14

Decentralized
Organizations, Transfer
Pricing, and Measures of
Profitability
© 2007 Pearson Education Canada Slide 14-1
 Decentralization versus Centralization

Decentralization

• The delegation of decision making authority to

managers throughout the organization

Centralization Decentralization
Minimum freedom Maximum freedom

© 2007 Pearson Education Canada Slide 14-2

 Decentralization (con’d)
Benefits of Decentralization

• Lower-level managers are more informed about

local conditions

• Managers acquire decision-making experience

that trains them to assume leadership roles in
organization

• Managerial independence leads to greater

motivation

© 2007 Pearson Education Canada Slide 14-3

 Decentralization (con’d)
Costs of Decentralization

• Managers may make goal incongruent decisions

• Duplication of services (accounting and

advertising)

• Increased cost of accumulating and processing

information

• Managers may waste time arguing about shared

services

© 2007 Pearson Education Canada Slide 14-4

 Decentralization (con’d)

• Most companies adopt a blend of decentralized and

centralized functions (decentralize marketing but
centralize tax planning)

• Decentralization is most successful when

organization's segments are relatively independent

Diversified Single Industry Single

Product Line Multi-Product Product
No Problems Common Problems

© 2007 Pearson Education Canada Slide 14-5

 Decentralization (con’d)

• Decentralization cannot work unless top

management is willing to abide by its
managers' decisions

• Stepping in and overriding managers'

decisions will quickly result in
motivational problems

© 2007 Pearson Education Canada Slide 14-6

 Profit Centres and Decentralization

• Be careful to separate these two ideas

• Profit centres hold a manager accountable

for revenues & expenses

• Decentralized manager has the freedom to

make decisions

• Cost centre may be more decentralized

than a profit centre if the cost centre
manager has more authority

© 2007 Pearson Education Canada Slide 14-7

 Transfer Pricing
• Transfer pricing deals with the valuation of goods and services traded
between profit or investment centres in decentralized organizations

Selling Transfer Buying Final

Division Division Market
Price

Intermediate Market

• Selling division wants the transfer price to be high

• Buying division wants the transfer price to be low

© 2007 Pearson Education Canada Slide 14-8

 Alternative Transfer Prices

• Cost-Based Transfer Price

• Variable cost plus a markup

• Full cost plus a markup

• Market-Based Transfer Price

• Negotiated Transfer Price

© 2007 Pearson Education Canada Slide 14-9

 Setting Transfer Prices
Transfer Price = Cost Plus

• Used by half of the major companies in the world

• Consider using cost-based transfer price when

market price is not available or too difficult to
determine

• What may be variable and fixed to the selling

division becomes completely variable to the buying
division

• Should always transfer at standard cost

© 2007 Pearson Education Canada Slide 14-10
 Setting Transfer Prices (con’d)
Transfer price = market price

• If the external market is competitive, using the

market price as the transfer price will generally
produce optimal results

• Adjustments may be made to reflect costs not

incurred on internally transferred goods and
services

• Market price forces divisional managers to be

competitive
© 2007 Pearson Education Canada Slide 14-11
 Setting Transfer Prices (con’d)
Negotiated transfer prices

• Common in organizations where managers have

considerable autonomy

• Do not let negotiations take up too much time

© 2007 Pearson Education Canada Slide 14-12

 Transfer Pricing in the Global Market
Headquarters and
manufacturing
division in Israel
• 4 plants (cost centre)

Transfer
Price = ?

U.S.-Based Lemmon
Marketing Division
• profit centre
Israel-Based
Marketing Division
• profit centre

Third Marketing
Division Sells
Worldwide on a
Made-to-Order Basis

© 2007 Pearson Education Canada Slide 14-13

 Irving Oil versus Revenue Canada

New Brunswick
Refinery

Bermuda

© 2007 Pearson Education Canada Slide 14-14

 Return on Investment (ROI%)
• Top management's determination of the overall
contribution of the division to corporate earnings
• Focus on long-run performance
• Are the dollars invested in the division generating an
adequate return?
• Should more or less money be put into these
activities?
ROI% = income / invested capital
= income x revenue
revenue invested capital
• Improve performance by
• Increasing income by reducing expenses
• Boost sales without increasing expenses
• Reduce investments in working capital and fixed
assets without decreasing sales
© 2007 Pearson Education Canada Slide 14-15
 Residual Income (RI)
• Residual income is a variation of ROI% which focuses on an
absolute dollar amount rather than a %
Residual income
= Divisional net income - (interest charge x invested capital)
• Imputed interest charge refers to the firm’s "cost of capital"
• Cost of capital is the minimum acceptable rate of return for
investments in a project or a division
• If divisions have different levels of risk, they should have
different imputed interest charges

Current New Proposal Revised

Net income $200,000 $75,000 $275,000
Invested capital $1,000,000 $500,000 $1,500,000
ROI% 20% 15% 18.3%
Capital charge (8%) $80,000 $40,000 $120,000
Residual income $120,000 $35,000 $155,000
© 2007 Pearson Education Canada Slide 14-16
 Economic Value Added (EVA)
• Variation of Residual Income
• Term coined and marketed by Stern Stewart & Co.
• Focuses on an absolute dollar amount rather than a %
Economic Value Added (EVA)
= Net operating income - [ Weighted-average cost of
capital x (Long-term liabilities + Shareholders’ equity) ]
• Weighted-average cost of capital is the after-tax cost of
long-term liabilities and shareholders’ equity weighted by
their relative size for the company or the division

X Y
2006 Sales Revenue ($millions) $12 $8
2007 Sales revenue ($millions) $21 $19
Invested capital ($millions) $20 $10

© 2007 Pearson Education Canada Slide 14-17

 Defining Invested Capital

• Possible alternative definitions of "invested capital"

include total assets, total assets employed, total
assets - current liabilities
• Best alternative depends on what the manager can
influence
• Centrally administered assets are often allocated to
divisions
• Allocations will not cause major problems if
allocation base is deemed by managers to be
reasonable

© 2007 Pearson Education Canada Slide 14-18

 Valuation of Plant & Equipment Assets

Gross Book Value

• Original cost of assets
• Objective [no amortization (depreciation)
allocations]
Net Book Value
• Original cost less accumulated amortization
(depreciation)
• Managers motivated to not invest in new assets
Current Value
• Figures may be costly (and sometimes
impossible) to determine

© 2007 Pearson Education Canada Slide 14-19