1. MANAGEMENT ACCOUNTING
Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

2. Management Accounting Decentralized organizations (Control)
Chapter 7
Management Accounting McWatters, Zimmerman, Morse

3. Objectives
Use the controllability principle to choose performance measures for managers
Identify responsibility centres based on the extent of each manager’s 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
Management Accounting McWatters, Zimmerman, Morse

4. The Controllability Principle
Holding managers responsible for decisions where they have authority
Controllable costs are costs that are affected by a manager’s decisions
Management Accounting McWatters, Zimmerman, Morse

5. The Controllability Principle
A single manager does not have control over all costs
The manager’s responsibilities are limited by the job description
Some costs are affected by the organization’s environment
Management Accounting McWatters, Zimmerman, Morse

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

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

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

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

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

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

12. Hierarchy of Responsibility Centres
Type of responsibility centre
Responsibilities
Performance 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 centre
Choose inputs and outputs with a fixed level of investment
Profit (maximize)
Investment centre
Choose inputs, outputs and level of investment
Return on investment, residual income (maximize)
Management Accounting McWatters, Zimmerman, Morse

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

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

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

16. 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
Management Accounting McWatters, Zimmerman, Morse

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

18. ÷ × ROI Sales Sales Turnover Total Investment Return on Investment
Earnings
Return on Sales
Sales Turnover
Return on Investment ×
Management Accounting McWatters, Zimmerman, Morse

19. ROI Numerical Example
An organization’s 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
Project
Required Investment (£)
Annual Earnings before interest (£)
ROI A
500,000
50,000
10% B
200,000
10,000 5% C
100,000
20,000
20%
Project A and C would add value as their ROI is greater than the opportunity cost of capital. Project B would not add value
Management Accounting McWatters, Zimmerman, Morse

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

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

22. Residual Income
Residual income is the difference between and investment centre’s profits and the opportunity cost of using the 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
It encourages managers to make profitable investments that would be rejected by managers using ROI
Management Accounting McWatters, Zimmerman, Morse

23. 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
Management Accounting McWatters, Zimmerman, Morse

24. 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
Comparisons across investment centres of different sizes are difficult
Management Accounting McWatters, Zimmerman, Morse

25. Multiple Performance Measures
The manager of an investment centre should not be evaluated by a single performance measure
In order to protect the firm’s 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
Management Accounting McWatters, Zimmerman, Morse

26. 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
Management Accounting McWatters, Zimmerman, Morse

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

28. Reasons for Transfer Pricing
Control (incentives and performance measures)
Decentralized planning decisions
International/tax reasons
Management Accounting McWatters, Zimmerman, Morse

29. Summary of Transfer Pricing Methods
Advantages
Disadvantages
Market-Based
Approximates 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 Cost
Approximates 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 Cost
Reduces 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
Negotiated
Maintains 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
Management Accounting McWatters, Zimmerman, Morse

30. 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
Management Accounting McWatters, Zimmerman, Morse

31. Transfer Pricing Numerical Example
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 unit 10 23
Parts cost per unit
Profit per unit
Assembly costs 4 9
Parts Division
Assembly Division
Revenue per unit 12 23
Parts cost per unit 10
Profit per unit 2
Assembly costs 4 7
Management Accounting McWatters, Zimmerman, Morse

32. 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
Management Accounting McWatters, Zimmerman, Morse

33. Transfer Prices for Decentralized Planning Decisions
Circumstance
Transfer Price
Market price exists
Market 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
Management Accounting McWatters, Zimmerman, Morse

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

35. 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
Management Accounting McWatters, Zimmerman, Morse

36. Management Accounting Decentralized organizations (Control)
End of Chapter 7
Management Accounting McWatters, Zimmerman, Morse