CHAPTER 10
DECENTRALIZATION: RESPONSIBILITY ACCOUNTING, PERFORMANCE EVALUATION,
AND TRANSFER PRICING
As a firm grows, there is a need to delegate decision-making responsibilities to subordinates. Most firms
tend to be decentralized in decision-making authority. Performance evaluation, management compensation,
and transfer pricing are issues related to decentralization and are addressed in this chapter.
LEARNING OBJECTIVES
After studying Chapter 10, students should be able to:
1. Define responsibility accounting, and describe the four types of responsibility centers.
2. Explain why firms choose to decentralize.
3. Compute and explain return on investment (ROI), residual income (RI), and economic value added
(EVA).
4. Discuss methods of evaluating and rewarding managerial performance.
5. Explain the role of transfer pricing in a decentralized firm.
6. Discuss the methods of setting transfer prices.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. Responsibility Accounting (LO 1)
2. Decentralization (LO 2)
3. Measuring the Performance of Investment Centers (LO 3)
4. Measuring and Rewarding the Performance of Managers (LO 4)
5. Transfer Pricing (LO 5)
6. Setting Transfer Prices (LO 6)
I. RESPONSIBILITY ACCOUNTING
As a firm grows, top management typically creates areas of responsibility known as responsibility
centers. Responsibility accounting is a system that measures the results of each responsibility center and
compares those results with some measure of expected or budgeted outcome. Although the responsibility
center manager has responsibility for only the activities of that center, decisions made by that manager
can affect other responsibility centers.
Four major types of responsibility centers are as follows:
1. Cost center: A responsibility center in which a manager is responsible only for costs.
2. Revenue center: A responsibility center in which a manager is responsible only for revenues.
3. Profit center: A responsibility center in which a manager is responsible for both revenues and
costs.
4. Investment center: A responsibility center in which a manager is responsible for revenues, costs,
and investments.
II. DECENTRALIZATION
Decentralization is the practice of delegating (or decentralizing) decision-making authority to lower
levels. The major issues that must be addressed related to decentralization include determining: (1) the
appropriate degree of decentralization, (2) how to measure performance, (3) the appropriate method to
compensate management, and (4) the appropriate transfer prices.
Decentralization is usually achieved by segmenting the company into divisions. One way in which
divisions are differentiated is by the types of goods or services produced. Organizing divisions as
responsibility centers not only differentiates them on the degree of decentralization, but also creates the
opportunity for control of the divisions through the use of responsibility accounting.
There are many reasons a firm might want to decentralize, including:
1. Better access to local information
2. Cognitive limitations
3. More timely response
4. Focusing of central management
5. Training and evaluation of segment managers
6. Motivation of segment managers
7. Enhanced competition
Teaching hint: Ask students what it means to decentralize. Next ask them why an organization would
choose to decentralize.
III. MEASURING THE PERFORMANCE OF INVESTMENT CENTERS
When companies decentralize decision making, they maintain control by organizing responsibility
centers, developing performance measures for each, and basing rewards on a manager’s performance at
controlling the responsibility center.
Performance measures are developed to provide some direction for managers of decentralized units and to
evaluate their performance. Performance evaluation measures for investment centers include return on
investment, residual income, and economic value added.
Return on investment (ROI) is the most common measure of performance for investment centers.
ROI can be defined in the following three ways:
ROI = Operating income/Average operating assets
ROI = Operating income/Sales × (Sales/Average operating assets)
ROI = Operating income margin × Operating asset turnover
Operating income refers to earnings before interest and income taxes. Operating assets include all assets
used to generate operating income, including cash, receivables, inventories, land, buildings, and
equipment.
The ROI formula can also be broken down into the product of margin and turnover. Margin is the ratio of
operating income to sales. Turnover is defined as sales divided by average operating assets.
Cornerstone 10.1 (p. 511) illustrates the calculation of average operating assets, margin, turnover, and
ROI.
Three advantages of using ROI to evaluate the performance of investment centers are:
1. It encourages investment center managers to pay careful attention to the relationships among
sales, expenses, and investment.
2. It encourages cost efficiency.
3. It discourages excessive investment in operating assets.
Two disadvantages of using ROI are:
1. It discourages managers from investing in projects that would decrease the divisional ROI but
would increase the profitability of the company as a whole. (Generally, projects with an ROI less
than a division’s current ROI would be rejected.)
2. It can encourage myopic behavior, in that managers may focus on the short run at the expense of
the long run.
Residual income is the difference between operating income and the minimum dollar return required on a
company’s operating assets. The equation for RI can be expressed as follows:
Residual income = Operating income − (Minimum rate of return × Operating assets)
Cornerstone 10.2 (p. 515) shows the computation of residual income.
An advantage of using residual income is that the investment center is evaluated on a dollar return
generated, not purely on percentages. Investment centers might reject potentially investments that would
cause ROI to decrease.
