EXAM 3 REVIEW

Behavioral Effects of Responsibility Accounting: Information vs. Blame

Proper focus of a responsibility-accounting system = information; does not emphasize blame System should identify individual in organization in best position to explain each particular event or financial result -- emphasis should be on providing that individual and higher-level managers with information to help them understand reasons behind organization's performance If managers feel they are beaten over the head with criticism and rebukes when unfavorable variances occur, they will tend to undermine the system and view it with skepticism When responsibility-accounting emphasizes its informational role, managers tend to react constructively, and strive for improved performance

Risk Aversion

Most people exhibit risk aversion → managers must be compensated for risks -- compensation comes in form of higher salaries or bonuses Design of managerial performance evaluation and reward system involves trade-off between: 1. Evaluation of a manager on basis of financial performance measures, which provide incentives for the manager to act in the organization's interests 2. Imposition of risk on a manager who exhibits risk aversion, because financial performance measures are controllable only partially by the manager

International Perspective on Transfer Prices

Multinational companies often consider domestic and foreign income-tax rates when setting transfer prices Imposition of import duties, or tariffs -- fees charged to an importer, generally on the basis of the reported value of the goods being imported Similar to taxation, countries sometimes pass laws to limit a multinational firm's flexibility in setting transfer prices for the purpose of minimizing import duties

Two Drawbacks to Negotiated Transfer Prices

Negotiations can lead to divisiveness and competition between participating division managers -- can undermine the spirit of cooperation and unity that is desirable throughout an organization Although negotiating skill is a valuable managerial talent, it should not be the sole or dominant factor in evaluating a division manager -- certain division managers may be better at negotiating than others

Specify the Criterion

Once a decision problem has been clarified, the manager should specify the criterion upon which a decision will be made Sometimes the objectives are in conflict, as in a decision problem where production cost is to be minimized but product quality must be maintained → one objective is specified as the decision criterion and the other objective is established as a constraint

Select an Alternative

Once the decision model is formulated and the pertinent data are collected, the appropriate manager makes a decision (qualitative)

Segments vs. Segment Managers

One advantage of segmented reports is they make a distinction between segments and segment managers Some costs that are traceable to a segment may be completely beyond the influence of the segment manager

Pay for Performance (Merit Pay/Incentive Compensation)

One-time cash payment to an investment-center manager as a reward for meeting a predetermined criterion on a specified performance measure

Excess Capacity

Only exists when more goods can be produced than the producer is able to sell, due to low demand for the product

Profit Center

Organizational subunit whose manager is held accountable for profit -- profit = revenue - costs → held accountable for revenue and costs attributed to their subunits

Cost Center

Organizational subunit, such as a department or division, whose manager is held accountable for the costs incurred in the subunit while accomplishing the department's organizational functions at a specified level of performance

Flexible Overhead Budget

Overhead costs on flexible budget are divided into variable and fixed costs Total budgeted variable overhead cost increases proportionately with increases in activity Total budgeted fixed overhead does not change with increases in activity Formula flexible budget -- express relationship between activity and total budgeted overhead cost (see formula below) Total budgeted monthly overhead cost = (Budgeted variable-overhead cost per unit x Total activity units) + budgeted fixed overhead cost per month

Transfer Price

Price at which products or services are transferred between two subunits (divisions) in an organization Affects profit of both buying and selling divisions → affects performance evaluation of responsibility centers High transfer price = high profit for selling division and low profit for the buying division, low transfer price = opposite → transfer-pricing policy can affect the incentives of autonomous division managers as they decide whether to make the transfer

Measuring Performance in Investment Centers

Primary goals of any profit-making enterprise include maximizing its profitability and using its invested capital as efficiently as possible Managerial accountants use 3 different measures to evaluate the performance of investment centers: return on investment (ROI), residual income (RI), and economic value added (EVA)

Net Book Value Disadvantage

Produces a misleading increase in ROI over time → can have a serious effect on incentives of investment-center managers Investment centers with old assets will show much higher ROIs than investment centers with relatively new assets → can discourage investment-center managers from investing in new equipment If this behavioral tendency persists, a division's assets can become obsolete, making the division uncompetitive

How can profit increase (ROI)?

