Cost Management ACCOUNTING AND CONTROL

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HANSEN & MOWENHANSEN & MOWEN

Cost ManagementCost ManagementACCOUNTING AND CONTROLACCOUNTING AND CONTROL

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Decentralization: Responsibility Accounting, Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer PricingPerformance Evaluation, and Transfer Pricing

10

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Responsibility AccountingResponsibility Accounting 1

Types of Responsibility Centers

1. Cost center: only responsible for costs

2. Revenue center: only responsible for revenues

3. Profit center: responsible for both revenues and costs

4. Investment center: responsible for revenues, costs, and investments

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.

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2DecentralizationDecentralization

Reasons for Decentralization

Better access to local information

Cognitive limitations

More timely response

Focusing of central management

Training and evaluation of segment managers

Motivation of segment managers

Enhanced competition

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3Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers

Return on investment (ROI) is the most common measure of performance for an investment center.

ROI = Operating income / Average operating assets

= (Operating income / Sales) (Sales / Average operating assets)

= Operating income margin Operating asset turnover

Margin: portion of sales available for interest,

taxes and profit

Turnover: how productively assets are being used to

generate sales

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3

Comparison of Divisional PerformanceComparison of Divisional PerformanceComparison of Divisional PerformanceComparison of Divisional Performance

Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers

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3

Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)Comparison of Divisional Performance (cont’d)

Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers

aOperating income divided by average operating assets.

bOperating income divided by sales.

cSales divided by average operating assets.

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Advantages of the ROI measure

1. Helps managers focus on the relationship between sales, expenses and investment.

2. Encourages cost efficiency.

3. Discourages excessive investment in operating assets

Disadvantages of the ROI measure

1. Discourages managers from investing in projects decreasing divisional ROI but increasing profitability of the company overall.

2. Encourages managers to focus on the short-term at the expense of the long-term.

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Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

Minimum rate of return Operating assets

Residual Income

=Operating

Income-

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Project I

Residual income = $1,300,000 - (0.10 $10,000,000)

= $1,300,000 - $1,000,000

= $300,000

Project II

Residual income = $640,000 - (0.10 $4,000,000)

= $640,000 $400,000

= $240,000

Advantages of Residual Income

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Add Add Add Both Maintain

Project I Project II Projects Status Quo

Operating assets $60,000,000 $54,000,000 $64,000,000 $50,000,000

Operating income $ 8,800,000 $ 8,140,000 $ 9,440,000 $ 7,500,000

Minimum return* 6,000,000 5,400,000 6,400,000 5,000,000

Residual income $ 2,800,000 $ 2,740,000 $ 3,040,000 $ 2,500,000

*0.10 Operating assets.

Preferred Preferred alternativealternative

Advantages of Residual Income (continued)

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Division A Division B

Average operating assets $15,000,000 $2,500,000

Operating income $ 1,500,000 $ 300,000

Minimum returna 1,200,000 200,000

Residual income $ 300,000 $ 100,000

Residual returnb 2% 4%

a0.08 Operating assets.

bResidual income divided by operating assets.

Disadvantages of Residual Income

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Disadvantages of Residual Income (continued)

1. It is an absolute measure of return which make it difficult to directly compare the performance of divisions.

2. It does not discourage myopic behavior.

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Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

Weighted average cost of capital Total capital

employedEVA =

After-tax operating income

-

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After-Tax Weighted Amount Percent x Cost = Cost

Mortgage bonds $ 2,000,000 0.133 0.0480.006

Unsecured bonds 3,000,000 0.200 0.0600.012

Common stock 10,000,000 0.667 0.1200.080

Total $15,000,000

Weighted average cost of capital 0.098

EVA Example

$15,000,000 x .098 = $1,470,000$15,000,000 x .098 = $1,470,000

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EVA Example (continued)

Furman’s EVA is calculated as follows:

After-tax profit$1,583,000

Less: Weighted average cost of capital 1,470,000

EVA$ 113,000

The positive EVA means that Furman, Inc., earned operating profit over and above the cost of the capital used.

