CH 10 Ima

Chapter 10 Management Control In Decentralized Organizations
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 1
Define decentralization and identify its expected benefits and costs.
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Decentralization
The delegation of freedom to make decisions is called decentralization.
The lower in the organization that this freedom exists, the greater the decentralization.
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Centralization versus Decentralization

Centralization Decentralization
Maximum Constraints Minimum Freedom
Minimum Constraints Maximum Freedom

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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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Costs and Benefits

Managers in decentralized units may waste time negotiating with other units about goods or services one unit provides to the other.
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Middle Ground
Cost-benefit considerations usually require that some management decisions be highly decentralized and others centralized. 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.
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Distinguish between profit centers and decentralization.
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Profit Centers and Decentralization

Profit centers Decentralization Accountability for revenue and expenses
Freedom to make decisions
These are entirely separate concepts and one can exist without the other.
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Profit Centers and Decentralization

All control systems are imperfect.
Judgments about their merits should concentrate on which alternative system will bring more of the actions top management seeks.
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Define transfer prices and identify their purpose.
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Transfer Prices
Transfer prices are the amounts charged by one segment of an organization for a product or service that it supplies to another segment of the same organization.
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Purpose of Transfer Pricing

Why do transfer-pricing systems exist? to communicate data that will lead to goal-congruent decisions
to evaluate segment performance and thus motivate managers toward goal-congruent decisions
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Purpose of Transfer Pricing

Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.
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Identify the relative advantages and disadvantages of basing transfer prices on total costs, variable costs, and market prices.
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Transfers at Cost
About half of the major companies in the world transfer items at cost.
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Transfers at Cost
What are some examples? Full cost plus a profit markup Variable costs Standard costs
Actual costs
Full cost
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Market-Based Transfer Prices
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 the desired goal congruence and managerial effort.
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Market-Based Transfer Prices
The major drawback to market-based prices is that market prices are not always available for items transferred internally.
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Variable-Cost Pricing
When market prices cannot be used, versions of cost-plus-a-profit are often used as a fair substitute.
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Variable-Cost Pricing
In situations where idle capacity exists, variable cost would generally be the better basis for transfer pricing and would lead to the optimum decision for the firm as a whole.
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Negotiated Transfer Prices
Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.
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Dysfunctional Behavior
Virtually any type of transfer pricing policy can lead to dysfunctional behavior actions taken in conflict with organizational goals.
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The Need for Many Transfer Prices

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.
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Identify the factors affecting multinational transfer prices.
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Multinational Transfer Pricing Example

An item is produced by Division A in a country with a 25% income tax rate. It is transferred to Division B in a country with a 50% income tax rate. An import duty equal to 20% of the price of the item is assessed. Full unit cost is $100, and variable cost is $60 (either transfer price could be chosen).
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Which transfer price should be chosen?
$100
Why?
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Income of A is $40 higher: 25% $40 = ($10) higher taxes Income of B is $40 lower: 50% $40 = $20 lower taxes Import duty paid by B: 20% $40 = ($8) Net savings = $2
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Explain how the linking of rewards to responsibility center results affects incentives and risk.
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Link Rewards to Results

Motivational Criteria Choices of Responsibility Centers and Incentives
Goal Congruence
Managerial Effort
Performance Measures
Rewards
Feedback Feedback
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Link Rewards to Results

Research shows that the more objective the measures of performance, the more likely the manager will provide effort. Thus accounting measures, which provide relatively objective evaluations of performance, are important.
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Agency Theory
Economists describe the formal choices of performance measures and rewards as agency theory. Employment contracts will trade off three factors: 1 Cost of measuring performance
2 Incentive 3 Risk
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Compute ROI, residual income, and economic value added (EVA) and contrast them as criteria for judging the performance of organization segments.
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Measures of Profitability
Segment managers in decentralized organizations are often evaluated based on their segments profitability. Is it net income? Income before taxes? Net income percentage based on revenue? Is it an absolute amount? A percentage?
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Return on Investment
ROI = Income Investment
ROI
Income Revenue
Revenue Investment
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Return on Investment
Project A: Operating income Investment required
$200,000 $500,000 = 40%

Project B: Operating income Investment required $150,000 $250,000 = 60%
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Residual Income
RI = Net operating income Imputed interest Imputed interest refers to the cost of capital. RI tells you how much your companys operating income exceeds what it is paying for capital.
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Economic Value Added
Economic value added = Income After-tax cost of capital (Long-term liabilities + Stockholders equity)
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Compare the advantages and disadvantages of various bases for measuring the invested capital used by organization segments.
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ROI or Residual Income?

Why do some companies prefer residual income (or EVA) to ROI? Under ROI, the message is go forth and maximize your rate of return, a percentage. Under RI, the message is go forth and maximize residual income, an absolute amount.
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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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Asset Allocation to Divisions
Commonly used bases for allocation, when assets are not directly identifiable with a specific division, include:
Possible Allocation Base Budgeted cash needs Sales weighted by terms Budgeted sales or usage Usage of services
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Asset Class Corporate cash Receivables Inventories Plant and equipment
Valuation of Assets
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. Most companies use net book value in calculating their investment base.
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Understand the role of management control systems in decentralized organizations.
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Keys to Successful Management Control Systems

Successful management control systems have several key factors in addition to appropriate measures of profitability. Controllability Management by objectives
Tailoring budgets for managers
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Focus on Controllability
A distinction should be made between the performance of the division manager and the performance of the division as an investment by the corporation. Managers should be evaluated on the basis of their controllable performance.
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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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Tailoring Budgets for Managers

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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End of Chapter 10
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Chapter 10 Management Control In Decentralized Organizations

Define decentralization and identify its expected benefits and costs.

Centralization versus Decentralization

Maximum Constraints Minimum Freedom

Minimum Constraints Maximum Freedom

Costs and Benefits

Costs and Benefits

Costs and Benefits

Distinguish between profit centers and decentralization.

Profit Centers and Decentralization

Freedom to make decisions

Profit Centers and Decentralization

Define transfer prices and identify their purpose.

Purpose of Transfer Pricing

Purpose of Transfer Pricing

Market-Based Transfer Prices

Market-Based Transfer Prices

Negotiated Transfer Prices

The Need for Many Transfer Prices

Identify the factors affecting multinational transfer prices.

Multinational Transfer Pricing Example

Multinational Transfer Pricing Example

Which transfer price should be chosen?

Multinational Transfer Pricing Example

Link Rewards to Results

Link Rewards to Results

$200,000 $500,000 = 40%

Economic Value Added

ROI or Residual Income?

Asset Allocation to Divisions

Asset Class Corporate cash Receivables Inventories Plant and equipment

Understand the role of management control systems in decentralized organizations.

Keys to Successful Management Control Systems

Tailoring Budgets for Managers

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