Chapter 10
Management Control in Decentralized Organizations
Decentralization - the delegation of decision-making authority to
managers throughout an organization. The lower in the
organization that this freedom exists, the greater the degree of
decentralization.
Costs and Benefits
Benefits of decentralization include:
1. better decisions made by lower-level managers
due to their having the best information regarding
local conditions,
2. the acquisition of decision-making ability and
other management skills that help lower-level
managers move up in an organization, and
3. better motivation and higher status of lower-level
managers.
Costs include:
1. making decisions that are not in the organization's
best interests,
2. duplication of services,
3. higher costs of accumulating and processing
information, and
4. the waste of time due to dickering with other
organizational units about goods or services one
unit provides to another.
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Responsibility Centers and Decentralization
Do not confuse profit centers (accountability for revenue and
expenses) with decentralization (freedom to make decisions).
Some profit center managers have considerable freedom in
making decisions, while others need top-management approval
for most decisions. Deciding on whether to use a cost center or a
profit center hinges on whether goal congruence and managerial
effort are enhanced, not on the degree of decentralization present
Performance Metrics and Management Control
Motivation, Performance, and Rewards
Managers tend to focus their efforts in areas where performance
is measured and where their performance affects rewards. The
more objective the measures of performance, the more likely the
manager will provide effort. The choice of rewards clearly
belongs within an overall system of management control. They
may be monetary, as in pay raises and bonuses, or they can be
nonmonetary, such as promotions, praise, self-satisfaction,
elaborate offices, and private dining rooms. The design of a
reward system is mainly the concern of top management.
Measures of Profitability
Return on Investment
Return on Investment (ROI) - income (or profit)
divided by the investment required to obtain that
income or profit. This is a better test of profitability
than is examining the income generated by different
business segments. Given the same risks, for any given
amount of resources required, the investor wants the
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maximum income. ROI is a useful common
denominator and can be compared with rates inside and
outside the organization, and with opportunities in other
projects and industries. The calculation of ROI is as
follows:
Income Revenue
ROI = x
Revenue Invested Capital
= return on sales x capital turnover
An improvement in either the Return on Sales -
income divided by revenue, or Capital Turnover -
revenue divided by invested capital, without changing
the other will improve ROI. Increasing turnover is one
of the advantages of implementing the JIT philosophy.
Economic Profit and Economic Value Added (EVA)
Some companies favor emphasizing an absolute
amount of income rather than a percentage return.
Economic Profit (Residual Income).
RI = Net operating profit after-tax (NOPAT) – capital
charge
Capital charge = weighted average cost of capital x
average invested capital.
Cost of Capital (“Imputed” interest) - what the firm
must pay to acquire more capital, whether or not it
actually has to acquire more capital to take on this
project. The cost of capital is the minimum acceptable
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rate of return for investments in a project or division.
The "imputed" interest rate used should reflect the risk
of the investment.
Economic Value Added (EVA)
EVA is a variant of residual income. EVA may
increase shareholder value due to better allocating,
managing, and redeploying scarce capital resources.
EVA = Adjusted* NOPAT – (weighted average cost of
adjusted average invested capital)
*for example adjust for R&D expense and R&D
amortization if any.
ROI or Economic Profit?
The use of ROI may cause some divisions to forgo investments
that are desirable from a company-wide viewpoint because the
investments lower the division's ROI. The use of economic profit
alleviates this problem, since all investments returning more than
the company's cost of capital is acceptable by all divisions
because residual income increases. Thus, the use of economic
profit promotes goal congruence and leads to better decisions than
ROI. Yet, most companies use ROI because it is easier for
managers to understand, it facilitates comparison across divisions
of different sizes, and when combined with appropriate growth
and profit targets, dysfunctional motivations can be minimized.
Definitions of Invested Capital
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Some possible definitions of invested capital are:
1. Total assets
2. Total assets employed (excludes vacant land and
construction in process)
3. Total assets less current liabilities
4. Stockholders' equity
Averages for the period are typically used.
Valuation of Assets
Assets can be valued using gross book value (original cost),
net book value (original cost less accumulated
depreciation), and historical cost, or some version of current
value. Practice is overwhelmingly in favor of net book value
based on historical cost.
