COST MANAGEMENT Accounting & Control · Explain the role of transfer pricing in a decentralized...

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

2

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.

3

Responsibility Accounting

Responsibility accounting

– measures the results of each responsibility

center

– compares those results with some measure of

expected or budgeted outcome.

4

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

5

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

6

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

7


Investment Centers

8


Investment Centers

9


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.

10

Residual income

the difference between operating income and the

minimum dollar return required on a company’s

operating assets


Investment Centers

Residual Operating Minimum rate of return= -Income Income Operating assets

11

Advantages of Residual Income


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

12

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


Investment Centers

ROI is an absolute measure of return; it

does not discourage myopic behavior

13

Economic value added (EVA)after-tax operating profit minus the total annual cost

of capital.


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

14

EVA Example


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$

15

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.


Investment Centers

16

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


Investment Centers

Average cost of capital = 11%

Capital used $10,000,000 $2,000,000

Cost of capital $1,100,000 $220,000

17

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


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

18

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.)

19



• 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

20



• 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

21



• 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.

22



• 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.

23



• 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

24

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.

25

Transfer Pricing

• A transfer pricing system should satisfy

three objectives:

– Accurate performance evaluation

– Goal congruence

– Preservation on divisional autonomy

26

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

27

Transfer Pricing

28

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.

29


• 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)

30

Negotiated transfer prices

Example 1: Avoidable Distribution Costs


31




32




33


Example 2: Excess Capacity


34


Example 2: Excess Capacity


35


• Negotiated Transfer Prices

– Disadvantages

• Time consuming

– Advantages

• Negotiation helps ensure goal congruence

• Comparable negotiating skills support motivation

and accurate performance measures

36


• 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

37


• Transfer Pricing and the MNC

– Performance evaluation

– Optimal determination of income taxes

• Shift costs to high-tax countries

• Shift revenues to low-tax countries

38


39


• 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

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

COST MANAGEMENT Accounting & Control · Explain the role of transfer pricing in a decentralized...

Documents

Transcript of COST MANAGEMENT Accounting & Control · Explain the role of transfer pricing in a decentralized...