RESPONSIBILITY ACCOUNTING

CHAPTER 22 & 231

Decentralization

Decentralization is the freedom for managers at lower levels of the organization to make decisions

Autonomy is the degree of freedom to make decisions. The greater the freedom, the greater the autonomy

2

Decentralization

Lower-level decisions

often based on

better information

Top management

freed to concentrate

on strategy

Leads to gains from faster decision making

Assists management development and learning

Increases motivation of subunit managers Advantages

3

Decentralization

May be a lack of

coordination among

Autonomous managers.

Lower-level managers may make decisions

without seeing the “big picture.”

Lower-level manager’s objectives may not be

those of the organization.

May be difficult to

spread innovative ideas

in the organization.

Disadvantages

4

Responsibility centers

ResponsibilityCenter

ResponsibilityCenter

CostCenterCost

CenterProfit

CenterProfit

CenterInvestment

CenterInvestment

Center

6

Cost Center A segment whose manager has control

over costs, but not over revenues

or investment funds.

Responsibility centers

7

Profit Center A segment whose manager has control

over both costs and revenues, but no control over investment funds.

Responsibility centers

8

Investment Center A segment whose

manager has control over costs,

revenues, and investments in

operating assets.

Corporate Headquarters

Responsibility centers

Performance measurement9

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Return on investment

ROI is an accounting measure of income divided by an accounting

measure of investment

ROI = IncomeInvestment

Return on Investment (ROI)

ROI = Operating IncomeOperating Assets

Cash, Account receivables,inventories, PP&E and other operating assets

Cash, Account receivables,inventories, PP&E and other operating assets

Earnings before interest & tax (EBIT)Earnings before interest & tax (EBIT)

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Benefits of ROI . . .

Encourage managers to focus on relationships between revenue, costs and investment.

Encourage managers to fo focus on cost efficiency.

Encourage managers to focus on asset efficiency.

Increase revenue

Reduce costs

Reduce assets

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ROI = ROI = Margin Margin Turnover Turnover

Operating income Sales

Sales Operating assets×ROI =

EBIT

Revenue

Investment

$30,000

$500,000

$200,000

XYZ Inc.

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$30,000--------------$500,000

$500,000--------------$200,000

x

Return on Investment

6% 2.5x

15%=14

Increase revenue . . .

Assume that XYZ is able to increase its revenue by $600,000.

Operating income increases by $42,000. Operating assets do not change. What will be effects on ROI?

15

-------------- --------------x

Return on Investment

x

=16

Reduce costs . . .

Assume that XYZ is able to reduce its costs by $10,000.

Operating income increases by $40,000. Operating assets do not change. What will be effects on ROI?

17

-------------- --------------x

Return on Investment

x

=18

Reduce assets . . .

Assume that XYZ is able to reduce its assets from $200,000 to $125,000.

Revenue and operating income do not change.

What will be effects on ROI?

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-------------- --------------x

Return on Investment

x

=20

Criticisms of ROI

As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus.

The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%.

You have an opportunity to invest in a new project that will produce an ROI of 25%.

As division manager would you invest in this project?

Criticisms of ROI

Managers evaluated on ROImay reject profitable

investment opportunities.

Residual Income

RI = Actual Income – Required Income

= EBIT – Required rate of return x Investment

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Residual Income (RI) is the operating income that an investment center earns above the minimum

required return on its operating assets. 

Division A Division B

Investment 1,000,000 3,000,000

EBIT 200,000 450,000

Required Income

Residual Income

Return on investment

24

Required Rate of Return = 12%

Residual Income

RI cannot be used to compare the performance of different divisions of different sizes.

RI encourages managers to make profitable investments but that would be rejected by managers using ROI.

Disadvantage Advantage

25

Residual Income

Example . . .

Assume that Division A has an investment opportunity of $250,000 with the expected return rate of 16%.

The current ROI of Division A is 20%. Should the project be accepted?

Required rate of return: 12%

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Rule for investment decision making

Accept the project if RI > 0

Reject the project if RI < 0

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Expected income should belarger than minimum

required income generated from investment.

Quick Check

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?a. 25%b. 5%c. 15%d. 20%

Quick Check

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?a. $240,000b. $ 45,000c. $ 15,000d. $ 51,000

Quick Check

If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Economic Value Added (EVA)

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EVA is a specific type of residual income calculation that has recently gained popularity

Weighted average cost of capital equals the after-tax average cost of all long-term funds in use

After-tax Weighted-Average Total CurrentOperating Income Cost of Capital Assets Liabilities ) }EVA {= X (

TRANSFER PRICING

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Key Concepts/Definitions

A transfer price is the price charged when one segment of a

company provides goods or services to another segment of

the company.

The fundamental objective in setting transfer prices is to

motivate managers to act in the best interests of the overall

company.

