Chapter 10 - Responsibility Acctg

Cornerstones of cost
management, 4e
Chapter 10
Decentralization: Responsibility
Accounting, Performance
Evaluation, and Transfer Pricing
© 2019 Cengage. All rights reserved.
Learning 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
Introduction
© 2019to Cost management
Cengage. All rights reserved.
Responsibility Accounting
• System that measures the results of each responsibility

center and compares those results with expected or
budgeted outcome
– Responsibility center: Part of the business whose
manager is accountable for specified activities
• System of responsibility, accountability, and
performance evaluation
Introduction
Types of Responsibility Centers
• Cost center: Manager is responsible only for costs

• Revenue center: Manager is responsible only for
revenues
• Profit center: Manager is responsible for both
revenues and costs
• Investment center: Manager is responsible for
revenues, costs, and investments
Introduction
Decentralization
• Practice of delegating decision-making authority to the

lower levels
• Decentralized decision making
– Allows managers at lower levels to make and implement
key decisions pertaining to their areas of responsibility
• Centralized decision making
– Decisions are made at the very top level and lower-level
managers are charged with implementing those
decisions
Introduction
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
Introduction
Units of Decentralization
• Achieved by segmenting the company into divisions

• Divisions can be differentiated by the types of goods or
services produced
• Companies create divisions according to the type of
customer served
Introduction
Performance evaluation measures for
investment centers
• Return on investment
• Residual income
• Economic value added
Introduction
Return on Investment (ROI) (1 of 2)
• Most common measure of performance for an

investment center
• Used by stockholders to indicate the health of a
company
• Used to measure the relative performance of divisions
Introduction
Return on Investment (ROI) (2 of 2)
• ROI = Operating income=Average operating assets
=(Operating income/Sales) × (Sales/Average
operating assets)
=Operating income margin × Operating asset
turnover
Average operating assets = (Beginning net book value +
Ending net book value)/2
• Operating income: Earnings before interest and
income taxes and is typically used for divisions
• Operating assets: All assets used to generate
operating income
Introduction
Component ratios of ROI
• Margin
– Ratio of operating income to sales
• Turnover
– Found by dividing sales by average operating assets
Introduction
Advantages of the ROI Measure
• Encourages investment center managers to focus on

the relationship between sales, expenses, and
investment
• Encourages cost efficiency
• Discourages excessive investment in operating assets
Introduction
Disadvantages of the ROI Measure
• Discourages managers from investing in projects that

decrease divisional ROI but would increase profitability
of the company overall
• Encourages managers to focus on the short run at the
expense of the long run
Introduction
Calculating Average Operating Assets,
Margin, Turnover, and ROI (1 of 3)
• Multidiv, Inc., provided the following information for
Snack Foods Division for last year:
Sales $30,000,000
Operating income 1,800,000
Operating assets, January 1 9,600,000
Operating assets, December 31 10,400,000

• Solution
Average operating assets = (Beginning assets + Ending
assets)/2
= ($9,600,000 þ $10,400,000)/2
= $10,000,000
Margin = Operating income/Sales
= $1,800,000/ $30,000,000
= 0:06, or 6%
Introduction
• Turnover = Sales/Average operating assets
= $30,000,000/ $10,000,000
= 3.0
• ROI = Margin × Turnover
= 0:06 × 3:0
= 0:18, or 18%
Or
• ROI = Operating income/Average operating assets
= $1,800,000/ $10,000,000
= 0:18, or 18%
Introduction
Residual Income (RI) (1 of 2)
• Difference between operating income and the minimum

dollar return required on a company’s operating assets
RI = Operating income − (Minimum rate of return ×
Operating assets)
Introduction
Residual income (RI) (2 of 2)
• Advantages
– Dollar measure of performance
– Refocuses the managers on dollar profit
• Disadvantages
– Absolute measure of return that makes it difficult to
directly compare the performance of divisions
– Does not discourage myopic behavior
Introduction
Calculating Residual Income (1 of 2)
• Multidiv, Inc., provided the following information for

