horngren_ima16_stppt10.ppt

Chapter 10
Management Control
in Decentralized Organizations

Chapter 10 Learning Objectives
1. Define decentralization and identify its expected
benefits and costs.
2. Distinguish between responsibility centers and
decentralization.
3. Explain how the linking of rewards to responsibility-
center performance metrics affects incentives and risk.
4. Compute return on investment (ROI), economic profit,
and economic value added (EVA).

Chapter 10 Learning Objectives
5. Compare the incentives created by income, ROI, and
economic profit (or EVA) performance measures.
6. Define transfer prices and identify their purpose.
7. State the general rule for transfer pricing and use it to
assess transfer prices based on total costs, variable costs,
and market prices.
8. Identify the factors affecting multinational transfer
prices.
9. Explain how controllability and management by
objectives (MBO) aid the implementation of management
control systems.

Decentralization
The delegation of freedom to make
decisions is called decentralization.
The process by which decision making is
concentrated within a particular location
or group is called centralization.
Learning
Objective 1
The process by which decision making is
concentrated within a particular location
or group is called centralization.

Costs and Benefits
Benefits of decentralization:
Lower-level managers have the best
information concerning local conditions.
It promotes management skills which,
in turn, helps ensure leadership continuity.
Managers enjoy higher status from being
independent and thus are better motivated.

Costs and Benefits
Costs of decentralization:
Managers may make decisions that are
not in the organization’s best interests.
Managers also tend to duplicate services
that might be less expensive if centralized.
Costs of accumulating and processing
information frequently rise.

Middle Ground
Many companies find that decentralization
works best in part of the company, while
centralization works better in other parts.
Decentralization is most successful
when an organization’s segments are
relatively independent of one another.

Segment Autonomy
If management has decided in favor of heavy
decentralization, segment autonomy, the
delegation of decision-making power to managers
of segments of an organization, is also crucial.
For decentralization to work, autonomy must be
real, not just “lip service.” Top managers must
be willing to abide by decisions made by
segment managers in most circumstances.

Responsibility Centers
and Decentralization
Design of a management control system should
consider two separate dimensions of control:
Responsibilities
1
Autonomy
2
Learning
Objective 2

Profit centers Cost Centers
Will a profit center or a cost center better
solve the problems of goal congruence and
management effort?
In designing accounting control systems, top
managers must consider the system’s impact
on behavior desired by the organization.

The management control system should
be designed to achieve the best possible
alignment between local manager decisions
and the actions central management seeks.
For example, a plant may seem to be a
“natural” cost center because the plant manager
has no influence over decisions
concerning the marketing of its products.

Performance Metrics and
Management Controls
Learning
Objective 3
Incentives are the rewards, both
implicit and explicit, for managerial
effort and actions.
Linking rewards to responsibility-
center performance metrics affects
incentives and risk.
A performance metric is a specific
measure of management
accomplishment.

Motivation, Performance, and Rewards
Incentives. . .
Performance-based rewards that
enhance managerial effort toward
organizational goals.
Rewards
Motivational
Criteria

Motivation, Performance, and Rewards
You get what you measure!
Therefore, accounting measures,
which provide relatively objective
evaluations of performance,
are important.

Management Controls
The design of a management control system
affects the actions of managers. It specifies
how outcomes translate into unit performance
metrics and into both explicit and implicit
rewards.

Management Controls
Agency theory provides a model to analyze
relationships where one party (the principal)
delegates decision-making authority to another
party (the agent).
Agency theory is useful to analyze situations
where there is imperfect alignment between
the principal’s and agent’s
1) Information and
2) Objectives.

Agency Theory, Performance,
Rewards, and Risks
Agency theory deals with contracting between
an organization and the managers that it hires
to make decisions on its behalf.
Incentive Risk
Cost of measuring
performance

Measures of Profitability
Measures of income are readily available from
the financial reporting system at any level of
the organization for which a company can
identify revenues and expenses.
Accountants can easily customize income
measures such as income before interest and
taxes (EBIT) or earnings before interest,
taxes, depreciation, and amortization (EBITDA).
Learning
Objective 4

Return on Investment
ROI is the product of two items:
ROI =
Income
Revenue
×
Revenue
Investment
A more comprehensive measure of profitability
that takes into account the investment
required to generate income is the return on
investment (ROI).
Return on
sales AND
Capital
turnover

Valuation of Assets
Should values be based on gross book value
(original cost) or net book value (original
cost less accumulated depreciation).
Practice is overwhelmingly in favor of using
net book value based on historical cost.
Most companies use net book value in
calculating their investment base.

Valuation of Assets
Asset values: beginning, ending, or average
If investment does not change throughout
the year, it will not matter whether assets
are measured at the beginning, the end,
or average for the year.
If investment changes throughout the year,
we should measure invested capital
as an average for the period.

Valuation of Assets
Because income is a flow of resources over
a period of time, and a company should
measure the effect of the flow on the
average amount invested.
The most accurate measures of average
investment take into account the amount
invested month-by-month, or even
day-by-day.

Capital charge is the cost of capital
multiplied by the amount of investment.
Economic Profit (Residual Income)
RI tells you how much a company’s
after-tax operating income exceeds
what it is paying for capital.
RI is defined as after-tax net operating
income less a capital charge.

