Week 9

Week 9
Chapter 22
Decentralization
and Transfer Pricing
11

Big Picture
Activity-Based versus Strategic-Based Responsibility Accounting
22
Responsibility
Accounting
Financial-based
centers (Cost,
Revenue, Profit,
Investment)
Strategy-based
Responsibility accounting system translates
the strategy of the organization into
operational objectives and measures
Which one is bottom up/top down?
Activity-based
AB system adds a process perspective to the
financial perspective of the functional-based
responsibility accounting system.

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
Big Idea
- 3 -

1. Size
- Large Manufacturing (ODM)
Firm (Fortune Ltd)
- Firm with many branches
(e.g. Yunhong group), countries
(e.g. MNC)
2. Competition
- Short life cycle (e.g. customers
buy new mobile phones every 6
months)
3. Environment
uncertainty
- Volatility
1. Automation
2. Aggregate knowledge
(e.g. ability to use an aggregate
measure like accounting to
capture knowledge, measure
performance)
3. Technology
(e.g. CCTV, RFID, Bar code)
Knowledge forces
(knowledge transfer
costs)
Decentralize
Give decision authority to
managers lower in your firm so
that you can do more.
Rewards
- Incentives
- Monetary
- Non-monetary
Measurement
- Financial measures
ROI
RI
EVA
Responsibility
Centers
- Activity based
- Strategy based
Accounting based
- Cost center
- Revenue center
- Profit center
- Investment center
Control costs
(agency costs)
(E.g. ABC Ltd)
Transfer pricing
- Goal congruence
- Management effort
- Subunit Performance evaluation
- Subunit autonomy
+
-
Why decentralize?
Why use responsibility
centers?
Why use transfer
pricing?
4
Decentralization and Control
-

5
Factors that
increase
knowledge
transfer costs
Factors that
decrease
knowledge
transfer costs
If you decentralize
then you need to
have a system to
assign some
responsibility (D)
If you assign some
responsibility then
you need to measure
the performance of
that responsibility
If you assign, then
measure then you
have to give some
incentive or the (H)
in DHL won’t
happen
Agency costs are the costs
of monitoring as well as the
bad behavior (H) of
employees (agents) –
(eg gamesmanship)

6
Factors that
increase
knowledge
transfer costs
Factors that
decrease
knowledge
transfer costs
Agency costs are the costs
of monitoring as well as the
bad behavior (H) of
employees (agents) –
(eg gamesmanship)

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
7
Management Control System Responsibility Centers Case StudyThree Legged Stool Benefit and Cost

8
 May hinder coordination among strategic business units
 Can cause conflict among strategic business units
 May hinder coordination among strategic business units
 Can cause conflict among strategic business units
Drawbacks of Decentralization

Cost to Employer
Need to make managers
responsible (responsibility
center), but it costs $$$ to
monitor (measure) performance
and reward achievement.
Benefit to
Employer
minimize information
processing (minimize
knowledge transfer
Knowledge Transfer and Agency Costs Trade Off
99

10
If you decentralize
then you need to
have a system to
assign some
responsibility (D)
If you assign some
responsibility then
you need to measure
the performance of
that responsibility
If you assign, then
measure then you
have to give some
in DHL won’t
happen

1111

1212
Decentralize
Give decision authority to managers lower
in your firm so that you can do more.
Decentralize
Give decision authority to managers lower
in your firm so that you can do more.
Measurement
- ROI
- RI
- EVA
Measurement
- ROI
- RI
- EVA
Rewards
- Incentives
- Monetary
- Non-monetary
Rewards
- Incentives
- Monetary
- Non-monetary

– The Three Legged Stool and DHL Control
Problem Framework
SCENARIO Decentralization Measurement Rewards
1 √
⨯
√
2 ⨯
√ √
3 √ √
⨯

No MeasurementNo Measurement
 Scenario 1: This will result the worker notScenario 1: This will result the worker not
being motivated to put in their best effort,being motivated to put in their best effort,
as there will be an unparalleled matchas there will be an unparalleled match
between incentives and effort withoutbetween incentives and effort without
proper measurement. In addition, thereproper measurement. In addition, there
will be a lack of direction as the incentiveswill be a lack of direction as the incentives
given to employees may be seen as angiven to employees may be seen as an
impartial treatment, and affect team’simpartial treatment, and affect team’s
morale.morale.

