LECTURE OUTLINE 2

4.0 MODULE 2 - MANAGEMENT CONTROL IN DECENTRALIZED

ORGANIZATIONS

Horgren – Chapter 10

Hansen,Mowen -– Chapter 10

Colin Drury –- Chapter 20 -21

4.1 Describe the organization structure in which transfer pricing may be required.

Definitionof decentralization: The delegation of freedom to make decisions. The lower in an organization freedom exists the greated the degree of decentralization.

Advantages of decentralization:

  • Faster response to situations
  • Wiser use of management’s time
  • Reduction of problems to manageable size
  • Training, evaluation and motivation of local managers

Disadvantages

  • Local managers make decisions that are not congruent with organizations’ goals
  • Cost of monitoring performance
  • Time wasting negotiating with other divisions
  • Duplication of resources

Decentralization is more popular in profit seeking organizations than in non- profit organizations

Segment autonomy–the delegation of decision making powers to segment managers

Responsibility centres and decentralization

Good management control systems should consider:

  1. The responsibility of managers
  2. The amount of autonomy they have

Rewards should be linked to responsibility centers’ results:

The link:

  • Motivation
  • Rewards => Incentive
  • => Performance

Incentives are formal and informal rewards that enhance managerial effort to achieve organizations’ goals.

Agency theory: Contraction between an organization and its managers to make decisions on behalf of the organisation

Measures of profitability

Objective 5: Prepare performance reports for investment centers using the traditional measures of return on investment and residual income and the newer measure of economic value added.

11.Return on investment (ROI) is a performance measure that takes into account both operating income and the assets invested to earn that income. It is computed as follows:

Return on Investment (ROI) / = / Operating Income
Assets Invested

In this formula, assets invested are the average of the beginning and ending asset balances for the period. Return on investment can also be examined in terms of profit margin and asset turnover. Profit margin is the ratio of operating income to sales; it represents the percentage of each sales dollar that results in profit. Asset turnover is the ratio of sales to average assets invested; it indicates the productivity of assets, or the number of sales dollars generated by each dollar invested in assets. Return on investment is equal to profit margin multiplied by asset turnover:

ROI = Profit Margin × Asset Turnover

or

ROI / = / Operating Income / × / Sales / = / Operating Income
Sales / Assets Invested / Assets Invested

12.Residual income (RI) is the operating income that an investment center earns above a minimum desired return on invested assets. The formula for computing residual income is

Residual Income = Operating Income – (Desired ROI × Assets Invested)

13.Economic value added (EVA) is an indicator of performance that measures the shareholder wealth created by an investment center. A manager can improve the economic value of an investment center by increasing sales, decreasing costs, decreasing assets, or lowering the cost of capital. The cost of capital is the minimum desired rate of return on an investment. The formula for computing economic value added is as follows:

EVA / = / After-Tax Operating Income – Cost of Capital in Dollars

or

EVA / = / After-Tax Operating Income – [Cost of Capital × (Total Assets – Current Liabilities)]

Objective 6: Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.

The effectiveness of a performance management and evaluation system depends on how well it coordinates the goals of responsibility centers, managers, and the entire company. Performance can be optimized by linking goals to measurable objectives and targets and by tying appropriate compensation incentives to the achievement of those targets through performance-based pay. Cash bonuses, awards, profit-sharing plans, and stock option programs are common types of incentive compensation. Each organization’s unique circumstances will determine its correct mix of performance measures and compensation incentives. If management values the perspectives of all stakeholder groups, its performance management and evaluation system will balance and benefit all interests.

Examples see horngern 13Ed , page 431

Example 1, ROI

Division ADivision B

NI = $200,000 $150,000

Capital Invested$500,000$250,000

ROI = 40%60%

Example 2, RI

After-tax operating income = $900,000

Average Invested capital(total assets) = $10million

Cot of capital 8%

RI = $900,000 –(8% x $10m) = $900,000 – 800,000 = $100,000

Example 3, EVA

EVA is fairly close to RI (but is used for the long-run case). The operating income as well as the capital is adjusted for items such as R&D (and several others) written off which are instead capitalized.

See page 434 Horngern

Also page 436 summary problem

Problems associated with ROI, RI, EVA

  1. Definition of capital invested
  2. Asset allocation to divisions
  3. Valuation of assets
  4. Plant and equipment at gross or net

Transfer pricing

Definition

Price that one segment of an organization charges to another in the same organization

Purpose of transfer pricing

  1. To establish performance system
  2. To preserve segment autonomy
  3. To minimize taxes

Types of transfer prices

  1. Cost based prices:

-Variable cost

-Full cost (cost + profit)

- Standard cost

- ABC cost

  1. Market bases prices
  2. Negotiated transfer prices

Problems with cost based transfer prices

Using Variable cost tends to ignore opportunity costs, assumes it is “0”

Full costs - actual cost tends to encourage inefficiency i.e. passing on cost to buying division

Under cuts segment autonomy

Market based transfer prices

If there is a competitive market . market prices tends to lead to goal congruence.

A general rule for transfer pricing

Transfer price = outlay cost + opportunity cost

Often boil down to:

Transfer price = Variable cost + (Market price - variable cost)

Problems with price based transfer prices

Market prices may not be available

Market must be perfect

There may be several market prices

Create dysfunctional decisions i.e. conflict with organizational goals

Negotiated transfer prices

Autonomous managers are often permitted to negotiate prices

Negotiations however tends to waste time

Maximum and minimum transfer prices

Basic guidelines:

Maximum transfer price of buying division – the price that makes the division no worst off.

A division will not buy at a price that will cause it to make a loss

i.e. Selling price – [variable cost of division - transferred in price] - fixed cost > 0

OR

Maximum transfer = Sp – VC/per unit (of buying division) – FC per unit = maximum transfer price, but not higher than market price.

Minimum transfer price - the price that makes the selling division no worst off.

i.e. Outlay cost + opportunity cost

If there is no excess capacity then minimum price = market price see general rule above

If there is excess capacity then minimum price = outlay cost often = incremental cost often, Variable cost

Lecture Questions

See tutorial sheet question 2

Mark Jackson @2009

End of Lecture 2