10-1
HANSEN & MOWENHANSEN & MOWEN
Cost ManagementCost ManagementACCOUNTING AND CONTROLACCOUNTING AND CONTROL
10-2
Decentralization: Responsibility Accounting, Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer PricingPerformance Evaluation, and Transfer Pricing
10
10-3
Responsibility AccountingResponsibility Accounting 1
Types of Responsibility Centers
1. Cost center: only responsible for costs
2. Revenue center: only responsible for revenues
3. Profit center: responsible for both revenues and costs
4. Investment center: responsible for revenues, costs, and investments
Responsibility accounting is a system that measures the results of each responsibility center and compares those results with some measure of expected or budgeted outcome.
10-4
2DecentralizationDecentralization
Reasons for Decentralization
Better access to local information
Cognitive limitations
More timely response
Focusing of central management
Training and evaluation of segment managers
Motivation of segment managers
Enhanced competition
10-5
3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Return on investment (ROI) is 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
Margin: portion of sales available for interest,
taxes and profit
Turnover: how productively assets are being used to
generate sales
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3
Comparison of Divisional PerformanceComparison of Divisional PerformanceComparison of Divisional PerformanceComparison of Divisional Performance
Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
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3
Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)
Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
aOperating income divided by average operating assets.
bOperating income divided by sales.
cSales divided by average operating assets.
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Advantages of the ROI measure
1. Helps managers focus on the relationship between sales, expenses and investment.
2. Encourages cost efficiency.
3. Discourages excessive investment in operating assets
Disadvantages of the ROI measure
1. Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall.
2. Encourages managers to focus on the short-term at the expense of the long-term.
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:
Minimum rate of return Operating assets
Residual Income
=Operating
Income-
10-10
3Measuring the Performance Measuring the Performance of Investment Centersof 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
Advantages of Residual Income
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Add Add Add Both Maintain
Project I Project II Projects Status Quo
Operating assets $60,000,000 $54,000,000 $64,000,000 $50,000,000
Operating income $ 8,800,000 $ 8,140,000 $ 9,440,000 $ 7,500,000
Minimum return* 6,000,000 5,400,000 6,400,000 5,000,000
Residual income $ 2,800,000 $ 2,740,000 $ 3,040,000 $ 2,500,000
*0.10 Operating assets.
Preferred Preferred alternativealternative
Advantages of Residual Income (continued)
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
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
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Disadvantages of Residual Income (continued)
1. It is an absolute measure of return which make it difficult to directly compare the performance of divisions.
2. It does not discourage myopic behavior.
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.
Weighted average cost of capital Total capital
employedEVA =
After-tax operating income
-
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
After-Tax Weighted Amount Percent x Cost = Cost
Mortgage bonds $ 2,000,000 0.133 0.0480.006
Unsecured bonds 3,000,000 0.200 0.0600.012
Common stock 10,000,000 0.667 0.1200.080
Total $15,000,000
Weighted average cost of capital 0.098
EVA Example
$15,000,000 x .098 = $1,470,000$15,000,000 x .098 = $1,470,000
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
EVA Example (continued)
Furman’s EVA is calculated as follows:
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.
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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
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
10-18
Operating income $1,000,000 $500,000
Less: Cost of capital 1,100,000 220,000
EVA $ (100,000) $280,000
3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers
Hardware Software Division Division
The EVA for each division can be calculated as follows:
10-19
Tends to focus on long-run Discourages myopic behavior
Behavioral Aspects of EVA
Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers 3
10-20
Why would managers not provide good service? There are three reasons:
They may have low ability.
They may prefer not to work hard.
They may prefer to spend company resources on perquisites.
Measuring and Rewarding Measuring and Rewarding the Performance of Managersthe Performance of Managers 4
Incentive Pay for Managers
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4Measuring and Rewarding Measuring and Rewarding the Performance of Managersthe Performance of Managers
• Frequently managerial rewards include incentives tied to performance.
• The objective of managerial awards is to encourage goal congruence, so that managers will act in the best interests of the firm.
