Performance Evaluation for Decentralized Operations & TRANSFER PRICING

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1.List and explain the advantages and disadvantages of decentralized operations. 2.Prepare a responsibility accounting report for a cost center. 3.Prepare responsibility accounting reports for a profit center. 4.Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. ObjectivesObjectives After studying this chapter, you should be able to:

5.Explain how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business. ObjectivesObjectives

Centralized and Decentralized Operations

Advantages of Decentralization  It allows managers to focus on acquiring expertise in their areas of responsibility.  Decentralizing decision making provides excellent training for managers.  Delegation improves employee morale.  Decentralization helps managers create good customer relations by responding quickly to customers’ needs.  Managers become more creative in suggesting operating and product improvement.

 Decisions made by one manager may negatively affect the profitability of the entire organization.  Assets and operating costs are duplicated (e.g., each division has its own administrative office staff). Disadvantages of Decentralized Operations

Responsibility Centers Managers are held accountable for controlling costs. Cost Centers Cost Centers Profit Centers Profit Centers Managers are held accountable for costs and making decisions that impact revenues favorably.

Investment Centers Investment Centers Managers are held accountable for costs and revenues and are also held accountable for the efficient use of assets. Responsibility Centers

COLLEGE Responsibility Accounting for Cost Centers College of Engineering College of Arts and Sciences College of Business UNIVERSITY Dept. of Management Dept. of Marketing Dept. of Accounting COST CENTERS IN A UNIVERSITY

Responsibility Accounting for Cost Centers DEPARTMENT COST CENTERS IN A UNIVERSITY Department of Accounting

OverUnder BudgetActualBudgetBudget Budget Performance Report Supervisor, Department 1—Plant A For the Month Ended October 31, 2006 Factory wages$ 58,100$ 58,000$100 Materials32,50034,225$1,725 Supervisory salaries6,4006,400 Power and light5,7505, Depreciation4,0004,000 Maintenance2,0001,99010 Insurance, taxes $109,725$111,280$1,725$170 Cost Centers These totals are shown on the Manager, Plant A’s budget performance report (Slide 13). $109,725$111,280$1,725$170

OverUnder BudgetActualBudgetBudget Administration$ 17,500$ 17,350$150 Department 1109,725111,280$1,555 Department 2 190,500192,6002,100 Department 3 149,750149, $467,475$470,330$3,655$800 From the Supervisor—Department 1, Plant A budget performance report (Slide 12). Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 Cost Centers Department 1 109, ,280 $1,555 Department 1 109, ,280 $1,555

Administration$ 17,500$ 17,350$150 Department 1109,725111,280$1,555 Department 2 190,500192,6002,100 Department 3 149,750149, $467,475$470,330$3,655$800 Cost Centers This is shown on the Vice-President’s budget production report (Slide 15). $467,475 $470,330 $3,655 $800 Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 OverUnder BudgetActualBudgetBudget

Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 OverUnder BudgetActualBudgetBudget Administration$ 19,500$ 19,700$ 200 Plant A467,475470,3302,855 Plant B 395, ,300$925 $882,200$884,330$3,055$925 Cost Centers Note that “Over Budget” is a net figure.

Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 OverUnder BudgetActualBudgetBudget Administration$ 19,500$ 19,700$ 200 Plant A467,475470,3302,855 Plant B 395, ,300$925 $882,200$884,330$3,055$925 Each of the line items above is supported by a cost center report. Cost Centers

Responsibility Accounting for Profit Centers In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues.

Profit centers may be divisions, departments, or products.

Profit Centers NEG, a diversified entertainment company, has two profit centers: the Theme Park Division and the Movie Production Division. Theme Park Division Movie Production Division Revenues$6,000,000$2,500,000 Operating expenses2,495,000405,000

Charging Service Department Costs to Production Divisions Purchasing Department: $400,000 (Activity base: number of purchase requisitions) Theme Park Division25,000 purchase requisitions Movie Production Division:15,000 purchase requisitions Total40,000 $400,000 40,000 purchase requisitions $10 per purchase requisition = Profit Centers

Charging Service Department Costs to Production Divisions Payroll Accounting: $255,000 (Activity base: number of payroll checks) $255,000 15,000 payroll checks = $17 per payroll check Theme Park Division12,000 payroll checks Movie Production Division: 3,000 payroll checks Total15,000 Profit Centers

Charging Service Department Costs to Production Divisions Legal Department: $250,000 (Activity base: number of payroll checks) $250,000 1,000 hours = $250 per hour Theme Park Division 100 billed hours Movie Production Division: 900 billed hours Total1,000 Profit Centers

Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 ThemeMovie ParkProduction Service DepartmentDivisionDivision Profit Centers Purchasing$250,000$150,000 25,000 purchase requisitions x $10 per purchase requisition 15,000 purchase requisitions x $10 per purchase requisition

