Accounting Responsibility Profit Center

							                        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
     business conditions

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.

Principles of Managerial Accounting Chapters 12 & 13          Page 1 of 12
Organizational Structure that impacts setting of goals:

      Responsibility Center
      A responsibility center is a set of activities assigned to a
       manager, a group of managers, or other employees.

      Responsibility Accounting
      Responsibility accounting is developing performance measures
       and targets for a responsibility center, and reporting on actual
       performance by each center.
Responsibility Centers:
   Cost Center
    Manager is accountable for costs only.

      Revenue Center
      Manager has control over generation of revenue but not costs

      Profit Centers
      Manager has responsibility for controlling revenues as well as
       costs(or expenses) ,in other words, profitability.

      Investment Center
       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
      SBU’s

Controllability
 Management control systems often distinguish between controllable
and uncontrollable events and between controllable and
uncontrollable costs.

Principles of Managerial Accounting Chapters 12 & 13     Page 2 of 12
      Uncontrollable Cost
       An uncontrollable cost is any cost that cannot be affected by
      the management of a responsibility center within a given time
      span.

      Controllable Cost
      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
      employees
     Be reasonably objective and easily measured
     Be used consistently and regularly

      Goal Congruence
       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.




Principles of Managerial Accounting Chapters 12 & 13    Page 3 of 12
Managing and Accounting For Segments
Segments
 Segments are responsibility centers for which a separate measure of
revenues and costs is obtained.

Decentralization
 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
organizations.
    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




Principles of Managerial Accounting Chapters 12 & 13   Page 4 of 12
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
        the other.
Middle Ground
    Cost-benefit considerations usually require that some
      management decisions be highly decentralized and other
      centralized.

      Decentralization is most successful when an organization’s
       segments are relatively independent of one another.

Segment Autonomy
   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
       the other.
Principles of Managerial Accounting Chapters 12 & 13   Page 5 of 12
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?
    A percentage?

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.

Margin
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
                               Sales
Return on Sales
    Profit After Tax = ROS
    Sales

Asset Turnover
   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



Principles of Managerial Accounting Chapters 12 & 13            Page 6 of 12
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
EBIT                                      $180,000
Avg. Invested Capital                     $1,000,000
Sales                                     $3,600,000
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

Residual Income
   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.




Principles of Managerial Accounting Chapters 12 & 13         Page 7 of 12
Weighted Average Cost of Capital (WACC)

WACC =
[(after tax cost of debt capital) x ( market value of debt) + (cost of
equity capital) (market value of equity)]

Divided by:

 (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’
    equity.

Example:Nike, Inc.
                              1997
Revenues                      $9,187
Operating expenses            $7,807
Interest expense              $52
Income taxes                  $499
Capital                       $3,156
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




Principles of Managerial Accounting Chapters 12 & 13      Page 8 of 12
 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
their investment.


Principles of Managerial Accounting Chapters 12 & 13     Page 9 of 12
Transfer Pricing
   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
     “cost”.

      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.




Principles of Managerial Accounting Chapters 12 & 13   Page 10 of 12
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
    managerial effort.

     The major drawback to market-based prices is that market prices
      are not always available for items transferred internally.

Variable-Cost Pricing
   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.




Principles of Managerial Accounting Chapters 12 & 13     Page 11 of 12
Dysfunctional Behavior
   Virtually any type of transfer pricing policy can lead to
     dysfunctional behavior -- actions taken in conflict with
     organizational goals.

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
     may dominate.




Principles of Managerial Accounting Chapters 12 & 13   Page 12 of 12