Management Accounting Chp8

Chapter 8

Responsibility Centers and Financial Control

Understand and be able to explain the nature and scope of financial control and its important roles both inside and outside organizations.

Understand why organizations use responsibility centers, the type of responsibility center that is appropriate in a given setting,the limitations of the responsibility center approach to evaluating performance, and what performance measures senior management uses to evaluate responsibility center.

Be able to design and interpret appropriate performance measures to evaluate the performance of each type of responsibility center Cost center, Profit center, Investment centres

Learning Objectives :

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Learning Objectives :

Investment centres ROI RI EVA

Responsibility Centers Interaction Controllability principle

Transfer pricing

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8.1 Introduction to Responsibility Accounting System

Responsibility accounting system Which is a part of the performance evaluation

system used to measure the operating results of the responsibility center.

Responsibility accounting centers are the stable subunits which compose an organization and form the work groups that define and characterize what each part of the organization does, i.e., each responsibility center is assigned a set of decision rights.

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The decision rights assigned to a subunit categorize the unit as a cost center, a profit center, or an investment center. Each of these categories implies a different partitioning of the decision rights and ,accordingly, a different performance measure system. In each case,decision rights are linked with the specialized knowledge necessary to exercise them.

Responsibility accounting system

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Responsibility Accounting

The definition of cost, profit, and investment is linked explicitly to agency theory because systems partitioning decision rights (that is, responsibility centres) are part of a firms attempt to solve agency problems efficiently.

Decision rights can be delegated to take advantage of someones superior expertise and information set, but centrally controlled performance measurement and reward systems must be added to offset the moral hazard problems that can result from this autonomy

A responsibility accounting system functions most effectively in an organization that is decentralized.

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Responsibility Accounting

Responsibility centres are also defined in terms of responsibility or accountability: managers are accountable for costs, profits, or investments ;

Assign certain levels of responsibility (over costs, profits, or investments) to given units of the firm.

Match measures of accountability to levels of responsibility assigned.

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Step1:the firm is organized into various responsibility centers according to decision rightStep2: Budgets are prepared for each responsibility centre and serve as performance targets for each responsibility centre.Key points: Goal congruence MotivationStep3: The accounting system measures the performance of each responsibility centre along the lines of management responsibility, timely performance reports are prepared that compare the actual performance of each centre with the amounts budgeted.Key point: Information qualitative characteristics

How does the responsibility accounting system work?

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Step4: Segment financial statements are prepared and responsibility performance of each manager are evaluated.

Variable costing is applied to prepare segment financial statements because each center is charged with only those costs that are directly traceable to that center.

How does the responsibility accounting system work?

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e.g.8.1 ,

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An Example of Responsibility Accounting

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8.1.1 Performance measures for cost center

Performance measures for cost center:

Minimize total cost for a fixed output

Maximize output for a fixed budget

Cost centers work most effectively if

The central managers have a good idea of the cost functions, can measure quantity, and can set the profit-maximizing output level and appropriate rewards;

The central managers can observe the quality of the cost centers output;

The cost central managers has specific knowledge of the optimal input mix;

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Performance measures for cost center

Costs of cost centres are responsibility costs rather than product costs

Accounting systems must accumulate separately the costs incurred by each cost centre

Furthermore costs of cost centres are controllable costs rather than all costs incurred by cost centres .

That is to say,cost centre evaluated primarily on (1) their ability to control costs (2) the quantity and the quality of the services that

they provide.

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8.1.2 Performance measures for profit center

Performance measures for cost and profit center

Actual profits

Actual profits compared with budgeted profits

In general, performance margin and segment margin serve as objective bases for evaluating the performance of a profit centre.

Performance margin= Contribution margin Controllable and traceable fixed costs

Segment margin (Responsibility margin)= Performance margin Uncontrollable and traceable fixed costs

( which is controllable for super manager )

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Performance measures for profit center

Three complications

How to price transfers of goods and services between business units?

Which (if any) corporate overhead costs to allocate to business units?

Whether there interdependencies among business units Firms often base incentive compensation not just on the

managers own profit center profits but also on a group of related profit centers profits and /or firmwide profits.Why?

Motivating individual profit centers to maximize profits will not generally maximize profits for the firm as a whole when there are interdependencies among business units.

Incentive Effects of Profit

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8.2 Investment centres

Managers of responsibility centres may not be motivated to make decisions that maximize profits for the firm as a whole.

The following two related performance measures are directed toward investment centres:

Return on investment (ROI)

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8.2.1 ROIReturn on investment (ROI)

ROI = Investment turnover x Return on sales

ROI

Two factors: Return on sales and sales turnover provide a rough explanation of an investment centres performance.

tmentTotalinvesSales

SalesEarinings

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Approaches for Improving ROI

Just reducing expense: e.g., a high profit can result from cutting down discretionary fixed cost and buying cheaper raw materials

Just decreasing investment : e.g., a low investment can result from decreasing inventory and accounts receivable.