Transfer Pricing
When segments interact greatly, there is an increased
possibility that what is best for one segment hurts another
segment badly enough to have a negative effect on the entire
organization. Such a situation may occur when one segment
provides products or services to another segment and
charges that segment a transfer price.
Transfer Prices - amounts charged by one segment of an
organization for a product or service that it supplies to
another segment of the same organization. It is revenue to
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the segment providing the product or service, and it is a cost
to the acquiring department.
Purposes of Transfer Pricing
Transfer prices exist within organizations to communicate
data that will lead to goal-congruent decisions. They should
help guide managers to make the best possible decisions
regarding whether to buy or sell products and services
inside or outside the total organization. They are also used
to help in evaluating segment performance and, thus,
motivate both the selling manager and buying manager
toward goal-congruent decisions. Finally, multinational
companies use transfer pricing to minimize their worldwide
taxes, duties, and tariffs.
A General Rule for Transfer Pricing
The general rule for transfer pricing is:
Transfer Price = Outlay Cost + Opportunity Cost
Outlay cost is the additional amount the selling segment
must pay to produce and transfer a product or service to
another segment. It is often a variable cost for producing
the item transferred. Opportunity cost is the maximum
contribution to profit that the selling segment forgoes by
transferring the item internally.
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Market-Based Transfer Prices
If a competitive market exists for the product or service
being transferred internally, the use of market price as a
transfer price will generally lead to the desired goal
congruence and managerial effort.
Some adjustments to market prices can be made for things
like selling and delivery expenses that are not necessary if
an internal transfer takes place. However, market prices are
not always available for items transferred internally.
Transfers at Cost
When market prices are not available, are inapplicable, or
are impossible to determine, versions of "cost-plus-a-
profit" are often used in order to provide a "fair" or
"equitable" substitute for regular market prices.
Approximately half of the major companies in the world
transfer items at cost. However, there are several possible
definitions of cost including actual variable cost, standard
variable cost, actual full cost, and standard full cost.
There may be a problem with the use of cost as a transfer
price. A cost's behavior pattern may be disguised since the
cost driver affecting the acquiring division is typically units
and those for the producing division may be more
complicated. Problems with the use of actual cost are that
the buying division is hindered in planning because actual
cost cannot be known in advance, and the supplying division
has no incentive to control its costs since any inefficiencies
are simply passed on to the buying division.
The use of budgeted or standard costs is preferred. Cost-
based transfer prices lead to dysfunctional decisions –
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decisions in conflict with the company’s goals.
Negotiated Transfer Prices
Companies committed to segment autonomy often allow their
managers to negotiate transfer prices. Cost and market prices
may be considered in the negotiations, but no policy requires this.
Supporters claim that, since these managers have the best
knowledge of what a company will gain or lose by producing and
transferring the product or service, negotiation allows managers
to make optimal decisions. Critics focus on the time wasted in
negotiations.
Multinational Transfer Pricing
While domestic companies focus on goal congruence and
motivation in establishing their transfer-pricing policies,
multinational companies use transfer prices to try to minimize
worldwide income taxes, import duties, and tariffs.
Divisions in relatively low-tax countries attempt to set high
transfer prices for products being sold to divisions in relatively
high-tax divisions, and vice versa.
Example: A company with several international divisions, one of
them is in Ireland, another one is in Germany. Tax rates in
Ireland and Germany are 12% and 40%, respectively. In addition,
suppose Germany impose an import duty equal to 20% of the
price of the item. If the full cost of a unit is $100 and variable
cost is $60. How much savings the company will have if they use
variable cost, instead of full cost, to price items shipped from
Ireland to Germany?
More tax in Ireland ($40 x 12%) ($4.80)
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Lower tax in Germany ($40 x 40%) 16.00
Additional import duty in Germany ($40 x 20%) (8.00)
Net savings $3.20
Management by Objectives and Setting Expectations
Management by Objectives (MBO) - the joint formulation by a
manager and his or her superior of a set of goals and of plans for
achieving the goals for a forthcoming period.
The plans often take the form of a responsibility accounting
budget (along with supplementary goals such as levels of
management training and safety that may not be incorporated into
the accounting budget).