Profit could increase without changing total sales revenue as a result of either an increase sales price while selling less quantity, or a decrease expenses -- neither is necessarily easy to do Increasing sales prices → division manager must be careful not to lose sales to the extent that total sales revenue declines Reducing expenses must not diminish product quality, customer services, or overall store atmosphere or could result in lost sales revenue

Importance of Nonfinancial Information

Proper evaluation of an organization and its segments requires that multiple performance measures be defined and used Balanced scorecard -- with lead and lag measures of performance, is one tool that is more widely used as a means of introducing nonfinancial measures into performance evaluation

Obtaining Information: Relevancy, Accuracy, and Timeliness

What criteria should the managerial accountant use in designing the accounting information system that supplies data for decision making? Information is relevant if it is pertinent to a decision problem Information must be accurate, or it will be of little use -- highly accurate but irrelevant data are of no use Information must be timely -- some situations involve a trade-off between the accuracy and timeliness of information More accurate information may take longer to produce → as accuracy improves, timeliness suffers, and vice versa

The Activity Measure (Flexible Budgeting)

When only a single product is produced, it makes no difference whether flexible budget is based on input or output Units of output is usually not meaningful measure in a multiproduct firm because it would require us to add numbers of unlike products → output is measured in terms of the standard allowed input, given actual output The flexible overhead budget is then based on this standard input measure

Hidden Quality Costs

When products of inferior quality make it to market, customers are dissatisfied → can decrease sales and tarnish company's reputation Can also experience lost sales in other product lines Hard to estimate or report

When do the general transfer-pricing rule and the external market price yield the same transfer price? When do they not?

When the producing division has no excess capacity and perfect competition prevails, where no single producer can affect the market price If the producing division has excess capacity or the external market is imperfectly competitive, the general rule and the external market price will not yield the same transfer price

Cost-Based Transfer Prices

Set the transfer price equal to the standard variable cost Problem with this approach = even when producing division has excess capacity, it isn't allowed to show any contribution margin on the transferred products or services → some companies avoid this by setting transfer price at standard variable cost plus a markup to allow producing division a positive contribution margin Alternative = set transfer price equal to full cost of transferred product or service -- full (or absorption) cost = product's variable cost + an allocated portion of fixed overhead Full-cost-based transfer prices lead buying division to view costs that are fixed for the company as a whole as variable costs to the buying division -- can cause faulty decision making

Performance Report

Shows budgeted and actual amounts, and variance between these amounts, of key financial results appropriate for type of responsibility center involved EX: cost center's performance report concentrates on budgeted and actual amounts for various cost items attributable to the cost center The data in a performance report helps managers use management by exception to control an organization's operations effectively Hierarchy -- each subunit manager reports to a higher-level manager + hierarchy of performance reports, since the performance of each subunit constitutes part of the performance of the next higher-level subunit

Pareto Diagram (TQM)

Shows graphically the frequency with which various quality control problems are observed for a company's products → Pareto diagram helps TQM team visualize and communicate to others what the most serious defects are and steps can be taken to attack the most serious and most frequent problems first

Develop a Decision Model

Simplified representation of the choice problem Unnecessary details are stripped away, and the most important elements of the problem are highlighted → brings together the elements listed above: the criterion, the constraints, and the alternatives

Behavioral Effects of Responsibility Accounting: Controllability

Some organizations use performance reports that distinguish between controllable and uncontrollable costs or revenues Identifying costs as controllable or uncontrollable is not always easy Many cost items are influenced by more than one person Time frame may be important -- some costs are controllable over a long time frame, but not short time

