2. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 1 Introduction to Management Accounting

3. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 2 Management Control in Decentralized Organizations Introduction to Management Accounting Chapter 10

4. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 3 Decentralization The delegation of freedom to make decisions is called decentralization. The delegation of freedom to make decisions is called decentralization. The lower in the organization that this freedom exists, the greater the decentralization. The lower in the organization that this freedom exists, the greater the decentralization. Learning Objective 1 The process by which decision making is concentrated within a particular location or group is called centralization. The process by which decision making is concentrated within a particular location or group is called centralization.

5. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 4 Costs and Benefits Benefits of decentralization: Lower-level managers have the best information concerning local conditions. Lower-level managers have the best information concerning local conditions. It promotes management skills which, in turn, helps ensure leadership continuity. It promotes management skills which, in turn, helps ensure leadership continuity. Managers enjoy higher status from being independent and thus are better motivated. Managers enjoy higher status from being independent and thus are better motivated.

6. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 5 Costs and Benefits Costs of decentralization: Managers may make decisions that are not in the organization’s best interests. Managers may make decisions that are not in the organization’s best interests. Managers also tend to duplicate services that might be less expensive if centralized. Managers also tend to duplicate services that might be less expensive if centralized. Costs of accumulating and processing information frequently rise. Costs of accumulating and processing information frequently rise.

7. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 6 Costs and Benefits Managers in decentralized units may waste time negotiating with other units about goods or services one unit provides to the other. Managers in decentralized units may waste time negotiating with other units about goods or services one unit provides to the other.

8. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 7 Middle Ground Many companies find that decentralization works best in part of the company, while centralization works better in other parts. Many companies find that decentralization works best in part of the company, while centralization works better in other parts. Decentralization is most successful when an organization’s segments are relatively independent of one another. Decentralization is most successful when an organization’s segments are relatively independent of one another.

9. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 8 Segment Autonomy If management has decided in favor of heavy decentralization, segment autonomy, the delegation of decision- making power to managers of segments of an organization, is also crucial. If management has decided in favor of heavy decentralization, segment autonomy, the delegation of decision- making power to managers of segments of an organization, is also crucial.

10. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 9 Responsibility Centers and Decentralization Design of a management control system should consider two separate dimensions of control: Design of a management control system should consider two separate dimensions of control: Responsibilities 1 Autonomy 2 Learning Objective 2

11. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 10 Responsibility Centers and Decentralization Profit centers DecentralizationDecentralization These are entirely separate concepts and one can exist without the other. These are entirely separate concepts and one can exist without the other.

12. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 11 Responsibility Centers and Decentralization All control systems are imperfect. The choice among systems should be based on which one will bring more of the actions top management seeks. The choice among systems should be based on which one will bring more of the actions top management seeks.

13. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 12 Motivation, Performance, and Rewards Criteria and Choices when Designing a Management Control System GoalCongruenceGoalCongruence ActionsActions PerformanceMeasuresPerformanceMeasuresRewardsRewards Feedback Motivational criteria ManagerialEffortManagerialEffort Feedback Choice of Responsibility Centers and Incentives Learning Objective 3

14. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 13 Motivation, Performance, and Rewards Incentives... Performance-based rewards that enhance managerial effort toward organizational goals. Performance-based rewards that enhance managerial effort toward organizational goals. RewardsRewards Motivational Criteria

15. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 14 Motivation, Performance, and Rewards You get what you measure! Therefore, accounting measures, which provide relatively objective evaluations of performance, are important. Therefore, accounting measures, which provide relatively objective evaluations of performance, are important.

16. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 15 Agency Theory, Performance, Rewards, and Risks Agency theory deals with contracting between an organization and the managers that it hires to make decisions on its behalf. Agency theory deals with contracting between an organization and the managers that it hires to make decisions on its behalf. IncentiveIncentiveRiskRisk Cost of measuring performance performance

17. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 16 Measures of Profitability Profitability does not mean the same thing to all people. Profitability does not mean the same thing to all people. Is it net income? Income before taxes? Net income percentage based on revenue? Is it an absolute amount? A percentage? Is it net income? Income before taxes? Net income percentage based on revenue? Is it an absolute amount? A percentage? Learning Objective 4

18. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 17 Return on Investment ROI = Income ÷ Investment ROIROI=IncomeRevenueIncomeRevenue×RevenueInvestmentRevenueInvestment

19. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 18 Return on Investment Division A ROI: = Income ÷ Investment $200,000 ÷ $500,000 = 40% $200,000 ÷ $500,000 = 40% Division A ROI: = Income ÷ Investment $200,000 ÷ $500,000 = 40% $200,000 ÷ $500,000 = 40% Division B ROI: = Income ÷ Investment $150,000 ÷ $250,000 = 60% $150,000 ÷ $250,000 = 60% Division B ROI: = Income ÷ Investment $150,000 ÷ $250,000 = 60% $150,000 ÷ $250,000 = 60%

20. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 19 Capital charge is the cost of capital multiplied by the amount of investment. Capital charge is the cost of capital multiplied by the amount of investment. Residual Income RI tells you how much a company’s after-tax operating income exceeds what it is paying for capital. RI tells you how much a company’s after-tax operating income exceeds what it is paying for capital. RI is defined as after-tax net operating income less a capital charge. RI is defined as after-tax net operating income less a capital charge.

21. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 20 Economic Value Added Economic value added (EVA) Economic value added (EVA) = Adjusted after-tax operating income – Cost of invested capital (%) × Adjusted average invested capital Economic value added (EVA) Economic value added (EVA) = Adjusted after-tax operating income – Cost of invested capital (%) × Adjusted average invested capital

22. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 21 ROI or Residual Income? Why do some companies prefer economic profit (or EVA) to ROI? Why do some companies prefer economic profit (or EVA) to ROI? Under ROI, the message is go forth and maximize your rate of return, a percentage. Under ROI, the message is go forth and maximize your rate of return, a percentage. Under EVA, the message is go forth and maximize economic profit, an absolute dollar amount. Under EVA, the message is go forth and maximize economic profit, an absolute dollar amount.

23. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 22 Invested Capital To apply either ROI or residual income, both income and invested capital must be measured and defined. To apply either ROI or residual income, both income and invested capital must be measured and defined.  Total assets  Total assets employed  Total assets less current liabilities  Stockholders’ equity  Total assets  Total assets employed  Total assets less current liabilities  Stockholders’ equity Learning Objective 5

24. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 23 Valuation of Assets Should values be based on historical cost or some version of current value? Should values be based on historical cost or some version of current value? Practice is overwhelmingly in favor of using net book value based on historical cost. Practice is overwhelmingly in favor of using net book value based on historical cost. Most companies use net book value in calculating their investment base. Most companies use net book value in calculating their investment base.

25. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 24 Transfer Prices The price that one segment charges another segment of the same organization for a product or service is a transfer price. The price that one segment charges another segment of the same organization for a product or service is a transfer price. Learning Objective 6

26. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 25 Purpose of Transfer Pricing Why do transfer-pricing systems exist? Management wants to create performance measurement systems. Management wants to create performance measurement systems. Decisions that maximize a segment’s profit should also maximize the profits of the entire company. Decisions that maximize a segment’s profit should also maximize the profits of the entire company.

27. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 26 Purpose of Transfer Pricing Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs. Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

28. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 27 General Rule Transfer price = Outlay cost + Opportunity cost Fabric division outlay cost = $6; Opportunity cost = $4 Sportswear division cost = Transfer price + Other costs $22 = $10 + $12; Selling price = $25 Sportswear division cost = Transfer price + Other costs $22 = $10 + $12; Selling price = $25 Fabric transfer price = $10 Learning Objective 7

29. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 28 Transfer-pricing Systems 1.Market-based transfer prices 2.Cost-based transfer prices a.Variable Cost b.Full cost (possibly pus profit) 3. Negotiated transfer prices 1.Market-based transfer prices 2.Cost-based transfer prices a.Variable Cost b.Full cost (possibly pus profit) 3. Negotiated transfer prices

30. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 29 Market-Based Transfer Prices Using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort. Using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort. In this case, the market price is equal to the variable cost plus opportunity cost. In this case, the market price is equal to the variable cost plus opportunity cost. If a market price exists, use it.

31. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 30 Market-Based Transfer Prices Drawbacks Market prices are not always available Market prices are not always available for items transferred internally. for items transferred internally. Market prices are not always available Market prices are not always available for items transferred internally. for items transferred internally. Imperfectly competitive markets exist. Imperfectly competitive markets exist. When market prices don’t exist, most companies resort to cost-based transfer prices. When market prices don’t exist, most companies resort to cost-based transfer prices.

32. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 31 Variable-Cost Pricing This transfer pricing system is most appropriate when the selling division forgoes no opportunity when it transfers the item internally. This transfer pricing system is most appropriate when the selling division forgoes no opportunity when it transfers the item internally. Cost-based transfer prices lead to dysfunctional decisions - decisions in conflict with the company’s goals. Cost-based transfer prices lead to dysfunctional decisions - decisions in conflict with the company’s goals.

33. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 32 Full-Cost Pricing This transfer pricing system includes not only variable cost but also an allocation of fixed costs (and, if included, the profit mark-up.) It is implicitly assumed that the allocation is a good approximation of the opportunity cost. This transfer pricing system includes not only variable cost but also an allocation of fixed costs (and, if included, the profit mark-up.) It is implicitly assumed that the allocation is a good approximation of the opportunity cost. Dysfunctional decisions arise with full-cost transfer prices when the selling segment has opportunity costs that differ significantly from the allocation of fixed costs and profit. Dysfunctional decisions arise with full-cost transfer prices when the selling segment has opportunity costs that differ significantly from the allocation of fixed costs and profit.

34. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 33 Negotiated Transfer Prices Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices. Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices. Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals. Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals.

35. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 34 The Need for Many Transfer Prices The “correct” transfer price depends on the economic and legal circumstances and the decision at hand. The “correct” transfer price depends on the economic and legal circumstances and the decision at hand. Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort. Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort. State fair-trade laws and national antitrust acts can also influence transfer pricing. State fair-trade laws and national antitrust acts can also influence transfer pricing.

36. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 35 Multinational Transfer Pricing Example A high-end running shoe produced by an Irish Nike division with a 12% income tax rate. A high-end running shoe produced by an Irish Nike division with a 12% income tax rate. It is transferred to a division in Germany with a 40% income tax rate. It is transferred to a division in Germany with a 40% income tax rate. An import duty equal to 20% of the price of the item is imposed by Germany. An import duty equal to 20% of the price of the item is imposed by Germany. Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen). Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen). Learning Objective 8

37. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 36 Multinational Transfer Pricing Example Which transfer price should be chosen? Tax authorities allow either variable- or full-cost transfer prices. Tax authorities allow either variable- or full-cost transfer prices.

38. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 37 Multinational Transfer Pricing Example Income of the Irish division is $40 higher: 12% × $40 = ($4.80) higher taxes Income of the Irish division is $40 higher: 12% × $40 = ($4.80) higher taxes Income of the German division is $40 lower: 40% × $40 = $16 lower taxes Income of the German division is $40 lower: 40% × $40 = $16 lower taxes Import duty paid by German division: 20% × $40 = ($8) Import duty paid by German division: 20% × $40 = ($8)  Net savings = $3.20

39. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 38 Management by Objectives MBO describes the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period. MBO describes the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period. The manager’s performance is then evaluated in relation to these agreed-upon budgeted objectives. The manager’s performance is then evaluated in relation to these agreed-upon budgeted objectives. Learning Objective 9

40. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 39 Budgets, Performance Targets, and Ethics Many of the troublesome motivational effects of performance evaluation systems can be minimized by the astute use of budgets. Many of the troublesome motivational effects of performance evaluation systems can be minimized by the astute use of budgets. The desirability of tailoring a budget to particular managers cannot be overemphasized. The desirability of tailoring a budget to particular managers cannot be overemphasized.

41. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 40 Budgets, Performance Targets, and Ethics Using budgets as performance targets also has its danger. Using budgets as performance targets also has its danger. Companies that make meeting a budget too important can motivate unethical behavior. Companies that make meeting a budget too important can motivate unethical behavior.

42. ©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 10 - 41 End of Chapter 10 The End