Managerial Accounting:

Chapter 11

Investment Center Performance Evaluation

2

Discuss the Nature of Divisionalized Organizations

• Top managers delegate or decentralize

authority and responsibility

• Some major advantages of decentralized

organizations include:

– It allows local personnel to respond quickly to

a changing environment

3

Discuss the Nature of Divisionalized Organizations

– Frees top management from detailed

operating decisions

– Divides large, complex problems into

manageable chunks

– Helps train managers and provides a basis for

their evaluation

– Motivates managers by allowing them to

make their own decisions

4

Discuss the Nature of Divisionalized Organizations

• Disadvantage - local managers may not act in ways consistent with overall organizational goals

– There may be conflicts between goals of a division and overall goals of the organization

• Planning, control, and incentive systems try to create goal congruence where division managers are motivated to act in ways consistent with overall organizational goals

5

Define Divisional Return on Investment (Slide 1 of 2)

• Divisions are expected to contribute to the company’s profitability– However, division profits need to be considered in

light of the amount of funds invested in the division

• Return on investment (ROI) is calculated as follows:

Division Operating Profit

Division Investment

6

Define Divisional Return on Investment (Slide 2 of 2)

• When using ROI as a divisional performance measure, the following questions must be addressed:– How does the firm measure revenue,

especially for transfers between divisions?– Which costs are deducted in measuring

divisional operating costs?– How is the investment in the division

measured?

7

What is transfer pricing?

• Transfers of products or services between

units in the organization are recorded in

the accounting records using a transfer

price

– Transfer prices are commonly used in

performance evaluation, product costing and

decision making

• Determining the appropriate transfer price is

important

8

Explain Alternative Ways to Set Transfer Prices

• The idea is to set transfer prices so that buyer and seller have goal congruence with the organization’s goals

• There are three general alternatives available for setting transfer prices

1. Top management sets the transfer price

2. Top management establishes transfer price policies followed by divisions

3. Division managers negotiate transfer prices

9

Explain Top Management Intervention

• If top management sets transfer prices, the “right” transfer prices may result, but– Top management may become swamped

with pricing disputes– Division managers lose flexibility and other

advantages of decentralization

• If transactions between divisions are infrequent, direct intervention in setting transfer prices may be beneficial

10

Explain Centrally Established Transfer Price Policies (Slide 1 of 4)

• Transfer pricing policy should:

– Allow for divisional autonomy

– Encourage managers to pursue corporate

goals consistent with their own personal goals

– Be compatible with the performance

evaluation system

11

Explain Centrally Established Transfer Price Policies (Slide 2 of 4)

• Economic transfer pricing rule - transfer at differential outlay cost to the selling division (typically variable cost), plus the opportunity cost of making the internal transfer

• Rule of thumb - if the selling division has:

– Excess capacity - transfer price should equal differential cost of production (usually variable cost)

– No excess capacity- transfer price should be market price

12

Explain Centrally Established Transfer Price Policies (Slide 3 of 4)

•Transfer prices based on market price are

–Generally considered the best basis when a competitive market exists for the product and market prices are readily available

• Advantage - Both buying and selling managers can buy and sell all they want at the market price

13

Explain Centrally Established Transfer Price Policies (Slide 4 of 4)

• Transfer prices based on costs could be based on what?

– Full-absorption costs

– Cost-plus transfers

– Standard costs or actual costs

14

Review Motivational Aspects of Transfer Pricing (Slide 1 of 2)

• If the transfer pricing policy does not give the selling division a profit, motivational problems can arise

– Fails to motivate seller to transfer internally, since there is no contribution toward profit

– If all transfers are internal, it may be more appropriate to set up the division as a cost center

15

Review Motivational Aspects of Transfer Pricing (Slide 2 of 2)

• Possible solutions to motivational problems

include:

– Using dual transfer prices - Charge the buyer the

cost of the unit and credit selling division with cost

plus a profit allowance

– Using balanced scorecard principles to evaluate

selling manager’s performance and explicitly

incorporate internal transfers in the reward

system

16

Division Managers Negotiate Transfer Prices

• Under this system, managers act as if they

managed independent companies

–Advantage - preserves autonomy of division

managers

–Disadvantages

• May require a great deal of management effort

• Final price may depend more on negotiating skills

rather than on what is best for the company

17

Comment on Global Transfer Pricing

In international transactions, as well as transfers

across state lines, transfer prices may affect

tax liabilities, royalties, and other payments

–Companies may be motivated to use transfer prices

as a mechanism to increase profits in low-tax

jurisdictions and reduce profits in high-tax

jurisdictions

• Major problem for many states and countries

18

Measuring Division Operating Profits (Slide 1 of 5)

In measuring divisional operating costs,

management must decide how to treat the

following costs:

–Controllable direct operating costs

–Noncontrollable direct operating costs

–Controllable indirect operating costs

–Noncontrollable indirect operating costs

19

Measuring Division Operating Profits (Slide 2 of 5)

• The issue is whether to include these costs in determining division operating profits for purposes of performance evaluation

– Direct versus indirect refers to whether the cost associates directly with the division

– Controllable versus noncontrollable refers to whether the manager can affect the cost

20

Measuring Division Operating Profits (Slide 3 of 5)

• Direct costs are almost always deducted

in determining division operating profits

–Should separate out costs assigned to a

division from those assigned to a manager• Could, for example, exclude costs that can’t be

controlled by a manager from that manager’s

performance evaluation

21

Measuring Division Operating Profits (Slide 4 of 5)

• Indirect controllable operating costs- may be at least partially controllable by division managers– Example: Centralized service department

costs such as the training function

– If the division is charged for the use of the services of these departments, the division may avoid using them

• This could be counter-productive

22

Measuring Division Operating Profits (Slide 5 of 5)

• Indirect noncontrollable operating costs

– May be necessary costs but the division manager lacks the ability to control these costs (e.g., salaries of top corporate management)

– May want to allocate these costs to divisions to raise awareness that sales revenue must cover not only divisional costs but also those of central headquarters

23

Assets Included in Investment Base

• When calculating ROI, assets to be

included in the denominator must be

determined and valued

– Most firms use acquisition cost

– Using book value can cause problems

• Managers may be reluctant to replace older

assets due to the negative impact on ROI

24

Components of Return on Investment

• Return on Investment (ROI) What is the equation?

ROI = Profit Margin % X Investment Turnover Ratio

Divisional Profit = Divisional Profit X Divisional RevenuesDivisional Divisional DivisionalInvestment Revenues Investment

25

Economic Value Added

• An alternative to ROI is Economic Value Added (EVA) What is the equation?

EVA = NOPAT - (WACC X Investment)

Where: NOPAT = Net Operating Profit After TaxWACC = Weighted-Average Cost of capital

Investment = Total Assets - Noninterest- Bearing Current

Liabilities

26

Residual Income

• Recall from the text that EVA is simply a repackaging of Residual Income (RI) where ,

RI = Income – (Investment X Min. Req. Return)