Clarify the Decision Problem

Sometimes the decision to be made is clear -- but the decision problem is seldom so clear and unambiguous Before a decision can be made, the problem needs to be clarified and defined in more specific terms -- considerable managerial skill is required to define a decision problem in terms that can be addressed effectively

ISO 9000 Standards and Managerial Accounting

Standards require extensive documentation of quality control system -- task often falls to finance department or controller's office Several of the largest public accounting firms offer assurance services to help companies meet ISO documentation requirements for certification ISO standards require costs and benefits of the quality control system be measured and documented -- managerial accountants are responsible for measuring and reporting product life-cycle costs, quality costs, and effectiveness of efforts at continuous improvement ISO 9000 standards have global impact on way companies approach their quality assurance objectives and affect virtually every area within a firm subject to their guidelines

Responsibility Center

Subunit in an organization whose manager is held accountable for specified financial results of the subunits activities

Segmented Income Statement

Subunits of an organization are often called segments → segmented reporting refers to preparation of accounting reports by segment and for the organization as a whole Many organizations prepare segmented income statements = show income for major segments and for entire enterprise In preparing segmented income statements, management must decide how to treat costs incurred to benefit more than one segment -- common costs Common costs are not traceable to activities of segments -- can be allocated to segments only on basis of some highly arbitrary allocation base → many organizations choose not to allocate them on segmented income statements Costs traceable to segments at one level in an organization may become common costs at a lower level in the organization

Undermining Divisional Autonomy

Most managers believe the benefits of decentralized decision making are important to protect, even if it means an occasional dysfunctional decision

Weighted-Average Cost of Capital (WACC)

(After-tax Cost Of Debt Capital)(Market Value Of Debt) + (Cost of Equity Capital)(Market Value of Equity)/(Market Value of Debt + Market Value Of Equity)

Economic Value Added (EVA)

Investment Center's After-Tax Operating Income - [(Investment Center's Total Assets - Investment Center's Current Liabilities) x Weighted-Average Cost of Capital] Is a dollar amount but differs from residual income in two ways: an investment center's current liabilities are subtracted from its total assets and the weighted-average cost of capital is used in the calculation Indicates how much shareholder wealth is being created

Behavioral Effects of Responsibility Accounting: Motivating Desired Behavior

Modified responsibility-accounting system made sales manager look at both costs and benefits associated with each rush order → then, sales manager could make necessary trade-off between costs and benefits in considering each rush order A well-designed responsibility-accounting system can make an organization run more smoothly and achieve higher performance

7 Steps in the Decision-Making Process

1. Clarify decision problem 2. Specify criterion 3. Identify alternatives 4. Develop a decision model 5. Collect data 6. Select an alternative 7. Evaluate decision effectiveness

Identify the Alternatives

A decision involves selecting between two or more alternatives

General Transfer-Pricing Rule

A general rule that will ensure goal congruence = transfer price = additional outlay cost per unit incurred because goods are transferred + opportunity cost per unit to the organization because of the transfer Outlay cost incurred by division that produces goods or services to be transferred -- includes direct variable costs of the product or service and any other outlay costs incurred only as a result of the transfer Opportunity cost incurred by the organization as a whole because of the transfer

Investment Center

Accountable for subunit's profit and return on invested capital used to generate profit -- manager also decides whether profits of investment center are paid as bonuses, reinvested in research and development, used for expansion, distributed to shareholders, etc. Capital = assets, such as buildings and equipment, used in subunit's operations

Evaluate Decision Effectiveness

After a decision has been implemented, the results of the decision are evaluated with the objective of improving future decisions (qualitative)

Collect the Data

Although the managerial accountant is chiefly responsible for this step Selecting data pertinent to decisions is one of the managerial accountant's most important roles in an organization

Six Sigma

Analytical method that aims at achieving near-perfect results in a production process

