Managerial Accounting: Chapter 11 Investment Center Performance Evaluation

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

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

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

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

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?

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

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 Top management sets the transfer price Top management establishes transfer price policies followed by divisions Division managers negotiate transfer prices

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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 Revenues Divisional Divisional Divisional Investment Revenues Investment

EVA = NOPAT - (WACC X Investment) 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 Tax WACC = Weighted-Average Cost of capital Investment = Total Assets - Noninterest- Bearing Current Liabilities

Residual Income Recall from the text that EVA is simply a repackaging of Residual Income (RI) where , RI = Income – (Investment X Min. Req. Return)