1.
Describe the structure and management
of decentralized organizations and
evaluate the benefits and drawbacks of
decentralization.
2. Evaluate how responsibility accounting is
used to help manage a decentralized
organization.
3. Define cost, revenue, profit, and
investment centers and explain why
managers of each must be evaluated
differently.
4. Compute and interpret segment
margin in an organization.
5. Compute, interpret, and compare
return on investment (ROI) and
residual income.
6. Transfer pricing
Introduction
• The challenge for companies is to
find tools that allow the evaluation
of managers at all levels in the
organization.
• One way to do this and react more
quickly to changing market
conditions is through a decentralized
structure.
Management of Decentralized
Organizations
Most organizations are decentralized to some degree,
but this varies between organizations.
Greatest Least
Decentralization Decentralization
Most firms fall in the middle
with a tendency toward
decentralization.
The Decentralized Spectrum
Benefits to Decentralization
(1) Decisions are
(2) Top management
made at the lowest
has more time to
level by managers
devote to long-range
most familiar with
decisions.
the problem.
(3) Managers have (4) Greater decision
higher job responsibility and
satisfaction in experience is given
decentralized to early career
environments. managers.
(5) Decisions are
made in a more
timely manner.
Drawbacks to Decentralization
(1) Decisions are
(2) Early stage
spread among too
managers may not
many managers
be adequately
causing a lack of
trained.
focus.
(3) There may be a (4) Decentralization
lack of coordination may make it difficult
and communication to share unique and
between segments. innovative ideas.
(5) Decentralization
may duplicate
efforts and costs.
Responsibility Accounting
and Segment Reporting
The key to effective decision making in a
decentralized organization is responsibility
accounting.
This means holding managers responsible for
only those things under their control.
Responsibility Levels at
Cost, Revenue, Profit, and
Investment Centers
To enhance the use of responsibility accounting for
decision making, organizations typically identify the
different segments, or levels of responsibility, as cost,
revenue, profit, or investment centers and attach
different levels of responsibility to each segment.
A Cost Center
A cost center manager has control over costs but
not over revenue or capital investment
(long-term purchasing) decisions.
Performance reports typically focus on
differences between budgeted and actual
costs using variance analysis.
Examples: Human
Purchasing Maintenance resources
manager of a manager in a manager of a
store hotel CPA firm
A Revenue Center
A revenue center manager has control over the
generation of revenue but not costs.
Performance reports of a revenue center often
focus on sales price variances.
Examples:
Sales
Sales Reservation
department of
manager of a a production department of
retail store an airline
facility
A Profit Center
A profit center manager has control over both
cost and revenue but not capital investment
decisions.
Performance reports typically focus on income
measures, such as the overall flexible budget
variance or segment margins.
Examples: Partner
Manager of an
Overall in-charge of
entire product
manager of a the tax
line in a
retail store department of
factory
a CPA firm
An Investment Center
An investment center is a separate business with
its own value chain, commonly referred to as
strategic business units (SBUs).
Investment center managers can be evaluated
similar to profit centers, but tools are adjusted
for the assets or investments they also control.
Corporate
Core division
Examples: headquarters
manager of an
in a large
international
decentralized
company
organization
Profit Center Performance and
Segmented Income Statements
Segmented income statements calculate income for each
major segment of an organization in addition to the
company as a whole.
Variable costs are traced directly to a segment, since
they vary in direct proportion to sales volume and
can be allocated to a segment on that basis.
Fixed costs that can be easily and conveniently
traced to a segment should be assigned to that
segment. Common costs (benefiting multiple
segments) are not allocated for performance
evaluation purposes.
A Good Test
• A good test for deciding
???
whether to allocate
indirect fixed costs is to
determine whether the
cost would be reduced or
eliminated if the segment
were eliminated.
• If the cost cannot be
reduced or eliminated, it is
referred to as a common
cost.
Application of Common Costs in
Practice
• In practice, companies sometimes allocate common
costs from headquarters to segments without using
them for evaluation purposes.
• This practice has the advantage of making the
segment manager aware that the cost is being
incurred and that the cost must ultimately be paid
for by revenue generated by the segment.
If other indirect costs are to be allocated to segments,
there should be sufficient causal relationships between
the costs and the segments. Arbitrary allocations may
lead to less-than-optimal decisions about a segment.
