Chapter 12 & 13
Responsibility Accounting/ Investment Centers/Transfer Pricing
Management Control System
A management control system is a combination of techniques
to gather and use information to make planning and control
decisions, set goals to motivate employee behavior, and to
evaluate performance and provide feedback.
Purposes of Management Control System
The purposes of a management control system is ultimately to:
Achieve the goals of the organization
Example: Increase profit by 5% a year; meet or exceed customer
satisfaction goals, grow market share by 10% annually, meet all
contractual customer shipping dates
A Management Control System must
clearly communicate the organization’s goals to everyone in the
organization, making sure everyone understands the specific
actions required to achieve the goals
A well designed system motivates employees to act
together to meet goals
then, when action is taken to meet goals, the system must
communicate the results across the organization
then, the management control system must adjust to changing
Important Elements of a Management Control System:
1. Set Goals
2. Define Measures and Targets (financial or non-financial)
3. Implement plans to achieve the goals
4. Execute the plans
5. Monitor results and learn from the results
6. Reward employees when appropriate
7. Modify the Control System to meet changing conditions.
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Organizational Structure that impacts setting of goals:
A responsibility center is a set of activities assigned to a
manager, a group of managers, or other employees.
Responsibility accounting is developing performance measures
and targets for a responsibility center, and reporting on actual
performance by each center.
Manager is accountable for costs only.
Manager has control over generation of revenue but not costs
Manager has responsibility for controlling revenues as well as
costs(or expenses) ,in other words, profitability.
An investment center is a responsibility center whose success is
measured not only by its income but also by relating that income
to its invested capital (such as facilities, equipment, or other
assets tied up in the activities of the responsibility center)
Investment Centers are also called “Strategic Business Units” or
Management control systems often distinguish between controllable
and uncontrollable events and between controllable and
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An uncontrollable cost is any cost that cannot be affected by
the management of a responsibility center within a given time
Controllable costs include any costs that are influenced by a
manager’s decisions and actions.
Measures of Performance
The well-designed management control system functions alike for
both financial and nonfinancial objectives to develop and report
measures of performance.
Good performance measures will:
Relate to the goals of the organization
Balance long-term and short-term concerns
Reflect the management of key actions and activities
Be affected by actions of managers and employees
Be readily understood by employees
Be used in evaluating and rewarding managers and
Be reasonably objective and easily measured
Be used consistently and regularly
Goal congruence exists when individuals and groups aim at the
same organizational goals and is achieved when employees,
working in their own perceived best interests, make decisions that
help meet the overall goals of the organization.
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Managing and Accounting For Segments
Segments are responsibility centers for which a separate measure of
revenues and costs is obtained.
The delegation of freedom to make decisions is called
decentralization. The lower in the organization that this freedom
exists, the greater the decentralization.
Centralization vs. Decentralization
Decentralization is not right for every firm.
Costs and Benefits
There are many benefits of at least some decentralization for most
Lower-level managers have the best information concerning
local conditions and therefore may be able to make better
decisions than their superiors.
Decentralization gives managers decision-making ability and
other management skills that help them move upward
Managers enjoy being independent which is a motivating factor
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Of course, decentralization has its costs.
Managers may make decisions that are not in the
organization’s best interests
They may act to improve their own segment’s performance at
the expense of the organization or because they are not
aware of the relevant facts from other segments.
Decentralized organizations may result duplicate services that
might be less expensive if centralized (e.g., accounting,
advertising, and personnel).
Costs of accumulating and processing information rise
because responsibility accounting reports are needed for top
management to learn about and evaluate decentralized units
and their managers.
Managers in decentralized units may waste time negotiating
with other units about goods or services one unit provides to
Cost-benefit considerations usually require that some
management decisions be highly decentralized and other
Decentralization is most successful when an organization’s
segments are relatively independent of one another.
If management has decided in favor of heavy decentralization,
segment autonomy, the delegation of decision-making power
to managers of segments of an organization, is also crucial.
Profit Centers and Decentralization
Do not confuse profit centers (accountability for revenue and
expenses) with decentralization (freedom to make decisions).
They are entirely separate concepts and one can exist without
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Measures of Profitability
A favorite objective of top management is to maximize profitability.
Segment managers in decentralized organizations are often
evaluated based on their segment’s profitability. The trouble is that
profitability does not mean the same thing to all people.
Is it net income?
Income before taxes?
Net income percentage based on revenue?
Is it an absolute amount?
WARNING: In practical application, individual companies may vary what is
included in some of these formulas – so always be sure to ask – don’t assume
there is one blueprint for financial ratios. Most of the time they will follow the
guidelines below, but you might see varying interpretations.
Net Operating Income (EBIT which stands for “earnings before
interest and taxes”) divided by Sales
Measures operating performance – how profitable were your sales?
