Chapter seven

Decentralization and Transfer

Pricing
7.1. Decentralization in organizations
• Decentralization: delegation of decision
making authority to lower level managers.
• In centralized organizations, lower level
managers have little or no freedom to make
decisions.
• In contrast decentralized organizations
empower decision making authority to even
the lowest level of managers.
• Advantages and disadvantages of
decentralization
• Major advantages
1. Top manager can concentrate on bigger issues
such as overall strategy.
2. Puts decision making authority in the hand of
those who have detailed and up to date
information about day-to-day operations.
3. By eliminating layers of decision making and
approvals, organizations can respond more
quickly to customers and to change in the
operating environment.
4.Helps train lower-level managers for higher-
level positions.
• Even if the level is different, every manager
needs to plan, budget and make decision.
• Therefore, while doing this, the lower level
managers will have the knowhow about
managing.
5.Empowering lower-level mangers increase
their motivation and job satisfaction.
• Major disadvantages
1. Lower level managers may make decisions
without fully understanding the big picture.
2. Coordination among departments or
segments may be lucking.
3. May have objectives that clash with objective
of organization.
4. Spreading innovative idea may be difficult.
• Responsibility Accounting
• Responsibility accounting is a system that
measures the plans, budgets and actual results of
each responsibility center.
• Decentralized organizations need responsibility
accounting system to measure the outcome of
the decisions made by each level of manager.
• If managers are given the authority to make a
decision it means they are responsible for the
outcome of their decision.
• Therefore, it is important to measure the
performance of each level of manager.
7.2. Responsibility Center
• Is a part, segment or subunit of an organization
whose manager is responsible for specific set of
activities.
• Responsibility centers are used for any part of an
organization whose managers has control over
and is accountable for cost, profit or investment
centers.
Types of responsibility centers
1. Cost center
2. Profit center
3. Investment center
• Cost center: manager have control over cost but
not over revenue and investment.
• It can make decision regarding costs only and
does not have responsibility for earning revenue
or making investment.
• Profit center: managers have control over costs
and revenues but not investments.
• They are evaluated by comparing actual profit to
targeted or budgeted profit.
• Investment center: managers have control over
cost, revenue and investment in operating assets.
• These managers are evaluated using either
return on investment (ROI) or residual income.
Evaluating investment center performance
• Segment income statement is used to
evaluate cost and profit centers.
• In the case of investment center, it requires
measuring beyond cost and profit.
• Return on investment: is defined as net
operating income divided by average
operating assets.
• ROI = net operating income
Average operating assets
• Higher level of ROI is interpreted as greater profit
earned per dollar invested in the segment
operating assets.
• Operating assets: include all assets held for
operating purposes.
• E.g. cash, A/R, inventory, plant and equipment
etc…
 Non-operating assets: -
• land held for future use
• Investment in another company
• Building rented to someone else.
• ROI can also be expressed as follows:
• ROI = margin * turnover
• Margin = net operating income
Sales
• turnover = sales
average operating assets
• Margin can be improved by increasing sales or
reducing operating expense.
• The lower the operating expense, the higher
the margin earned.
• Turnover is also a crucial thing in measuring
the investment in operating assets.
• Excessive fund tied up in operating assets
depresses turnover and as a result lowers ROI.
Inefficient use of operating assets can also
have the same effect.
• To improve ROI, one of the following
measures could be taken:
– Increase sales
– Reduce operating expense
– Reduce operating assets.
•
• Illustration: a certain company expects the
following operating results
• Sales br. 100,000
• Operating expense br. 90,000
• Net operating income br. 10,000
• Average operating asset br. 50,000
• This company is planning to buy new machine by
investing br. 2000.
• The new machine is expected to increase sales by
br. 4000 and
• require additional operating expenses of br.
1000.
• The new ROI would be:
• ROI = 13,000 * 104,000 = 0.125 * 2 = 25%
104,000 52,000
• The manager would probably decide to invest on
the new machine because it is expected to
increase the ROI.
