate Karl’s performance?

The university should use a mix of financial and non-financial measures. Relying on financial measures alone is not advisable

because Karl can always postpone maintenance to come in below budgeted expenditures. However, we do need to make sure that the budget is not over-spent by a lot. Non-financial measures such as time to respond to complaints and general score on upkeep seem

useful as a way to make sure that Karl is providing the desired service quality.

The university should use a mix of financial and non-financial measures. Relying on financial measures alone is not advisable

because Karl can always postpone maintenance to come in below budgeted expenditures. However, we do need to make sure that the budget is not over-spent by a lot. Non-financial measures such as time to respond to complaints and general score on upkeep seem

useful as a way to make sure that Karl is providing the desired service quality.

1. 2 decentralization lo1: explain costs and benefits of decentralization practice of delegating...

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