Decentralization, Responsibility Accounting and Transfer Pricing Management Control System

Cost Center- A cost center is an organizational subunit, such as a

department or division, whose manager is held accountable for the costs incurred in the subunit. E.g. The Painting Department in an

automobile plant

Revenue Center- The manager of revenue center is held accountable for the revenue attributed to the subunit. E.g. The Reservation Department

of an airline and the Sales Department of a manufacturer

Profit Center- A profit center is an organizational subunit whose

manager is held accountable for profit. Since profit is equal to revenue

minus expenses, profit-center managers are held accountable for both the revenue and expenses attributed to their subunits. E.g. A company-

owned restaurant in a fast food chain.

Investment Center- The manager of an investment center is held accountable for the subunits profit and the invested capital used by the

subunit to generate its profit. E.g. A division of a large corporation

A subunit in an organization whose manager is held accountable for specified financial results.

Cost Center Segment has control over the incurrence of costs.

Revenue Center

Segment
is responsible for the revenue of a unit.

The Paint Department in an automobile plant.

The Reservations Department of an airline.

Profit Center Segment has control over both costs and

Investment Center

Segment has control over

profits and invested capital.

revenues.

Company-owned restaurant in a fast-food chain.

A division of a large corporation.

The performance of each responsibility center is summarized periodically on

a performance report. A performance report shows the budgeted and the actual amounts, and the variances between these amounts, of key financial

results appropriate for the type of responsibility center involved.

Evaluation Tool
Cost Center
Profit Center Investment Center

Cost standards
Contribution income statement Rate of return on invested funds (ROI) or residual income (RI)

Shows the budgeted and actual amounts, and the variances between these amounts, of key financial results appropriate for the type of responsibility

center.

Traditional responsibility-accounting systems tend to focus on the financial performance measures of cost, revenue, and profit for subunits of the organization.

Activity-based costing systems associate costs with the activities that drive those costs. In activity-based responsibility accounting

attention is directed not only to costs incurred but also to the

activity creating the cost.

Most large organizations are decentralized. Managers throughout these

organizations are given autonomy to make decisions for their subunits.

Decentralization takes advantage of the specialized knowledge and skills of managers, permits an organization to respond quickly to events, and relieves

top management of the need to direct the organizations day-to-day activities.

The biggest challenge in making a decentralized organization function effectively is to obtain goal congruence among the organizations autonomous managers.

Suncoast Food Centers (Top Management)

Gulf Division

Food Processing Division

Atlantic Division

Individual grocery stores in Tampa, St. Petersburg, and Sarasota

Dairy Processing Plants

Bakeries

Meat Processing Plants

Individual grocery stores in Miami, Daytona Beach, and Jacksonville

Particulars
Gulf Division

Invested Income (in $) Capital (in $) 3,000,000 20,000,000

ROI (%) 15

Food Processing Division

Atlantic Division

3,600,000
6,750,000

18,000,000
45,000,000

20
15

Return on Investment =

Income Invested capital

Income X Sales revenue

Sales revenue Invested capital

Particulars
Gulf Division

Income (in $)

Sales Sales Invested Rev/Invest Revenue (in Income/Sale Capital (in ed Capital ROI $) s Rev (i) $) (ii) (i) * (ii) % 0.05 20,000,000 3 0.15 15

3,000,000 60,000,000

Food Processing Division 3,600,000 9,000,000

0.40

18,000,000

0.5

0.2

20

Atlantic Division 6,750,000 135,000,000

0.05

45,000,000

0.15

15

Sales Margin X Capital turnover = ROI

Return on Investment = Income X Sales revenue Sales revenue Invested capital

Although ROI is the most popular investment-center performance

measure, it has one major drawback. To illustrate, suppose Suncoasts

Food Processing Division manager can buy a new food processing machine for $500,000, which will save $80,000 in operating expenses and

thereby raise divisional profit by $80,000. The return on this investment in

new equipment is 16 percent (= 80,000/ 5,00,000).

Now suppose it costs Suncoast Food Centers 12 cents for each dollar of
capital to invest in operational assets. (Cost of Capital)

Now consider what is likely to happen. The Food Processing Division managers performance evaluated on the basis of his divisions ROI. Without the new equipment, the

divisional ROI is 20 percent ($3,600,000 of divisional profit $18,000,000 of invested

capital). If he purchases the new equipment, his divisional ROI will decline: Food processing Divisions Return on Investment Without Investment in New Equipment $3,600,000 $ 18,00,000 = 20% With Investment in New Equipment $3,600,000 + $80,000 $18,000,000 + $500,000 20%

The problem is that the ROI measure leaves out an important piece of information: it
ignores the firms cost of raising investment capital. For this reason, many managers prefer to use a different investment center performance measure instead of ROI.

