Decentralization:

Responsibility Accounting,
Performance Evaluation,
and Transfer Pricing
Learning of Objectives

1. Define responsibility accounting, and describe the four types

of responsibility centers
2. Explain why firms choose to decentralize
3. Compute and explain return on investment (R O I), residual
income (R I), and economic value added (E V A)
4. Discuss methods of evaluating and rewarding managerial
performance
5. Explain the role of transfer pricing in a decentralized firm
6. Discuss the methods of setting transfer prices
Responsibility Accounting

❑ Is a system that measures the results of each responsibility center

and compares those results with expected or budgeted outcome
❑ Responsibility center are part of the business whose manager is
accountable for specified activities.

❑ Types of Responsibility Centers

❑ Cost center- the manager is responsible only for costs
❑ Revenue center – the manager is responsible only for revenues
❑ Profit center – the manager is responsible for both revenues and costs
❑ Investment center – the manager is responsible for revenues, costs, and
investments
Decentralization

❑ The practice of delegating decision-making authority

to the lower levels
❑ Decentralized decision making allows managers at
lower levels to make and implement key decisions
pertaining to their areas of responsibility
❑ Centralized decision making are made at the very top
level and lower-level managers are charged with
implementing those decisions
Reasons for Decentralization

❑ Better access to local information

❑ Cognitive limitations
❑ More timely response
❑ Focusing of central management
❑ Training and evaluation of segment managers
❑ Motivation of segment managers
❑ Enhanced competition
Performance evaluation measures
for Investment Centers
❑Returnon investment (ROI)
❑Residual income (RI)
❑Economic value added (EVA)
Return on Investment
❑ Most common measure of performance for an investment center
❑ Used by stockholders to indicate the health of a company
❑ Used to measure the relative performance of divisions

ROI = Operating Income x Average Operating Assets

 Operating income   Sales 

=   Average operating assets 
×
 Sales   
= Operating income margin × Operating asset turnover
(Beginning net book value+ Endingnet book value)
Average operating assets =
2
Advantages & Disadvantages of
ROI
❑ Advantages:
❑ Encourages investment center managers to focus on the relationship
between sales, expenses, and investment
❑ Encourages cost efficiency
❑ Discourages excessive investment in operating assets
❑ Disadvantages:
❑ Discourages managers from investing in projects that decrease
divisional R O I but would increase profitability of the company overall
❑ Encourages managers to focus on the short run at the expense of the
long run
Illustration - Average Operating
Assets, Margin, Turnover, and R O I
• Multidiv, Inc., provided the following information for Snack Foods
Division for last year:
Solution - ROI
 Beginning assets + Ending assets 
Average operating assets =  
 2 
 $9,600,000 þ $10,400,000 
= 
 2 
= $10,000,000
Operating income
Margin =
Sales
$1,800,000
=
$30,000,000
= 0 : 06, or 6%
Solution - ROI
Residual Income
❑ Difference between operating income and the minimum dollar return
required on a company’s operating assets
RI = Operating income − (Minimum rate of return × Operating assets)

❑ Advantages
❑ Dollar measure of performance
❑ Refocuses the managers on dollar profit
❑ Disadvantages
❑ Absolute measure of return that makes it difficult to directly compare the
performance of divisions
❑ Does not discourage myopic behavior
Illustration- RI
Solution- RI
Economic Value- Added (EVA)

❑ After-tax operating profit minus the total annual cost of capital

❑ Positive EVA - Company is creating wealth
❑ Negative EVA - Company is destroying wealth
❑ Encourages managers to use existing and new capital for maximum
gain
❑ EVA = After-tax operating income − (Weighted average cost of
capital × total capital employed)
Illustration- EVA
❑ Furman, Inc., had after-tax operating income last year of $1,583,000
❑ Three sources of financing were used by the company
❑ $2 million of mortgage bonds paying 8 percent interest
❑ $3 million of unsecured bonds paying 10 percent interest
❑ $10 million in common stock, which was considered to be no more or less risky than other
stocks.
Rate of return on long-term U.S. Treasury bonds is 6 percent and Furman, Inc., pays a
marginal tax rate of 40 percent
❑ Calculate:
❑ After-tax cost of each method of financing
❑ Weighted average cost of capital for Furman, Inc.
❑ Total dollar amount of capital employed for Furman, Inc.
❑ Economic value added (E V A) for Furman, Inc., for last year
❑ Is Furman, Inc., creating or destroying wealth
Solution- EVA

