Week 9

Week 9Chapter 22

Decentralization and Transfer Pricing

11

Big PictureActivity-Based versus Strategic-Based Responsibility Accounting

22

Responsibility Accounting

Financial-based centers (Cost,

Revenue, Profit, Investment)

Strategy-basedResponsibility 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. Automation2. 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)

DecentralizeGive decision authority to managers lower in your firm so that you can do more.

Rewards- Incentives- Monetary- Non-monetary

Measurement- Financial measures

ROIRIEVA

ResponsibilityCenters

- Activity based- Strategy basedAccounting 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


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






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

Drawbacks of Decentralization


Cost to EmployerNeed to make managers responsible (responsibility center), but it costs $$$ to monitor (measure) performance and reward achievement.

Benefit to Employerminimize information processing (minimize knowledge transfer costs) – in order to fuel faster expansion

Knowledge Transfer and Agency Costs Trade Off

99


10

Decentralization and ControlIf you decentralize then you need to have a system to

assign some responsibility (D)


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

1111


1212

DecentralizeGive decision authority to managers lower

in your firm so that you can do more.


- ROI- RI- EVA

Rewards- Incentives

- Monetary- Non-monetary



Decentralization and Control – The Three Legged Stool and DHL Control

Problem Framework

SCENARIO Decentralization Measurement Rewards

1 √ ⨯ √2 ⨯ √ √

3 √ √ ⨯

No MeasurementNo MeasurementScenario 1: This will result the worker not Scenario 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 match as there will be an unparalleled match between incentives and effort without between incentives and effort without proper measurement. In addition, there will proper measurement. In addition, there will be a lack of direction as the incentives be a lack of direction as the incentives given to employees may be seen as an given to employees may be seen as an impartial treatment, and affect team’s impartial treatment, and affect team’s morale.morale.

No decentralisationNo decentralisationScenario 2: They know what they should Scenario 2: They know what they should

do, but are not given authority and do, but are not given authority and autonomy to do so. Although they are not autonomy to do so. Although they are not able to make crucial decision, tight able 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 a Thus, this may result in frustration and a lack of motivation. In addition, there will lack of motivation. In addition, there will also be an increase in knowledge transfer also be an increase in knowledge transfer cost as the top management may not have cost as the top management may not have access to the local environment.access to the local environment.

No rewardNo rewardScenario 3: There will be a lack of Scenario 3: There will be a lack of

motivation. Even though they have the motivation. Even though they have the autonomy to do anything, and autonomy to do anything, and measurements of effort are in place, they measurements of effort are in place, they are still going to end up with a fixed or are still going to end up with a fixed or comparable pay. Here, there is a case comparable pay. Here, there is a case when incentives do not match up to the when incentives do not match up to the effort put in.effort put in.

17

Decentralization and ControlIf you

decentralize then you need to have

a system to assign some

responsibility (D)


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


- 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.


19

Decentralization and ControlIf you

decentralize then you need to have


responsibility (D)

Types of Responsibility Centers1. 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).

Student

Example: Value for Money in Government Organizations


23


Transfer pricing- Motivations

a)Excess capacityb)Save Sales

expenses

Types Qualitative ExampleConditions Impact Transfer 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

Types Qualitative ExampleConditions ImpactTransfer Pricing Setting Transfer Pricing

2929

Exhibit 22-3Exhibit 22-3

Criteria Market-Based Cost-Based Negotiated

Achieves goal Achieves goal congruencecongruence

Yes, when markets are competitive

Often, but not always Yes

Motivates Motivates 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 evaluating Useful for evaluating subunit performancesubunit performance


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 subunit Preserves subunit autonomyautonomy


No, because it is rule-based Yes, because it is based on negotiations between subunits

Other Other 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 Determininga Minimum Transfer Price

Minimum transfer price=

Incremental costs per unit incurredup 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 StatementsExample 1: Avoidable distribution costs

External Market

Printed circuit boards $22.00


3232


Comparative Income Statements (continued)

Example 1: Avoidable Distribution Costs

Internal Market


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


Sales = less $81,900 Costs = less $182,000

Net saving = $100,100


3333


Comparative StatementsExample 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

Setting Transfer PricesPharmaceutical 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


Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003 36






If you decentralize then you need to have


responsibility (D)


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)


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 $ 9Fixed costs per barrel of oil $ 6

Refining: Variable costs per barrel of oil $30Fixed 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 PricingTypes Qualitative ExampleConditions Impact Transfer Pricing Setting Transfer Pricing

Transfer PricingTransfer PricingAssume 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) $7,200B) $7,800C) $10,800 D) $20,400

4242


Transfer PricingTransfer PricingA 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


Transfer PricingTransfer PricingAn 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

DecentralizeGive decision authority to managers

lower in your firm so that you can do more.


- ROI- RI- EVA

Rewards- Incentives

- Monetary- Non-monetary



FRC (Autonomy

KTC)

SRC (Customer

WHY)

Management Control Systems