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RESPONSIBILITY ACCOUNTING
CHAPTER 22 & 231
Decentralization
Decentralization is the freedom for managers at lower levels of the organization to make decisions
Autonomy is the degree of freedom to make decisions. The greater the freedom, the greater the autonomy
2
Decentralization
Lower-level decisions
often based on
better information
Top management
freed to concentrate
on strategy
Leads to gains from faster decision making
Assists management development and learning
Increases motivation of subunit managers Advantages
3
Decentralization
May be a lack of
coordination among
Autonomous managers.
Lower-level managers may make decisions
without seeing the “big picture.”
Lower-level manager’s objectives may not be
those of the organization.
May be difficult to
spread innovative ideas
in the organization.
Disadvantages
4
Responsibility centers
ResponsibilityCenter
ResponsibilityCenter
CostCenterCost
CenterProfit
CenterProfit
CenterInvestment
CenterInvestment
Center
6
Cost Center A segment whose manager has control
over costs, but not over revenues
or investment funds.
Responsibility centers
7
Profit Center A segment whose manager has control
over both costs and revenues, but no control over investment funds.
Responsibility centers
8
Investment Center A segment whose
manager has control over costs,
revenues, and investments in
operating assets.
Corporate Headquarters
Responsibility centers
Performance measurement9
10
Return on investment
ROI is an accounting measure of income divided by an accounting
measure of investment
ROI = IncomeInvestment
Return on Investment (ROI)
ROI = Operating IncomeOperating Assets
Cash, Account receivables,inventories, PP&E and other operating assets
Cash, Account receivables,inventories, PP&E and other operating assets
Earnings before interest & tax (EBIT)Earnings before interest & tax (EBIT)
11
Benefits of ROI . . .
Encourage managers to focus on relationships between revenue, costs and investment.
Encourage managers to fo focus on cost efficiency.
Encourage managers to focus on asset efficiency.
Increase revenue
Reduce costs
Reduce assets
12
ROI = ROI = Margin Margin Turnover Turnover
Operating income Sales
Sales Operating assets×ROI =
EBIT
Revenue
Investment
$30,000
$500,000
$200,000
XYZ Inc.
13
$30,000--------------$500,000
$500,000--------------$200,000
x
Return on Investment
6% 2.5x
15%=14
Increase revenue . . .
Assume that XYZ is able to increase its revenue by $600,000.
Operating income increases by $42,000. Operating assets do not change. What will be effects on ROI?
15
-------------- --------------x
Return on Investment
x
=16
Reduce costs . . .
Assume that XYZ is able to reduce its costs by $10,000.
Operating income increases by $40,000. Operating assets do not change. What will be effects on ROI?
17
-------------- --------------x
Return on Investment
x
=18
Reduce assets . . .
Assume that XYZ is able to reduce its assets from $200,000 to $125,000.
Revenue and operating income do not change.
What will be effects on ROI?
19
-------------- --------------x
Return on Investment
x
=20
Criticisms of ROI
As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus.
The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%.
You have an opportunity to invest in a new project that will produce an ROI of 25%.
As division manager would you invest in this project?
Criticisms of ROI
Managers evaluated on ROImay reject profitable
investment opportunities.
Residual Income
RI = Actual Income – Required Income
= EBIT – Required rate of return x Investment
23
Residual Income (RI) is the operating income that an investment center earns above the minimum
required return on its operating assets.
Division A Division B
Investment 1,000,000 3,000,000
EBIT 200,000 450,000
Required Income
Residual Income
Return on investment
24
Required Rate of Return = 12%
Residual Income
RI cannot be used to compare the performance of different divisions of different sizes.
RI encourages managers to make profitable investments but that would be rejected by managers using ROI.
Disadvantage Advantage
25
Residual Income
Example . . .
Assume that Division A has an investment opportunity of $250,000 with the expected return rate of 16%.
The current ROI of Division A is 20%. Should the project be accepted?
Required rate of return: 12%
26
Rule for investment decision making
Accept the project if RI > 0
Reject the project if RI < 0
27
Expected income should belarger than minimum
required income generated from investment.
Quick Check
Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?a. 25%b. 5%c. 15%d. 20%
Quick Check
Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No
Quick Check
The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No
Quick Check
Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?a. $240,000b. $ 45,000c. $ 15,000d. $ 51,000
Quick Check
If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No
Economic Value Added (EVA)
33
EVA is a specific type of residual income calculation that has recently gained popularity
Weighted average cost of capital equals the after-tax average cost of all long-term funds in use
After-tax Weighted-Average Total CurrentOperating Income Cost of Capital Assets Liabilities ) }EVA {= X (
TRANSFER PRICING
34
Key Concepts/Definitions
A transfer price is the price charged when one segment of a
company provides goods or services to another segment of
the company.
The fundamental objective in setting transfer prices is to
motivate managers to act in the best interests of the overall
company.