Segmented Income Statement
Segmented Income Statement
This format (1) The contribution (2) Segment margin is a
margin is primarily a measure of long-term
has the
measure of short-run profitability and is more
following profitability, as it appropriate in addressing
advantages: ignores fixed costs (for long-term decisions, such
CVP and special order as whether to drop
analyses). product lines.
Investment Centers and
Measures of Performance
• Investment center managers can make
capital purchasing decisions, including
decisions like expanding facilities.
• Investment centers are typically major
divisions of a company involved in all
aspects of the value chain.
• Evaluating investment centers requires
focusing on the level of investment
needed to generate a segment’s profit.
• Performance reports focus on return on
investment and residual income.
Return on Investment
Return on investment (ROI) measures
the rate of return generated by an investment
center’s assets.
The calculation of ROI is generally broken
down into two components—a measure of
operating performance (called margin) and
a measure of how effectively assets are used
during a period (called asset turnover).
Return on Investment Formulas
ROI = Margin X Turnover
Margin = Net operating income
Sales
Turnover = Sales
Average operating assets
Return on Investment – The
Numerator
• Net operating income is a measure of
operating performance and is defined
as income before interest and taxes.
• Interest and taxes are typically
omitted from the measure of income
in the ROI calculation because they
may not be controllable by the
manager of the segment being
evaluated.
Return on Investment – The
Denominator
• The most common measure of
investment is average operating
assets (an average of beginning and
end-of-period numbers).
• Operating assets typically include
cash, accounts receivable, inventory,
and the property, plant, and
equipment needed to operate a
business.
Residual Income
• As an alternative to ROI, the manager of an
investment center can be evaluated on the basis
of the residual income generated by the
investment center.
• Residual income is the amount of income
earned in excess of a predetermined minimum
rate of return on assets.
• All other things being equal, the higher the
residual income of an investment center, the
better.
ROI versus Residual Income
In some cases, evaluating the
performance of an investment
center and its manager
using ROI can cause problems.
If the current ROI at a facility is 25%
and a manager is evaluated on the
basis of the location’s ROI, he may
reject potential projects or
investments that would be profitable
but lower the location’s overall ROI.
Using Residual Income
avoids this problem.
Problems with Residual Income
Since Residual Income is an absolute measure, it should
not be used to compare the performance of investment
centers of different sizes.
Residual income is
Since ROI is
more useful as a
independent of size,
performance
it is better suited as a
measure for a
comparative
single investment
measure.
center.
Responsibility Centers Located in
More than One Country
Decentralization at the local level offers advantages to
multinational companies facing the following factors in
various countries:
• Economic Factors, like the stability of the economy,
local currency strength, and inflation.
• Legal and Political Factors, like the degree of
government control and regulation of business.
• Educational Factors, like a trained workforce.
• Cultural Factors, like the attitude toward authority,
work ethic, and commitment to employer by employees.
Basis for transfer price
• COST BASE TRANSFER PRICE
Variable cost
Full cost
Full absorption cost
Cost-plus
MARKET PRICE
NEGOTIATED TRANSFER PRICE
ARBITRARY PRICE
DUAL PRICE
EXAMPLE
Consider the following data in analyzing possible transfer prices
of part 23R4 between division A (Selling division) and Division B
(buying division) of cool corporation:
Selling price of outside supplier 50
Costs of internal production:
Direct materials 20
Direct labor 20
Variable overhead 4
Fixed overhead 8
Required: Determine the effect to the profit or loss of Division A, Division B, and
Cool corporation under the following possible transfer prices (TP):
5.1 Market price
5.2 Cost-based price
5.3 Negotiated price of 47
5.4 Dual pricing
Solution Guide
Market price
Division A Division B Cool Corp (Parent)
Transfer price 50 Transfer price 50 Transfer price 50
-Cost 44 -Cost 50 -Cost 44
Profit 6 Profit 0 Profit 6
Cost base price
Division A Division B Cool Corp (Parent)
Transfer price 44 Transfer price 50 Transfer price 50
-Cost 44 -Cost 44 -Cost 44
Profit 0 Profit 6 Profit 6
Negotiated price
Division A Division B Cool Corp (Parent)
Transfer price 47 Transfer price 50 Transfer price 50
-Cost 44 -Cost 47 -Cost 44
Profit 3 Profit 3 Profit 6
Dual Pricing
Division A Division B Cool Corp (Parent)
Transfer price 50 Transfer price 50 Transfer price 50
-Cost 44 -Cost 44 -Cost 44
Profit 6 Profit 6 Profit 6