Four Types of Quality Costs

Appraisal, external failure, internal failure, and prevention

Unique Decisions

Arise infrequently or only once Compiling data for unique decisions usually requires a special analysis by the managerial accountant -- the relevant information often will be found in many diverse places in the organization's overall information system

Adaptation of Management Control Systems

As organization grows, managers need more formal information systems in order to maintain control → accounting systems are established to record events and provide the framework for internal and external financial reports Budgets become necessary to plan the organization's activity As the organization gains experience in producing its goods or services, cost standards and flexible budgets often are established to help control operations As the organization continues to grow, need delegation of decision making Decentralization is often the result of this tendency toward delegation Ultimately, a fully developed responsibility-accounting system emerges -- managerial accountants designate responsibility centers and develop appropriate performance measures for each subunit

Static Budget

Based on a particular planned level of activity

Total Quality Management (TQM)

Broad set of management and control processes designed to focus the entire organization and all of its employees on providing products or services that do the best possible job of satisfying the customer An effective TQM program includes methods for identifying quality control problems

Flexible Budget

Budget that is valid for a range of activity and can tell us, after the fact, what it should have cost to produce a particular level of output Flexible overhead budget = detailed plan for controlling overhead costs that is valid in the firm's relevant range of activity Key control concept for analyzing cost variances, because it allows us to split the variance in spending into different, more easily explained pieces Provides benchmark against which actual revenues, expenses, and profits are compared -- important to use a flexible budget so that appropriate conclusions can be made Variances between budgeted and actual performance are often broken down into smaller components to help management pinpoint responsibility and diagnose performance

Shareholder Value Analysis

Calculates residual income for a major product line, with objective of determining how it affects firm's value to shareholders

Observable Costs

Can be measured and reported, often on basis of info in accounting records

Key Features of Segmented Reporting

Contribution format -- income statements subtract variable expenses from sales revenue to obtain contribution margin Controllable vs. uncontrollable expenses -- income statements highlight the costs that can be controlled, or heavily influenced by each segment manager, this approach is consistent with responsibility accounting Segmented income statement -- segmented reporting shows income statements for the company as a whole and for its major segments

Cost Allocation (Process)

Cost pool = a collection of objects assigned to a set of cost objects EX: all utility costs in a hotel would be combined into a utility cost pool -- includes costs of electricity, water, sewer, trash collection, television cable, and telephone Cost objects = responsibility centers, products, or services to which costs are assigned Cost allocation or cost distribution = process of assigning costs in cost pool to cost objects

Four Common Types of Responsibility Centers

Cost, investment, profit, and revenue

External Failure Costs

Costs incurred after defective products have been delivered

Appraisal Costs

Costs of determining whether defects exist

Prevention Costs

Costs of preventing defects

Internal Failure Costs

Costs of repairing defects found prior to product delivery

Eight Quality Management Principles (ISO 9000)

Customer focus -- organizations depend on their customers and therefore should understand current and future customer needs, should meet customer requirements and strive to exceed customer expectations Leadership -- leaders establish unity of purpose and direction of the organization; should create and maintain the internal environment in which people can become fully involved in achieving the organization's objectives Involvement of people -- people at all levels are the essence of an organization and their full involvement enables their abilities to be used for the organization's benefit Process approach -- a desired result is achieved more efficiently when activities and related resources are managed as a process System approach to management -- identifying, understanding and managing interrelated processes as a system contributes to the organization's effectiveness and efficiency in achieving its objectives Continual improvement -- continual improvement of the organization's overall performance should be a permanent objective of the organization Factual approach to decision making -- effective decisions are based on analysis of data and information Mutually beneficial supplier relationships -- an organization and its suppliers are interdependent and a mutually beneficial relationship enhances the ability of both to create value

Under extreme conditions, basing transfer prices on market prices can lead to ____?

