Transcript Document 7577070

Managerial Accounting:
An Introduction To Concepts, Methods, And Uses
Chapter 13
Investment Center
Performance Evaluation
Maher, Stickney and Weil
Learning Objectives




(Slide 1 of 3)
Identify the benefits and disadvantages of
decentralization.
Identify the issues that must be addressed
when using return on investment as a
divisional performance measure.
Identify examples of differential analysis to
make-or-buy decisions with different transfer
prices.
Discuss transfer pricing issues and methods.
C13 - 2
Learning Objectives




(Slide 2 of 3)
Discuss multinational transfer prices.
Identify types of costs to be considered in
measuring divisional operating cost.
Identify issues in measuring the investment
base for calculating return on investment.
Explain the contribution approach alternative
to return on investment for division
performance measurement.
C13 - 3
Learning Objectives


(Slide 3 of 3)
Describe the purpose of the return on
investment calculation, and identify its
shortcomings.
Explain how to calculate economic value
added, and identify its use.
C13 - 4
Nature of Divisionalized
Organizations (Slide 1 of 2)


Top managers delegate or decentralize authority and
responsibility
Major advantages of a decentralized organization
include:





Allows local personnel to respond quickly to a changing
environment
Frees top management from detailed operating decisions
Divides large, complex problems into manageable chunks
Helps train managers and provides a basis for their
evaluation
Motivates managers by allowing them to make their own
decisions
C13 - 5
Nature of Divisionalized
Organizations (Slide 2 of 2)

Disadvantage - local managers may not act in
ways consistent with overall organizational
goals


There may be conflicts between goals of a division
and overall goals of the organization
Planning and control systems try to create
goal congruence where division managers are
motivated to act in ways consistent with
overall organizational goals
C13 - 6
Return on Investment
(Slide 1 of 2)

Divisions are expected to contribute to the
company’s profitability


However, division profits need to be considered in
light of the amount of funds invested in the
division
Return on investment (ROI) is calculated as
follows:
Division Operating Profit
Division Investment
C13 - 7
Return on Investment
(Slide 2 of 2)

When using ROI as a divisional
performance measure, the following
questions must be addressed:



How does the firm measure revenue,
especially for transfers between divisions?
Which costs are deducted in measuring
divisional operating costs?
How is the investment in the division
measured?
C13 - 8
Transfer Pricing

(Slide 1 of 2)
Transfers of products or services
between units in the organization are
recorded in the accounting records
using a transfer price

Transfer prices are commonly used in
performance evaluation, product costing
and decision making

Determining the appropriate transfer price is
important
C13 - 9
Transfer Pricing


(Slide 2 of 2)
Determining the appropriate transfer price
depends critically on whether the selling
division has excess capacity
As a general rule, if the selling division has:


Excess capacity - transfer price should equal
differential cost of production (usually variable
cost)
No excess capacity- transfer price should be
market price
C13 - 10
Alternative Ways to Set
Transfer Prices


Idea is to set transfer prices so that buyer
and seller have goal congruence with
organization’s goals
Three general alternatives available for
setting transfer prices



Top management sets transfer prices
Top management establishes transfer price
policies followed by divisions
Division managers negotiate transfer prices
C13 - 11
Top Management Intervention

If top management sets transfer prices, the
“right” transfer prices may result, but



Top management may become swamped with
pricing disputes
Division managers lose flexibility and other
advantages of decentralization
If transactions between divisions are
infrequent, direct intervention in setting
transfer prices may be beneficial
C13 - 12
Centrally Established
Transfer Price Policies (Slide 1 of 4)

Transfer pricing policy should:



Allow divisional autonomy
Encourage managers to pursue corporate
goals consistent with their own personal
goals
Be compatible with the performance
evaluation system
C13 - 13
Centrally Established
Transfer Price Policies (Slide 2 of 4)


Economic transfer pricing rule - transfer at
differential outlay cost to the selling division
(typically variable cost), plus opportunity cost
of making the internal transfer
Rule of thumb -if the selling division has:


Excess capacity - transfer price should equal
differential cost of production (usually variable
cost)
No excess capacity- transfer price should be
market price
C13 - 14
Centrally Established
Transfer Price Policies (Slide 3 of 4)

Transfer prices based on market price
 Generally considered the best basis when a
competitive market exists for the product
and market prices are readily available


Good estimation of differential cost +
opportunity cost
Advantage - Both buying and selling managers
can buy and sell all they want at market price
C13 - 15
Centrally Established
Transfer Price Policies (Slide 4 of 4)