An investment centers residual income is defined as follows

Residual income= Investment centers ( Investment center s X Imputed profit invested capital interest rate where the imputed interest rate is the firms cost of acquiring investment capital. )

Food processing Divisions Residual Income

Without Investment in New Equipment

With investment in New Equipment

$3,680,0000

Divisional profit $3,600,000 Less imputed interest charge: Invested capital $18,000,0000 $18,500,000 X Imputed interest rate X .12 X .12 Imputed interest charge 2,160,000 Residual Income $1,440,000

2,220,000 $1,460,000

Investment in new equipment raises residual income by $20,000

ROI =

Investment centers profit Investment centers investment

Two pieces of data X Imputed interest rate )

Residual = Investment centers Income profit

( Investment centers invested capital

Three pieces of data

Comparison of Residual Income: Two Divisions Gulf Division Atlantic Division Divisional profit Less imputed interest charge: Invested capital $20,000,000 X Imputed interest rate X .12 Imputed interest charge Residual Income $3,000,000 $45,000,000 X .12 $6,750,000

2,400,000 $600,000

5,400,000 $1,350,000

The Atlantic Divisions residual income is much higher simply because it is larger than the Gulf Division Neither ROI nor RI provides a perfect measure of investment center performance. ROI can undermine goal congruence while RI distorts comparisons between investment centers of different sizes.

Division Gulf Division Food Processing Division Atlantic Division..

Total Assets(mn) $20 $18 $45

Current Liabilities(mn) $ 0.40 $1.00 $0.60

EVA (Economic value added) computation ( Before tax Kd = 9%, Ke =12%, Tax rate = 30%, Wke =60%, WKd = 40%). After tax Kd = 9%(1-30%) = 6.3% WACC = Wke Ke + WKd Kd = (0.6 12)+(0.4 6.3) = 9.72%
Division Gulf Food Aftertax operating income [ (Total assets Current liabilities) X WACC ] = (in millions) (in millions) (in millions) $3.00 x (1 -.30) [( $20 $ .4) x.0972] $3.60 x (1 -.30) [( $18 $1.0) x.0972] EVA = $194,880 = $867,600

Processing Atlantic $6.75 x (1 -.30) [( $45 $ .6) x.0972] = $409,320

Transfer price = Additional Outlay cost per unit + Opportunity cost per unit to the incurred because goods are transferred organization because of the transfer

In applying the general transfer-pricing rule, we will distinguish between two different scenarios. Production: Standard variable cost per rack (including packaging)..$7.00 Transportation: Standard variable cost per rack to transport bread......$ 0.25

Outlay cost: Standard variable cost of production..$ 7.00 per rack Standard variable cost of transportation .25 per rack Total outlay cost $ 7.25 per rack Opportunity cost: Selling price per unit in external market..$ 11.00 per rack Less: Variable cost of production and transportation.. 7.25 per rack Opportunity cost (foregone contribution margin).$ 3.75 per rack N0 excess Capacity General Transfer Pricing Rule: Transfer price = Outlay cost + Opportunity cost $11.00 = $7.25 + $3.75

Suppose the Gulf div grocery stores sell it at $18 in the market Contribution to Suncoast Food Centers Contribution to Suncoast Food Centers from Sale in External Market from Transfer to Gulf Division Wholesale selling price per rack. $11.00 Retail selling price per rack. $18.00 Less: Variable costs 7.25 Less: Variable costs. 7.25 Contribution margin. $3.75 Contribution margin $10.75 Contribution to Suncoast Food Centers If Special Offer is Accepted Special price per rack $9.60 per rack Less: Variable costs to company . 7.25 per rack Contribution to company , per rack.. $2.35 per rack Suppose Food processing Div. has excess capacity Transfer Price = Outlay cost + Opportunity cost $7.25 = $7.25 + 0 Special price per rack $9.60 per rack Less: Transfer price paid by Gulf Division.. 7.25 per rack Contribution to Gulf Division .. $2.35 per rack

Transfer Price = Outlay cost = Variable cost of production and transportation = $7.25

+ + +

Opportunity cost Foregone contribution margin of an external sale ($11.00 - $7.25) =

$11.00

Transfer price = External market price = $11.00 If the producing div has no excess capacity, the general rule and external mkt price will yield the same transfer price. Food Processing Division Gulf Division Transfer price $11.00 per rack Retail sales price ... $18.00 per rack Less: Variable costs 7.25 per rack Less: Transfer price. 11.00 per rack Contribution margin $3.75 per rack Contribution margin $ 7.00 per rack Suncoast Food Centers Retail sales price .... $18.00 per rack Less: Variable costs.. 7.25 per rack Contribution margin $ 10.75 per rack

Full cost

= Variable cost = $7.25 per rack = = $ 7.25 $9.75 per rack

+ + +

Allocated fixed overhead $500,000 budgeted fixed overhead 200,000 budgeted racks of bread $2.50

Special price per rack.$9.60 per rack Less: Transfer price based on full cost 9.75 per rack Loss..$ .15 per rack Special price per rack.$9.60 per rack Less: Variable cost in Food Processing Division.. 7.25 per rack Loss $2.35 per rack When there is no excess capacity the offer should not be accepted. But when it has excess capacity, it should be accepted.