❑ After-tax cost of mortgage bonds = Interest rate − (Tax

rate × Interest rate) = [0.08 − (0.4×0.08)] = 0.048
❑ After-tax cost of unsecured bonds = Interest rate − (Tax
rate × Interest rate) = [0.10 − (0.4 × 0.10)] = 0.06
❑ Cost of common stock = Return on long-term Treasury
bonds + Average premium = 0.06 + 0.06 = 0.12
Solution - EVA
Solution - EVA
Managerial Rewards
❑ Incentives tied to performance
❑ Objective - To encourage goal congruence
❑ Goal congruence: Goals of managers are closely aligned with
the goals of the firm
❑ Consists of:
❑ Salary increases
❑ Bonuses based on reported income
❑ Stock options
❑ Noncash compensations
Transfer Prices

❑ Levied on goods produced by one division and transferred to

another

❑ It affects the revenues of the transferring division and the costs of

the receiving division

❑ The profitability, return on investment, and managerial

performance evaluation of both divisions are affected
The Impact of Transfer Pricing on Income
Setting Transfer Prices

❑ Transfer pricing system should satisfy three objectives

1. Accurate performance evaluation
2. Goal congruence
3. Preservation of divisional autonomy
❑ Opportunity cost approach identifies:
❑ Minimum price that a selling division would be willing to accept
❑ Maximum price that the buying division would be willing to pay
Market Price

❑ Only possible transfer price because it is

the:
❑Minimum transfer price for the selling division
❑Maximum price for the buying division
Illustration
Yarrow Manufacturers is a large, privately held corporation that produces small appliances.
The company has adopted a decentralized organizational structure. The Parts Division,
which is at capacity, produces parts that are used by the Motor Division. The parts can also
be sold to other manufacturers and to wholesalers at a market price of $8. For all practical
purposes, the market for the parts is perfectly competitive. Suppose that the Motor Division,
operating at 70 percent capacity, receives a special order for 100,000 motors at a price of
$30. Full manufacturing cost of the motors is $31, broken down as follows.

Should the Parts Division lower the transfer price to allow the Motor Division to accept the
special order?
Solution
Since the Motor Division is under capacity, the fixed overhead
portion of the motor’s cost is not relevant. The relevant costs are
those additional costs that will be incurred if the order is accepted.
These costs, excluding for the moment the cost of the transferred-in
component, equal $13 ($10 + $2 + $1). Thus, the contribution to
profits before considering the cost of the transferred-in component is
$17 ($30 - $13).

The division could pay as much as $17 for the component and still
break even on the special order. However, since the component
can always be purchased from an outside supplier for $8, the
maximum price that the division should pay internally is $8. As a
result, the market price is the best transfer price.
Negotiated Price
❑ Alternative pricing when imperfections exist in the market for the
intermediate product
❑ Compliance with goal congruence, autonomy, and accurate
performance evaluation

❑ Disadvantages
❑ One divisional manager with private information may take advantage of
another divisional manager
❑ Performance measures may be distorted by the negotiating skills of
managers
❑ Negotiation can consume considerable time and resources
Illustration
Assume that a division produces a circuit board that can be sold
in the outside market for $22. The division can sell all that it
produces to the outside market at $22. If it does so, however, it
incurs a distribution cost of $2 per unit. Currently, the division sells
1,000 units per day, with a variable manufacturing cost of $12 per
unit. Alternatively, the board can be sold internally to the
company’s recently acquired Electronic Games Division. The
distribution cost is avoidable if the board is sold internally.

