978-0133058789 Chapter 10 Part 1

CHAPTER 10

COVERAGE OF LEARNING OBJECTIVES

LEARNING OBJECTIVE

FUNDA–

MENTAL

ASSIGN–

MENT

MATERIAL

CRITICAL

THINKING

EXERCISES

AND

EXERCISES

PROBLEMS

CASES,

EXCEL,

COLLAB., &

INTERNET

EXERCISES

LO1: Define decentralization and

identify its expected benefits and

costs.

A2, A4, B4

25, 26

59, 60

LO2: Distinguish between

responsibility centers and

decentralization.

46

55

LO3: Explain how the linking of

rewards to responsibility center

results affects incentives and risk.

23

37, 43

LO4: Compute ROI, economic

profit and economic value added

(EVA).

A1, A4, B2,

B4

27, 28, 29, 30,

31,32,33

38, 40, 41, 42,

44

57, 58

LO5: Compare the incentives

created by income, ROI, and EVA

performance measures.

B1,

24, 25

39, 40, 43, 44,

45, 54

LO6: Define transfer prices and

identify their purpose.

A2, A3, A4,

B3, B4

26

46, 47, 48, 49,

50, 51, 54

55

LO7: State the general rule for

transfer pricing and use it to assess

transfer prices based on total costs,

variable costs, and market prices.

A2, A3, A4,

B1, B3, B4

34, 35

46, 47, 48, 49,

52, 54

55

LO8: Identify the factors affecting

multinational transfer prices.

36

53

LO9: Explain how controllability

and management by objectives

(MBO) aid the implementation of

management control systems.

56

409

CHAPTER 10

Management Control in Decentralized Organizations

10-A1 (10-15 min.) Dollar amounts are in thousands.

Division

Hubert Duane Louis

Return on sales:

2. If ROI is used for judging relative performance, Duane is best for this period.

3. Division

Hubert Duane Louis

410

10-A2 (30 min.)

1. Assume that fixed costs will continue. The company as a whole will be worse

off if Lucerne buys from outside supplier:

2. Company will benefit if Lucerne buys outside:

Purchase costs from outsider, 3,000 units

3. Company will benefit if Lucerne buys on outside:

Purchase costs from outsider,

4. As president, I would not want to become immersed in these disputes. If

arbitration is necessary, it probably should be conducted by some other officer

on the corporate staff. One possibility is to have the immediate line boss of the

two managers make a decision.

If decentralization is to be strictly adhered to, the arbitrator probably should not

411

Suppose, however, that Geneva refuses to meet the price of CHF300. This

would mean that the company will be CHF60,000 poorer in the short run.

Should top management interfere and force a transfer at CHF300? This would

undercut the philosophy of decentralization. Many managers would not interfere

because they would view the CHF60,000 as the price that has to be paid for true

decentralization. But how high must this price go before the temptation to

interfere would be irresistible? CHF70,000? CHF80,000? How much? On the

other hand, the Geneva manager may realize that CHF60,000 is being sacrificed

but may have decided that it is worth more than CHF60,000 to achieve some

long-term subjective benefits.

In sum, the point of this question is that any structure that interferes with lower-

level decision-making weakens decentralization. Of course, such interference

may occasionally be necessary to prevent horrendous blunders. But recurring

interference and constraints simply transform a decentralized organization into a

centralized organization.

10-A3 (10 min.)

The company as a whole would benefit because the CHF60,000 disadvantage of

purchasing from an outside supplier calculated in 10-A2 Part 1 would be more

10-A4 (30-35 min.)

1. a. 20% of $960,000 = $192,000 target operating income

Let X = Unit sales price

2. a, b.

Sales Volume

150,000 170,000 130,000

Units* Units Units

3. If the units are not sold to the other division, average available assets would

decrease by $150,000, from $960,000 to $810,000. Fixed overhead would be

reduced to $300,000 – $22,500 = $277,500. Results would be:

Sell Sell Difference

105,000 150,000 45,000

original overall target rate of return of 20% is unattainable, the division will

nevertheless earn a better rate of return on assets with the intracompany business

than without it. The additional units will earn a 30.9% incremental rate of return,

which exceeds the 8.26% rate earned on 105,000 units. As a result, the overall

rate of return would increase from 8.26% to 11.80%, as shown in the schedule

above.

413

Despite this economic analysis, the Austin Division manager may still decide

against transferring goods at such a low price. For example, he may feel entitled

to a higher profit. This would mean that the company would be worse off,

assuming the incremental costs of the other division are $2.25.