The manager's performance is then evaluated in relation to these
agreed-upon objectives. Use of MBO allows managers to accept
assignments to less profitable segments with less reluctance since
the manager will be evaluated on budgeted results that are
negotiated with a superior and not on absolute profitability.
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Exercises
1. Which of the following statements is NOT a benefit of decentralization?
A) Lower-level managers are able to make faster and better decisions on local decisions
than higher-level managers.
B) By delegating decision-making authority to local managers, higher-level managers free
up time to deal with larger issues and fundamental strategy.
C) Local managers who are given more authority often have greater motivation and job
satisfaction.
D) Managers in decentralized units may spend time negotiating transfer prices for goods
transferred between units.
2. ________ is the delegation of decision-making power to segment managers of an
organization.
A) Goal congruence
B) Segment autonomy
C) Managerial effort
D) Segment contribution
3. Which of the following statements about management control systems is FALSE?
A) In designing management control systems, top managers must consider the system's
impact on the employee behavior desired by the organization.
B) The management control system should be designed to achieve the best possible
alignment between local manager decisions and the actions central management seeks.
C) The design of a management control system should consider the responsibilities of
managers and the amount of autonomy they have.
D) Profit-center managers always have more decentralized decision-making authority than
cost-center managers.
4. Which of the following statements about management control systems is FALSE?
A) In designing management control systems, top managers must consider the system's
impact on the employee behavior desired by the organization.
B) The management control system should be designed to achieve the best possible
alignment between local manager decisions and the actions central management seeks.
C) The design of a management control system should consider the responsibilities of
managers and the amount of autonomy they have.
D) Profit-center managers always have more decentralized decision-making authority than
cost-center managers.
5. The following information is available for the Super Company:
Sales $1,000,000
Invested capital 312,500
Return on investment 20%
What is the operating income?
A) $62,500
B) $100,000
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C) $312,500
D) $687,500
6. The following information is available for the Trompeter Company:
Sales $1,000,000
Invested capital 500,000
Return on investment 10%
What is the capital turnover ratio?
A) 0.10
B) 0.35
C) 0.50
D) 2.00
7. Return on investment can be computed as ________ times ________.
A) residual income; capital turnover
B) cost of capital; EVA
C) return on sales; capital turnover
D) net income; cost of capital
8. Operating income divided by sales is ________.
A) residual income
B) capital turnover
C) return on investment
D) return on sales
9. The following information pertains to the Voyager Company:
Total assets $150,000
Total current liabilities 110,000
Total expenses 70,000
Total liabilities 115,000
Total revenues 80,000
Return on sales equals ________.
A) 12.5%
B) 50.0%
C) 75.0%
D) 133.0%
10. Pearson Company reports the following information:
After-tax operating income $100,000
Before-tax operating income 300,000
Average invested capital 500,000
After-tax cost of capital 10%
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What is the residual income for Pearson Company?
A) $30,000
B) $50,000
C) $250,000
D) $450,000
11. Yoon Company reports the following information:
Net operating profit after taxes $500,000
Adjusted net operating profit after taxes 670,000
Average invested capital 500,000
Adjusted average invested capital 700,000
After-tax cost of capital 10%
The adjusted figures reflect adjustments used by Stern Stewart & Company.
What is the EVA for Yoon Company?
A) $430,000
B) $450,000
C) $600,000
D) $620,000
12. To calculate economic value added, several adjustments are made to after tax
operating profit that include ________ and ________.
A) the use of LIFO inventory valuation; capitalization of research and development costs
B) taxes paid rather than tax expense; capitalization of research and development costs
C) the use of average cost inventory valuation; current costs of fixed assets
D) the use of LIFO inventory valuation; current costs of fixed assets
13. From the view of the company as a whole, managers should accept investment projects
that earn more than the ________. ________ should not be used for investment decisions.
