Decentralization, Segment Reporting and Transfer Pricing:
Decentralization and Segment Reporting:
When an organization grows beyond a few
people, it becomes impossible for the top manager to make decisions about
everything.
Managers have to delegate decisions to
some degree to those who are at lower levels in the organization. However
the degree to which decisions are delegated varies from organization to
organization.
Decentralization in organizations:
A decentralized organization is one in which decision making is not
confined to a few top executives but rather is throughout the
organization, with managers at various levels making key operating
decisions relating to their sphere of responsibility. Decentralization is
a matter of degree, since all organizations are decentralized to some
extent out of necessity. At one extreme, a strongly decentralized
organization is one in which even the lowest-level managers and employees
are empowered to make decisions. At the other extreme, in a strongly
decentralized organization, lower-level managers have little freedom to
make decisions.
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article about definition, advantages and disadvantages of
decentralization.
Traceable and common fixed
costs: The most puzzling
aspect of segmented income statements is probably the treatment of fixed
costs. While preparing segmented income statements the fixed cost is
divided into tow parts on is traceable fixed cost and other is common
fixed cost. Only traceable fixed costs are assigned to the segment. If a
cost is not traceable then it is not assigned to segments.
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definition, examples and explanation of traceable and common fixed costs.
Segment reporting
and profitability analysis-segmented income statements:
A different kind of income statement is required for evaluating the
performance of a profit or investment center. This income statement
should emphasize on the segment rather than the performance of the
company as a whole. A contribution margin format income statement
is used to evaluate the performance of different segments. In a
contribution margin format income statement cost of goods sold consists
only of the variable manufacturing costs.
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Hindrances/Problems to Proper Cost Assignment in Segmented Reporting:
For segment reporting to accomplish its
intended purposes, costs must be properly assigned to segments. If the
purpose is to determine the profits being generated by particular segment
or division, then all of the costs attributable to that division or
segment--and only those costs--should be assigned to it. Unfortunately,
three practices greatly hinder proper cost assignment:
- Omission of some costs in the
assignment process.
- The use of inappropriate methods for
allocating costs among segments of a company.
- The assignment of costs to segments
when they are really common costs.
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Segmented Financial Information on External Reports:
The Financial Accounting Standards Board (FASB) now requires that
companies in the united states include segmented financial and other data
in their annual reports and that the segmented reports prepared for
external users must use the same method and definitions that the
companies use in internal segmented reports that are prepared to aid in
making operating decisions. This is a very usual requirement.
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Return on Investment
(ROI) for Measuring Managerial
Performance:
In a truly
decentralized company, segment managers are given a great deal of
autonomy. Profit and investment centers are virtually independent
businesses, with their managers having about the same control over
decisions as if they were in fact running their own independent firms.
With this autonomy, fierce competition often develops among managers,
with each striving to make his or her segment the "best" in the company.
Competition between investment centers is particularly keen for
investment funds. How do managers in corporate headquarters go
about deciding who gets new investment funds as they become available and
how do these managers decide which investment centers are most
profitability using the funds that have already been entrusted to their
care? One of the most important ways of making these judgments is
to measure the rate of return that investment managers are able to
generate on their assets. This rate of return is called the
return on investment (ROI).
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Controlling and Improving
Rate of Return on Investment:
Return on investment is normally used to judge the
managerial performance in an investment center. Managers therefore try to
control and improve the ROI of their investment center.
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article.
Return on Investment (ROI) and Balanced
Scorecard:
Simply exhorting
managers to increase return on investment (ROI) is not sufficient.
Managers who are told to increase return on investment (ROI) will
naturedly wonder how this is to be accomplished. Generally speaking, ROI
can be increased by increasing sales, decreasing costs, and/or decreasing
investments in operating assets. However it may not be obvious to
managers how they are supposed to increase sales, decrease costs, and
decrease investments in a way that is consistent with the company's
strategy.
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Criticism, Disadvantages
or Limitations of Return on Investment (ROI):
Although the return on investment is widely
used in evaluating performance, it is not a perfect tool. It is not
without criticism.
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Residual Income-Another
Method to Measure Managerial Performance:
Residual income is the net operating income that an
investment center earns above the minimum required return on its
operating assets. Residual income
is another approach to measuring an investment center's performance.
Economic Value Added (EVA) is an adoption of residual income that has
recently been adopted by many companies. Under EVA, companies often
modify their accounting principles in various ways. For example funds
used for research and development are often treated as investment rather
than as expenses under EVA. These complications are best dealt with in more advanced
courses. Here we will focus on the basics and will not draw any
distinction between residual income and EVA.
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Limitations, Criticism or
Disadvantage of Residual Income Method:
The residual income approach has one
major disadvantage. It cannot be used to compare the performance of
divisions of different sizes. You would expect larger divisions to have
more residual income than smaller divisions, not necessarily because they
are better managed but simply because they are bigger.
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Transfer Pricing:
Definition of Transfer pricing:
A transfer price is the
price charged when one segment of a company provides goods or services to
another segment of the company. For example, most companies in the oil
industry have a petroleum refining and retail sales divisions that are
usually evaluated on the basis of return on investment (ROI) or residual
income method.
The petroleum refining division processes crude oil into
gasoline, kerosene, and other end products. The retail sales division
takes gasoline and other products from the refining division and sells
them through the company's chain of service stations. Each product has a
price for transfers within the company. Suppose the transfer price for
the gasoline is $0.80 a gallon. Then the refining division gets credit
for $0.80 a gallon of revenue on its segment report and the retailing
division must deduct $0.80 a gallon as an expense on its segment report.
Clearly the refining division would like the transfer price as high as
possible, whereas the retailing division would like the transfer price to
be as low as possible. However, the transaction has no direct effect on
the entire company's reported profit. It is like taking money out of one
pocket and putting it into the other.
Managers are intensively interested in how
transfer prices are set, since transfer prices can have a dramatic effect
on the apartment profitability of a division. Three common approaches are
used to set transfer prices.
-
Allow the managers involved in the transfer to negotiate
their own transfer price (negotiated transfer pricing).
-
Set transfer prices at cost using variable
or full (absorption) cost
-
Set transfer prices at the market price
Divisional Autonomy and
Sub optimization:
How much autonomy should be granted to
divisions in setting their own transfer prices and in making decisions
concerning whether to sell internally or to sell outside? Should the
divisional heads have complete authority to make these decisions, or
should top corporate management step in if it appears that a decision is
about to be made that would result in sub optimization? For example, if the
selling division has idle capacity and divisional managers are unable to
agree on a transfer price, should top corporate management step in and
force a settlement?
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International
Aspects of Transfer Pricing:
The objective of transfer pricing change when multinational corporations
involved and the goods and services being transferred cross international
borders. The objective of international transfer pricing focus on
minimizing taxes, duties, and foreign exchange risks, along with
enhancing a company's competitive position and improving its relations
with foreign governments.
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