Net Operating Income = Margin
Return on Sales
Profit After Tax = ROS
Sales divided by Average Operating Assets
Operating Assets include assets except Land or assets held for
resale or idle assets
May also see this calculation as Sales divided by Total Assets
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Return on Investment
One measure of profitability is the rate of return on investment
(ROI), which is Net Operating Income divided by the investment
required to obtain that income or profit – the invested capital.
ROI = Net Operating Income / Average Invested Capital
After Tax Income $100,000
Avg. Invested Capital $1,000,000
Cost of Capital 10%
ROI $180,000 / $1,000,000 = 18%
Margin $180,000/$3,600,000 = 5%
Asset Turnover $3,600,000/$1,000,000 = 3.6
Residual Income $180,000 – (.10 X $1,000,000) = $80,000
Some managers favor emphasizing an absolute amount of
income rather than a percentage rate of return.
Residual income (RI) is defined as a net operating income less
“imputed” interest on invested capital, i.e. operating assets
“Imputed” interest refers to the cost of capital, what a firm must
pay to acquire more capital -- whether or not it actually has to
acquire more capital to take on a project.
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Weighted Average Cost of Capital (WACC)
[(after tax cost of debt capital) x ( market value of debt) + (cost of
equity capital) (market value of equity)]
(market value of debt + market value of equity)
Economic Value Added
Economic value added (EVA) equals net after tax operating
income minus the after-tax weighted-average cost of capital
multiplied times the sum of long-term liabilities and stockholders’
Operating expenses $7,807
Interest expense $52
Income taxes $499
Suppose that Nike’s cost of capital is 12.5%. What is their EVA?
$9,187 Revenues - $7,807 Operating expenses - $499 Income
taxes – (12.5% X $3,156) = $487
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Under ROI, the basic message is:
Go forth and maximize your rate of return, a percentage.
Managers of divisions currently earning 20% may be reluctant to
invest in projects that earn only 15% because doing so would
reduce their average ROI.
From the viewpoint of the company as a whole, top
management may want this division manager to accept projects
that earn 15%.
If the company’s cost of capital is 8%, investing in projects
earning 15% will increase the company’s profitability.
Under the residual income approach, the basic message is:
Go forth and maximize residual income, an absolute amount.
When performance is measured by residual income, managers
tend to invest in any project earning more than the imputed
interest rate and thus raise the firm’s profits.
Under EVA, the basic message is:
Maximize shareholder wealth by increasing after-tax profits over the
cost of capital
The cost of capital is the expense require to pay interest on debt plus
the cost of equity(stock).
The cost of debt is easy to comprehend: interest expense
The cost of equity is harder: it is the cost of dividends plus the capital
appreciation that the stockholder expects as an adequate return on
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Transfer prices are the amounts charged by one segment of an
organization for a product or service that it supplies to another
segment of the same organization.
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.
Why do transfer-pricing systems exist?
To product goal-congruent decisions.
Multinational companies use transfer pricing to minimize their
worldwide taxes, duties, and tariffs.
Organizations solve their problems by using cost-based prices
for some transfers, market-based prices for other transfers, and
negotiated prices for others.
Transfers at Cost
About half of the major companies in the world transfer items at
Some companies use only variable costs, other use full cost,
and still others use full cost plus a profit markup. Some use
standard costs and some use actual costs.
Costs are accumulated in one segment and then assigned to (or
transferred to) another segment.
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Market-Based Transfer Prices
If there is a competitive market for the product or service being
transferred internally, using the market price as a transfer price
will generally lead to the desired goal congruence and
The major drawback to market-based prices is that market prices
are not always available for items transferred internally.
Market prices have innate appeal in a profit-center context, but
they are not cure-all answers to transfer-pricing problems.
Sometimes market prices do not exist, are inapplicable, or are
impossible to determine. When market prices cannot be used,
versions of “cost-plus-a-profit” are often used as a fair substitute.
In situations where idle capacity exists, variable cost would
generally be the better basis for transfer pricing and would lead
to the optimum decision for the firm as a whole.
Negotiated Transfer Prices
Companies heavily committed to segment autonomy often allow
managers to negotiate transfer prices.
The theory is that the managers involved have the best
knowledge of what the company will gain or lose by producing
and transferring the product or service, so open negotiation
allows the managers to make optimal decisions.
Drawback is the time and effort spent negotiating, an activity that
adds nothing directly to the profits of the company.
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Virtually any type of transfer pricing policy can lead to
dysfunctional behavior -- actions taken in conflict with
The Need for Many Transfer Prices
The “correct” transfer price depends on the economic and legal
circumstances and the decision at hand.
Organizations may have to make trade-offs between pricing for
congruence and pricing to spur managerial effort.
Multinational Transfer Pricing
In multinational companies, other factors such as tax strategy
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