A) return on investment; Return on sales
B) return on sales; Capital turnover
C) cost of capital; Return on investment
D) capital turnover; Return on sales
14. Nelson Company has two divisions. The following information is available:
North Division South Division
Revenue $300,000 $500,000
After-tax operating income 100,000 90,000
Average invested capital 100,000 200,000
Invested capital at end of period 200,000 300,000
Cost of capital 20% 15%
Required:
Compute the following for each division:
A) Return on investment
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B) Return on sales
C) Capital turnover
D) Residual income
15. he following information pertains to Jupiter Company:
Total assets $50,000
Total current liabilities 30,000
Total expenses 60,000
Total liabilities 45,000
Total revenues 100,000
Invested capital is defined as total assets. What is the capital turnover?
A) 0.40
B) 0.63
C) 1.79
D) 2.00
16. The Johnsen Company has gathered the following data:
Total assets $4,000,000
Total current liabilities 600,000
Total liabilities 800,000
Revenue 1,500,000
Expenses 900,000
Required:
A) Compute ROI assuming invested capital is equal to total assets.
B) Compute ROI assuming invested capital is equal to total assets minus current liabilities.
C) Compute ROI assuming invested capital is equal to stockholders' equity.
17. Highpointe Division sells a part internally to Low Division. Low Division uses the part
to produce inexpensive products sold at discount stores. Highpointe Division incurs costs of
$1.50 per part, while Low Division incurs additional costs of $4.80 per product. Highpointe
Division sells the part to Low Division for $2.00 per part.
Low Division can purchase the part from an outside supplier for $1.00 per part, but does
not accept the offer. The final product is sold to external customers for $8.00 each. Which
of the following formulas correctly reflects the company's operating income?
A) $8.00 - $1.50 - $4.80 - $2.00 - $1.00 = $(1.30)
B) $8.00 - $1.50 - $4.80 = $1.70
C) $8.00 - $4.80 - $2.00 = $1.20
D) $8.00 - $1.50 = $6.50
18. The West and East Divisions are part of the same company. Currently the East Division
buys a part from West Division for $384 per unit. The West Division wants to increase the
price of the part it sells to East Division by $96 to $480. The manager of the East Division
has stated that he cannot pay that much insofar as the division's profit goes below zero.
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The manager of the East Division can buy the part from an outside supplier for $448 per
unit. The cost data pertaining to the part is supplied by the West Division:
Direct materials $136
Direct labor 200
Variable overhead 40
Fixed overhead 42
If West Division does not produce the parts for the East Division, it will be able to avoid
one-third of the fixed manufacturing overhead costs. The West Division has excess
capacity but no alternative uses for the facilities. From the standpoint of the company as a
whole, should the East Division buy the part from the West Division or the outside supplier?
A) East Division should buy the part from the West Division because the Company's profit
will be $14.00 per unit larger.
B) East Division should buy the part from the West Division because the company's profit
will be $32.00 per unit larger.
C) East Division should buy the part from the West Division because the company's profit
will be $58.00 per unit larger.
D) East Division should buy from an outside supplier.
19. The Nicholson and Cage Divisions are in the same company. Currently the Cage
Division buys a part from the Nicholson Division for $82 per unit. The Nicholson Division
wants to increase the price of the part to $100 per unit. Cage Division can buy the part for
$94 from an outside supplier. The cost data for the part obtained from the Nicholson
Division is below:
Direct materials $25.50
Direct labor 32.50
Variable indirect production22.50
Fixed indirect production 9.60
If Nicholson does not provide the parts to Cage, it will save one-fourth of the fixed indirect
production costs. The Nicholson Division has excess capacity but no alternative uses of the
facilities.
Required:
A) From the standpoint of the company as a whole, should Cage Division continue to buy
the part from Nicholson Division?
B) From the standpoint of Cage Division only, should Cage Division continue to buy the
part from Nicholson Division?
20. The variable cost of Part X is $50 per unit and the full cost of the part is $80 per unit.
The part is produced in Country Z and transferred to a plant in Country B. Country Z has a
30% income tax rate. Country B has a 50% income tax rate and an import duty equal to
10% of the price of the item. Part X can be transferred at full cost or variable cost.
Assume Part X is transferred at full cost. By using full cost instead of variable cost for the
transfer price, the income tax effect per unit in Country B is ________.
A) a decrease in tax by $9 per unit
B) an increase in tax by $9 per unit
C) a decrease in tax by $15 per unit
D) an increase in tax by $15 per unit
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