University:
California State University, Northridge
Course:
ACCT 230 | Introduction to Managerial Accounting
Academic year:

2024
Views:

66

Pages:

20
Author:

Gemzam7x

Chapter 12: Performance Evaluation and Decentralization Part 2 3 Residual Income ►To compensate for the tendency of ROI to discourage investments that are profitable for a company but that lower a division’s ROI, some companies have adopted alternative performance measures such as residual income. ►Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets: Residual income = Operating income – (Minimum rate of return x Average operating assets) 3 Cornerstone 12-2 Calculating Residual Income 3 Cornerstone 12-2 Calculating Residual Income (continued) 3 Advantage of Residual Income ►The advantage of using residual income is that its use encourages managers to accept any project that earns a return that is above the minimum rate. ►This prevents the fallacy of using ROI that may reject a profitable project that reduces divisional ROI. 3 Disadvantages of Residual Income ►Unfortunately, residual income, like ROI, can encourage a short-run orientation. ►Another problem with residual income is that, unlike ROI, it is an absolute measure of profitability. Thus, direct comparison of the performance of two different investment centers becomes difficult, as the level of investment may differ. ►One possible way to correct this disadvantage is to compute both ROI and residual income and to use both measures for performance evaluation. ROI could then be used for interdivisional comparisons. 3 Economic Value Added (EVA) ►Another financial performance measure that is similar to residual income is economic value added. ►Economic value added (EVA) is after tax operating income minus the dollar cost of capital employed. ►The dollar cost of capital employed is the actual percentage cost of capital multiplied by the total capital employed. ►EVA is expressed as follows: 3 Cornerstone 12-3 Calculating Economic Value-Added 3 Cornerstone 12-3 Calculating Economic Value-Added (continued) 3 Behavioral Aspects of Economic Value Added ► The key feature of EVA is its emphasis on after-tax operating profit and the actual cost of capital. ► Investors like EVA because it relates profit to the amount of resources needed to achieve it. ► A number of companies have discovered that EVA helps to encourage the right kind of behavior from their divisions in a way that emphasis on operating income alone cannot. The underlying reason is EVA’s reliance on the true cost of capital. ► In some companies, the responsibility for investment decisions rests with corporate management. As a result, the cost of capital is considered a corporate expense rather than an expense attributable to particular divisions. ► Without an EVA analysis, the result of investments do not show up as reducing divisional operating income and may seem free to divisions who want more. 4 Transfer Pricing ►In many decentralized organizations, the output of one division is used as the input of another. ►As a result, the value of the transferred good is revenue to the selling division and cost to the buying division. ►This value, or internal price, is called the transfer price. ►Transfer price is the price charged for a component by the selling division to the buying division of the same company. Impact of Transfer Pricing on 4 Divisions and the Firm as a Whole ►When one division of a company sells to another division, both divisions as well as the company as a whole are affected. ►The price charged for the transferred good affects both ►the costs of the buying division ►the revenues of the selling division ►Thus, the profits of both divisions, as well as the evaluation and compensation of their managers, are affected by the transfer price. Impact of Transfer Pricing on Divisions 4 and the Firm as a Whole (continued) ► Since profit-based performance measures of the two divisions are affected, transfer pricing often can be an emotionally charged issue. The above exhibit illustrates the effect of the transfer price on two divisions of a company. Division A wants the transfer price to be as high as possible while Division C prefers it to be as low a as possible. 4 Transfer Pricing Policies ►Several transfer pricing policies are used in practice, including: ►market price ►cost-based transfer prices ►negotiated transfer prices 4 Transfer Pricing Policies: Market Price ►If there is a competitive outside market for the transferred product, then the best transfer price is the market price. ►In such a case, divisional managers’ actions will simultaneously optimize divisional profits and firm-wide profits. ►Furthermore, no division can benefit at the expense of another. In this setting, top management will not be tempted to intervene. ►The market price, if available, is the best approach to transfer pricing. 4 Transfer Pricing Policies: Cost-Based Transfer Prices ►Frequently, there is no good outside market price. ►The lack of a market price might occur because the transferred product uses patented designs owned by the parent company. ►Then, a company might use a cost-based transfer pricing approach. ►Since a transfer price at cost does not allow for any profit for the selling division, top management may define cost as ‘‘cost plus, ’’ which allows a certain percentage to be tacked onto the cost. 4 Transfer Pricing Policies: Negotiated Transfer Prices ►Finally, top management may allow the selling and buying division managers to negotiate a transfer price. ►This approach is particularly useful in cases with market imperfections, such as the ability of an in-house division to avoid selling and distribution costs that external market participants would have to incur. ►Using a negotiated transfer price then allows the two divisions to share any cost savings resulting from avoided costs. 4 Negotiated Transfer Prices: Bargaining Range ►When using negotiated transfer prices, a bargaining range exists. ►Minimum Transfer Price (Floor): The transfer price that would leave the selling division no worse off if the good were sold to an internal division than if the good were sold to an external party. This is sometimes referred to as the ‘‘floor’’ of the bargaining range. ►Maximum Transfer Price (Ceiling): The transfer price that would leave the buying division no worse off if an input were purchased from an internal division than if the same good were purchased externally. This is sometimes referred to as the ‘‘ceiling’’ of the bargaining range. 4 Cornerstone 12-4 Calculating Transfer Price 4 Cornerstone 12-4 Calculating Transfer Price (continued)