Two disadvantages of residual income are that it is an absolute measure of return and that it does not
discourage myopic behavior.
The third method for measuring the performance of investment centers is the economic value added
(EVA) approach. Economic value added (EVA) is after-tax operating income minus the total annual cost
of capital. An important aspect of EVA is the calculation of cost of capital.
There are two steps involved in computing the annual cost of capital:
1. Determine the weighted average cost of capital (a percentage figure)
2. Determine the total dollar amount of capital employed.
The equation for EVA is expressed as follows:
EVA = After-tax operating income – (Weighted average cost of capital × Total capital employed)
A number of companies have discovered that EVA helps to encourage the right kind of behavior from
their divisions in a way that emphasis on operating income alone cannot. The underlying reason is EVA’s
reliance on the true cost of capital. In many companies, the responsibility for investment decisions rests
with corporate management. As a result, the cost of capital is considered a corporate expense. If a division
builds inventories and investment, the cost of financing that investment is passed along to the overall
income statement and does not show up as a reduction from the division’s operating income.
ROI, residual income, and EVA are important measures of managerial performance. However, they are
financial measures and, as such, have limitations. Investment centers need to focus on nonfinancial
measures as well. For example, top management could look at such factors as market share, customer
retention, and personnel development.
IV. MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS
A. Incentive Pay for Managers—Encouraging Goal Congruence
Factors under the responsibility center manager’s control should be used when determining managerial
compensation. Compensation plans are important because each manager is different and certain behavior
is needed in order to have congruence between the goals of a manager and the owners. A well-structured
incentive pay plan can help encourage goal congruence between the two parties.
Managerial rewards generally include incentives tied to performance. These rewards include salary
increases, bonuses based on reported income, stock options, and noncash compensation.
Raises are one way for a company to reward good managerial performance. Many companies use a
combination of salary and bonus to reward performance by keeping salaries fairly level and allowing
bonuses to fluctuate with reported income. However, income-based compensation can encourage
dysfunctional behavior, such as postponing needed maintenance in years when income is down or
deferring revenues in years when the maximum bonus has been received.
Both noncash compensation and perquisites are an important part of the management reward structure.
Companies frequently offer stock options to managers. A stock option is the right to buy a certain number
of shares of the company’s stock, at a particular price and after a set length of time.
B. Measuring Performance in the Multinational Firm
The presence of divisions in more than one country creates the need for performance evaluation that takes
into consideration the differences in divisional operating environments. It is important for the MNC to
separate the evaluation of the manager of a division from the evaluation of the division. A manager should
be evaluated on factors over which he or she exercises control.
International environmental conditions may be very different from, and more complex than, domestic
conditions. Environmental variables facing local managers of divisions include economic, legal, political,
social, and educational factors.
The authors suggest that multiple measures of performance should be used. The existence of differing
environmental factors makes interdivisional comparison of ROI potentially misleading. Both EVA and ROI
have a short-run focus. Therefore, top management should look at factors that relate more closely to the
long-run health of the company such as market share and market potential.
V. TRANSFER PRICING
Transfer pricing affects both the transferring divisions and overall firm through its impact on divisional
performance measures, firmwide profits, and divisional autonomy. A transfer price is the price charged
for a good produced by one division and transferred to another. The price chosen is important because it
affects the profitability, return on investment, and managerial performance evaluation of both the selling
division (through revenues) and the buying division (the transfer price is an input cost).
VI. SETTING TRANSFER PRICES
A transfer pricing system should satisfy three objectives: accurate performance evaluation, goal
congruence, and preservation of divisional autonomy. Using the opportunity cost approach, it is possible
to identify the minimum and maximum transfer prices and use these to determine whether an internal
transfer should occur.
The opportunity cost approach defines a minimum and maximum transfer price as follows:
1. The minimum transfer price is the transfer price that would leave the selling division no worse off
if the good is sold to an internal division.
2. The maximum transfer price is the transfer price that would leave the buying division no worse
off if an input is purchased from an internal division.
A good should be transferred internally whenever the minimum transfer price (set by the selling division)
is less than the maximum transfer price (set by the buying division). By using this rule, total profits of the
firm are not decreased by an internal transfer.
Central management rarely sets specific transfer prices. Instead, most companies develop some general
policies that divisions must follow. Three commonly used policies are market-based transfer pricing,
negotiated transfer pricing, and cost-based transfer pricing.
A. Market Prices
If there is an outside market for the good to be transferred and that outside market is perfectly
competitive, the correct transfer price is the market price. The opportunity cost approach also signals that
the correct transfer price is the market price. Since the maximum transfer price for the selling division is
the market price and since the maximum price for the buying division is also the market price, the only
possible transfer price is the market price.
