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Chapter 10

Management Control in Decentralized Organizations

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Chapter 10 Learning Objectives

1. Define decentralization and identify its expected benefits and costs. 2. Distinguish between responsibility centers and decentralization. 3. Explain how the linking of rewards to responsibilitycenter performance metrics affects incentives and risk.

4. Compute return on investment (ROI), economic profit, and economic value added (EVA).

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Chapter 10 Learning Objectives

5. Compare the incentives created by income, ROI, and economic profit (or EVA) performance measures. 6. Define transfer prices and identify their purpose. 7. State the general rule for transfer pricing and use it to assess transfer prices based on total costs, variable costs, and market prices. 8. Identify the factors affecting multinational transfer prices. 9. Explain how controllability and management by objectives (MBO) aid the implementation of management control systems.
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Learning Objective 1

Decentralization

The delegation of freedom to make decisions is called decentralization. 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.
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Costs and Benefits

Benefits of decentralization:
Lower-level managers have the best information concerning local conditions.
It promotes management skills which, in turn, helps ensure leadership continuity. Managers enjoy higher status from being independent and thus are better motivated.
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Costs and Benefits

Costs of decentralization: Managers may make decisions that are not in the organizations best interests. Managers also tend to duplicate services that might be less expensive if centralized. Costs of accumulating and processing information frequently rise.
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Middle Ground

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 organizations segments are relatively independent of one another.

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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.

For decentralization to work, autonomy must be real, not just lip service. Top managers must be willing to abide by decisions made by segment managers in most circumstances.

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Learning Objective 2

Responsibility Centers and Decentralization

Design of a management control system should consider two separate dimensions of control:

1
Responsibilities

2
Autonomy
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Responsibility Centers and Decentralization

Profit centers Cost Centers

Will a profit center or a cost center better solve the problems of goal congruence and management effort? In designing accounting control systems, top managers must consider the systems impact on behavior desired by the organization.
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Responsibility Centers and Decentralization

The management control system should be designed to achieve the best possible alignment between local manager decisions and the actions central management seeks.

For example, a plant may seem to be a natural cost center because the plant manager has no influence over decisions concerning the marketing of its products.

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Learning Objective 3

Performance Metrics and Management Controls

Linking rewards to responsibilitycenter performance metrics affects incentives and risk. Incentives are the rewards, both implicit and explicit, for managerial effort and actions. A performance metric is a specific measure of management accomplishment.
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Motivation, Performance, and Rewards

Incentives. . .
Performance-based rewards that enhance managerial effort toward organizational goals.

Motivational Criteria

Rewards
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Motivation, Performance, and Rewards

You get what you measure!

Therefore, accounting measures, which provide relatively objective evaluations of performance, are important.

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Performance Metrics and Management Controls

The design of a management control system affects the actions of managers. It specifies how outcomes translate into unit performance metrics and into both explicit and implicit rewards.
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Performance Metrics and Management Controls

Agency theory provides a model to analyze relationships where one party (the principal) delegates decision-making authority to another party (the agent). Agency theory is useful to analyze situations where there is imperfect alignment between the principals and agents 1) Information and 2) Objectives.
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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.

Incentive

Risk

Cost of measuring performance

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Learning Objective 4

Measures of Profitability

Measures of income are readily available from the financial reporting system at any level of the organization for which a company can identify revenues and expenses. Accountants can easily customize income measures such as income before interest and taxes (EBIT) or earnings before interest, taxes, depreciation, and amortization (EBITDA).

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Return on Investment
A more comprehensive measure of profitability that takes into account the investment required to generate income is the return on investment (ROI).

ROI is the product of two items:

Return on sales AND Capital turnover

ROI

Income Revenue = Revenue Investment

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Valuation of Assets

Should values be based on gross book value (original cost) or net book value (original cost less accumulated depreciation). 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.
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Valuation of Assets
Asset values: beginning, ending, or average If investment does not change throughout the year, it will not matter whether assets are measured at the beginning, the end, or average for the year. If investment changes throughout the year, we should measure invested capital as an average for the period.
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Valuation of Assets

Because income is a flow of resources over a period of time, and a company should measure the effect of the flow on the average amount invested. The most accurate measures of average investment take into account the amount invested month-by-month, or even day-by-day.
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Economic Profit (Residual Income)

RI is defined as after-tax net operating income less a capital charge. Capital charge is the cost of capital multiplied by the amount of investment. RI tells you how much a companys after-tax operating income exceeds what it is paying for capital.
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Economic Value Added

Net operating profit after-tax (NOPAT) is income before interest expense but after tax.