Should top management interfere and force a transfer of $2.25? Such intervention

would weaken the decentralization structure. Obviously, authoritarian action

sometimes may be needed to prevent costly mistakes. But recurring interference

by top management effectively transforms a decentralized organization into a

centralized organization. Of course, if managers repeatedly make costly

dysfunctional decisions, a more centralized organizational design may be

desirable.

1. The percentage return for each project is as follows:

Percentage

Project Return

1 $1,200,000 ÷ $4,800,000 = 25%

2 $ 627,000 ÷ $1,900,000 = 33%

The manager taking the above projects would be following the company rule.

b. Under assumption (b), the rational manager will take only project 2, since

this gives a return on investment of $627,000 ÷ $1,900,000 = 33% (and an

economic profit of $627,000 – ($1,900,000 × .20) = $247,000). Adding any

further projects at lower returns lowers the overall return on capital invested.

414

c. Under assumption (c), the manager will take projects 1, 2, 5 and 6, which

have returns greater than the cost of capital.

Total investment $7,650,000

Total income $2,053,500

Return on investment (2,053,500 7,650,000) 26.84%

Economic profit $ 523,500*

*$2,053,500 – ($7,650,000 × .20)

2. The essence of the concept of economic profit is that it requires the manager to

take all projects that promise a return to the company over and above the cost of

the capital invested. This will maximize total return to the company for the

10-B2 (10 min.) Amounts are in millions.

1. 20X4 20X5

Pretax operating income $6,105 $6,100

2. Although profit after tax increased slightly in 20X5, EVA decreased by ($1,945 –

10-B3 (20 min.)

The appropriate transfer price is the market price of $3.35 per gallon. As long as

the market price is met, the buying divisions must purchase from the internal divisions.

At this price, both divisions have incentives to make choices that maximize operating

income for the corporation as a whole. At this price, the analysis by the manager of the

416

10-B4 (30-45 min.)

1. a. Contribution margin per unit = ¥7,350 – ¥4,900 = ¥2,450

Total contribution = ¥2,450 × 3,350 units = ¥8,207,500

2. a. Desired operating income

= 24% × ¥16,000,000 = ¥3,840,000

Let X = units to be sold to reach desired return

¥2,450 × X units = ¥5,700,000 + ¥3,840,000

3. Examine the operating income and rate of return on assets with and without the

1,200-unit transfer (amounts are thousands of Japanese Yen):

Sell Sell Difference

2,950 4,150 1,200

units units units

417

Based on the information given, the Sendai division should sell 1,200 units to the

European Marketing division at the ¥6,150 price. Both divisions and the

company as a whole will benefit from such a decision. Although the original

overall target rate of return of 24% is unattainable, the division will nevertheless

earn a better rate of return with the intracompany business than without it. The

additional units earn a 24% incremental rate of return, which exceeds the 16.6%

rate earned on 2,950 units. As a result, the overall rate of return will increase

from 16.6% to 18.9%, as shown in the schedule above. In addition, the extra sales

meet the return target of 24%.

Despite this economic analysis, the Sendai manager may still decide against

transferring goods at such a low price. For example, he may feel entitled to a

10-1 Benefits of decentralization include: 1) lower-level managers may make better

decisions because they have better knowledge of local conditions; 2) managers develop

their management skills so that there are more managers qualified to move up in the

10-2 One of the limitations in decentralization is lack of knowledge in segments of the

organization. This is especially true in geographically decentralized operations.

10-3 It is more difficult to hold managers of nonprofit organizations responsible for

10-4 No. Profit centers facilitate decentralization, but one can exist without the other.

They are different concepts, as the chapter explains.

10-5 Decentralization is usually most successful in organizations where segments are

10-6 Employment contracts must balance the incentives created for managers, the risk

10-7 The major advantage of the rate of return analysis of performance is its attention

10-9 The major difference is that economic profit includes a capital charge, that is, a

cost of using all capital. In contrast, net income includes a charge for using debt capital

R&D.

10-10 Economic value added (EVA) is after-tax operating income minus the after-tax

weighted-average cost of capital multiplied by the sum of average long-term liabilities

and stockholders’ equity. Companies can improve EVA by

• Investing in products or projects that generate more after-tax operating

income than the cost of the capital used,

419

Total assets = Total liabilities + Stockholders’ equity

Current assets + Non-current assets = Current liabilities + Long-term debt +

Stockholders’ equity

Current assets – Current liabilities + Non-current assets = Long-term debt +

Stockholder’s equity

The right-hand side of the above equation represents the capital structure of an

organization – that is, how capital is financed. The left-hand side represents the actual

capital — working capital and non-current assets. Either definition can be used.