No decentralisationNo decentralisation
 Scenario 2: They know what they shouldScenario 2: They know what they should
do, but are not given authority anddo, but are not given authority and
autonomy to do so. Although they are notautonomy to do so. Although they are not
able to make crucial decision, tightable to make crucial decision, tight
controls are in place to measure them.controls are in place to measure them.
Thus, this may result in frustration and aThus, this may result in frustration and a
lack of motivation. In addition, there willlack of motivation. In addition, there will
also be an increase in knowledge transferalso be an increase in knowledge transfer
cost as the top management may notcost as the top management may not
have access to the local environment.have access to the local environment.

No rewardNo reward
 Scenario 3: There will be a lack ofScenario 3: There will be a lack of
motivation. Even though they have themotivation. Even though they have the
autonomy to do anything, andautonomy to do anything, and
measurements of effort are in place, theymeasurements of effort are in place, they
are still going to end up with a fixed orare still going to end up with a fixed or
comparable pay. Here, there is a casecomparable pay. Here, there is a case
when incentives do not match up to thewhen incentives do not match up to the
effort put in.effort put in.

If you
decentralize then
you need to have
a system to
assign some
responsibility (D)
If you assign some
responsibility then
you need to
measure the
performance of
that responsibility
If you assign, then
measure then you
have to give some
in DHL won’t
happen

- 18 -
Financial results controls ...
Three core elements:
– Financial responsibility centers
» The apportioning of accountability for financial results within
the organization.
– Formal management processes (planning & budgeting)
» To define performance expectations and standards for
evaluating performance.
– Motivational contracts
» To define the links between results and various organizational
incentives.

If you
decentralize then
you need to have
a system to
assign some
responsibility (D)

Types of Responsibility Centers
1. Revenue center: only responsible for revenues
2. Cost center: only responsible for costs
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.
Responsibility Accounting
2020

Cost Centers-Producing and Support Departments
2121
The discretionary-cost method is
input oriented, since costs are
considered largely uncontrollable and
discretion is applied at the planning
stage.
The engineer-cost method is the
output-oriented approach since costs
are variable and therefore
“engineered,” that is, controllable
Two methods of implementing cost SBUs for
producing and support departments

2222
Administration dept’s are typical cost centers
– Discretionary cost centers
» Money is budgeted based on inputs
» E.g. number of student enrollments
– Engineered cost centers
» Focus is on improving the efficiency of the administration process
» Number of students per staff processed, or
» Cost to administer each student.
» The aim is to improve this efficiency ratio over time regardless of the size of the
input (number of enrolments).
StudentStudent
Example: Value for Money in Government Organizations

Transfer pricing
- Motivations
a)Excess capacity
b)Save Sales
expenses
Types Qualitative ExampleConditionsImpactTransfer Pricing Setting Transfer Pricing

Transfer Pricing
Goal Congruence
Performance
Evaluation
Incentives
Autonomy (KT)
- 24 -

Consumer Products
Division
Motor Products
Division
Product: Sorbet maker
-Selling Price: $ 89
-50,000 Units
-Require: Electric Motor
-Variable cost: $ 54/unit
-Fixed cost: $180,000/yr
-Additional operating
assets: $3,000,000 (ROI)
Product: Electric Motor
-Variable cost:$12/unit
-Fixed cost:$30,000/yr
-Additional operating
assets: $400,000 (ROI)
Divisional manager
performance: Minimum
required rate of return: 20% 2525

Consumer Products
Division
Motor Products
Division
$69.60
target price + 19.40
selling price = $89.00
VC $ 54.00
FC 3.60
ROI 12.00
VC $ 13.00
FC 0.60
ROI 1.60
$15.20
Solutions
2626

- 27 -
Transfer pricing ...
The price at which products or services are transferred
between profit centers within the same corporation.
– It affects the revenues of the producing profit center (PC),
the costs of the buying PC, and hence, the profits of both
entities.
Purposes
– Provide proper economic signals so that PC managers make
good economic decisions from a corporate standpoint;
– Provide information for evaluating PC performance;
– Purposely move profits between company entities / locations.
» e.g., for tax purposes, or in joint-ventures.

2828
A transfer pricing system should satisfy three objectives:
 Accurate performance evaluation
 Goal congruence
 Preservation on divisional autonomy
Setting Transfer Prices
The opportunity cost approach identifies the minimum transfer price
and the maximum transfer price.
Pareto optimal
Div managers select actions that maximize firm wide profits
Maintain decision freedom among
divisional managers