B. Negotiated Transfer Prices
When imperfections exist in the market for the intermediate product, market price may no longer be
suitable. In this case, negotiated transfer prices may be a practical alternative. Negotiated transfer prices
have three disadvantages that are commonly mentioned.
1. One divisional manager with private information may take advantage of another divisional
manager.
2. Performance measures may be distorted by the negotiating skills of managers.
3. Negotiation can consume considerable time and resources.
C. Cost-Based Transfer Prices
Three forms of cost-based transfer pricing are considered: full cost, full cost plus markup, and variable
cost plus fixed fee. The use of these methods is not desirable. However, despite the disadvantages of cost–
based transfer prices, many companies use these methods, especially full cost and full cost plus markup,
due to their simplicity and objectivity. Cornerstone 10.5 (p. 536) shows how and why cost-based transfer
prices are calculated.
D. Transfer Pricing and the Multinational Firm
In a multinational firm, transfer pricing will have an effect on performance evaluation as well as on
calculation of income taxes.
In a multinational firm, the Parent Corporation often dictates the transfer price. Consequently, the use of
ROI and net income are suspect because they are not under the control of divisional managers.
Multinational companies may choose to use transfer pricing to shift costs to high-tax countries and to shift
revenues to low–tax countries. U.S.-based multinationals are subject to Internal Revenue Code Section 482
on the pricing of intercompany transactions. This code section requires that sales be made at “arm’s length.”
There are three acceptable transfer pricing methods according to IRS regulations: the comparable
uncontrolled price method, the resale price method, and the cost-plus method. The comparable uncontrolled
price method is essentially market price. The resale price method is equal to the sales price received by the
reseller less an appropriate markup. The cost-plus method is simply the cost-based transfer price.
VII. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described on the following page according to coverage of content, learning
objective(s), and level of difficulty. The time required to solve the problems is roughly proportional to the
level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer, and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
CS 10.1
Calculating Average Operating Assets, Margin,
Turnover, Return on Investment (ROI)
LO 3
Basic
CS 10.2
Calculating Residual Income
LO 3
Basic
CS 10.3
Calculating Weighted Average Cost of Capital and
Economic Value Added (EVA)
LO 3
Basic
CS 10.4
Determining Market-Based and Negotiated Transfer
Prices
LO 6
Basic
CS 10.5
Determining Market-Based and Negotiated Transfer
Prices
LO 6
Basic
CS 10.6
Determining Market-Based and Negotiated Transfer
Prices
LO 6
Basic
10.7
ROI, Margin, Turnover
LO 3
Basic
10.8
ROI and Investment Decisions
LO 3
Moderate
10.9
Residual Income and Investment Decisions
LO 3
Moderate
10.10
Calculating EVA
LO 3
Moderate
10.11
Operating Income for Segments
LO 3
Moderate
10.12
Transfer Pricing, Idle Capacity
LO 5, 6
Moderate
10.13
Transfer Pricing and Section 482
LO 6
Moderate
10.14
Transfer Pricing and Section 482
LO 6
Moderate
10.15
Transfer Pricing and Section 482
LO 6
Moderate
10.16
ROI and Residual Income
LO 3
Moderate
10.17
Margin, Turnover, ROI
LO 3
Moderate
10.18
ROI, Residual Income
LO 3
Basic
10.19
Stock Options
LO 4
Moderate
10.20
CPA-Type Exercise
LO3
Basic
10.21
CPA-Type Exercise
LO3
Basic
10.22
CPA-Type Exercise
LO3
Basic
10.23
CPA-Type Exercise
LO3
Basic
10.24
CPA-Type Exercise
LO3
Basic
10.25
Transfer Pricing
LO 5, 6
Moderate
10.26
ROI, Residual Income
LO 1, 3, 4
Moderate
10.27
Bonuses and Stock Options
LO 4
Challenging
10.28
Setting Transfer Prices—Market Price versus Full Cost
LO 5, 6
Moderate
10.29
Transfer Pricing with Idle Capacity
LO 3, 5, 6
Moderate
10.30
Transfer Pricing: Various Computations
LO 5, 6
Moderate
10.31
Managerial Performance Evaluation
LO 1, 2, 3
Moderate
10.32
Management Compensation
LO 4
Challenging
10.33
ROI, Residual Income, Behavioral Issues
LO 3
Moderate
10.34
Transfer Pricing in the MNC
LO 5
Moderate
10.35
Case on ROI and Residual Income, Ethical
Considerations
LO 3
Moderate
10.36
Cyber Research Case
LO 3
Challenging
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 10.1
Impact of Transfer Price on Transferring Divisions and the Company as a Whole
Exhibit 10.2
Summary of Sales and Production Data
Exhibit 10.3
Comparative Income Statements
Exhibit 10.4
Comparative Statements
Exhibit 10.5
Use of Transfer Pricing to Affect Income Taxes Paid