Increasing sales: The higher a firms operating leverage is , the more sensitive profit is to sales change.

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e.g.8.2 , , ,

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Discussion on Incentive Effects of ROI

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Discussion on Incentive Effects of ROI (contd)

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Summary: Incentive Effects of ROI

Managers have incentives to reject profitable projects whose ROIs are below the mean ROI for the division .

Managers have an incentive to plunge into risky projects if managers are rewarded solely for increasing their ROI without being charged for any additional risk imposed on the firm.

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8.2.2 Residual income (RI)

RI is the other measure of investment centre performance which is tied to economic profits through calculation of an opportunity cost.

Conceptual versions:

RI = Actual income Opportunity cost

RI = Actual income Capital chargeCalculation version:RI = Actual income (Cost of capital x Invested

capital)

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ROI & RIEXHIBIT 8-2Centre Media

Data for 1998 fiscal year

Entertainment Telecommunications Publishing technology

Sales $120,000 $200,000 $160,000Invested capital (total assets) 30,000 100,000 40,000Income 6,000 18,000 3,600Required cost of capital 15% 18% 12%

Required:1) Compute ROI for each investment centre and rank them by ROI.2) Compute RI for each investment centre and rank them by RI, if

possible

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RI of each department

EXHIBIT 8-3Centre Media

Calculation of residual income Entertainment Telecommunications Publishing technology

Invested capital 30,000 100,000 40,000Times cost of capital 0.15 0.18 0.12Capital charge 4,500 18,000 4,800

Actual income 6,000 18,000 3,600Less: Capital charge -4,500 -18,000 -4,800Residual income 1,500 0 -1,200

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ROI vs. RI

Suppose that each investment centre receives an investment opportunity that would generate a certain return next year (1999) of 18% on a $10,000 (in thousands of dollars) investment. Does the manager of each department accept it? Why or why not?

About ROI and RI

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8.2.3 Economic value added (EVA)

EVA is a type of RI calculation.

RI = Actual income (Cost of capital x Invested capital)

EVA = Adjusted accounting earnings

(Weighted average cost of capital x Total capital)

or EVA = NOPAT (WACC Total capital)Where NOPAT is net operating profit after taxes

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EVA adjustments

These adjustments turn capital into a more accurate measure of the base upon which investors expect their returns to accrue and make NOPAT a more realistic measure of the actual cash yield generated for investors from recurring business activities -- Purpose of the adjustments

EVA adjustments: R&D costs

The adjustment is to treat R&D costs as noncurrent assets by adding them back to income, then amortizing the cost over future periods, usually five years.

EVA adjustments: Goodwill

The adjustment is to add any amortized goodwill back to earnings and to total capital.

EVA adjustments are also made to deferred tax reserves, other intangible assets, full-cost reserves, cumulative unusual losses and gains, and other reserves, such as bad debts.

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EVA calculation

for the purpose of demonstrating the principle behind EVA rather than obtaining complete calculations, make the following three simplifying assumptions:

Assume there are no deferred taxes.

This allows you to add R&D and goodwill adjustments back to accounting income after taxes without any additional adjustments to reconcile differences between tax expense and taxes paid.

Assume that all EVA adjustments to income and balance sheet numbers required for prior periods have already been made.

You will be given a number called EVA-adjusted total capital, December 31, 20XX, and be required to make EVA adjustments for costs incurred and expenses recognized in year 20XX + 1. You will use the EVA-adjusted total capital figure as your measure of total capital, meaning that your calculations will be based on beginning- of-period capital.

Assume that the firm-wide WACC is relevant to individual divisions, even though they may vary in terms of risk, industry, and so on.

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Calculation of EVA

Atlantic Division is an investment centre of Cuthbert Inc. The following information is available for the year ended December 31, 1999. Assume that R&D costs of 1999 occur on January 1, 1999. Capitalized development costs are amortized over a period of five years in GAAP income; research and development costs are amortized over the same period in NOPAT.

Cuthbert Inc. and Atlantic DivisionCuthbert Inc.:

Marginal tax rate 40%Market yield on equivalent debt 12%Cost of equity 18%Capital structure is one-quarter debt and three- quarters equity.

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Calculation of EVA

Atlantic Division:

GAAP income $300,000

EVA-adjusted total capital, Dec. 31, 1998 1,200,000

Research costs in 1999 expensed under GAAP 50,000

Development costs in 1999 expensed under GAAP 20,000

Development costs in 1999 capitalized under GAAP 8,000

Amortization of goodwill attributed to Atlantic Division and included in its calculation of GAAP income

34,000

NOPAT

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Calculation of EVA NOPAT

Calculation of NOPAT:GAAP income 300,000Add back R&D not capitalized under GAAP 70,000Deduct 1999 amortization of R&D1

($70,000

5) -14,000

Add back amortization of goodwillincluded in 1999 GAAP income 34,000

NOPAT 390,000

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Calculation of EVA WACC

Calculation of WACC

WACC=[ 12% (1 0.4) ]

0.25 + 0.18

0.75

= 15.3%

EVA = $390,000 (15.3% $1,200,000) = $206,400

Incentive Effects of EVA

8.3 Responsibility Centers Interaction

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Controllability Principle

Controllability principle is the assertion that managers should be held responsible for only those decisions for which they have authority.

