Responsibility Accounting and Transfer Pricing Chapter Five.
COST MANAGEMENT Accounting & Control · Explain the role of transfer pricing in a decentralized...
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COST MANAGEMENTAccounting & Control
Hansen▪Mowen▪Guan
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
1
Chapter 10
Decentralization:Responsibility Accounting,
Performance Evaluation, and Transfer Pricing
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Study Objectives
1. Define responsibility accounting, and describe the four
types of responsibility centers.
2. Explain why firms choose to decentralize.
3. Compute and explain return on investment (ROI),
residual income (RI), and economic value added (EVA).
4. Discuss methods of evaluating and rewarding
managerial performance.
5. Explain the role of transfer pricing in a decentralized
firm.
6. Discuss the methods of setting transfer prices.
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Responsibility Accounting
Responsibility accounting
– measures the results of each responsibility
center
– compares those results with some measure of
expected or budgeted outcome.
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Responsibility Accounting
Types of Responsibility Centers
– Cost center: only responsible for costs
– Revenue center: only responsible for
revenues
– Profit center: responsible for both revenues
and costs
– Investment center: responsible for revenues,
costs, and investments
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Decentralization
Reasons for Decentralization
– Better access to local information
– More timely response
– Focusing of central management
– Training and evaluation of segment managers
– Motivation of segment managers
– Enhanced competition
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Return on investment (ROI)the most common measure of performance for
an investment center
ROI = Operating income ÷ Average operating assets
= (Operating income ÷ Sales) (Sales ÷ Average operating assets)
= Operating income margin Operating asset turnover
Measuring the Performance of
Investment Centers
Margin: portion of sales
available for interest, taxes
and profit
Operating income
Sales
Turnover: how productively
assets are being used to
generate sales
Sales
Average operating assets
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Measuring the Performance of
Investment Centers
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Measuring the Performance of
Investment Centers
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Measuring the Performance of
Investment Centers
Advantages of the ROI measure– Helps managers focus on the relationship between
sales, expenses and investment.
– Encourages cost efficiency.
– Discourages excessive investment in operating assets
Disadvantages of the ROI measure
– Discourages managers from investing in projects
decreasing divisional ROI but increasing profitability
of the company overall.
– Encourages managers to focus on the short-term at
the expense of the long-term.
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Residual income
the difference between operating income and the
minimum dollar return required on a company’s
operating assets
Measuring the Performance of
Investment Centers
Residual Operating Minimum rate of return= -Income Income Operating assets
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Advantages of Residual Income
Measuring the Performance of
Investment Centers
Project I
Residual income = $1,300,000 - (0.10 $10,000,000)
= $1,300,000 - $1,000,000
= $300,000
Project II
Residual income = $640,000 - (0.10 $4,000,000)
= $640,000 $400,000
= $240,000
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Division A Division B
Average operating assets $15,000,000 $2,500,000
Operating income $ 1,500,000 $ 300,000
Minimum returna 1,200,000 200,000
Residual income $ 300,000 $ 100,000
Residual returnb 2% 4%
a0.08 × Operating assets.
bResidual income divided by operating assets.
Disadvantages of Residual Income
Measuring the Performance of
Investment Centers
ROI is an absolute measure of return; it
does not discourage myopic behavior
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Economic value added (EVA)after-tax operating profit minus the total annual cost
of capital.
Measuring the Performance of
Investment Centers
After-tax
Weighted average cost of capitalEVA = operating -
Total capital employedincome
Total capital employed = capital assets
plus other expenditures meant to have a
long-term payoff
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EVA Example
Measuring the Performance of
Investment Centers
Amount Percent
After-Tax
Cost
Weighted
Cost
Mortgage bonds 2,000,000$ 13.3% 0.0480 0.006
Unsecured bonds 3,000,000 20.0% 0.0600 0.012
Common Stock 10,000,000 66.7% 0.1200 0.080
Total Sources 15,000,000$
Weighted average cost of capital 0.098
Capital employed 15,000,000$
Cost of capital 1,476,000$
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EVA Example (continued)
Furman’s EVA is:
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.
Measuring the Performance of
Investment Centers
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Behavioral Aspects of EVA
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
Measuring the Performance of
Investment Centers
Average cost of capital = 11%
Capital used $10,000,000 $2,000,000
Cost of capital $1,100,000 $220,000
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Operating income $1,000,000 $500,000
Less: Cost of capital 1,100,000 220,000
EVA $ (100,000) $280,000
Hardware Software
Division Division
Measuring the Performance of
Investment Centers
Tends to focus on long-run
Discourages myopic behavior
Behavioral Aspects of EVA
Positive EVA = wealth is being created
Negative EVA = capital is being destroyed
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Measuring and Rewarding the
Performance of Mangers
• Measuring performance in the MNC
– Evaluate the division
– Evaluate the manger
• Base on factors where control exists
• Do not evaluate on factors over which there is no
control (currency fluctuations, income taxes, etc.)