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Behavioral Aspects of EVA

Hardware Software Division Division

Sales $5,000,000 $2,000,000

Cost of goods sold 2,000,000 1,100,000

Gross profit $3,000,000 $ 900,000

Divisional selling and

administrative expenses 2,000,000 400,000

Operating income $1,000,000 $ 500,000

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Operating income $1,000,000 $500,000

Less: Cost of capital 1,100,000 220,000

EVA $ (100,000) $280,000


Hardware Software Division Division

The EVA for each division can be calculated as follows:

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Tends to focus on long-run Discourages myopic behavior

Behavioral Aspects of EVA

Measuring the Performance Measuring the Performance of Investment Centersof Investment Centers 3

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Why would managers not provide good service? There are three reasons:

They may have low ability.

They may prefer not to work hard.

They may prefer to spend company resources on perquisites.

Measuring and Rewarding Measuring and Rewarding the Performance of Managersthe Performance of Managers 4

Incentive Pay for Managers

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4Measuring and Rewarding Measuring and Rewarding the Performance of Managersthe Performance of Managers

• Frequently managerial rewards include incentives tied to performance.

• The objective of managerial awards is to encourage goal congruence, so that managers will act in the best interests of the firm.

• Managerial rewards include salary increases, bonuses based on reported income, stock options, and noncash compensations.

Managerial Rewards

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Good management performance may be rewarded by granting periodic raises.

Unlike periodic raises, bonuses are more flexible.

Many companies use a combination of salary and bonus to reward performance by keeping salaries fairly level and allow bonuses to fluctuate with reported income.

Cash Compensation


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Stock options frequently are offered to manager to make

them part owners of the company—thus encourage

goal congruence.

Stock options frequently are offered to manager to make

them part owners of the company—thus encourage

goal congruence.

A stock option is 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.

A stock option is 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.

The price of the stock is usually set approximately at market

price at the time of issue. Then, if the stock price rises in the

future, the manager may exercise the option.

The price of the stock is usually set approximately at market

price at the time of issue. Then, if the stock price rises in the

future, the manager may exercise the option.

Stock-Based Compensation


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Transfer prices are the prices charged for goods produced by one division and transferred to another. The price charged affects the revenues of the transferring division and the costs of the receiving division.

Transfer PricingTransfer Pricing 5

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Transfer PricingTransfer Pricing 5

Impact of Transfer Price on Transferring Impact of Transfer Price on Transferring Divisions and the Company as a WholeDivisions and the Company as a Whole

Impact of Transfer Price on Transferring Impact of Transfer Price on Transferring Divisions and the Company as a WholeDivisions and the Company as a Whole

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A transfer pricing system should satisfy three objectives:

Accurate performance evaluation Goal congruence Preservation on divisional autonomy

Setting Transfer PricesSetting Transfer Prices 6

The opportunity cost approach identifies the minimum transfer price and the maximum transfer price.

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Market price

Negotiated transfer prices

Cost-based transfer prices

Variable cost

Full (absorption cost)


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Summary of Sales and Production DataSummary of Sales and Production DataSummary of Sales and Production DataSummary of Sales and Production Data

Example 1: Avoidable Distribution Costs

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Comparative Income StatementsComparative Income StatementsComparative Income StatementsComparative Income Statements


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Comparative Income Statements (continued)Comparative Income Statements (continued)Comparative Income Statements (continued)Comparative Income Statements (continued)


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Comparative StatementsComparative StatementsComparative StatementsComparative Statements

Example 2: Excess Capacity

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Comparative Statements (continued)Comparative Statements (continued)Comparative Statements (continued)Comparative Statements (continued)

Example 2: Excess Capacity

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1. One division manager, possessing 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.


Disadvantages of Negotiated Transfer Prices

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Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and

accurate performance evaluation.

Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and

accurate performance evaluation.


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Full-cost transfer pricing

Full cost plus markup

Variable cost per fixed fee

Propriety of use

Setting Transfer PricesSetting Transfer Prices

Disadvantages of Negotiated Transfer Prices

6

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Use of Transfer Pricing to Affect Income Taxes Use of Transfer Pricing to Affect Income Taxes PaidPaid

Use of Transfer Pricing to Affect Income Taxes Use of Transfer Pricing to Affect Income Taxes PaidPaid

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End of End of Chapter 10Chapter 10

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Cost Management ACCOUNTING AND CONTROL

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