Transcript 14 Decentralized Organizations, Transfer Pricing, and Measures of

14
Decentralized
Organizations, Transfer
Pricing, and Measures of
Profitability
© 2007 Pearson Education Canada
Slide 14-1
Decentralization versus Centralization
Decentralization
• The delegation of decision making authority to
managers throughout the organization
Centralization
Minimum freedom
© 2007 Pearson Education Canada
Decentralization
Maximum freedom
Slide 14-2
Decentralization (con’d)
Benefits of Decentralization
• Lower-level managers are more informed about
local conditions
• Managers acquire decision-making experience
that trains them to assume leadership roles in
organization
• Managerial independence leads to greater
motivation
© 2007 Pearson Education Canada
Slide 14-3
Decentralization (con’d)
Costs of Decentralization
• Managers may make goal incongruent decisions
• Duplication of services (accounting and
advertising)
• Increased cost of accumulating and processing
information
• Managers may waste time arguing about shared
services
© 2007 Pearson Education Canada
Slide 14-4
Decentralization (con’d)
• Most companies adopt a blend of decentralized and
centralized functions (decentralize marketing but
centralize tax planning)
• Decentralization is most successful when
organization's segments are relatively independent
Diversified
Product Line
No Problems
© 2007 Pearson Education Canada
Single Industry
Multi-Product
Single
Product
Common Problems
Slide 14-5
Decentralization (con’d)
• Decentralization cannot work unless top
management is willing to abide by its
managers' decisions
• Stepping in and overriding managers'
decisions will quickly result in
motivational problems
© 2007 Pearson Education Canada
Slide 14-6
Profit Centres and Decentralization
• Be careful to separate these two ideas
• Profit centres hold a manager accountable
for revenues & expenses
• Decentralized manager has the freedom to
make decisions
• Cost centre may be more decentralized
than a profit centre if the cost centre
manager has more authority
© 2007 Pearson Education Canada
Slide 14-7
Transfer Pricing
• Transfer pricing deals with the valuation of goods and services traded
between profit or investment centres in decentralized organizations
Selling
Division
Transfer
Price
Buying
Division
Final
Market
Intermediate Market
• Selling division wants the transfer price to be high
• Buying division wants the transfer price to be low
© 2007 Pearson Education Canada
Slide 14-8
Alternative Transfer Prices
• Cost-Based Transfer Price
• Variable cost plus a markup
• Full cost plus a markup
• Market-Based Transfer Price
• Negotiated Transfer Price
© 2007 Pearson Education Canada
Slide 14-9
Setting Transfer Prices
Transfer Price = Cost Plus
• Used by half of the major companies in the world
• Consider using cost-based transfer price when
market price is not available or too difficult to
determine
• What may be variable and fixed to the selling
division becomes completely variable to the buying
division
• Should always transfer at standard cost
© 2007 Pearson Education Canada
Slide 14-10
Setting Transfer Prices (con’d)
Transfer price = market price
• If the external market is competitive, using the
market price as the transfer price will generally
produce optimal results
• Adjustments may be made to reflect costs not
incurred on internally transferred goods and
services
• Market price forces divisional managers to be
competitive
© 2007 Pearson Education Canada
Slide 14-11
Setting Transfer Prices (con’d)
Negotiated transfer prices
• Common in organizations where managers have
considerable autonomy
• Do not let negotiations take up too much time
© 2007 Pearson Education Canada
Slide 14-12
Transfer Pricing in the Global Market
Headquarters and
manufacturing
division in Israel
• 4 plants (cost centre)
Transfer
Price = ?
U.S.-Based Lemmon
Marketing Division
• profit centre
Israel-Based
Marketing Division
• profit centre
Third Marketing
Division Sells
Worldwide on a
Made-to-Order Basis
© 2007 Pearson Education Canada
Slide 14-13
Irving Oil versus Revenue Canada
New Brunswick
Refinery
Bermuda
© 2007 Pearson Education Canada
Slide 14-14
Return on Investment (ROI%)
• Top management's determination of the overall
contribution of the division to corporate earnings
• Focus on long-run performance
• Are the dollars invested in the division generating an
adequate return?
• Should more or less money be put into these
activities?
ROI% = income / invested capital
= income x
revenue
revenue
invested capital
• Improve performance by
• Increasing income by reducing expenses
• Boost sales without increasing expenses
• Reduce investments in working capital and fixed
assets without decreasing sales
© 2007 Pearson Education Canada
Slide 14-15
Residual Income (RI)
• Residual income is a variation of ROI% which focuses on
an absolute dollar amount rather than a %
Residual income
= Divisional net income - (interest charge x invested capital)
• Imputed interest charge refers to the firm’s "cost of capital"
• Cost of capital is the minimum acceptable rate of return for
investments in a project or a division
• If divisions have different levels of risk, they should have
different imputed interest charges
Net income
Invested capital
ROI%
Capital charge (8%)
Residual income
© 2007 Pearson Education Canada
Current
New Proposal
Revised
$200,000
$1,000,000
20%
$80,000
$120,000
$75,000
$500,000
15%
$40,000
$35,000
$275,000
$1,500,000
18.3%
$120,000
$155,000
Slide 14-16
Economic Value Added (EVA)
• Variation of Residual Income
• Term coined and marketed by Stern Stewart & Co.
• Focuses on an absolute dollar amount rather than a %
Economic Value Added (EVA)
= Net operating income - [ Weighted-average cost of
capital x (Long-term liabilities + Shareholders’ equity) ]
• Weighted-average cost of capital is the after-tax cost of
long-term liabilities and shareholders’ equity weighted by
their relative size for the company or the division
2006 Sales Revenue ($millions)
2007 Sales revenue ($millions)
Invested capital ($millions)
© 2007 Pearson Education Canada
X
Y
$12
$21
$20
$8
$19
$10
Slide 14-17
Defining Invested Capital
• Possible alternative definitions of "invested capital"
include total assets, total assets employed, total
assets - current liabilities
• Best alternative depends on what the manager can
influence
• Centrally administered assets are often allocated to
divisions
• Allocations will not cause major problems if
allocation base is deemed by managers to be
reasonable
© 2007 Pearson Education Canada
Slide 14-18
Valuation of Plant & Equipment Assets
Gross Book Value
• Original cost of assets
• Objective [no amortization (depreciation)
allocations]
Net Book Value
• Original cost less accumulated amortization
(depreciation)
• Managers motivated to not invest in new assets
Current Value
• Figures may be costly (and sometimes
impossible) to determine
© 2007 Pearson Education Canada
Slide 14-19