Transfer prices based on costs could be based
on:
 Full-absorption costs
 Activity-based costing
 Cost-plus transfers
 Standard costs or actual costs
C13 - 16
Motivational Aspects
of Transfer Pricing (Slide 1 of 2)

If transfer pricing policy does not give
the supplier a profit, motivational
problems can arise


Fails to motivate seller to transfer
internally, since there is no contribution
toward profit
If all transfers are internal, it may be more
appropriate to set up division as a cost
center
C13 - 17
Motivational Aspects
of Transfer Pricing (Slide 2 of 2)

Possible solutions to motivational
problems include:


Using dual transfer prices - Charge the
buyer the cost of the unit and credit selling
division with cost plus a profit allowance
Using balanced scorecard principles to
evaluate selling manager’s performance
and explicitly incorporate internal transfers
in the reward system
C13 - 18
Division Managers
Negotiate Transfer Prices

Under this system, managers act as if
they managed independent companies


Advantage - preserves autonomy of
division managers
Disadvantages


May require a great deal of management effort
Final price may depend more on negotiating
skills rather than on what is best for the
company
C13 - 19
Global Transfer Pricing



(Slide 1 of 2)
Nearly half of companies use transfer
prices based on cost
About one-third use a market pricebased system
Negotiated prices tend to fall between
the market price and some measure of
cost
C13 - 20
Global Transfer Pricing

(Slide 2 of 2)
In international transactions, as well as
transfers across state lines, transfer
prices may affect tax liabilities,
royalties, and other payments

Companies may be motivated to use
transfer prices as a mechanism to increase
profits in low-tax jurisdictions and reduce
profits in high-tax jurisdictions

Major problem for many states and countries
C13 - 21
Measuring Division
Operating Profits (Slide 1 of 5)

In measuring divisional operating costs,
management must decide how to treat
the following costs:




Controllable direct operating costs
Noncontrollable direct operating costs
Controllable indirect operating costs
Noncontrollable indirect operating costs
C13 - 22
Measuring Division
Operating Profits (Slide 2 of 5)

The issue is whether to include these costs in
determining division operating profits for
purposes of performance evaluation


Direct versus indirect refers to whether the cost
associates directly with the division
Controllable versus noncontrollable refers to
whether the manager can affect the cost
C13 - 23
Measuring Division
Operating Profits (Slide 3 of 5)

Direct costs - almost always deducted in
determining division operating profits

Can separate out costs assigned to a division from
those assigned to a manager

Could, for example, exclude costs that can’t be controlled
by a manager from that manager’s performance
evaluation
C13 - 24
Measuring Division
Operating Profits (Slide 4 of 5)

Indirect controllable operating costs- may be
at least partially controllable by division
managers


Example: Centralized service department costs
such as the training function
If division is charged for use of services of these
departments, division may avoid using them

Could be counter-productive
C13 - 25
Measuring Division
Operating Profits (Slide 5 of 5)

Indirect noncontrollable operating costs


May be necessary costs but division manager lacks
the ability to control these costs (e.g., salaries of
top corporate management)
May want to allocate these costs to divisions to
raise awareness that sales revenue must cover not
only divisional costs but also those of central
headquarters
C13 - 26
Assets Included
in Investment Base

When calculating ROI, assets to be
included in the denominator must be
determined and valued


Most firms use acquisition cost
Using book value can cause problems

Managers may be reluctant to replace older
assets due to the negative impact on ROI
C13 - 27
Components of
Return on Investment

Return on Investment (ROI) is
calculated as follows:
ROI = Profit Margin % X Investment Turnover Ratio
Profit Margin
Divisional
Investment
=
Profit Margin
Divisional
Revenues
X
Divisional Revenues
Divisional
Investment
C13 - 28
Economic Value Added

An alternative to ROI is Economic Value
Added (EVA) calculated as follows:
EVA = NOPAT - (WACC X Investment)
Where:
NOPAT = Net Operating Profit After Tax
WACC = Weighted-Average Cost of Capital
Investment = Total Assets - NoninterestBearing Current Liabilities
C13 - 29
If you have any comments or suggestions concerning this
PowerPoint Presentation for Managerial Accounting, An
Introduction To Concepts, Methods, And Uses, please contact:
Dr. Donald R. Trippeer, CPA
[email protected]
Colorado State University-Pueblo
C13 - 30