10-11 Division A’s manager would reject the proposed project because it would reduce

the division’s ROI. Division B’s manager would accept the proposed project because it

10-12 Three possible definitions of invested capital are:

2. Total assets less current liabilities

10-13 There is some truth to this statement. However, using a historical cost accounting

10-14 The use of gross book value rather than net book value of assets to compute ROI

may affect the speed with which managers replace assets. Gross book value leads to

10-15 Companies need transfer-pricing systems to accurately determine the efficiency of

various divisions of a company’s operation when using profit or investment centers. If

10-16 Using full costs can mask the real behavior of a cost. Any transfer price that

includes a fixed cost element makes a fixed cost in the producing department look like a

10-17 If a producing division has idle capacity, a transfer price at the variable cost will

usually be optimal. Why? Because it costs the firm as a whole only the variable costs to

10-18 Variable-cost transfer prices can also lead to dysfunctional decisions. For

10-19 Negotiated transfer prices are likely to lead to better transfer pricing decisions

10-20 Multinational transfer prices are influenced by the relative income-tax rates in the

10-21 In organizations using management by objectives (MBO), managers and their

10-22 When making performance targets becomes too important, managers may be

10-23 A decision to decentralize is based on a desire to achieve specific objectives in a

particular environment. If a company’s objectives change or its environment change, a

10-24 No. ROI and economic profit create different motivations for managers. Goal

congruence and managerial effort would usually be accomplished better by economic

profit.

10-25 Profit measures and other performance measures by themselves do not cause

unethical behavior. However, the way managers use them may. Managers charged with

10-26 When top management second-guesses divisional managers frequently, many

advantages of decentralization are lost. Segment autonomy disappears. Essentially, top

1. Turnover of capital = Sales ÷ Invested capital

2. Return on sales = $9,100÷ $227,500

= 4.0%

10-28 (5 min.)

The basic equation: ROI = Return on Sales × Capital turnover

10-29 (15-20 min.)

1. The filled-in blanks are underscored:

Division

X Y Z

2. Division

X Y Z

3. If the criterion for judging relative performance is ROI, Division Z is best for

this period. If the criterion is economic profit, then both Division Y and Division

10-30 (10 – 15 min.) Dollar amounts are in thousands.

1.

20X1: Adjusted net operating profit after tax

2. Lohmann’s overall performance improved, with EVA increasing from a negative

423

10-31 (20 min.)

1. Hope Crosby

Assets $3,000,000 $3,000,000

Liabilities 1,240,000 0

2. The gross rate of return on assets (before considering interest expense) is 690,000

÷ 3,000,000 = 23%. For Crosby, with no debt in the capital structure, the return

on assets and return on stockholders’ equity are the same. For Hope, with a large

amount of debt in the capital structure, there is a large impact of debt on the net

10-32 (20-30 min.) This problem presses the student more than those immediately

preceding it. Dollar amounts are in thousands.

1. Division

J K L

Income: .27 × $5,000;

.16 × $20,000 $ 450 $ 1,350 $ 3,200

2. This requirement can generate much discussion or little discussion, as the

instructor desires. Using ROI as the criterion, J is the best performer. Using

10-33 (15 min.)

1 & 2.

(2) (1)

3. LaVilla might prefer the net book value because it always gives a higher ROI.

However, she might prefer to be evaluated based on gross book value for two

1. (b) (a)

Sell to Outsiders

Process Further at Transfer Point

Finishing Finishing

2. If the transfer price is based on variable cost of $52, the manager of the Finishing

Division would want the product processed further. But this would hurt overall

company performance. The incremental revenue from finishing the chair ($83–

10-35 (10-15 min.)

1. If wheels were available for $14 each in the market, Dayton would not be willing

to pay more than $14 to Toledo. If wheels could not be purchased in the market,

the maximum price would be $20, computed as follows:

bicycles.

2. Because there is excess capacity, any transfer price above the variable cost of

$10 would result in a positive contribution margin. No price below $10 would

1. Princeton is better off using a £800 transfer price. A £800 transfer price places

an extra £800 – £500 = £300 of income in Ireland instead of Japan, while a £500

transfer price places an extra £300 of income in Japan instead of Ireland. In

2. The total taxes saved by the £800 transfer price is £24 per unit.

427

10-37 (20-25 min.)

1. The two contracts illustrate the tradeoff between incentive and risk in

employment contracts. The bonus contract provides more incentive to generate

profits than does the straight salary. This should benefit Tamura International.

On the other hand, it may cause the manager to focus too much on short-run

2. Managers are generally risk averse. This means that they prefer a contract with

less risk to one with more risk if the expected compensation does not differ. It

does not mean that managers avoid risks, only that they want to be compensated

for such risk-seeking. If a risky contract has an expected compensation high