Purchasing$250,000$150,000 Payroll accounting204,00051,000 12,000 payroll checks x $17 per payroll check 3,000 payroll checks x $17 per payroll check Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 ThemeMovie ParkProduction Service DepartmentDivisionDivision Profit Centers

Purchasing$250,000$150,000 Payroll accounting204,00051,000 Legal25,000225,000 Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 ThemeMovie ParkProduction Service DepartmentDivisionDivision Profit Centers 100 hours x $250 per hour 900 hours x $250 per hour

Purchasing$250,000$150,000 Payroll accounting204,00051,000 Legal 25, ,000 Total service department charges$479,000$426,000 Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 ThemeMovie ParkProduction Service DepartmentDivisionDivision Profit Centers

Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division Movie Production Division Income from operations before service department charges. Revenues$6,000,000$2,500,000 Operating expenses 2,495, ,000 Income from operations$3,505,000$2,095,000

Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division Movie Production Division Revenues$6,000,000$2,500,000 Operating expenses 2,495, ,000 Income from operations$3,505,000$2,095,000 Less service dept. charges: Purchasing$ 250,000$ 150,000 Payroll accounting204,00051,000 Legal 25, ,000 Total service department charges$ 479,000$ 426,000 Income from operations$3,026,000$1,669,000

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Responsibility Accounting for Investment Centers In an investment center, the unit manager has the responsibility and the authority to make decisions that affect not only costs and revenues but also the assets invested in the center.

Datalink Inc. Divisional Income Statements For the Year Ended December 31, 2006 NorthernCentralSouthern DivisionDivisionDivision Revenues$560,000$672,000$750,000 Operating expenses 336, , ,500 Income from operations before service dept. charges$224,000$201,600$187,500 Service department charges 154, , ,500 Income from operations$ 70,000$ 84,000$ 75,000 Invested assets$350,000$700,000$500,000 Rate of return on investment20%12%15% Investment Centers 20% 12% 15% 20% 12% 15%

Revenues Rate of Return on Investment (ROI)

Investment Turnover Profit Margin Profit Rate of Return on Investment (ROI)

The profit margin indicates the rate of profit on each sales dollar. The investment turnover indicates the rate of sales on each dollar of invested assets. Profit Margin Investment Turnover Rate of Return on Investment (ROI)

Income from operation Sales Invested assets x ROI = $ 70,000 $560,000 x $350,000 ROI = 12.5% x 1.6 = 20% Rate of Return on Investment (ROI)

Income from operation Sales Invested assets x ROI = Rate of Return on Investment (ROI) Profit Margin Inventory Turnover

NorthernCentralSouthern DivisionDivisionDivision Profit Margin Profit Margin Income from operations $ 70,000$ 84,000 $ 75,000 Revenues (Sales) $560,000$672,000$750,000 Profit margin12.5%12.5%10.0% Investment Turnover Investment Turnover Revenues (Sales) $560,000$672,000$750,000 Invested assets$350,000$700,000$500,000 Investment turnover Return on Investment (ROI) Return on Investment (ROI) Income from operations $ 70,000$ 84,000$ 75,000 Invested assets$350,000$700,000$500,000 Rate of return on investment 20% 12% 15%

Income from Operations Minimum Acceptable Rate of Return on Assets – = Residual Income

NorthernCentralSouthern DivisionDivisionDivision Baldwin Company Divisional Income Statements For the Year Ended December 31, 2006 Income from operations$70,000$84,000$75,000 Minimum acceptable income from operations as a percent of invested assets: $350,000 x 10%35,000 $700,000 x 10%70,000 $500,000 x 10%50,000 Residual income$35,000$14,000$25,000

The balance scorecard is a set of financial and nonfinancial measures that reflect multiple performance dimensions of a business.

Innovation and Learning R&D investment R&D pipeline Skills and training Time to market Innovation and Learning R&D investment R&D pipeline Skills and training Time to market Customer Satisfaction Loyalty Perception Customer Satisfaction Loyalty Perception Efficiency Quality Time Efficiency Quality Time Financial ROI Residual income Profit Cost Sales Financial ROI Residual income Profit Cost Sales Internal Process

Transfer Pricing

When divisions transfer products or render services to each other, a transfer pricing is used to charge for the products or services

Benefits of Transfer Pricing 1.Divisions can be evaluated as profit or investment centers. 2.Divisions are forced to control costs and operate competitively. 3.If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

1.Market price approach sets the price at which the product transferred could be sold to outside buyers. 2.Negotiated price approach allows decentralized managers to agree (negotiate) among themselves. 3.Cost price approach (variable or full) uses a variety of cost concepts for setting the transfer price. Commonly Used Transfer Prices

Variable Cost per Unit $10 Market Price per Unit $20 Full Cost per Unit $13 Negotiated Price Commonly Used Transfer Prices

Transfer Pricing—Negotiated Price Approach 1.Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity. 2.Division N purchases 20,000 units of the same product at $20 per unit from an outside source. Assumptions Assumptions If the division managers agree on a price of $15 per unit, how much will each division’s income increase?

JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.