Decisions not in the best interests of the overall company Basing transfer prices on artificially low distress market prices could lead producing division to sell or close productive resources devoted to producing product for transfer Under distress market prices, producing division manager might prefer to move division into a more profitable product line -- could improve division's profit in short run but contrary to best interests of company overall It might be better for the company as a whole to avoid divesting itself of any productive resources and to ride out the period of market distress To encourage an autonomous division manager to act in this fashion, some companies set the transfer price equal to the long-run average external market price, rather than current (possibly depressed) market price

Decentralization

Most large organizations are decentralized -- managers are given autonomy to make decisions for their subunits (to be effective, must have goal congruence) Takes advantage of specialized knowledge and skills of managers, permits an organization to respond quickly to events, and relieves top management of need to direct day-to-day activities

Internal Control System

Designed to provide reasonable assurance of the achievement of objectives in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with laws and regulations Theft or misuse of an organization's resources = fraud → to prevent and detect, organizations establish well-defined procedures that prescribe how valuable resources will be handled Designed to prevent managers from intentionally (or accidentally) misstating an organization's financial records -- internal audit staff reviews financial records throughout organization to ensure accuracy Activities such as bribery, deceit, illegal political campaign contributions, and kickbacks = corruption -- most organizations have internal control procedures and codes of conduct to prevent and detect corrupt practices Foreign Corrupt Practices Act, passed by U.S. Congress in 1977, prohibits a variety of corrupt practices in foreign business operations Sometimes a well-meaning employee is tempted to take an action not illegal or unethical, but is contrary to organization's policies → designed to detect and prevent unauthorized actions by an organization's employees, when those actions could reflect unfavorably on the organization To be effective, internal control procedures require top management's full support and intolerance of intentional violations

Zero-Defect Perspective

Due largely to influence of Japanese product quality expert Genichi Taguchi, most companies now assess the optimal cost of quality from this perspective Contemporary view is that if both observable and hidden costs of quality are considered, any deviation from a product's target specifications results in increased quality costs Optimal level of product quality occurs at the zero defect level Observable and hidden costs of internal and external failure increase as the percentage of defective products increases Observable and hidden costs of prevention and the appraisal increase slightly and then decrease as the percentage of defects increases

How can ROI be improved?

Either increase sales margin, increase capital turnover or increase both

Grade

Extent of a product's capabilities in performing an intended purpose, in relation to other products with the same functional use

Quality of Conformance

Extent to which a product meets the specifications of its design

Qualitative Characteristics

Factors in a decision problem that can't be expressed effectively in numerical terms Can allow decision maker to put a "price" on the sum total of the qualitative characteristics Weighing quantitative and qualitative considerations in making decisions is the essence of management Skill, experience, judgment, and ethical standards of managers all come to bear on choices

What happens when the general transfer-pricing rule can't be implemented?

General transfer-pricing rule will always promote goal-congruent decision making if the rule can be implemented but is often difficult or impossible to implement due to the difficulty of measuring opportunity costs Problem may occur if external market may not be perfectly competitive -- under perfect competition, market price does not depend on quantity sold by any one producer Imperfect competition = single producer or group of producers can affect market price by varying amount of product available in market -- external market price depends on the production decisions of the producer (opportunity cost incurred by the company as a result of internal transfers depends on quantity sold externally) These interactions may make it impossible to measure accurately the opportunity cost caused by a product transfer

Goal Congruence

Goal congruence = obtained when managers of subunits throughout an organization strive to achieve goals set by top management; successful managers have been given positive incentives to achieve them Difficult to achieve -- managers often are unaware of effects of their decisions on organization as a whole, more concerned with performance of their subunit Managerial accountant's objective in designing a responsibility-accounting system is to provide these incentives to the organization's subunit managers Key factor in deciding how well the responsibility-accounting system works is extent to which it directs managers' efforts toward organizational goals Accounting measures used to evaluate investment-center managers should provide them with incentives to act in interests of overall organization

Transfer Pricing + Goal Congruence

Goal in setting transfer prices = establish incentives for autonomous division managers to make decisions that support overall goals of the organization Goal of the company's controller in setting transfer price = provide incentives for each division manager to act in company's best interests

If the transfer price is set at the market price, the producing division should ____?