The Electronic Games Division is also at capacity, producing and

selling 350 games per day. These games sell for $45 per unit and
have a variable manufacturing cost of $32 per unit. Variable
selling expenses of $3 per unit are also incurred.
Illustration

How could the Games Division and the Circuit Board Division set a transfer price?
Solution
Let’s assume that the Games Division currently pays $22 per circuit board. Clearly, the Games
Division would refuse to pay more than $22; thus, the maximum transfer price is $22. The
minimum transfer price is set by the Circuit Board Division. While this division prices its circuit
boards at $22, it will avoid $2 of distribution cost if it sells internally. Therefore, the minimum
transfer price is $20 ($22 - $2). If a bargaining range exists, the transfer price will fall somewhere
between $22 and $20.
Suppose that the Game Division manager offered a transfer price of $20. That division would be
better off by $2 per circuit board, since it had previously paid $22 per board. Its profits would
increase by $700 per day ($2 X 350 units per day). The Circuit Board Division, on the other hand,
would be no better, or worse, off than before and no incremental profit would accrue to the
division. While a transfer price of $20 per circuit board is possible, it is unlikely that the Circuit
Board manager would agreeto it.
Now suppose that the Circuit Board Division counters with an offer of $21.10 per board. That
transfer price allows the Circuit Board Division to increase its profits by $385 per day [($21.10 -
$20.00) x 350 units]. The Games Division would increase its profits by $315 per day [($22 -
$21.10) x 350 units].
Comparative Income Statement
Cost- Based Transfer Prices

❑ Full-cost transfer pricing and full cost plus markup

❑ Very simple and objective
❑ It provide perverse incentives and distort performance measures
❑ Variable cost plus fixed fee
❑ Useful if fixed fee is negotiable
❑ Advantage - Variable cost is selling division's opportunity cost if it
is operating below capacity
Illustration- Cost- Based
Omni, Inc., has a number of divisions, including Alpha Division, producer of circuit
boards, and Delta Division, a heating and air conditioning manufacturer.
Alpha produces the cb-117 model that can be used by Delta Division in the production
of thermostats that regulate the heating and air conditioning systems. The market price
of the cb-117 is $14. Cost information for the cb-117 model is:
Variable product cost $2.50
Fixed cost $6.50
Total product cost $9.00
Delta needs 30,000 units of model cb-117 per year. Alpha Division is at full capacity
(100,000 units of cb-117)
Question:
If the company has a transfer pricing policy that requires transfer at full product cost,
what would the transfer price be? Do you suppose that Alpha and Delta divisions would
choose to transfer that price?
Illustration- Cost- Based

Answer:
The full cost transfer price is $9.00. Delta would be
delighted with that price, but Alpha would refuse to
transfer since $14.00 could be earned in the outside
market.
Illustration- Cost- Based

Refer to previous data

Question:
If the company has a transfer pricing policy that
requires transfer at full cost plus 25%, what would the
transfer price be? Do you suppose that Alpha and Delta
divisions would choose to transfer that price?
Illustration- Cost- Based

Answer:
The cost plus transfer price is $11.25 ($9.00 + $2.25). Delta would
be delighted with that price, but Alpha would refuse to transfer
since $14.00 could be earned in the outside market.
Illustration- Cost- Based

Question:
If the company has a transfer pricing policy that requires
transfer at variable product cost plus a fixed fee of $12.00
per unit, what would the transfer price be? Do you suppose
that Alpha and Delta divisions would choose to transfer
that price?
Illustration- Cost- Based

Answer:
The variable product cost plus fixed fee is $14.50 ($2.50 +
$12.00). In this case Alpha would be delighted, but Delta
would refuse, since it can buy all it needs on the outside
market for $14.00.
Illustration- Cost- Based

Question:
What if Alpha Division plans to produce and sell only
65,000 units of cb-117 next year? The company policy is that
all transfers be at full cost. Which division sets the minimum
transfer price, and what is it? Which division sets the
maximum transfer price, and what is it? Do you suppose
that Alpha and Delta divisions would choose to transfer?
Illustration- Cost- Based

Answer:
Minimum transfer price is $9.00 (the full cost of
production). This price is set by Alpha, the selling
division.
Maximum transfer price is $14.00. This is the market
price and it is set by Delta, the buying division.