Managerial Accounting - Ottawa Week 3

1. Instructor: Mary Haines, MBA, CPA

2. Organizational
Architecture
Chapter Four
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

3.  Individuals act in their own self interest
 They are limited by their own knowledge
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 Can produce more in a team than acting
alone (help each other)
 Share knowledge, etc.

4. Free-rider problem: Incentives to shirk because
individual efforts not directly observable.
Solutions: Incentive contracts, monitoring, etc.
Horizon problem: Agents expecting to leave firm in
near future place less weight on long-term
consequences.
Solutions: Incentive contracts, monitoring, etc.
Employee theft: Employees take firm resources for
unauthorized purposes.
Solutions: Buy fidelity bond, monitoring, inventory
control
Empire-building: Managers seek to manage larger
number of agents to increase their own job security or
compensation.
Solutions: Modify incentive contracts, benchmarking
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5. Adverse selection: Prior to
contracting, agents have
better private information
than principals.
Solutions: pre-contract
investigation, post-
contract penalties.
Moral hazard: After
contracting, agents have
an incentive to deviate
because the principal
cannot readily observe
deviations (hidden action
or hidden information).
Solutions: inspecting,
monitoring.
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6.  The issue of corporate jet pilots
refueling on intercontinental flights
in the middle of the country, e.g.,
Kansas or Nebraska.
 Some refuelers offer incentives to
pilots to forgo discounts in
exchange for unreported gifts such
as steaks, wine, or top-of-the-line
golf gear.
 What kind of agency problem is
this?
 What strategy would you use to
address the problem?

7. Decision rights are restrictions on how
economic assets of a firm can or cannot be
used.
Management determines how decision rights
are to be allocated among various agents
within a firm.
Alternative styles of allocating decision rights:
 Centralize (“micro-management”)
 Decentralize (employee empowerment)
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8. Some knowledge useful for decision making is
costly to acquire, store, and process.
Linking knowledge and decision rights is a key
issue for organizational architecture.
Example where knowledge and decision rights
are linked:
Machine operator schedules own machine.
Example where knowledge and decision rights
are not linked:
Sales representatives know customer’s demand curve
best, but only sales manager may approve sales price
changes. Giving pricing decision rights to representatives
could result in customer kickbacks.
4-8

9. Firms can obtain goods and
services by either:
 making within the firm, or
 buying from outside markets
(outsource).
Factors to consider in make-
versus-buy:
 Efficiency and effectiveness
 Cost of acquiring knowledge
 Contracting costs
 Monitoring costs

10. Problem: Agents spend time
and other resources trying to
influence decision makers.
Solution: Limit active decision
making by imposing
bureaucratic rules.
Example: Airlines allocate
routes to flight attendants
based on seniority  there is no
supervisor deciding who gets
which route.

11. Organizational architecture depends on 3 legs:
(1)Measure performance
(2)Reward and punish performance
(3)Partition decision rights
In external markets these functions are
served by market prices, supply and
demand, and the law of contracts.
For transactions inside the firm,
management must implement
administrative devices to accomplish these
functions.
All three legs must be balanced and
coordinated.
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12. Types of performance measures
 Objective criteria: production rate, sales, meeting
budgets and schedules
 Subjective criteria: helping others, innovation,
improving team spirit, etc.
 Financial measures: profits, costs, revenues,
inventory level, etc.
 Nonfinancial measures: quality, defects, customer
satisfaction, employee turnover, etc.
Design issues
 Determining relative weight for each measure.
 Costs to collect and analyze measures.
 Internal accounting system provides some of these
measures.
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13. Types
 Pecuniary rewards: salary, bonuses, retirement
benefits, etc.
 Nonpecuniary rewards: prestigious job titles,
better office location and furnishings, reserved
parking places, country club memberships, etc.
 Punishments: reprimands, ridicule, demotion,
termination, etc.
Design Issues
 Linked to performance measures
 External job market
 Employment and tax law
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14. Types
 Centralize decision rights with top executives
 Decentralize decision rights to lower levels
Design issues
 Board of Directors has ultimate authority
 Linking knowledge and decision rights
Self-Study Problem, “Span of Control.”
4-14

