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© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman,

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Presentation on theme: "© Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman,"— Presentation transcript:

1 © Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

2 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Management Accounting Decentralized organizations (Control) Chapter 7

3 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Objectives Use the controllability principle to choose performance measures for managers Identify responsibility centres based on the extent of each managers responsibilities Choose performance measures for cost, profit and investment centres Identify the strengths and weaknesses of using ROI and residual income as performance measures for investment centres Choose transfer prices to create performance measures that reflect the activities controlled by each manager Use opportunity costs to choose transfer prices that will lead to decentralized decision making that is best for the organization Choose transfer prices to minimize taxes and overcome international obstacles

4 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse The Controllability Principle Controllable costs are costs that are affected by a managers decisions Holding managers responsible for decisions where they have authority

5 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse The Controllability Principle Some costs are affected by the organizations environment The managers responsibilities are limited by the job description A single manager does not have control over all costs

6 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Performance measures based on controllable costs lead to more predictable rewards for managers Management actions Uncontrollable environmental effects Costs Managers only partially control costs Performance measures Rewards The Controllability Principle

7 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Performance measures and rewards will influence management to focus on controllable costs The Controllability Principle Management Actions Uncontrollable Environmental Effects Costs Performance Measures Rewards

8 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse When performance measures are affected by uncontrollable environmental effects management may try to control performance measures rather than the underlying costs The Controllability Principle Management Actions Uncontrollable Environmental Effects Costs Performance Measures Rewards

9 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Relative performance measurement attempts to remove uncontrollable factors by comparing performance measures of different managers facing similar circumstances The Controllability Principle

10 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Responsibility Centres A Cost Center manager has control over the incurrence of costs, but no control over revenues or investment funds An Investment Center manager has control over costs, revenues, and investment funds A Profit Center manager has control over both costs and revenues, but no control over investment funds

11 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Responsibility Accounting Responsibility Accounting is the process of recognizing sub-units within the organization assigning responsibilities to managers evaluating the performance of those managers

12 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Hierarchy of Responsibility Centres Type of responsibility centre ResponsibilitiesPerformance measurement Cost centre (type 1)Choose output for a given cost of inputs Output (maximize given quality constraints) Cost centre (type 2)Choose input mix to achieve a given output Cost (minimize given quality constraints) Profit centreChoose inputs and outputs with a fixed level of investment Profit (maximize) Investment centreChoose inputs, outputs and level of investment Return on investment, residual income (maximize)

13 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Hierarchy of Responsibility Centers Cost Centers Mfg.Sales Product 1 Mfg.Sales Product 2 Division A Mfg. Sales Product 3 Division B Chief Executive Officer

14 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Hierarchy of Responsibility Centers { Profit Centers Mfg.Sales Product 1 Mfg.Sales Product 2 Division A Mfg. Sales Product 3 Division B Chief Executive Officer

15 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Hierarchy of Responsibility Centers Mfg.Sales Product 1 Mfg.Sales Product 2 Division A Mfg. Sales Product 3 Division B Chief Executive Officer { Investment Centers

16 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Responsibility Centers Numerical Example The television division requests 100 million to develop, manufacture and sell a new flat-screen model Central administration borrows 100 million at a 10% interest rate to provide the cash. The television department invests the 100 million to generate profits of 6 million The net effect: Interest expense 10 million annually less profit on the new model 6 million The investment resulted in a 4 million loss The net effect: Interest expense 10 million annually less profit on the new model 6 million The investment resulted in a 4 million loss

17 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Return on Investment (ROI) Can be compared against the opportunity cost of capital Return on= Earnings before / Total assets of Investment Interest the Investment Return on= Earnings before / Total assets of Investment Interest the Investment An evaluation of profit as measured against the size of the investment centre

18 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse ROI Return on Sales Sales Turnover Total Investment Sales ÷ Earnings ÷ Return on Investment ×

19 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse ROI Numerical Example An organizations investment centre has a number of investment opportunities. The opportunity cost of capital of the organization is 8%. What is the ROI of these investment opportunities and which would add value to the organization ProjectRequired Investment (£)Annual Earnings before interest (£)ROI A500,00050,00010% B200,00010,0005% C100,00020,00020% Project A and C would add value as their ROI is greater than the opportunity cost of capital. Project B would not add value

20 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Problems with ROI ROI does not necessarily recognize the risk of projects and incentives to under- or over-invest ROI may lead to an under- or over-investment in assets –Only assets with high returns will be purchased ROI may lead to an under- or over-investment in assets –Only assets with high returns will be purchased ROI does not recognize the risk of the investment centre –Higher returns imply higher risk ROI does not recognize the risk of the investment centre –Higher returns imply higher risk

21 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Increase Sales Increase Sales Reduce Expenses Reduce Expenses Reduce Assets Reduce Assets Return on Investment (ROI) Ways to improve ROI