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Measuring and Rewarding the
Performance of Mangers
• MNC divisional ROIs impacted by
– International vs domestic environmental
conditions (economic, legal, political, social,
etc.)
• Multiple measures of performance for
MNC divisions
– Consider market potential and market share
– Residual income and ROI should not be the
sole measures for MNC divisions
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Measuring and Rewarding the
Performance of Mangers
• Managerial rewards
– Separation of ownership and management creates the possibility that managers may not operate the business in the best interest of the shareholders
• Managers do not exert the most productive effort for the company
• Managers may spend company resources on perquisites
– A well-structured incentive compensation system encourages goal congruence
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Measuring and Rewarding the
Performance of Mangers
• Cash compensation
– Reward good management performance by granting
periodic raises
• Become a permanent part of the compensation package
– Bonuses provide more flexibility
• Income-based compensation may encourage dysfunctional
behavior.
– A combination of salary and bonus keeps salaries
fairly level and allows bonuses to fluctuate with
reported income.
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Measuring and Rewarding the
Performance of Mangers
• Stock-based compensation
– A stock option is the right to buy a certain number of
shares of the company’s stock, at a particular price
and after a set length of time.
– Stock options are offered to managers
• They become owners (shareholders) of the company
• Ownership encourages goal congruence
– The price of the stock is usually set to approximate
market price at the time of issue.
• If the stock price rises in the future, the manager may
exercise the option.
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Measuring and Rewarding the
Performance of Mangers
• Issues to consider
– Single-measure outcomes encourage gaming behavior
– The Big Bath
– Cash bonuses and stock options encourage short-term orientation by management
• Noncash compensation
– Autonomy
– Perquisites
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Transfer Pricing
Transfer prices are the prices charged for
goods produced by one division and
transferred to another.
The price charged affects the revenues of
the transferring division and the costs of the
receiving division.
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Transfer Pricing
• A transfer pricing system should satisfy
three objectives:
– Accurate performance evaluation
– Goal congruence
– Preservation on divisional autonomy
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Transfer Pricing
Opportunity cost approach identifies
– The minimum price that a selling division
would be will to accept
Floor: leaves the selling division no worse off for
having sold to an internal division
– The maximum price that the buying division
would be willing to pay
Ceiling: leaves the buying division no worse off for
having purchased from an internal division
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Transfer Pricing
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Setting Transfer Prices
A good should be transferred internally
whenever
the opportunity cost (minimum price)
of the selling division
is less than
the opportunity cost (maximum price)
of the buying division.
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Setting Transfer Prices
• Commonly used policies
– Market price• Price in an outside, perfectly competitive, market
– Negotiated transfer prices• Agreed to only if the opportunity cost of the selling
division is less than the opportunity cost of the buying division
– Cost-based transfer prices• Variable cost
• Full (absorption cost)
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Negotiated transfer prices
Example 1: Avoidable Distribution Costs
Setting Transfer Prices
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Negotiated transfer prices
Example 1: Avoidable Distribution Costs
Setting Transfer Prices
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Negotiated transfer prices
Example 1: Avoidable Distribution Costs
Setting Transfer Prices
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Negotiated transfer prices
Example 2: Excess Capacity
Setting Transfer Prices
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Negotiated transfer prices
Example 2: Excess Capacity
Setting Transfer Prices
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Setting Transfer Prices
• Negotiated Transfer Prices
– Disadvantages
• Time consuming
– Advantages
• Negotiation helps ensure goal congruence
• Comparable negotiating skills support motivation
and accurate performance measures
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Setting Transfer Prices
• Cost-Based Transfer Prices
– Forms
• Full-cost transfer pricing
• Full cost plus markup
• Variable cost plus fixed fee
– Propriety of use
• Impact on divisional profit is negligible
• Ease of cost measurement is beneficial
• Result of negotiations
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Setting Transfer Prices
• Transfer Pricing and the MNC
– Performance evaluation
– Optimal determination of income taxes
• Shift costs to high-tax countries
• Shift revenues to low-tax countries
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Setting Transfer Prices
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Setting Transfer Prices
• IRS Code §482
– Requires arms’-length transactions
– Allowable pricing methods
• Comparable uncontrolled price method
• Resale price method
• Cost-plus method
• Negotiated between the company and the IRS
• Income taxes are universal
– Market-based transfer prices
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COST MANAGEMENTAccounting & Control
Hansen▪Mowen▪Guan
COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning.
Cengage Learning and South-Western are trademarks used herein under license.
40
End Chapter 10