Have option of either producing goods for internal transfer or selling in external market Buying division should be required to purchase goods from inside its organization if producing division's goods meet product specifications -- otherwise, buying division should have the autonomy to buy from a supplier outside its own organization To handle pricing disputes that may arise, an arbitration process should be established

Historical-Cost Accounting

Historical-cost accounting for internal purposes -- required for external reporting → historical-cost data already are available, while installing current-value accounting would add substantial incremental costs to the organization's information system

Quality of Design

How well a product is conceived or designed for its intended use

Current-Value Accounting

Impact of price-level changes should not be forgotten During periods of inflation, historical-cost asset values soon cease to reflect cost of replacing those assets → some accountants argue investment-center performance measures based on historical-cost accounting are misleading Surveys of corporate managers indicate accounting system based on current values would not alter their decisions Most managers believe measures based on historical-cost accounting are adequate when used in conjunction with budgets and performance targets -- build their expectations about inflation into budgets and performance targets

Measuring Invested Capital

In choosing a measure of invested capital, must choose between using gross book value (acquisition cost) or the net book value of long-lived assets (acquisition cost - accumulated depreciation) Some companies control certain assets centrally, although these assets are needed to carry on operations in the divisions -- common examples = cash and accounts receivable Divisions need cash in order to operate, but many companies control cash balances centrally in order to minimize their total cash holdings Some large retail firms manage accounts receivable centrally -- credit customer of some national department store chains can make a payment either at the local store or by mailing payment to corporate headquarters

Return on Investment (ROI)

Income/Invested Capital ROI calculation for each division takes into account both divisional income and the capital invested in the division Can rewrite the ROI formula as: (Income/Sales Revenue)(Sales Revenue/Invested Capital) Sales margin = income/sales revenue -- measures percentage of each sales dollar that remains as profit after all expenses are covered Capital turnover = sales revenue/invested capital -- focuses on number of sales dollars generated by every dollar of invested capital Profit could increase without changing total sales revenue by increasing sales price while selling less quantity, or decreasing expenses -- neither is necessarily easy to do Increasing sales prices → division manager must be careful not to lose sales to the extent that total sales revenue declines Reducing expenses must not diminish product quality, customer services, or overall store atmosphere -- any of these changes could also result in lost sales revenue Improved capital turnover = sales revenue increase or the division's invested capital decrease Division manager can lower invested capital somewhat by reducing inventories and can increase sales revenue by using store space more effectively but reducing inventories may lead to stockouts and lost sales, and crowded aisles may drive customers away

How can capital turnover be improved?

Increase sales revenue or decrease the division's invested capital Division manager can lower invested capital somewhat by reducing inventories and can increase sales revenue by using store space more effectively but reducing inventories may lead to stockouts and lost sales, and crowded aisles may drive customers away

Residual Income

Investment Center's Profit - (Investment Center's Capital x Imputed Interest Rate) Imputed interest rate = firm's cost of acquiring investment capital (division profit - residual income) ROI and residual income are common performance measures for investment centers -- relate profit earned from selling final product to capital required to carry out production operations Residual income is a dollar amount of an investment center's profit that remains (as a residual) after subtracting an imputed interest rate Reflects firm's minimum required rate of return on invested capital In some firms, imputed interest rate depends on riskiness of investment for which the funds will be used → sometimes divisions with different levels of risk get different imputed interest rates Residual income shouldn't be used to compare performance of different-sized investment centers because it incorporates a bias in favor of larger investment center