Impact of Transfer Pricing on Divisions and the Firm as a Whole ► The price charged for the transferred good
affects both► the costs of the buying division► the revenues of the selling division
36
Three Primary Approaches
There are three primary approaches to setting
transfer prices:
1. Negotiated transfer prices
2. Transfers at the cost to the selling division
3. Transfers at market price
Transfer Pricing Approaches: Market Price38
If there is a competitive outside market for the transferred product, then the best transfer price is the market price.
In such a case, divisional managers’ actions will simultaneously optimize divisional profits and firm-wide profits.
Furthermore, no division can benefit at the expense of another. In this setting, top management will not be tempted to intervene.
The market price, if available, is the best approach to transfer pricing.
Transfer Pricing Approaches: Cost-Based Transfer Prices39
Frequently, there is no good outside market price.
Since a transfer price at cost does not allow for any profit for the selling division, top management may define cost as ‘‘cost plus, ’’ which allows a certain percentage to be tacked onto the cost.
Transfer Pricing Approaches: Negotiated Transfer Prices40
This approach is particularly useful in cases with market imperfections, such as the ability of an in-house division to avoid selling and distribution costs that external market participants would have to incur.
Using a negotiated transfer price then allows the two divisions to share any cost savings resulting from avoided costs.
When should managers agree to transfer?
Upper limit is determined by the buying division.
Lower limit is determined by the selling division.
Range of Acceptable Transfer Prices
The minimum transfer price (floor): The transfer price that would leave the selling division no worse off if the good were sold to an internal division than if the good were sold to an external party.
The maximum transfer price (ceiling): The transfer price that would leave the buying division no worse off if an input were purchased from an internal division than if the same good were purchased externally.
Vinacomin Hạ Long Heritage Hotel has 100 rooms. Customers are charged at the rate of VND 400,000 per room-night. Variable cost is VND100,000 per room-night. The Hotel is running at a 100% capacity utilization rate. Thong Nhat Coal Company wants to book 10 rooms for 3 nights for its summer holiday. The rate of other similar hotels in Bai Chay also is VND 400,000 per room-night.
What is the minimum accepted price for Ha Long Heritage Hotel? What is the maximum accepted price for Thong Nhat Coal Company? Is the transfer important? If Ha Long heritage and Thong Nhat Coal agree to transfer, how to determine the transfer price?
Example42
Assume that Ha Long Heritage Hotel might avoid sale commission cost of VND 30,000 if transfer. What is the minimum accepted price for Ha Long Heritage Hotel? What is the maximum accepted price for Thong Nhat Coal Company? Should Ha Long Heritage and Thong Nhat Coal decide to transfer? If yes, what is the benefit for Vinacomin?
Example43
Assume that Ha Long Heritage Hotel is running at a 80% capacity utilisation rate. Determine a fair transfer price.
Example44
Assume that Ha Long Heritage Hotel is running at a 96% capacity utilisation rate. Determine a fair transfer price.
Example45
Highland Coffee – An Example
Coffee Division Production capactiy per month 10,000 cansVariable cost per can of coffee VND4,000 per canFixed costs per month VND700mil.Selling price of Highland Coffee on the outside market VND7,000 per can
Pho 24 DivisionPurchase price of regular brand of coffee VND6,000 per canMonthly comsumption of coffee 2,000 cans
Highland CoffeeThe selling division’s (Coffee division) lowest acceptable transfer price is
calculated as:
Variable cost Total contribution margin on lost salesper unit Number of units transferred
Transfer Price +
Transfer Price Cost of buying from outside supplier
The buying division’s (Pho 24) highest acceptable transfer price is calculated as:
Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.
Transfer Price Profit to be earned per unit sold (not including the transfer price)
If an outside supplier does not exist, the highest acceptable transfer price is calculated as:
Highland Coffee
If Coffee Division has sufficient idle capacity (3,000 cans) to satisfy Pho 24’s demands (2,000 cans) without sacrificing sales to other customers, then the
lowest and highest possible transfer prices are computed as follows:
Transfer Price
Selling division’s lowest possible transfer price:
Transfer Price Cost of buying from outside supplier =Buying division’s highest possible transfer price:
Highland Coffee
If Coffee Division has no idle capacity (0 cans) and must sacrifice other customer orders (2,000 cans) to meet Pho 24’s demands (2,000 cans), then the lowest and highest possible transfer prices are computed as follows:
Transfer Price
Selling division’s lowest possible transfer price:
Transfer Price Cost of buying from outside supplier =Buying division’s highest possible transfer price:
Highland Coffee
If Coffee Division has some idle capacity (1,000 cans) and must sacrifice other customer orders (1,000 cans) to meet Pho 24’s demands (2,000 cans),
then the lowest and highest possible transfer prices are computed as follows:
Transfer Price Cost of buying from outside supplier =Buying division’s highest possible transfer price:
Selling division’s lowest possible transfer price:
Transfer Price
International Aspects of Transfer Pricing
Transfer Pricing Objectives
Domestic• Greater divisional autonomy• Greater motivation for managers• Better performance evaluation• Better goal congruence
International• Less taxes, duties, and tariffs• Less foreign exchange risks• Better competitive position• Better governmental relations
End of chapter 22&2352