22 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Residual income is the difference between and investment centres profits and the opportunity cost of using the assets Residual Income It encourages managers to make profitable investments that would be rejected by managers using ROI Residual = Profits – (Opportunity cost of capital x Total assets) Income = (Profits/Total assets x Total assets) – (Opportunity cost of capital x Total Assets) =(ROI x Total assets) – (Opportunity cost of capital x Total Assets) = ROI – Opportunity cost of capital x Total Assets Residual = Profits – (Opportunity cost of capital x Total assets) Income = (Profits/Total assets x Total assets) – (Opportunity cost of capital x Total Assets) =(ROI x Total assets) – (Opportunity cost of capital x Total Assets) = ROI – Opportunity cost of capital x Total Assets

23 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Residual Income Numerical Example A tractor division has profits (not including interest expense) of £20 Million and investment (Total assets) of £100 million. The division has an opportunity cost of capital of 15%. What is the residual income of the division £20 Million – (15% x £100 Million) = £5 Million

24 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Problems with Residual Income Changes in market value are not measured The historical cost of assets is used Managers will try to increase residual income, while the stockholders would like to see market value increase Changes in market value are not measured The historical cost of assets is used Managers will try to increase residual income, while the stockholders would like to see market value increase Comparisons across investment centres of different sizes are difficult

25 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Multiple Performance Measures The manager of an investment centre should not be evaluated by a single performance measure In order to protect the firms reputation investment centre managers are usually constrained in terms of the quality of products they can sell and the market niches that they can enter

26 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Transfer Pricing The amount charged when one division sells goods or services to another division The transfer price affects the profit measure for the selling division and the buying division

27 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse The External and Internal Transfer of Products External Supplier Division A Division B External Customer Intermediate Product Finished Product Raw Materials

28 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Reasons for Transfer Pricing 1.Control (incentives and performance measures) 2.Decentralized planning decisions 3.International/tax reasons 1.Control (incentives and performance measures) 2.Decentralized planning decisions 3.International/tax reasons

29 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Summary of Transfer Pricing Methods MethodAdvantagesDisadvantages Market-BasedApproximates opportunity cost if competitive market exists Excludes effects of internal transaction costs on transfer price May not have external market for intermediate good Excludes effects of internal transaction costs of transfer price Variable CostApproximates opportunity cost if fixed costs are sunk Does not allow selling division to recover fixed costs Provides incentive for selling division to convert fixed costs to variable costs Full CostReduces disputes as the figure is objective Simple to compute as it parallels accounting system figures Approximates opportunity cost if division operating at capacity Overstates opportunity cost if excess capacity exists NegotiatedMaintains managerial autonomy Preserves upper-management time Is time consuming and relies on negotiation skills of divisional managers May not be the optimal transfer price for the firm as a whole Can lead to conflicts between responsibility centres

30 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Control Issues Transfer prices can be used as inputs to the performance measurement system Transfer pricing assigns costs to managers who are responsible for the costs

31 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Transfer Pricing Numerical Example Parts Division£Assembly Division£ Revenue per unit12Revenue per unit23 Parts cost per unit10Parts cost per unit12 Profit per unit2Assembly costs4 Profit per unit7 The Parts division manufactures parts that it sells to the Assembly division The cost to the Parts division is £10 per unit. The Assembly division assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit. What is the profit per unit if the transfer price is £12 each What is the profit per unit if the transfer price is £10 each Parts Division£Assembly Division£ Revenue per unit10Revenue per unit23 Parts cost per unit10Parts cost per unit10 Profit per unit0Assembly costs4 Profit per unit9

32 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Transfer Pricing for Decentralized Planning Purposes Some divisions are required to buy internally produced items The internal producer may not have an incentive to keep costs down When managers have the decision right to buy outside, the internal producer must stay competitive on both quality and cost Some divisions are required to buy internally produced items The internal producer may not have an incentive to keep costs down When managers have the decision right to buy outside, the internal producer must stay competitive on both quality and cost

33 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Transfer Prices for Decentralized Planning Decisions CircumstanceTransfer Price Market price existsMarket price No market price exists; supplying division has no alternative use of capacity Variable cost No market price exists; supplying division has alternative use of capacity Full Cost* *The full cost is intended to be a rough approximation of the forgone opportunity of using the facilities of the supplying division to do something else

34 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Choosing Transfer Prices A transfer price that maximizes firm value (a planning issue) may not maximize a managers performance measure (a control issue) Negotiated transfer prices are more effective when there is an external market alternative

35 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Globalization and Transfer Pricing Tax Minimization – if a multinational transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countries Political Considerations can affect the transfer- pricing decision, if there is a risk of expropriation of assets the company may use high transfer prices to reduce the apparent profitability of their foreign subsidiaries

36 © Pearson Education Limited Management Accounting McWatters, Zimmerman, Morse Management Accounting Decentralized organizations (Control) End of Chapter 7


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