15. Steps in the decision process
1. Initiation (management)
2. Ratification (control)
3. Implementation (management)
4. Monitoring (control)
Separation of management and control
 Separation is particularly important for actions with
large impacts across many agents, such as
employee hiring, plant construction, etc.
 Hierarchical structure of organizations allocates the
decision rights over these four steps to different
managers or agents.
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16. 1. Initiation: Division managers with specialized knowledge of
production process and customers initiate construction proposal.
2. Ratification: Proposal is analyzed by specialists in finance,
marketing, human resources, real estate, and other areas. Senior
management uses all this information to decide whether to
accept, reject or modify proposal.
3. Implementation: Employees and outside agents construct
facilities.
4. Monitoring: Internal accountants prepare financial reports on
project.
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17. Accounting reports are more useful for control
(ratifying and monitoring) than for decision
management (initiation and implementation).
[Recall Chapter 4.]
Decision management requires forward-looking
opportunity costs, but accounting data is primarily
backward-looking historical results. [Recall
Chapter 2.]
Accounting also reduces some agency costs such
as employee theft and shirking. [Recall Chapter 4.]
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18.  Effective control systems require that
accounting and audit functions are
independent of the people being monitored
 Accounting data may aggregate so many
individual transactions that they are not useful
for decision making.
 But aggregate accounting data are useful for
control by averaging out random fluctuations.
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19.  Useful information for decision making, such
as product quality, customer demand, machine
performance, etc.
 Nonaccounting measures are often custom-
designed for each individual or team.
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20. Economic Darwinism implies
that seemingly irrational
accounting procedures survive
when the benefits of these
procedures exceed agency costs.
Examples:
 Average historical costs
achieved by a department are
useful for control, even
though may not be useful for
decision making
 Depreciation and other
indirect costs are allocated to
production departments to
make them use firm-wide
resources more efficiently
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21. Agency Problem: Align interests of shareholders (principals) and
top executives (agents).
(1) Measure performance: Board of Directors’ compensation
committee sets performance goals based on financial and
nonfinancial measures.
(2) Reward and punish performance: Compensation consists of base
salary and bonuses. Bonus plans may have lower and upper
limits.
(3) Partition decision rights: Directors initiate contracts.
Shareholders ratify contracts. Accountants monitor performance.
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22.  A person should not be
assigned decision rights if the
exercise of these rights cannot
be measured and rewarded.
 Is this a maxim for all seasons?
 Is this a maxim for all
environments?

23. Responsibility
Accounting and
Transfer Pricing
Chapter Five
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

24. 5-24
Characteristics of responsibility centers are:
 Knowledge of the centers’ managers is difficult to
acquire, maintain, or analyze at higher levels
 Decision rights are specified for each center
 Performance measurement is obtained from internal
accounting system
(Recall organizational architecture concepts in
Chap. 4.)
Types of responsibility centers: cost, profit,
investment.
See Table 5-1 in the textbook.

25. Knowledge:
 Central manager knows optimal production
quantity and budget
 Cost center manager knows optimal mix of
inputs
Decision rights:
 Cost center manager chooses quantity and
quality of inputs used in cost center (labor,
material, supplies)
Measurement:
 Minimize total cost for a fixed output
 Maximize output for a fixed budget
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26.  Minimizing average costs does not necessarily
maximize profits. Cost centers have an
incentive to produce more units to spread fixed
costs over a large number of units.
 Quality of products produced by cost center
must be monitored.
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27. Knowledge:
 Profit center managers’ knowledge of product
mix, demand, and pricing is difficult to transfer
to central management
Decision rights:
 Can chose input mix, product mix, and selling
prices
 Given fixed capital budget
Measurement:
 Actual profits
 Actual profits compared to budget
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28.  Setting appropriate transfer prices on goods
and services transferred within the firm
 How to allocate corporate overhead costs to
responsibility centers
 Profit centers that focus only on their own
profits often ignore how their actions affect
other responsibility centers
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29. Knowledge:
 Investment center manager has knowledge of
investment opportunities and operating
decisions
Decision rights:
 Ratify and monitor decisions of cost and profit
centers
 Decide amount of capital invested or disposed
Measurement:
 Return on Investment (ROI)
 Residual Income (RI)
 Economic Value Added (EVA)
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30. Return on Investment (ROI) =
Accounting net income for an investment center
 Total assets invested in that investment center
DuPont formula separates ROI into two components:
ROI = Sales turnover Return on sales
ROI = (Sales  Total Investment)  (Net Income  Sales)
ROI increases with smaller investments and larger profit
margins.
Focusing on ROI can cause underinvestment.
See Self Study Problem 1, part a.
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31. Residual income (RI) =
Accounting net income of investment center
 (Required rate of return  Capital invested in
that center)
 RI is determined with financial accounting
measurements of net income and capital
 Each investment center could be assigned a
different required rate of return depending on its
risk
 RI can be increased by increasing income or
decreasing investment
See Self Study Problem 1, part b.
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32. EVA is the same as residual income with
some adjustments to accounting the
reported accounting numbers.
Economic value added (EVA) =
Adjusted accounting net income of
investment center
 (Weighted average cost of capital 
Capital invested in that center)
Examples of EVA adjustments to accounting:
 Research and development (R&D) is
amortized over 5 years for EVA, but
expensed immediately for financial
accounting.
 Unamortized R&D is included in capital for
EVA, but treated is treated as an expired
cost (zero value) for financial accounting.