2929
Exhibit 22-3Exhibit 22-3
Criteria Market-Based Cost-Based Negotiated
Achieves goalAchieves goal
congruencecongruence
Yes, when markets are
competitive
Often, but not always Yes
MotivatesMotivates
management effortmanagement effort
Yes Yes, when based on budgeted costs;
less incentive to control costs if
transfers are based on actual costs
Yes
Useful for evaluatingUseful for evaluating
subunit performancesubunit performance
competitive
Difficult unless transfer price exceeds
full cost and even then is somewhat
arbitrary
Yes, but transfer prices are
affected by bargaining
strengths of the buying and
selling divisions
Preserves subunitPreserves subunit
autonomyautonomy
competitive
No, because it is rule-based Yes, because it is based on
negotiations between subunits
OtherOther
factorsfactors
Market may not exist, or
markets may be imperfect
or in distress
Useful for determining full cost of
products and services; easy to
implement
Bargaining and negotiations
take time and may need to be
reviewed repeatedly as
conditions change
Comparison of Transfer-Pricing Methods

General Guideline for Determining
a Minimum Transfer Price
Minimum transfer price
=
Incremental costs per unit incurred
up to the point of transfer
+
Opportunity costs per unit
to the selling division

Summary of Sales and Production Data
Example 1: Avoidable Distribution Costs
Avoidable
distribution
costs
1. What is the maximum transfer price that Games division will pay? $22, $21 or $20
2. What does each party want?
 Board Division?
 Games Division?
Printed
circuit
boards
Games division will like to
buy 91,000 circuit boards
from the board division
3131
At
Capacity

Comparative Income Statements
Example 1: Avoidable distribution costs
External Market
Printed circuit
boards $22.00
3232

Comparative Income Statements
(continued)
Example 1: Avoidable Distribution Costs
Internal
Market
Printed
circuit
boards
$21.10
Extra revenue 1.1 ($2.00
sell costs saved - $0.90
lower price) * 91,000 =
$100,100
Saving
$0.90*
91,000 =
$81,900
internal
Market
Printed
circuit
boards
$21.10
Sales = less $81,900 Costs =
less $182,000
Net saving = $100,100
3333

Comparative Statements
Example 2: Excess Capacity
1. Special order 250,000 bottles @ $0.85 per bottle less VC (aspirins) $0.60 = $0.25
2. What is the maximum transfer price that Pharmaceuticals will pay? $0.20, $0.25 or $0.40?
3. What is the minimum transfer price that Plastics want to receive?
Transfer
plastic bottles
to Pharma
division
250,000 *
0.60
0.40
250,000 *
0.60
0.25
Pharmaceutical division
will like to buy 250,000
bottles from the plastics
division
3434

Comparative Statements (continued)
Example 2: Excess Capacity
250,000 *
0.60
0.20
250,000 *
0.60
0.15
3535

Factors that
increase
knowledge
transfer costs
Factors that
decrease
knowledge
transfer costs
If you
decentralize then
you need to have
a system to
assign some
responsibility (D)
If you assign some
responsibility then
you need to
measure the
performance of
that responsibility
If you assign, then
measure then you
have to give some
in DHL won’t
happen
Agency costs are the
costs of monitoring as
well as the bad behavior
(H) of employees (agents)
–
(eg gamesmanship)

Big Idea
- 37 -

My first job - Junior Clerical Stores Person- 1980

4141
Dakoil Corporation has two divisions, Refining and
Production. The company's primary product is Enkoil Oil.
Each division's costs are provided below:
Production: Variable costs per barrel of oil $ 9
Fixed costs per barrel of oil $ 6
Refining: Variable costs per barrel of oil $30
Fixed costs per barrel of oil $36
The Refining Division has been operating at a capacity of
40,000 barrels a day and usually purchases 25,000 barrels of
oil from the Production Division and 15,000 barrels from
other suppliers at $20 per barrel.
Transfer PricingTransfer Pricing

Assume 200 barrels are transferred from the Production
Division to the Refining Division for a transfer price of $18
per barrel. The Refining Division sells the 200 barrels at a
price of $120 each to customers. What is the operating
income of both divisions together?
A) $7,200
B) $7,800
C) $10,800
D) $20,400
4242

A benefit of using a market-based transfer price is the:
A) profits of the transferring division are sacrificed for the
overall good of the corporation
B) profits of the division receiving the products are
sacrificed for the overall good of the corporation
C) economic viability and profitability of each division can
be evaluated individually
D) None of these answers is correct.
4343

An advantage of using budgeted costs for transfer pricing
among divisions is that:
A) overall corporate profitability is usually higher
B) it usually provides a basis for optimal decision making
C) the divisions know the transfer price in advance
D) it promotes subunit autonomy
4444

4545
Decentralize
Give decision authority to managers lower in
your firm so that you can do more.
Measurement
- ROI
- RI
- EVA
Rewards
- Incentives
- Monetary
- Non-monetary

FRC
(Autonomy
KTC)
SRC
(Customer
WHY)
Management Control Systems

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