ISO 9000 Standards

Key factor in determining quality of a company's products and services is its quality control system -- organizational structure, personnel, procedures, and policies that monitor product quality will greatly affect ability to achieve high-quality standards 1987 -- ISO (International Org for Standardization), based in Geneva, Switzerland, issued a set of quality control standards for companies selling products in Europe Widely adopted in U.S. and other countries -- standards focus on processes a company uses to match the quality of design and quality of conformance that its products and services offer with the expectations of its customers Require company to have a well-defined, extensively documented quality control system in place, and that the target level of product quality can be maintained consistently

Measuring Investment Center Income

Key issue in deciding how to measure a center's income = controllability, choice involves extent to which uncontrollable items are allowed to influence income measure Some companies reward investment-center managers with cash bonuses if they meet a predetermined target on a specified performance criterion, such as residual income, ROI, or EVA In evaluating manager's performance, only revenues and costs manager can control or significantly influence should be included in the profit measure No performance measure can motivate a manager to make decisions about costs they can't control Evaluating a division as a viable economic investment is different -- traceability of costs rather than controllability is the issue

Advantages of Net Book Value

Maintains consistency with balance sheet prepared for external reporting purposes -- allows for more meaningful comparisons of ROI measures across different companies More consistent with definition of income, which is the numerator in ROI calculations -- in computing income, the current period's depreciation on long-lived assets is deducted as an expense

Revenue Center

Manager is held accountable for revenue generated by subunit -- often includes timing of when revenues are received, mix of products and services sold, discounts awarded, and creditworthiness of customers

Management by Objectives (MBO)

Managers participate in setting goals that they then strive to achieve -- goals are usually expressed in financial or other quantitative terms, and the responsibility-accounting system is used to evaluate performance in achieving them

Negotiated Transfer Prices

Many companies use negotiated transfer prices Division managers or their representatives actually negotiate the price at which transfers will be made -- sometimes they start with the external market price and then make adjustments for various reasons EX: producing division may enjoy some cost savings on internal transfers that are not obtained on external sales Commissions may not have to be paid to sales personnel on internally transferred products -- in such cases, a negotiated transfer price may split the cost savings between the producing and buying divisions In other instances, a negotiated transfer price may be used because no external market exists for the transferred product

Measuring Performance in Nonprofit Organizations

Many people participate in a nonprofit organization at some personal sacrifice, motivated by humanitarian or public service ideals → less receptive to formal control procedures than their counterparts in business Goals of nonprofit organizations often are less clear than those of businesses -- public service objectives may be difficult to specify with precision and to measure in terms of achievement

Cause-and-Effect Diagram (TQM)

Method in which a quality improvement team identifies a wide range of possible causes for errors → after which they can take systematic steps to eliminate root causes of errors

Invested Capital

ROI, residual income, and EVA are computed for a period of time, such as a year or a month Asset balances are measured at a point in time -- divisional asset balances generally will change over time, we use average balances in calculating ROI, residual income, and EVA Total assets -- appropriate if division manager has considerable authority in making decisions about all division's assets, including non-productive assets Total productive assets -- in some companies, division managers are directed by top management to keep non-productive assets, such as vacant land or construction in progress → appropriate to exclude from the measure of invested capital and then average total productive assets is used to measure invested capital Total assets - current liabilities -- some companies allow division managers to secure short-term bank loans and other short-term credit → invested capital often is measured by average total assets less average current liabilities (encourages investment-center managers to minimize resources tied up in assets and maximize use of short-term credit to finance operations)

Issues in Segment Performance Evaluation

ROI, residual income, and EVA are short-run performance measures -- only focus on one period of time but an investment center is really a collection of assets (investments), each of which has a multiperiod life Investment-center performance = evaluated separately -- actual divisional profit for a time period is compared to a flexible budget, and variances are used to analyze performance and division's major investments are evaluated through a postaudit of the investment decisions Evaluating periodic profit through flexible budgeting and variance analysis, with postaudits of major investment decisions = more complicated approach to evaluating investment centers but helps management avoid single-period measures

Responsibility Accounting

Refers to various concepts and tools used by managers to measure performance of people and departments in order to foster goal congruence

Why does residual income facilitate goal congruence while ROI does not?