Impact of Transfer Pricing on Divisions and the Firm as a Whole ► The price charged for the transferred good

affects both► the costs of the buying division► the revenues of the selling division

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Three Primary Approaches

There are three primary approaches to setting

transfer prices:

1. Negotiated transfer prices

2. Transfers at the cost to the selling division

3. Transfers at market price

Transfer Pricing Approaches: Market Price38

If there is a competitive outside market for the transferred product, then the best transfer price is the market price.

In such a case, divisional managers’ actions will simultaneously optimize divisional profits and firm-wide profits.

Furthermore, no division can benefit at the expense of another. In this setting, top management will not be tempted to intervene.

The market price, if available, is the best approach to transfer pricing.

Transfer Pricing Approaches: Cost-Based Transfer Prices39

Frequently, there is no good outside market price.

Since a transfer price at cost does not allow for any profit for the selling division, top management may define cost as ‘‘cost plus, ’’ which allows a certain percentage to be tacked onto the cost.

Transfer Pricing Approaches: Negotiated Transfer Prices40

This approach is particularly useful in cases with market imperfections, such as the ability of an in-house division to avoid selling and distribution costs that external market participants would have to incur.

Using a negotiated transfer price then allows the two divisions to share any cost savings resulting from avoided costs.

When should managers agree to transfer?

Upper limit is determined by the buying division.

Lower limit is determined by the selling division.

Range of Acceptable Transfer Prices

The minimum transfer price (floor): The transfer price that would leave the selling division no worse off if the good were sold to an internal division than if the good were sold to an external party.

The maximum transfer price (ceiling): The transfer price that would leave the buying division no worse off if an input were purchased from an internal division than if the same good were purchased externally.

Vinacomin Hạ Long Heritage Hotel has 100 rooms. Customers are charged at the rate of VND 400,000 per room-night. Variable cost is VND100,000 per room-night. The Hotel is running at a 100% capacity utilization rate. Thong Nhat Coal Company wants to book 10 rooms for 3 nights for its summer holiday. The rate of other similar hotels in Bai Chay also is VND 400,000 per room-night.

What is the minimum accepted price for Ha Long Heritage Hotel? What is the maximum accepted price for Thong Nhat Coal Company? Is the transfer important? If Ha Long heritage and Thong Nhat Coal agree to transfer, how to determine the transfer price?

Example42

Assume that Ha Long Heritage Hotel might avoid sale commission cost of VND 30,000 if transfer. What is the minimum accepted price for Ha Long Heritage Hotel? What is the maximum accepted price for Thong Nhat Coal Company? Should Ha Long Heritage and Thong Nhat Coal decide to transfer? If yes, what is the benefit for Vinacomin?

Example43

Assume that Ha Long Heritage Hotel is running at a 80% capacity utilisation rate. Determine a fair transfer price.

Example44

Assume that Ha Long Heritage Hotel is running at a 96% capacity utilisation rate. Determine a fair transfer price.

Example45

Highland Coffee – An Example

Coffee Division Production capactiy per month 10,000 cansVariable cost per can of coffee VND4,000 per canFixed costs per month VND700mil.Selling price of Highland Coffee on the outside market VND7,000 per can

Pho 24 DivisionPurchase price of regular brand of coffee VND6,000 per canMonthly comsumption of coffee 2,000 cans

Highland CoffeeThe selling division’s (Coffee division) lowest acceptable transfer price is

calculated as:

Variable cost Total contribution margin on lost salesper unit Number of units transferred

Transfer Price +

Transfer Price Cost of buying from outside supplier

The buying division’s (Pho 24) highest acceptable transfer price is calculated as:

Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

Transfer Price Profit to be earned per unit sold (not including the transfer price)

If an outside supplier does not exist, the highest acceptable transfer price is calculated as:

Highland Coffee

If Coffee Division has sufficient idle capacity (3,000 cans) to satisfy Pho 24’s demands (2,000 cans) without sacrificing sales to other customers, then the

lowest and highest possible transfer prices are computed as follows:

Transfer Price

Selling division’s lowest possible transfer price:

Transfer Price Cost of buying from outside supplier =Buying division’s highest possible transfer price:

Highland Coffee

If Coffee Division has no idle capacity (0 cans) and must sacrifice other customer orders (2,000 cans) to meet Pho 24’s demands (2,000 cans), then the lowest and highest possible transfer prices are computed as follows:

Transfer Price

Selling division’s lowest possible transfer price:

Transfer Price Cost of buying from outside supplier =Buying division’s highest possible transfer price:

Highland Coffee

If Coffee Division has some idle capacity (1,000 cans) and must sacrifice other customer orders (1,000 cans) to meet Pho 24’s demands (2,000 cans),

then the lowest and highest possible transfer prices are computed as follows:

Transfer Price Cost of buying from outside supplier =Buying division’s highest possible transfer price:

Selling division’s lowest possible transfer price:

Transfer Price

International Aspects of Transfer Pricing

Transfer Pricing Objectives

Domestic• Greater divisional autonomy• Greater motivation for managers• Better performance evaluation• Better goal congruence

International• Less taxes, duties, and tariffs• Less foreign exchange risks• Better competitive position• Better governmental relations

End of chapter 22&2352