CHAPTER 7

DECENTRALIZATION
AND
TRANSFER PRICING
 Learning Objectives

1. Explain how and why firms choose to decentralize.

2. Compute and explain return on investment.
3. Compute and explain residual income and economic
value added.
4. Explain the role of transfer pricing in a decentralized
firm.
 Decentralization and Responsibility Centers
 In general, a company is organized along lines of
responsibility. Today, most companies use a more
flattened hierarchy that emphasizes teams.
 Firms with multiple responsibility centers usually choose
one of two decision-making approaches to manage their
diverse and complex activities: centralized or
decentralized.
 In centralized decision making, decisions are made at
the very top level, and lower level managers are
charged with implementing these decisions.
 Decentralized decision making allows managers at
lower levels to make and implement key decisions
pertaining to their areas of responsibility. The practice
of delegating decision-making authority to the lower
levels of management in a company is called
Centralization and Decentralization
 Reasons for Decentralization
 Firms decide to decentralize for several reasons,
including the following:
 ease of gathering and using local information
 focusing of central management
 training and motivating of segment managers
 enhanced competition, exposing segments to market
forces
 Divisions in the Decentralized Firm
 Decentralization involves a cost-benefit trade-off.
 As a firm becomes more decentralized, it passes more
decision authority down the managerial hierarchy.
 Decentralization usually is achieved by creating units
called divisions.
 Divisions can be differentiated a number of different
ways, including the following:
 types of goods or services
 geographic lines
 responsibility centers
 Responsibility Centers
 Divisions differ is by the type of responsibility given to the
divisional manager.
 A responsibility center is a segment of the business whose
manager is accountable for specified sets of activities.
 The four major types of responsibility centers are as follows:
 Cost center: Manager is responsible only for costs.
 Revenue center: Manager is responsible only for sales, or
revenue.
 Profit center: Manager is responsible for both revenues and
costs.
 Investment center: Manager is responsible for revenues, costs,
and investments.
 Responsibility Centers and Accounting
Information Used to Measure Performance
Investment centers represent the greatest degree of
decentralization (followed by profit centers and finally by
cost and revenue centers) because their managers have the
freedom to make the greatest variety of decisions.
 Responsibility Center Interdependencies
 It is important to realize that while the responsibility
center manager has responsibility only for the activities
of that center, decisions made by that manager can affect
other responsibility centers.
 Organizing divisions as responsibility centers creates the
opportunity to control the divisions through the use of
responsibility accounting.
 Return on Investment
 One way to relate operating profits to assets employed is
to compute the return on investment (ROI), which is
the profit earned per dollar of investment.
 ROI is the most common measure of performance for an
investment center and is computed as follows:
Operating income ÷ Average Operating Assets
 Operating income refers to earnings before interest and taxes.
 Operating assets are all assets acquired to generate operating
income, including cash, receivables, inventories, land, buildings,
and equipment.
 Average operating assets is computed as:
(Beginning assets + Ending assets) ÷ 2
 Margin and Turnover
 A second way to calculate ROI is to separate the formula
(Operating income ÷ Average operating assets) into
margin and turnover.
 Margin is the ratio of operating income to sales.
 It tells how many cents of operating income result from each
dollar of sales; it expresses the portion of sales that is available
for interest, taxes, and profit.
 Turnover is sales ÷ average operating assets.
 Turnover tells how many dollars of sales result from every dollar
invested in operating assets.
 Margin and Turnover (continued)

The equation that yields ROI from the Margin and

Turnover is as follows:
Margin Turnover
ROI = Operating Income X Sales
Sales Average Operating
Assets