Residual-income formula incorporates firm's minimum required rate of return on invested capital but ROI does not

Transfer prices based on market prices are consistent with the ____?

Responsibility-accounting concepts of profit centers and investment centers In addition to encouraging division managers to focus on divisional profitability, market-based transfer prices help to show the contribution of each division to overall company profit

Transfer Pricing in the Service Industry

Service industry firms and nonprofit organizations also use transfer pricing when services are transferred between responsibility centers

The cost of equity capital is...

The investment opportunity rate

Relevant Information

To be relevant to a decision, cost or benefit information must involve a future event and the costs or benefits must differ among the alternatives Managerial accountant must predict amounts of relevant costs and benefits -- often will use estimates of cost behavior based on historical data Costs or benefits that are the same across all the available alternatives have no bearing on the decision

Allocation Base

To distribute (or allocate) costs to responsibility centers, the company's managerial accountant chooses an allocation base for each cost pool Allocation base (cost driver) = measure of activity, physical characteristic, or economic characteristic associated with the responsibility centers, which are cost objects in allocation process Allocation base chosen for a cost pool should reflect some characteristic of the various responsibility centers related to the incurrence of costs Each cost pool is distributed to each responsibility center in proportion to that center's relative amount of the allocation base

Performance-Evaluation for Responsibility-Center Managers

Trade-offs often must be made between competing objectives -- overall objective is to achieve goal congruence by providing incentives for managers to act in the best interests of the organization as a whole Financial performance measures such as divisional income, ROI, and residual income go a long way toward achieving this but have disadvantage of imposing risk on a manager, because measures are also affected by factors beyond the manager's control

Activity-Based Responsibility Accounting

Traditional responsibility-accounting systems tend to focus on financial performance measures of cost, revenue, and profit for subunits of an organization Contemporary cost management systems focus more on activities -- costs are incurred in organizations and their subunits because of activities ABC systems associate costs with activities that drive those costs Database created by an ABC system and nonfinancial measures of operational performance for each activity, enables management to employ activity-based responsibility accounting Under this approach, management's attention is directed not only to the cost incurred in an activity but also to the activity itself Is the activity necessary?; Does it add value to the organization's product or service?; Can the activity be improved? By seeking answers to these questions, managers can eliminate non-value-added activities and increase the cost-effectiveness of the activities that do add value

Observable-Cost Perspective

Traditional view of quality costs -- finding optimal level of product quality is a balancing act between incurring costs of prevention and appraisal on one hand and incurring costs of failure on the other Adding costs of prevention, appraisal, and internal and external failure yields total quality costs Optimal product quality level = point that minimizes total quality costs

Standard vs. Actual Costs

Transfer prices should not be based on actual costs -- would allow an inefficient producing division to pass excess production costs on to buying division in transfer price When standard costs are used in transfer-pricing formulas, buying division is not forced to pick up the tab for the producer's inefficiency → producing division is given an incentive to control its costs, since any inefficient costs can't be passed on

Customer-Profitability Analysis

Uses concept of ABC to determine how serving particular customers causes activities to be performed and costs to be incurred EX: customer A frequently changes its orders after they're placed, customer B typically does not → costs incurred in updating sales orders for changes should be recorded in a manner that reflects that customer A is more responsible for those activities and costs than is customer B

Advantages of Flexible Budgets

Using static budget, manager compares cost incurred at the actual activity level with the budgeted cost at the planned activity level -- if activity levels are different then we should expect cost to be different Flexible budget provides correct basis for comparison between actual and expected costs, given actual activity

Advantages of Gross Book Value

Usual methods of computing depreciation, such as straight-line and declining-balance methods, are arbitrary -- should not be allowed to affect ROI, residual-income, or EVA calculations When long-lived assets are depreciated, their net book value declines over time -- results in misleading increase in ROI, residual income, and EVA across time