1 CHAPTER 22 & 23 RESPONSIBILITY ACCOUNTING
Decentralization 2 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
Decentralization Lower-level decisions Leads to gains from faster decision making often based on better information Assists management development and learning Increases motivation of subunit managers Advantages Top management freed to concentrate 3 on strategy
Decentralization May be difficult to May be a lack of spread innovative ideas coordination among in the organization. Autonomous managers. Disadvantages 4 Lower-level managers may make decisions without seeing the “big picture. ” Lower-level manager’s objectives may not be those of the organization.
Responsibility centers Cost Center Profit Center Responsibility Center Investment Center
Responsibility centers Cost Center A segment whose manager has control over costs, but not over revenues or investment funds. 6
Responsibility centers Profit Center A segment whose manager has control over both costs and revenues, but no control over investment funds. 7
Responsibility centers Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. Corporate Headquarters 8
Performance measurement 9 Investment center Return on investment (ROI) Profit center Cost center Residual Income (RI) Profitability Cost control Service quality & quantity
Return on investment 10 ROI is an accounting measure of income divided by an accounting measure of investment ROI = Income Investment
Return on Investment (ROI) 11 Earnings before interest & tax (EBIT) ROI = Operating Income Operating Assets Cash, Account receivables, inventories, PP&E and other operating assets
Benefits of ROI. . . 12 Reduce costs Encourage managers to focus on relationships Increase revenue Reduce assets between revenue, costs and investment. Encourage managers to fo focus on cost efficiency. Encourage managers to focus on asset efficiency. ROI = Margin Turnover ROI = Operating income Sales × Sales Operating assets
XYZ Inc. EBIT $30, 000 Revenue Investment 13 $500, 000 $200, 000
Return on Investment $30, 000 -------$500, 000 6% x 2. 5 = 14 x $500, 000 -------$200, 000 15%
Increase revenue. . . 15 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?
Return on Investment ------- x x = 16 -------
Reduce costs. . . 17 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?
Return on Investment ------- x x 18 = -------
Reduce assets. . . 19 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?
Return on Investment ------- x 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 ROI may reject profitable investment opportunities.
Residual Income 23 Residual Income (RI) is the operating income that an investment center earns above the minimum required return on its operating assets. RI = Actual Income – Required Income = EBIT – Required rate of return x Investment
Residual Income 24 Investment EBIT Required Income Division A 1, 000 200, 000 Residual Income Return on investment Required Rate of Return = 12% Division B 3, 000 450, 000
Residual Income 25 Disadvantage RI cannot be used to compare the performance of different divisions of different sizes. Advantage RI encourages managers to make profitable investments but that would be rejected by managers using ROI.
Example. . . 26 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%
Rule for investment decision making 27 Accept the project if RI > 0 Reject the project if RI < 0 Expected income should be larger 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. Yes b. 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. Yes b. 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, 000 b. $ 45, 000 c. $ 15, 000 d. $ 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. Yes b. 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
34 TRANSFER PRICING
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.
36 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
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
38 Transfer Pricing Approaches: Market Price 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 Prices 39 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.
40 Transfer Pricing Approaches: Negotiated Transfer Prices 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? 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. Range of Acceptable Transfer Prices Upper limit is determined by the buying division. Lower limit is determined by the selling division.
Example 42 Vinacomin Hạ Long Heritage Hotel has 100 rooms. Customers are charged at the rate of VND 400, 000 per room-night. Variable cost is VND 100, 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?
Example 43 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?
Example 44 Assume that Ha Long Heritage Hotel is running at a 80% capacity utilisation rate. Determine a fair transfer price.
Example 45 Assume that Ha Long Heritage Hotel is running at a 96% capacity utilisation rate. Determine a fair transfer price.
Highland Coffee – An Example
Highland Coffee The selling division’s (Coffee division) lowest acceptable transfer price is calculated as: Let’s calculate the lowest and highest acceptable transfer prices under three scenarios. The buying division’s (Pho 24) highest acceptable transfer price is calculated as: 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: Selling division’s lowest possible transfer price: 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: Selling division’s lowest possible transfer price: 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: Selling division’s lowest possible transfer price: Buying division’s highest possible transfer price:
International Aspects of 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
52 End of chapter 22&23
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