Criticism of ROI
• Just telling managers to increase ROI is not
enough. They may increase ROI in a way that
is inconsistent with company strategy; they
may take action that will increase ROI in the
short run but harm the company in the long
run.
• Managers may reject investment
opportunities that are profitable for the whole
company but have negative impact on
manager’s performance evaluation
• Residual income (RI)
• Residual income is the net operating income
that an investment center earns above the
minimum required return of operating assets.
• RI = net operating income – (average
operating assets * minimum required rate of
return)
• In this case the objective is to maximize the
total amount of residual income.
• Consider the following data
• Average operating asset br. 100,000
• Net operating income br. 20,000
• Minimum required rate of return 15%
• RI = 20,000 – (100,000 * 0.15)
= 20,000 – 15,000
= 5000 br.
• Residual income approach encourages
managers to make investments that are
profitable for the entire company that would
have been rejected by managers evaluated
using the return on investment.
• Suppose the previous company is planning to
invest on a machine.
• The machine would cost 25,000 br and is
expected to generate additional operating
income of 4,500br a year.
• Based on residual income
• New project = 4,500 – (25,000 * 0.15)
= 4,500 – 3,750
= 750
• Over all = 5000 + 750
= br. 5,750
• Based on ROI
• Before the new project = 20,000 = 20%
• 100,000
• New project = 4,500 = 18%
25,000
• Over all = 24,500 = 19.6%
125,000
• The new investment would decrease the
divisions ROI even through it would be a good
investment from the standpoint of the
company as a whole.
• This shows that companies managers who are
evaluated based on residual income make
better decisions concerning investment
projects than managers who are evaluated
based on ROI.
• Residual income has one major disadvantage
that is it cannot be used to compare the
performance of different size divisions.
• Large divisions will probably have more
residual income than smaller divisions
because of greater net operating income they
earn due to their size.
• To avoid such misinterpretation, it is better to
focus on percentage change in residual
income from year to year rather than on the
absolute amount of the residual income
• Decentralization and segment reporting
• In order for decentralization to be effective,
segmented reporting is required.
• A segment is a part or activity of organization
about which managers would like cost, revenue or
profit data.
• Each type of responsibility center is regarded as
segment.
• The profitability and performance of each segment
need to be measured in order to assess the
accountability of each segment manager.
• One way of measuring is the preparation of
segmented income statement.
• Building a segmented income statement
• To construct segmented report, costs need to
be properly segregated for each segment.
• Most of the time, fixed costs are difficult to
allocate/segregate for each segment because
they are common for each segment.
• One method of preparing segment income
statement is the use of contribution format.
When the contribution format is used:
a) Cost of goods sold consists only of variable
manufacturing costs.
b) Variable and fixed costs are listed in separate
sections.
c) Contribution margin is computed
• When using this format, fixed costs are future
classified as traceable and common costs, which
will help for the preparation of segment margin.
• Segment margin
• Shows the companies divisional manager how much
each of their divisions is contributing to the company’s
profits.
• This amount is obtained by deducting the traceable
fixed cost of a segment from the segments
contribution margin.
• Segment margin is the best way of evaluating the long-
run profitability of a segment.
• A segment should be dropped if it cannot cover its
own costs.
• A contribution margin on the other hand is most useful
in decisions involving short-run changes such as
volume and price.
 Sales and contribution margin
• To prepare segmented income statement, variable
expenses are deducted from sales to yield contribution
margin for the segment.
• Contribution margin tells us what happens to profit as
volume changes.
 Traceable and common fixed costs
• A traceable fixed cost of a segment is cost incurred because
of the existence of the segment.
• If the segment had never existed, the fixed cost would not
have been incurred.
E.g.
 salary for segment manager
 Maintenance cost for the building in which the segment
products are stored.
