ACCT CH 10

What is a transfer price?

A transfer price is the amount that one division charges when it sells goods or services to another division in the same company.

How does EVA differ from residual income?

EVA is similar to residual income, but uses after-tax operating income as the measure of performance, the after-tax cost of capital as the hurdle rate, and uses total capital employed as the measure of investment.

Explain how relying on return on investment for performance evaluation of investment center managers could lead to goal incongruence.

Evaluation based on return on investment (ROI) can sometimes cause managers to reject an investment that would benefit the company's bottom line profit simply because it would lower the division's current ROI and negatively affect the manager's performance evaluation.

Explain how centralized and decentralized companies differ. What are the advantages and disadvantages of each?

In a centralized organization, decision-making authority is kept at the very top level of the organization. Top executives make all of the strategic and operational decisions, and lower level managers are charged with implementing those decisions.In a decentralized organization, decision-making authority is spread throughout the organization, and managers are responsible for deciding how to manage their particular area of responsibility. The primary advantage of decentralization is that managers at the lower levels of the organization are usually "closer to the action" and can make more informed and quicker decisions based on local information. Giving managers more authority also helps develop their managerial expertise and fosters competition among divisions and managers, while allowing upper management to focus on the strategic direction of the organization. Disadvantages of decentralization include potential duplication of resources and suboptimal decisions, or decisions that are not in the best interest of the organization overall.

How do investment center managers differ from profit center managers?

Investment center managers are responsible for generating a profit (revenue-cost) and investing assets. Profit center managers do not make decisions concerning the investment of assets.

What are negotiated transfer prices? Explain two possible disadvantages of allowing managers to negotiate a transfer price.

Negotiated transfer prices allow division managers to negotiate the transfer price. Possible disadvantages of this method include the time spent in the negotiation process and the adversarial relationship that may be created between the divisions

Why are profit center managers evaluated on segment margin instead of net operating income?

Profit center managers are evaluated on segment margin because that is the portion of income that is under the manager's immediate control. Segment margin excludes fixed costs that result from decisions made at the corporate level (such as administrative costs or corporate-wide advertising) because the segment manager cannot directly control these costs.

How is residual income calculated?

Residual income is calculated as operating profit less the minimum required profit that is needed to compensate for the investment in assets. Specifically, Residual income = Operating profit - (Invested Assets x Hurdle Rate).

Return on investment may be separated into two components. Name them and describe what each can tell you.

Return on investment (ROI) can be broken down into two components: investment turnover and profit margin. Investment turnover indicates how efficiently assets are being used to generate revenue, while profit margin is the percentage of sales revenue that remains as profit (after costs are covered)

Briefly explain the difference between segment margin and net operating income.

Segment margin is calculated as sales revenue less all costs that are directly attributable to a particular business segment, including variable costs and direct fixed costs. A direct fixed cost is one that is incurred by the business segment and is therefore within the control of the segment manager. Even though these costs arefixed, or independent of the number of units produced or sold, they are incurred to support that specific business segment and are therefore considered within control of the segment manager. In contrast, common fixed costs are typically incurred at a higher level of the organization, and are therefore outside of the control of the segment manager. Bottom-line profit margin includes costs that are not controllable by the manager.

Other than the one(s) mentioned in the text, give an example of an action that management might take to improve financial performance in the short run that could prove detrimental in the long run.

Students' answers will vary, but advertising is one example. Companies will often cut advertising when faced with budget problems. In the long run, reduced advertising will only reduce future revenues

Explain the balanced scorecard approach to performance evaluation. What advantages does this approach have over using only financial measurements?

The balanced scorecard is a comprehensive performance measurement system in which performance is measured on four key dimensions: customer perspective, learning and growth perspective, internal business processes, and financial perspective. Its advantages include communication of organizational strategy into operational objectives, incorporation of both lead and lag indicators of performance, and a focus on both financial and non-financial measures of performance.

What is the controllability principle and why is it crucial to responsibility accounting?

The controllability principle states that managers should only be held accountable for items they can control. It is important in responsibility accounting because we do not want to penalize (or reward) managers for things that are beyond their control.

Describe the cost-based method of transfer pricing.

The cost-based method uses a cost-based measure such as variable cost or full cost as the basis for setting the transfer price.

Name the four types of responsibility centers and describe the managers' responsibilities and authority in each.

The four types of responsibility centers include cost centers, revenue centers, profit centers, and investment centers. Cost center managers are responsible for incurring and controlling costs. Revenue center managers are responsible for generating revenue. Profit center managers are responsible for profit, which includesboth revenue and costs. Investment center managers are responsible for profit (revenue - costs) and the investment of assets.

Explain why two managers employed by the same company may be diametrically opposed to each other when considering a transfer price.

The manager of the selling division is motivated to achieve the highest possible price; the manager of the buying division is motivated to pay the lowest possible price. Although the transfer price does not really matter from the overall company's perspective,1 it can make a big difference to individual managers

What is the market-price method of transfer pricing?

The market-price method uses the amount that would be charged to an external customer as the transfer price.

Explain the meaning of minimum and maximum transfer prices and identify who (the buyer or the seller) would determine each.

The minimum transfer price is the minimum amount the seller would be willing to accept. The maximum transfer price is the most the buyer would be willing to pay.

What role do return on investment and residual income play in responsibility accounting?

The most common method for evaluating investment center performance is return on investment (ROI). A less commonly used method is residual income. Each of these measures provides information about how much profit or income is being generated relative to a given investment in assets.

Why are incentive systems that emphasize long-term performance more consistent with a balanced scorecard approach?

The objectives and metrics included in the balanced scorecard should have a cause and effect relationship, where performance in one area of the scorecard ultimately affects performance in the others.

What are the primary limitations of financial measures of performance?

The primary limitations of financial measures of performance are that they are lagging indicators of historical performance and the fact that actions taken to improve financial performance in the short run can prove harmful to the organization in the long run.

What are the four dimensions of a balanced scorecard? What does each dimension represent?

There are four component areas of a balanced scorecard. The customer perspective represents the way in which customers view the organization. The learning and growth perspective captures the organization's ability to continue to change and improve through things such as research and development, employee education, and the like. The internal business process perspective represents the way the company does business in order to meet the needs of customers, employees, and shareholders. The financial perspective represents the financial results that are provided to shareholders and regulators.

What benefit does residual income offer in comparison to return on investment when evaluating performance?

Using residual income to evaluate investment center performance helps to align the manager's goals with the organization's objective of earning a minimum return on its investments.

Why does decentralization create the need for responsibility accounting in an organization?

When managers are given decision-making authority and responsibility in a decentralized organization, the organization will need a system to monitor and evaluate managers' performance to ensure that they are acting in the best interest of the company.

How does excess capacity affect a transfer price?

When there is excess capacity, a division is not fully utilizing all of its production capability and could therefore produce more units or serve more customers without increasing fixed costs. In this case, the minimum transfer price is the variable manufacturing costs associated with the internal transfer of goods

Why must a company consider its incentive and reward system when implementing a balanced scorecard approach?

While the metrics in the balanced scorecard are intended to focus manager's attention on the company's long-term strategy, managers are often motivated by short-term financial results. For example, managers often receive bonuses based on achieving short-term financial results. Unless the company's incentive and reward system is re-designed to focus on long-term results, the balanced scorecard may not serve its intended purpose.