Chapter 11 Reporting for Control.docx

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University of Waterloo
Accounting & Financial Management
AFM 102
Tom Vance

11– Reportingfor Control Chapter 11: Reporting for Control Decentralization inOrganization  decentralized organization: an organization in which decision making is spread throughout the organization rather than being confined to a few top executives Decentralization and Segment Reporting  reports are needed for individual segments of the organization  a segment is a part or activity of an organization where managers would like cost, revenue or profit data Cost, Profit, and Investment Centers  responsibility center: any business segment whose manager has control over cost or profit or the use of investment funds  the 3 primary types of responsibility centers are cost, profit and investment centers  cost center: a business segment whose manager has control over cost but no control over revenue or the use of investment funds  expected to minimize cost while providing the level of services or the amount of products demanded by other parts of the organization  should not be held accountable for controlling common costs arbitrarily allocated to their segment  profit center: a business segment whose manager has control over cost and revenue but not over the use of investment funds  evaluated by comparing actual profit to targeted or budgeted profit  investment center: a business segment whose manager has control over cost and revenue and also control over the use of investment funds  evaluated based on return on investment or residual income measures Transfer Pricing  transfer price: the price charged when one division or segment provides goods and services to another division or segment of an organization  managers are intensely interested in how transfer prices are set because the dollar amount is very large  3 common approaches to set transfer prices:  allow the managers involved in the transfer to negotiate their own transfer prices  set transfer prices at cost using either variable cost or full absorption cost  set transfer prices at the market price  suboptimization: an overall level of profitability that is less than a segment or a company is capable of earning NegotiatedTransfer Prices  negotiated transfer price: a transfer price agreed on between buying and selling divisions  preserves the autonomy of the divisions and is consistent with the spirit of decentralization  managers are likely to have much better info about the potential costs and benefits of the transfer than others in the company  the selling division will agree to the transfer if the profits of the selling division increase after the transfer  the purchasing division will agree to the transfer if the profits of the purchasing division also increase after transfer  if the transfer price is below the selling divisions cost, a loss will occur and the transfer will not go through page 1 of 8 11– Reportingfor Control  range of acceptable transfer prices: the range of transfer prices within which the profits of both the selling division and purchasing division would increase as a result of a transfer  seller’s prospective: total contributionmargin onlost sales transfer price ≥ variable cost per unit + number of units transferred  purchaser’s prospective: transfer price ≤ cost of buying from outside supplier The max. capacity is 10,000 barrels and is considering transferring 2,000 barrels. The cost of buying from an outside supplier is $18. If 7,000 barrels are sold a month then: 8 + 0/2000 = 8 ≤ transfer price ≤ 18 therefore: 8 ≤ transfer price ≤ 18 If 10,000 barrels are sold a month then: 8 + [(20 - 8) * 2000]/2000 = 20 ≤ transfer price ≤ 18 Which doesn’t make sense – therefore there is no agreement If 9,000 barrels are sold a month then: 8 + [(20 – 8) * 1000]/2000 = 14 ≤ transfer price ≤ 18 Therefore: 14 ≤ transfer price ≤ 18  not all managers understand their own business or are cooperative  negotiations often break down even when they shouldn’t  most companies rely on some other means because of these potential problems Transfer to the Selling Division at Cost  using the cost (particularly full cost) as a transfer price can lead to bad decision s and suboptimization  the selling division will never show a profit on any internal transfer  they do not provide incentives to control costs Transfersat Market Price  market price: the price being charged for an item on the open (intermediate) market  intermediate market: a market in which a transferred product/service is sold in its present form to outside customers  if the selling division has no idle capacity, the market price in the intermediate market should be the transfer price  problems occur when the selling division has idle capacity Divisional Autonomy and Suboptimization  companies should grant managers autonomy to set transfer prices and to making decisions regarding selling internally and externally  if to management intervenes, the purposes of decentralization are defeated  if a division manager consistently makes suboptimal decisions, the performance of the division will suffer International Aspects ofTransfer Pricing  the objectives of transfer pricing change when a multinational corporation is involved and the gools and services must cross international borders  transfer prices have a significant influence on a firm’s duties and income taxes (one