The controllability principle is not always observed and clear-cut in practice because of agency costs

Conditional controllability, when variable v is controllable by the manager if p(v | a) depends nontrivially on the managers supply of input a.

Relative performance evaluation

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Balanced Scorecard (BSC)

Financial

CustomerInternal process

Learning and Innovation

Revenue growth and mixCost reduction/profitability improvement Asset utilization/investment strategy

The efficiency and effectiveness of a firms processes

Market share, Customer acquisitionRetention, Satisfaction, ProfitabilityKnowledge use and

managementEmployee satisfaction Retention productivity

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8.4 Transfer pricingWhen goods are transferred from one profit (or cost,

investment) center to another, an internal price (the transfer price) is assigned to the units transferred.

The four most common methods of transfer pricing: Full-cost transfer pricingMarket-based transfer pricingNegotiated transfer pricesVariable-cost transfer prices Useful Lower-Cost Transfer Pricing

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Economics of transfer pricing

The optimal transfer price for a product or service is its opportunity cost or the value forgone by not using the transferred product in the next best alternative use.A critical factor affecting choices of

transfer pricing methods is the existence of perfect or asymmetric information.

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Firm profit-maximizing transfer pricing formulas with perfect information

In the perfect information case, everyone in the firm knows the following about any particular exchange between two divisions:

each divisions marginal costs of production, which are usually defined as variable costs when there is excess capacity

each divisions opportunity costs, which depend on whether excess capacity exists

Minimum transfer price = Opportunity cost of transfer

Minimum transfer price = Marginal production cost + Other opportunity costs

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Transfer pricing with asymmetric information

In the asymmetric information case, prices not based on variable costs may be used, including:

market-based transfer prices full-cost transfer prices negotiated transfer pricesThe asymmetric information is more common

and complicates the decision.

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The Effects of Transfer Pricing on Profit Centre Versus Firm Profits

There are two profit centers: the Seller and Buyer divisions. The Seller Division produces and sells an intermediate product (electric motors) to the Buyer Division. The Buyer Division uses the motors in making a toy car. Both divisions are profit centers and maximize their divisions profits. The following outlines the cost structure of the two divisions

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The Effects of Transfer Pricing on Profit Centre Versus Firm Profits (contd)

Seller BuyerFixed costs $ 150.00/day $ 100.00 (for 100 units or less)Variable costs/unit $ 0.10/unit $ 0.20/unit (over 100 units)Demand for buyer division's final output

Quantity sold Price100 $ 2.00 200 $ 1.80 300 $ 1.50 400 $ 1.30 500 $ 1.20 600 $ 1.04

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Summary: Criteria on Transfer Pricing

Each one of various methods is better than the others in some situations, but not in others.

Managers select the best one for their particular situation according to the below principles, Goal congruenceIs it help to maximize the segments and firms profit ?MotivationIs it fair for each parts performance evaluation ? Autonomy/decentralizationIs it good for decision rights assignment ?

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Transfer pricing and international taxation

Often transfer prices are set to minimize international taxes paid. The tax savings may be greater than the agency-cost, minimizing savings generated from other transfer pricing decisions.i.e., main reasons for transfer pricing within

firms: International taxation Performance measurement of responsibility

center

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Review: An Example on Transfer Pricese.g.8.5 ,A

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Reference:

Chapter 12

Self-study

p626, Question12-2,12-11,12-15

Exercises 12-36,37; 12-38Assignment

Case 8

Review (for 5th edition ):

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Chapter 8Learning Objectives :Learning Objectives :8.1 Introduction to Responsibility Accounting SystemResponsibility AccountingResponsibility Accounting 8 9 10 11 12 138.1.1 Performance measures for cost center 158.1.2 Performance measures for profit centerPerformance measures for profit center8.2 Investment centres8.2.1 ROIApproaches for Improving ROI 21 22 23Summary: Incentive Effects of ROI8.2.2 Residual income (RI)ROI & RIRI of each departmentROI vs. RI8.2.3 Economic value added (EVA)EVA adjustments EVA calculationCalculation of EVACalculation of EVACalculation of EVA NOPAT Calculation of EVA WACC 8.3 Responsibility Centers Interaction Controllability PrincipleBalanced Scorecard (BSC)8.4 Transfer pricingEconomics of transfer pricing Firm profit-maximizing transfer pricing formulas with perfect informationTransfer pricing with asymmetric informationThe Effects of Transfer Pricing on Profit Centre Versus Firm ProfitsThe Effects of Transfer Pricing on Profit Centre Versus Firm Profits (contd)Summary: Criteria on Transfer PricingTransfer pricing and international taxationReview: An Example on Transfer Prices 8: 49 50 51 52 53 54 55 56 57 58 59 60