33.  EVA can be increased by three basic methods:
◦ Increase the efficiency of existing operations, and
thus the spread between the investment return and
the firm’s weighted average cost of capital
◦ Increase the amount of capital invested in projects
with positive spreads between investment return and
the firm’s weighted average cost of capital
◦ Withdraw capital from operations where the
investment return is less than the firm’s weighted
average cost of capital
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34. 5-34
Disputes over how to measure
income and capital.
1
Difficult to compare
investment centers of
different sizes.
2
Firm’s central management
must monitor product quality
and market niches of
investment centers to reduce
possibility for self-interested
investment center to damage
firm’s reputation.
3

35. Controllability Principle:
 Hold center managers responsible for only
those costs and decisions for which they have
authority
Drawbacks of controllability principle:
 If managers suffer no consequences from
events outside their direct control, they have
no incentive to take actions that can affect the
consequences of uncontrollable events (such as
storms, corporate income taxes, etc.)
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36.  Discuss the implications of using ROI, RI,
and/or EVA individually or in combinations as a
way to preclude “overinvestment”.
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37. Provide a solution which is
•Practical – from a
cost/effectiveness point of view,
and
•Effective – from a goal congruence
point of view
1
Be specific!
2

38. Transfer Price defined:
the internal price (or cost allocation)
charged by one segment of a firm for
a product or service supplied to
another segment of the same firm
Examples of transfer prices:
 Internal charge paid by final assembly
division for components produced by
other divisions
 Service fees to operating departments
for telecommunications,
maintenance, and services by support
services departments
 Cost allocations for central
administrative services (general
overhead allocation)

39. Transfer prices have multiple effects on firm
value:
Performance measurement:
 Reallocate total company profits among business
segments
 Influence decision making by purchasing, production,
marketing, and investment managers
Rewards and punishments:
 Compensation for divisional managers
Partitioning decision rights:
 Disputes over determining transfer prices
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40. Ideal transfer price would be:
 Opportunity cost, or the value forgone by not
using the transferred product in its next best
alternative use
 Opportunity cost is either
◦ Variable production cost if the firm has excess
capacity
◦ Revenue available if the product is sold outside if the
firm does not have excess capacity
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41.  External market price
◦ If external markets are comparable
 Variable cost of production
◦ Exclude fixed costs which are unavoidable
 Full-cost of production
◦ Average fixed and variable cost
 Negotiated prices
◦ Depends on bargaining power of divisions
Review Self-Study Problem 2 in our textbook.
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42.  Disputes over transfer pricing occur frequently
because transfer prices influence performance
evaluation of managers
 Internal accounting data are often used to set
transfer prices, even when external market prices are
available
 Classifying costs as fixed or variable can influence
transfer prices determined by internal accounting
data
 To reduce transfer pricing disputes, firms may
reorganize by combining interdependent segments
or spinning off some segments as separate firms
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43. When products or services of a multinational firm are
transferred between segments located in countries
with different tax rates, the firm attempts to set a
transfer price that minimizes total income tax
liability.
Segment in higher tax country:
Reduce taxable income in that country by charging
high prices on imports and low prices on exports.
Segment in lower tax country:
Increase taxable income in that country by charging
low prices on imports and high prices on exports.
Government tax regulators try to reduce transfer
pricing manipulation.
5-43