of the goals is to minimize these)  CRA seeks Canada’s fair share of tax revenue by adopting policies and practices basd on the principle of arm’s length pricing  Managers need to be sensitive to legal rules in establishing transfer prices (CRA rules, foreign trade practices under NAFTA and GATT, etc) Evaluating Investment Center Performance – Return on Investment page 2 of 8 11– Reportingfor Control The Return on Investment (ROI) formula  ROI= operating income averageoperating assets  the higher the ROI of a business segment, the greater the profit generated per dollar invested in the segment’s operating assets Operating Income and Operating AssetsDefined  operating income: income before interest and income taxes have been deducted  the income figure used should be consistent with the base to which it is applied  the denominator (operating assets) has no debt included and interest is paid for by the profits from the operating assets and thus is a distribution of those profits rather than an expenses  operating assets: cash, A/R, inventory, plant and equipment, and all other assets held for productive use in an organization  land held for future use, investment in another company, etc are no included in the operating assets Plant and Equipment: Net Book Valueor GrossCost?  widely used approach: net book value (the plant’s original cost less accumulated depreciation  another approach: ignore depreciation and include the plant’s entire gross cost in the operating assets base  arguments for using NPV to measure operating assets in ROI computations  consistent with how plant and equipment are reported on the b/s  consistent with the computation of operating income, includes depreciation as an operating expense  arguments for using gross cost to measure operating assets in ROI computations  eliminates both the age of equipment and the method of depreciation as factors in ROI computations  does not discourage replacement of old, worn-out equipment Understanding ROI  ROI = margin × turnover = operating income × sales sales averageoperating assets  margin: operating income divided by sales  turnover: the amount of sales generated in an investment center for each dollar invested in operating assets  margin and turnover are very important concepts because  margins is ordinarily improved by increasing sales or reducing operating expenses  turnover incorporates a crucial area of a manager’s responsibility  an increase in ROI must involve at least one of the following:  increased sales  reduced operating assets  reduced operating expenses Criticismsof ROI  just telling managers to increase ROI may not work because managers may not know how to do it properly  a manager who takes over a business segment inherits many committed costs which they have no control over  managers who are evaluated based on ROI may reject profitable investment opportunities (to play safe) Residual Income  residual income: the operating income that an investment center earns above the required return on its operating assets  residualincome= operatingincome-(averageoperatingassets×minimumrequiredrate ofreturn)  economic value added (EVA): a concept similar to residual income  funds used for R&D are treated as investments rather than as an expense page 3 of 8 11– Reportingfor Control  when residual income or EVA is used to measure performance, the purpose is to maximize the amount of residual income, not ROI Motivation and Residual Income  one of the main reasons controllers may want to switch from ROI to residual income is because the residual income approach encourages managers to make investments that are profitable for the entire company  generally, a manager who is evaluated based on ROI will want to reject any project whose rate of return is below the division’s current ROI (even if the rate of return on the project is above the minimum required rate of return for the entire company)  any project whose rate of return is above the minimum requires rate of return for the company will result in an increase in residual income and adds value for shareholders Divisional Comparison and Residual Income  one major disadvantage of the residual income approach: it cannot be used to compare the performance of divisions of different sizes  this problem can be reduced to some degree by focusing on the percentage change in residual income from year to year Criticism of Residual Income  residual income is based on historical accounting data, so the accounting values used for capital assets can suffer from being out of date (leads to inflated amounts of residual income)  does not indicate what earnings should be for a particular business unit  comparing is needed because it provides external benchmarks based on key competitors or evaluates trends in residual income  calculating residual income requires a lot of adjustments to financial info and can increase the cost of preparation  is a financial metric that doesn’t include important leading non-financial indicators of success (like employee motivation or customer satisfaction) Balanced Scorecard  balanced scorecard: an integrated set of performance measures that is derived from and supports the organization’s strategy  a theory about how to achieve the organization’s goals and deals with issues such as how to attract customers, what products/services to provide, what markets to enter a
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