Economic Value Added
Economic value added (EVA) =
adjusted NOPAT – (weighted average cost of
capital × adjusted average invested capital)
Net operating profit after-tax (NOPAT)
is income before interest expense but
after tax.

Incentives from Income,
ROI, or Economic Profit
Why do some companies prefer
economic profit (or EVA) to ROI?
ROI can motivate segment managers to make
investment decisions that are not in the best
interests of the company as a whole.
Economic profit (or EVA) motivate managers to
invest only in projects earning more than the
cost of capital because only those projects
increase the division’s economic profit.
Learning
Objective 5

Invested Capital
To apply either ROI or residual income,
both income and invested capital
must be measured and defined.
 Total assets
 Total assets employed
 Total assets less current liabilities
 Stockholders’ equity

Transfer Prices
The price that one segment charges another
segment of the same organization for a
product or service is a transfer price.
Learning
Objective 6
When one segment of a company produces
and sells an item to another segment,
a transfer price is required.
The transfer price is revenue to the producing
company and cost to the acquiring segment.

Purpose of Transfer Pricing
Transfer prices should guide managers
to make the best possible decisions
regarding whether to buy or sell products
inside or outside of the company.
A company wants profitability metrics that
reward the segment manager for decisions
that increase both a segment’s profitability
and the profitability of the entire company.

General Rule
Transfer price = Outlay cost + Opportunity cost
Outlay costs require a cash disbursement.
They are essentially the additional amount the
producing segment must pay to produce the
product or service.
Opportunity cost is the contribution to profit
that the producing segment forgoes by
transferring the item internally.
Learning
Objective 7

Transfer-Pricing Systems
Popular transfer-pricing systems:
1. Market-based transfer prices
2. Cost-based transfer prices
a. Variable cost
b. Full cost (possibly plus profit)
3. Negotiated transfer prices
Transfer-pricing systems have multiple
goals. The general rule provides a good
benchmark by which to judge transfer
pricing systems.

Market-Based Transfer Prices
If there is a competitive market for the product
or service being transferred internally, using
the market price as a transfer price will
generally lead to goal congruence . . .
. . . because the market price equals the
variable cost plus opportunity cost.
If a market price exists, use it.
Sometimes market prices are not always
available for items transferred internally.

Market-Based Transfer Prices -
Drawbacks
Cost-based transfer prices are
easy to understand and use.
When market prices don’t exist, companies
resort to cost-based transfer prices.
Cost-based transfer prices lead to
dysfunctional decisions - decisions in
conflict with the company’s goals.

Full-Cost Pricing
This transfer pricing system includes not only
variable cost but also an allocation of fixed
costs (and, if included, the profit mark-up.)
It is implicitly assumed that the allocation
is a good approximation of the opportunity cost.
Dysfunctional decisions arise with full-cost
transfer prices when the selling segment has
opportunity costs that differ significantly from
the allocation of fixed costs and profit.

Variable-Cost Pricing
This transfer pricing system is
most appropriate when the
selling division forgoes no
opportunity when it transfers
the item internally.
Variable-cost transfer prices cause
dysfunctional decisions when the
selling segment has significant
opportunity costs.

Negotiated Transfer Prices
Companies heavily committed to segment
autonomy often allow managers
to negotiate transfer prices.
Critics of negotiated prices focus on the
time and effort spent negotiating, an activity
that adds nothing directly to the profits
of the company.
Open negotiation allows the managers to
make optimal decisions.

Multinational Transfer Pricing
Multinational companies use transfer
pricing to minimize their worldwide
taxes, duties, and tariffs.
Divisions in a high-income-tax-rate country
produce components for another division in a
low-income-tax-rate country. A low transfer
price would allow the company to recognize
most of the profit in the low-income-tax-rate
country, thereby minimizing taxes.
Learning
Objective 8

Multinational Transfer Pricing Example
U.S. multinationals must follow an Internal
Revenue Code rule specifying that transfers
be priced at “arm’s-length” market values,
or at the price one division would pay another
if they were independent companies.
Tax authorities also recognize the incentive
to set transfer prices to minimize taxes and
import duties. Therefore, most countries
have restrictions on allowable transfer prices.

A high-end running shoe produced by an Irish
Nike division with a 12% income tax rate.
It is transferred to a division in
Germany with a 40% income tax rate.
An import duty equal to 20% of the
price of the item is imposed by Germany.
Full unit cost is $100, and variable cost is
$60 (either transfer price could be chosen).

Income of the Irish division is $40 higher:
12% × $40 = ($4.80) higher taxes
Income of the German division is $40 lower:
40% × $40 = $16 lower taxes
Import duty paid by German division:
20% × $40 = ($8)
Net savings = $3.20

Management by Objectives
MBO describes the joint formulation by
a manager and his or her superior of a
set of goals and plans for achieving
the goals for a forthcoming period.
The manager’s performance is then
evaluated in relation to these
agreed-upon budgeted objectives.
Learning
Objective 9

Budgets, Performance Targets, and Ethics
Many of the troublesome motivational
effects of performance evaluation
systems can be minimized by
the astute use of budgets.
The desirability of tailoring a budget
to particular managers cannot
be overemphasized.

Budgets, Performance Targets, and Ethics
Using budgets as performance
targets also has its danger.
Companies that make meeting
a budget too important can
motivate unethical behavior.

All rights reserved. No part of this publication
may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.

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