Economic value added (EVA) = adjusted NOPAT (weighted average cost of capital adjusted average invested capital)

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Learning Objective 5

Incentives from Income, ROI, or Economic Profit

Why do some companies prefer economic profit (or EVA) to ROI?

ROI can motivate segment managers to make investment decisions that are not in the best interests of the company as a whole. Economic profit (or EVA) motivate managers to invest only in projects earning more than the cost of capital because only those projects increase the divisions economic profit.
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Invested Capital

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

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Learning Objective 6

Transfer Prices

The price that one segment charges another segment of the same organization for a product or service is a transfer price. When one segment of a company produces and sells an item to another segment, a transfer price is required. The transfer price is revenue to the producing company and cost to the acquiring segment.
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Purpose of Transfer Pricing

A company wants profitability metrics that reward the segment manager for decisions that increase both a segments profitability and the profitability of the entire company.

Transfer prices should guide managers to make the best possible decisions regarding whether to buy or sell products inside or outside of the company.

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Learning Objective 7

General Rule

Transfer price = Outlay cost + Opportunity cost Outlay costs require a cash disbursement. They are essentially the additional amount the producing segment must pay to produce the product or service. Opportunity cost is the contribution to profit that the producing segment forgoes by transferring the item internally.

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Transfer-Pricing Systems
Transfer-pricing systems have multiple goals. The general rule provides a good benchmark by which to judge transfer pricing systems. Popular transfer-pricing systems: 1. Market-based transfer prices 2. Cost-based transfer prices a. Variable cost b. Full cost (possibly plus profit) 3. Negotiated transfer prices
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Market-Based Transfer Prices

If a market price exists, use it.
If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to goal congruence . . . . . . because the market price equals the variable cost plus opportunity cost. Sometimes market prices are not always available for items transferred internally.
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Market-Based Transfer Prices Drawbacks

When market prices dont exist, companies resort to cost-based transfer prices.
Cost-based transfer prices are easy to understand and use.

Cost-based transfer prices lead to dysfunctional decisions - decisions in conflict with the companys goals.
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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.
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.
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Variable-Cost Pricing
This transfer pricing system is most appropriate when the selling division forgoes no opportunity when it transfers the item internally. Variable-cost transfer prices cause dysfunctional decisions when the selling segment has significant opportunity costs.
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Negotiated Transfer Prices

Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.

Open negotiation allows the managers to make optimal decisions.

Critics of negotiated prices focus on the time and effort spent negotiating, an activity that adds nothing directly to the profits of the company.
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Learning Objective 8

Multinational Transfer Pricing

Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

Divisions in a high-income-tax-rate country produce components for another division in a low-income-tax-rate country. A low transfer price would allow the company to recognize most of the profit in the low-income-tax-rate country, thereby minimizing taxes.
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Multinational Transfer Pricing Example

Tax authorities also recognize the incentive to set transfer prices to minimize taxes and import duties. Therefore, most countries have restrictions on allowable transfer prices. U.S. multinationals must follow an Internal Revenue Code rule specifying that transfers be priced at arms-length market values, or at the price one division would pay another if they were independent companies.

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Multinational Transfer Pricing Example

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. 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).
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Multinational Transfer Pricing Example

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 Import duty paid by German division: 20% $40 = ($8) Net savings = $3.20
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Learning Objective 9

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.

The managers performance is then evaluated in relation to these agreed-upon budgeted objectives.
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Budgets, Performance Targets, and Ethics

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.

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Budgets, Performance Targets, and Ethics

Using budgets as performance targets also has its danger. Companies that make meeting a budget too important can motivate unethical behavior.

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