Notice that ‘‘Sales’’ in the above formula can be cancelled

out to yield the original ROI formula of Operating
income/Average operating assets.
Calculating Average Operating Assets, Margin,
Turnover, and Return on Investment
Calculating Average Operating Assets, Margin,
Turnover, and Return on Investment (continued)
 Advantages of Return on Investment
 At least three positive results stem from the use of ROI:
 It encourages managers to focus on the relationship among sales,
expenses, and investment, as should be the case for a manager of
an investment center.
 It encourages managers to focus on cost efficiency.
 It encourages managers to focus on operating asset efficiency.
 Disadvantages of the
Return on Investment Measure
 Overemphasis on ROI can produce myopic behavior.
 Two negative aspects associated with ROI frequently are:
 It can produce a narrow focus on divisional profitability at the expense
of profitability for the overall firm.
 It encourages managers to focus on the short run at the expense of the
long run.
 Residual Income
 To compensate for the tendency of ROI to discourage
investments that are profitable for a company but that
lower a division’s ROI, some companies have adopted
alternative performance measures such as residual
income.
 Residual income is the difference between operating
income and the minimum dollar return required on a
company’s operating assets:
Residual income = Operating income – (Minimum
rate of return x Average operating assets)
Calculating Residual Income
Calculating Residual Income (continued)
 Advantage of Residual Income
The advantage of using residual income is that its use
encourages managers to accept any project that earns a
return that is above the minimum rate.
This prevents the fallacy of using ROI that may reject a
profitable project that reduces divisional ROI.
Disadvantages of Residual Income
 Unfortunately, residual income, like ROI, can encourage
a short-run orientation.
 Another problem with residual income is that, unlike
ROI, it is an absolute measure of profitability. Thus,
direct comparison of the performance of two different
investment centers becomes difficult, as the level of
investment may differ.
 One possible way to correct this disadvantage is to
compute both ROI and residual income and to use both
measures for performance evaluation. ROI could then
be used for interdivisional comparisons.
 Economic Value Added (EVA)
 Another financial performance measure that is similar to
residual income is economic value added.
 Economic value added (EVA) is after tax operating
income minus the dollar cost of capital employed.
 The dollar cost of capital employed is the actual
percentage cost of capital multiplied by the total capital
employed.
 EVA is expressed as follows:
Calculating Economic Value-Added
Calculating Economic Value-Added (continued)
 Transfer Pricing
 In many decentralized organizations, the output of one
division is used as the input of another.
 As a result, the value of the transferred good is revenue
to the selling division and cost to the buying division.
 This value, or internal price, is called the transfer price.
 Transfer price is the price charged for a component by
the selling division to the buying division of the same
company.
 Impact of Transfer Pricing
on Divisions and the Firm as a Whole
 When one division of a company sells to another
division, both divisions as well as the company as a
whole are affected.
 The price charged for the transferred good affects both
 the costs of the buying division
 the revenues of the selling division

 Thus, the profits of both divisions, as well as the

evaluation and compensation of their managers, are
affected by the transfer price.
 Impact of Transfer Pricing
on Divisions and the Firm as a Whole (continued)

 Since profit-based performance measures of the two divisions are

affected, transfer pricing often can be an emotionally charged
issue. The above exhibit illustrates the effect of the transfer price
on two divisions of a company. Division A wants the transfer price
to be as high as possible while Division C prefers it to be as low a
as possible.
 Transfer Pricing Policies
 Several transfer pricing policies are used in practice,
including:
 market price
 cost-based transfer prices
 negotiated transfer prices
 Transfer Pricing Policies: Market Price
 If there is a competitive outside market for the transferred
product, then the best transfer price is the market price.
 In such a case, divisional managers’ actions will
simultaneously optimize divisional profits and firm-wide
profits.
 Furthermore, no division can benefit at the expense of
another. In this setting, top management will not be
tempted to intervene.
 The market price, if available, is the best approach to
transfer pricing.
 Transfer Pricing Policies:
Cost-Based Transfer Prices
 Frequently, there is no good outside market price.
 The lack of a market price might occur because the
transferred product uses patented designs owned by the
parent company.
 Then, a company might use a cost-based transfer pricing
approach.
 Since a transfer price at cost does not allow for any profit
for the selling division, top management may define cost
as ‘‘cost plus, ’’ which allows a certain percentage to be
tacked onto the cost.
 Transfer Pricing Policies:
Negotiated Transfer Prices
 Finally, top management may allow the selling and
buying division managers to negotiate a transfer price.
 This approach is particularly useful in cases with market
imperfections, such as the ability of an in-house division
to avoid selling and distribution costs that external
market participants would have to incur.
 Using a negotiated transfer price then allows the two
divisions to share any cost savings resulting from
avoided costs.
 Negotiated Transfer Prices: Bargaining
Range
 When using negotiated transfer prices, a bargaining range
exists.
 Minimum Transfer Price (Floor): The transfer price that would
leave the selling division no worse off if the good were sold to
an internal division than if the good were sold to an external
party. This is sometimes referred to as the ‘‘floor’’ of the
bargaining range.
 Maximum Transfer Price (Ceiling): The transfer price that would
leave the buying division no worse off if an input were
purchased from an internal division than if the same good were
purchased externally. This is sometimes referred to as the
‘‘ceiling’’ of the bargaining range.
Calculating Transfer Price
Calculating Transfer Price (continued)