• Managerial rewards include salary increases, bonuses based on reported income, stock options, and noncash compensations.
Managerial Rewards
10-22
Good management performance may be rewarded by granting periodic raises.
Unlike periodic raises, bonuses are more flexible.
Many companies use a combination of salary and bonus to reward performance by keeping salaries fairly level and allow bonuses to fluctuate with reported income.
Cash Compensation
Measuring and Rewarding Measuring and Rewarding the Performance of Managersthe Performance of Managers 4
10-23
Stock options frequently are offered to manager to make
them part owners of the company—thus encourage
goal congruence.
Stock options frequently are offered to manager to make
them part owners of the company—thus encourage
goal congruence.
A stock option is 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.
A stock option is 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.
The price of the stock is usually set approximately at market
price at the time of issue. Then, if the stock price rises in the
future, the manager may exercise the option.
The price of the stock is usually set approximately at market
price at the time of issue. Then, if the stock price rises in the
future, the manager may exercise the option.
Stock-Based Compensation
Measuring and Rewarding Measuring and Rewarding the Performance of Managersthe Performance of Managers 4
10-24
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.
Transfer PricingTransfer Pricing 5
10-25
Transfer PricingTransfer Pricing 5
Impact of Transfer Price on Transferring Impact of Transfer Price on Transferring Divisions and the Company as a WholeDivisions and the Company as a Whole
Impact of Transfer Price on Transferring Impact of Transfer Price on Transferring Divisions and the Company as a WholeDivisions and the Company as a Whole
10-26
A transfer pricing system should satisfy three objectives:
Accurate performance evaluation Goal congruence Preservation on divisional autonomy
Setting Transfer PricesSetting Transfer Prices 6
The opportunity cost approach identifies the minimum transfer price and the maximum transfer price.
10-27
Market price
Negotiated transfer prices
Cost-based transfer prices
Variable cost
Full (absorption cost)
Setting Transfer PricesSetting Transfer Prices 6
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Setting Transfer PricesSetting Transfer Prices 6
Summary of Sales and Production DataSummary of Sales and Production DataSummary of Sales and Production DataSummary of Sales and Production Data
Example 1: Avoidable Distribution Costs
10-29
Setting Transfer PricesSetting Transfer Prices 6
Comparative Income StatementsComparative Income StatementsComparative Income StatementsComparative Income Statements
Example 1: Avoidable Distribution Costs
10-30
Setting Transfer PricesSetting Transfer Prices 6
Comparative Income Statements (continued)Comparative Income Statements (continued)Comparative Income Statements (continued)Comparative Income Statements (continued)
Example 1: Avoidable Distribution Costs
10-31
Setting Transfer PricesSetting Transfer Prices 6
Comparative StatementsComparative StatementsComparative StatementsComparative Statements
Example 2: Excess Capacity
10-32
Setting Transfer PricesSetting Transfer Prices 6
Comparative Statements (continued)Comparative Statements (continued)Comparative Statements (continued)Comparative Statements (continued)
Example 2: Excess Capacity
10-33
1. One division manager, possessing private information, may take advantage of another divisional manager.
2. Performance measures may be distorted by the negotiating skills of managers.
3. Negotiation can consume considerable time and resources.
Setting Transfer PricesSetting Transfer Prices 6
Disadvantages of Negotiated Transfer Prices
10-34
Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and
accurate performance evaluation.
Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and
accurate performance evaluation.
Setting Transfer PricesSetting Transfer Prices 6
10-35
Full-cost transfer pricing
Full cost plus markup
Variable cost per fixed fee
Propriety of use
Setting Transfer PricesSetting Transfer Prices
Disadvantages of Negotiated Transfer Prices
6
10-36
Setting Transfer PricesSetting Transfer Prices 6
Use of Transfer Pricing to Affect Income Taxes Use of Transfer Pricing to Affect Income Taxes PaidPaid
Use of Transfer Pricing to Affect Income Taxes Use of Transfer Pricing to Affect Income Taxes PaidPaid
10-37
End of End of Chapter 10Chapter 10
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