 Insurance payment for segment
• A common fixed cost is a cost that supports the
operations of more than one segment, but is not
traceable in whole or in part to any one segment.
• Eliminating a segment will not change common
fixed costs.
e.g. - salary of CEO
-Rent for whole building of the organization
-Only traceable fixed costs are charged to
particular segments.
• Common fixed costs cannot be assigned to a
particular segment.
 Any allocation of common costs to segments reduces
the value of the segment margin as a measure of long-
run segment profitability and segment performance.
 7.3.Transfer pricing

• A transfer price is the price charged when one

segment of a company provides goods or
services to another segment of the same
company.
• The selling segment would like the transfer
price to be as high as possible where as the
buying segment would like the transfer price
to be as low as possible.
 There are three approaches to set transfer prices.
1) Negotiated transfer prices
2) Transfers at the cost to the selling division
3) Transfer at market prices
1.Negotiated transfer prices
• This price results from discussions between the selling
and buying divisions.
• Two things that should be pointed out here is that
1) the selling division will agree to the transfer price only
if its profits increase as a result of the transfer.
2) The buying division will agree to the transfer price only
if its profit also increases as a result of the transfer.
• Selling divisions lowest acceptable transfer price
• Transfer price must not fall below the variable cost.
• If the selling division does not have sufficient capacity
to fulfill the buying division’s requirement, it would
have to scarify some of its regular sales.
• The selling division expects to be compensated for
contribution margin lost on sales.
• Therefore,
Transfer price > variable cost per unit + total contribution
margin on lost sales
Number of units transferred
• Buying divisions highest acceptable transfer
price
• Buying division will agree to prices that will
increase its profit.
• If buying division have an outside supplier, it will
buy from inside supplier if the price is less than
the price offered by the outside supplier.
• If buyer division has no outside supplier, the
highest price the division would be willing to pay
depends on how much it expects to make on the
transferred units – excluding the transfer price.
Therefore,
• Transfer price < cost of buying from outside
supplier
• If an outside supplier does not exist:
• Transfer price < profit to be earned per unit sold
2.Transfer at the cost to the selling division
• Many companies set transfer prices at variable
cost or full cost incurred by the selling division.
• This method is easier to apply.
• If the selling division is having perfect capacity,
the transfer is going to take place at variable cost
only.
• But if the requirement is more than its capacity,
it will affect the sellers fixed cost therefore full
(absorption) cost is applied.
Some limitation of transfer at cost
• Use of cost, particularly full cost as a transfer
price can lead to bad decisions and sub
optimization.
• If cost is used as the transfer price, the selling
division will never show a profit on any
internal transfer.
• Cost based prices do not provide incentive to
control costs. To overcome this problem
companies use standard costs rather than
actual costs.
3.Transfer at market price
• In this case, competitive market price that is the
price charged for an item on the open market is
used as a transfer price.
• This approach is designed for situations where
there is an outside market for the transferred
product or service.
• If selling division has no ideal capacity, the
market price is the correct choice for transfer
price because the real cost of the transfer is the
opportunity cost of the lost revenue on the
outside sales.
• Illustration: certain company has plastic tubes
division that manufactures and sells plastic
tubes for different industries.
Capacity in units 100,000
Selling price to outside customer br.30
Variable cost per unit br.16
• The company also has a construction division
that uses these tubes for different sites. The
construction division is currently purchasing
10,000 tubes from outside supplier at a cost of
br. 29/ tube.
• Required:
1) Assuming the seller division has all the capacity
to handle the buyer’s need, what would be the
acceptable rage of transfer price?
2) Assume the seller division is selling all of the
tubes it can produce to outside customer, what
is the acceptable range?
3) Again assume the seller division is selling all of
the tubes it can produce to outside customers
and also assume that br.3 variable expenses can
be avoided on transfers within the company due
to reduced selling cost. What is the acceptable
range?
•Thank you!!!