Chapter 11: Notes

True or false: Return on investment (ROI) is defined as net operating income divided by average operating assets.

True

3 common approaches used to set transfer prices:

1. Allow managers involved in the transfer to negotiate the transfer price. 2. Set transfer prices at cost using either variable cost or full (absorption) cost. 3. Set transfer prices at the market price.

Major advantages of decentralization:

1. By delegating day-to-day problem solving to lower-level managers, top-level managers can concentrate on bigger issues, such as overall strategy. 2. Empowering lower-level managers to make decisions puts the decision making authority in the hands of those who tend to have the most detailed and up-to-date information about day-to-day operations. 3. By eliminating layers of decision-making and approvals, organizations can respond more quickly to customers and to changes in the operating environment. 4. Granting decision-making authority helps train lower-level managers for higher-level positions. 5. Empowering lower-level managers to make decisions can increase their motivation and job satisfaction.

Major disadvantages of decentralization:

1. Lower-level managers may make decisions without fully understanding the company's overall strategy. 2. If lower-level managers make their own decisions independently of each other, coordination may be lacking. 3. Lower-level managers may have objectives that clash with the objectives of the entire organization. For example, a manager may be more interested in increasing the size of his or her department, leading o more power and prestige, than in increasing the department's effectiveness. 4. Spreading innovative ideas may be difficult in a decentralized organization. Someone in one part of the organization may have a terrific idea that would benefit other parts of the organization, but without strong central direction the idea may not be shared with, and adopted by, other parts of the organization.

True or false: Service departments such as accounting, finance, general administration, legal, and personnel are usually classified as cost centers.

True

True or false: Negotiated transfer prices also have two important disadvantages - not all managers understand their own businesses and not all managers are cooperative negotiators. As a result, negotiators often break down even when it would be in the managers' own best interests to come to an agreement.

True

True or false: Net operating income is income before interest and taxes and is sometimes referred to as EBIT (earnings before interest and taxes).

True

True or false: Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.

True

True or false: Profit managers are often evaluated by comparing actual profit to budgeted profit.

True

ROI Calculation:

Margin * Turnover

Residual Income Calculation:

Net operating income - (Avg. Operating Assets * Minimum Required Rate of Return)

Margin Calculation:

Net operating income/ Sales

ROI Calculation:

Net operating income/ average operating assets

True or false: Residual income is another approach to measuring an investment center's performance.

True

Turnover Calculation:

Sales/ Average operating assets

True or false: In strongly decentralized organizations, even the lowest-level managers are empowered to make as many decisions as possible.

True

True or false: Investment center managers are often evaluated using return on investment (ROI) or residual income measures.

True

True or false: Return on investment (ROI) is a financial measure that is commonly used to evaluate investment center performance.

True

True or false: Many decentralized organizations use responsibility accounting systems to link lower-level managers' decision-making authority with accountability for the outcomes of those decisions.

True

True or false: Flexible budget variances and standard cost variances are often used to evaluate cost center performance.

True

True or false: In a decentralized organization, decision-making authority is spread throughout the organization rather than being confined to a few top executives

True

True or false: In strongly centralized organizations, decision-making authority is reluctantly delegated to lower-level managers who have little freedom to make decisions.

True

True or false: The basic idea underlying responsibility accounting is that a manager should be held responsible for those items and only those items - that the manager can actually control to a significant extent.

True

True or false: The fundamental objective in setting transfer prices is to avoid suboptimization by motivating managers to act in the best interests of the overall company.

True

True or false: The manager of a cost center has control over costs, but not over revenue or the use of investment funds.

True

True or false: The manager of an investment center has control over cost, revenue, and investments in operating assets.

True

True or false: The operating assets base used in the formula is typically computed as the average of the operating assets between the beginning and end of the year.

True

True or false: The profit center has control over both costs and revenue, but not over the use of investment funds.

True

True or false: The term responsibility center is used for any part of an organization whose manager has control over and is accountable for cost, profit, or investments.

True

True or false: Turnover incorporates a crucial area of a manager's responsibility - the investment in operating assets.

True

True or false: Two responsibility center managers will agree to a transfer of products or services only if the transfer price falls within a range of acceptable transfer prices that increases both the buyer's and seller's profits.

True

True or false: When residual income is used to measure performance, the objective is to maximize the total amount of residual income, not to maximize.

True

Residual income:

is the net operating income that an investment center earns above the minimum required return on its operating assets.

Transfer price

is the price charged when one responsibility center within a company provides goods or services to another responsibility center in the same company.

Suboptimization:

occurs when responsibility center managers forego additional companywide profits by making decisions that are not in the best interests of the overall company or even in the best interests of their own responsibility center.