Appliance Division for last year:
Sales $117,000,000
Operating income 3,510,000
Average operating assets 19,500,000
• Multidiv, Inc., requires a 12 percent minimum rate

of return
– Calculate residual income for the Appliance
Division

Calculating Residual Income (2 of 2)
• Solution
• Residual income = Operating income – (Minimum rate
of return ×Operating assets)
= $3,510,000 – (0.12 × $19,500,000)
= $1,170,000
Introduction
Economic Value Added (EVA)
• After-tax operating profit minus the total annual cost of

capital
– Positive EVA - Company is creating wealth
– Negative EVA - Company is destroying wealth
• Encourages managers to use existing and new capital
for maximum gain
• EVA = After-tax operating income – (Weighted average
cost of capital × total capital employed)
Introduction
Calculating the Weighted Average Cost of
Capital and EVA (1 of 5)
• Furman, Inc., had after-tax operating income last year
of $1,583,000
– Three sources of financing were used by the company
 $2 million of mortgage bonds paying 8 percent interest
 $3 million of unsecured bonds paying 10 percent interest
 $10 million in common stock, which was considered to be
no more or less risky than other stocks
Introduction
– Rate of return on long-term U.S. Treasury bonds is 6
percent and Furman, Inc., pays a marginal tax rate of 40
percent
• Calculate:
– After-tax cost of each method of financing
– Weighted average cost of capital for Furman, Inc.
– Total dollar amount of capital employed for Furman, Inc.
– Economic value added (EVA) for Furman, Inc., for last
year
 Is Furman, Inc., creating or destroying wealth?
Introduction
• Solution
• After-tax cost of mortgage bonds = Interest rate – (Tax
rate × Interest rate)
= [0:08 – (0.4×0.08)] = 0.048
• After-tax cost of unsecured bonds = Interest rate – (Tax
rate × Interest rate)
= [0:10 – (0.4 × 0:10)] = 0:06
• Cost of common stock = Return on long-term Treasury
bonds + Average premium
= 0.06 + 0.06 = 0:12
Introduction
Calculating the Weighted Average
Cost of Capital and EVA (4 of 5)
Amount Percent × After-Tax = Weighted Cost

Cost
Mortgage bonds $ 2,000,000 0.1333 0.048 0.0064
Unsecured bonds 3,000,000 0.2000 0.060 0.0120
Common stock 10,000,000 0.6667 0.120 0.0800
Total $15,000,000 0.0984
Weighted average percentage cost of capital =

0.0984, or 9.84%
Total dollar amount of capital employed = 0.0984 ×
$15,000,000 = $1,476,000
Calculating the Weighted Average
Cost of Capital and EVA (5 of 5)
After-tax operating income $1,583,000

Less: Total dollar amount of capital employed 1,476,000
EVA $ 107,000
• Furman, Inc., is creating capital because EVA is

positive (the after-tax earnings are greater than
the after-tax cost of capital)

Planning Incentive Pay for Managers
• Problem areas
– Managers may:
 Have low ability
 Prefer not to work hard
 Prefer to spend company resources on perquisites
• Remediations
– Owners need to:
 Discover information about the managers before hiring
them
 Monitor their manager
 Arrange an incentive scheme that will more closely align
the managerial goals with those of the owner
Introduction
Managerial Rewards
• Incentives tied to performance

• Objective - To encourage goal congruence
– Goal congruence: Goals of managers are closely
aligned with the goals of the firm
• Consists of:
– Salary increases
– Bonuses based on reported income
– Stock options
– Noncash compensations
Introduction
Cash Compensation
• Salaries and bonuses

– Raises - Way for a company to reward good managerial
performance
– Bonuses give more flexibility
• Combination of salary and bonus is used to reward
performance by many firms
– Keeps salaries fairly level and allows bonuses to
fluctuate with reported income
• Can encourage dysfunctional behavior
Introduction
Stock-Based Compensation
• Stock - Share in the company

• Issue of stock to managers makes them part owners of
the company
• Encourages goal congruence
• Disadvantage - Share price can fall for reasons beyond
the control of managers
• Companies offer stock options to managers
– Stock option: Right to buy a certain number of shares
of the company’s stock, at a particular price, after a set
length of time
Introduction
Issues to Consider in Structuring Income-
Based Compensation
• Single measures of performance are subject to gaming
behavior
– Managers may increase short-term measures at the
expense of long-term measures
• Owners and managers may be affected differently by
risk
– Managers with their own capital invested in the company
may be less apt to take risks
– Owners have the ability to diversify away some of the
risk and may prefer a more risk-taking attitude
Introduction
Noncash Compensation
• Important part of the management reward structure

