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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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Typical Organization Structure
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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?
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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
LO1: Explain costs and benefits of decentralizationLO1: Explain costs and benefits of decentralization
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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?
LO2: Apply the principles of performance measurementLO2: Apply the principles of performance measurement
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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
LO2: Apply the principles of performance measurementLO2: Apply the principles of performance measurement
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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Sample ROI Calculations
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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!
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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Project Evaluation: ROI Vs. Ri
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO4: Evaluate the performance of investment LO4: Evaluate the performance of investment centerscenters
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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
LO5: Describe transfer pricingLO5: Describe transfer pricing
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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.
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