• Type - Autonomy in the conduct of daily business
• Perquisites can be used to make managers more
efficient
– Perquisites: Type of fringe benefit received over and
above salary
Introduction
Transfer Prices
• Levied on goods produced by one division and

transferred to another
– Affects the revenues of the transferring division and the
costs of the receiving division
 Profitability, return on investment, and managerial
performance evaluation of both divisions are affected
Introduction
Setting Transfer Prices (1 of 2)
• Transfer pricing system should satisfy three objectives

– Accurate performance evaluation
– Goal congruence
– Preservation of divisional autonomy
• Opportunity cost approach: Identifies:
– Minimum price that a selling division would be willing to
accept
– Maximum price that the buying division would be willing
to pay
Introduction
Setting Transfer Prices (2 of 2)
• Minimum and maximum prices correspond to the

opportunity costs of transferring internally and define a
bargaining range
– Minimum transfer price: Leaves the selling division no
worse off if the good is sold to an internal division
– Maximum transfer price: Leaves the buying division no
worse off if an input is purchased from an internal
division
Introduction
Market Price
• Only possible transfer price because it is the:

– Minimum transfer price for the selling division
– Maximum price for the buying division
• Moving away from the market price will decrease the
overall profitability of the firm
Introduction
Negotiated Transfer Prices (1 of 2)
• Alternative when imperfections exist in the market for

the intermediate product
• Advantage - Compliance with goal congruence,
autonomy, and accurate performance evaluation
Introduction
Negotiated Transfer Prices (2 of 2)
• Disadvantages
– One divisional manager with private information may
take advantage of another divisional manager
– Performance measures may be distorted by the
negotiating skills of managers
– Negotiation can consume considerable time and
resources
Introduction
Cost-Based Transfer Prices
• Full-cost transfer pricing and full cost plus markup

– Simple and objective
– Provide perverse incentives and distort performance
measures
• Variable cost plus fixed fee
– Useful if fixed fee is negotiable
– Advantage - Variable cost is selling division's opportunity
cost if it is operating below capacity
Introduction
Transfer Pricing for Multinational Firm
• Objectives - Performance evaluation and optimal

determination of income taxes
• U.S.-based multinationals are subject to Internal
Revenue Code Section 482
– IRS accepts four transfer pricing policies
 Comparable uncontrolled price method
 Resale price method
 Cost-plus method
 Advanced pricing agreements (APAs)
Introduction

Chapter 10 - Responsibility Acctg

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Chapter 10 - Responsibility Acctg

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Cornerstones of cost

1. Define responsibility accounting, and describe the four

• System that measures the results of each responsibility

• Cost center: Manager is responsible only for costs

• Practice of delegating decision-making authority to the

• Better access to local information

• Achieved by segmenting the company into divisions

• Most common measure of performance for an

• Encourages investment center managers to focus on

• Discourages managers from investing in projects that

© 2019 Cengage. All rights reserved.

• Difference between operating income and the minimum

• Multidiv, Inc., provided the following information for

• Multidiv, Inc., requires a 12 percent minimum rate

© 2019 Cengage. All rights reserved.

• After-tax operating profit minus the total annual cost of

Amount Percent × After-Tax = Weighted Cost

Weighted average percentage cost of capital =

After-tax operating income $1,583,000

• Furman, Inc., is creating capital because EVA is

© 2019 Cengage. All rights reserved.

• Incentives tied to performance

• Salaries and bonuses

• Stock - Share in the company

• Important part of the management reward structure

• Levied on goods produced by one division and

• Transfer pricing system should satisfy three objectives

• Minimum and maximum prices correspond to the

• Only possible transfer price because it is the:

• Alternative when imperfections exist in the market for

• Full-cost transfer pricing and full cost plus markup

• Objectives - Performance evaluation and optimal

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