Performance Measurement in

Decentralized Organizations
Chapter 11

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 11-2

Decentralization in
Organizations
Benefits of Top
Top management
management
Decentralization freed
freed toto concentrate
concentrate
on
on strategy.
strategy.
Lower-level decisions
Lower-level decisions
often
often based
based on
on
better
better information.
information. Lower
Lower level
level managers
managers
can
can respond
respond quickly
quickly
to
to customers.
customers.
Lower-level
Lower-level managers
managers
gain
gain experience
experience inin
decision-making.
decision-making. Decision-making
Decision-making
authority
authority leads
leads to
to
job
job satisfaction.
satisfaction.
 11-3

Decentralization in
Organizations
Lower-level
Lower-level managers
managers
may
may make
make decisions
decisions
without
without seeing
seeing the
the
May
May be
be aa lack
lack of
of “big
“big picture.”
picture.”
coordination
coordination among
among
autonomous
autonomous
managers.
managers. Disadvantages of
Decentralization
Lower-level
Lower-level manager’s
manager’s
objectives
objectives may
may not
not
be
be those
those of
of the
the May
May bebe difficult
difficult to
to
organization.
organization. spread
spread innovative
innovative ideas
ideas
in
in the
the organization.
organization.
 11-4

Cost, Profit, and Investments

Centers

Cost
Cost Profit
Profit Investment
Investment
Center
Center Center
Center Center
Center

Cost, profit,
and investment
centers are all Responsibility
Responsibility
known as Center
Center
responsibility
centers.
 11-5

Cost Center
A segment whose manager has control over
costs, but not over revenues or investment
funds.
 11-6

Profit Center

Revenues
A segment whose
Sales
manager has control
Interest
over both costs and
Other
revenues,
Costs
but no control over
investment funds. Mfg. costs
Commissions
Salaries
Other
 11-7

Investment Center
Corporate Headquarters

A segment whose
manager has control
over costs,
revenues, and
investments in
operating assets.
 11-8

Learning Objective 1

Compute return on
investment (ROI)
and show how
changes in sales,
expenses, and
assets affect ROI.
 11-9

Return on Investment (ROI)

Formula
Income
Incomebefore
beforeinterest
interest
and
andtaxes
taxes(EBIT)
(EBIT)

Net operating income

ROI =
Average operating assets

Cash,
Cash, accounts
accountsreceivable,
receivable, inventory,
inventory,
plant
plantand
andequipment,
equipment, and
andother
other
productive
productiveassets.
assets.
 11-10

Net Book Value versus Gross

Cost
Most companies use the net book value of
depreciable assets to calculate average
operating assets.

Acquisition cost
Less: Accumulated depreciation
Net book value
 11-11

Understanding ROI
Net operating income
ROI =
Average operating assets
Net operating income
Margin =
Sales

Turnover = Sales
Average operating
assets
Margin  Turnover
ROI =
 11-12

Increasing ROI – An Example

Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000

What is Regal Company’s ROI?

ROI =
Margin  Turnover
ROI = Net operating income × Sales
Sales Average operating assets
 11-13

Increasing ROI – An Example

ROI =
Margin  Turnover
Sales
ROI = Net operating income × Average operating assets
Sales

ROI = $30,000 × $500,000

$500,000 $200,000

ROI =6%  2.5 = 15%

 11-14

Investing in Operating Assets to

Increase Sales
Assume that Regal's manager invests in a $30,000
piece of equipment that increases sales by
$35,000, while increasing operating expenses
by $15,000.

Regal Company reports the following:

Net operating income $ 50,000
Average operating assets $ 230,000
Sales $ 535,000
Operating expenses $ 485,000

Let’s calculate the new ROI.

 11-15

Investing in Operating Assets to

Increase Sales

ROI =
Margin  Turnover
ROI = Net operating income × Sales
Sales Average operating assets

ROI = $50,000 × $535,000

$535,000 $230,000

ROI =
9.35%  2.33 = 21.8%

ROI
ROI increased
increased from
from 15%
15% to
to 21.8%.
21.8%.
 11-16

Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.

Managers often inherit many

committed costs over which
they have no control.

Managers evaluated on ROI

may reject profitable
investment opportunities.
 11-17

Learning Objective 2

Compute residual
income and
understand its
strengths and
weaknesses.
 11-18

Residual Income - Another

Measure of Performance

Net operating income

above some minimum
return on operating
assets
 11-19

Calculating Residual Income

( )
Net Average Minimum
Residual  required rate of
= operating - operating
income
income assets return

This computation differs from ROI.

ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
 11-20

Residual Income – An Example

••The
The Retail
Retail Division
Division of
of Zephyr,
Zephyr, Inc.
Inc. has
has
average
average operating
operating assets
assets of
of $100,000
$100,000 and
and is
is
required
required toto earn
earn aa return
return of
of 20%
20% on
on these
these
assets.
assets.
••InIn the
the current
current period,
period, the
the division
division earns
earns
$30,000.
$30,000.

Let’s calculate residual income.

 11-21

Residual Income – An Example

Operating
Operating assets
assets $$100,000
100,000
Required
Required rate
rate of
of return
return ×× 20%
20%
Minimum
Minimum required
required return
return $$ 20,000
20,000

Actual
Actual income
income $$ 30,000
30,000
Minimum
Minimum required
requiredreturn
return (20,000)
(20,000)
Residual
Residual income
income $$ 10,000
10,000
 11-22

Motivation and Residual

Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
 11-23

Quick Check 

Redmond Awnings, a division of Wrap-up Corp.,

has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%
 11-24

Quick Check 

Redmond Awnings, a division of Wrap-up Corp.,

has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
ROI = NOI/Average operating assets
c. 15%
d. 20% = $60,000/$300,000 = 20%
 11-25

Quick Check 

Redmond Awnings, a division of Wrap-up

Corp., has a net operating income of $60,000
and average operating assets of $300,000. If
the manager of the division is evaluated
based on ROI, will she want to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year?
a. Yes
b. No
 11-26

Quick Check 

Redmond Awnings, a division of Wrap-up

Corp., has a net operating income of $60,000
and average operating assets of $300,000. If
the manager of the division is evaluated
based on ROI, will she want to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year? ROI = $78,000/$400,000 = 19.5%
a. Yes
This lowers the division’s ROI from
b. No
20.0% down to 19.5%.
 11-27

Quick Check 

The company’s required rate of return is

15%. Would the company want the manager
of the Redmond Awnings division to make
an investment of $100,000 that would
generate additional net operating income of
$18,000 per year?
a. Yes
b. No
 11-28

Quick Check 

The company’s required rate of return is

15%. Would the company want the manager
of the Redmond Awnings division to make
an investment of $100,000 that would
generate additional net operating income of
$18,000 per year?
ROI = $18,000/$100,000 = 18%
a. Yes
b. No The return on the investment
exceeds the minimum required rate
of return.
 11-29

Quick Check 

Redmond Awnings, a division of Wrap-up Corp.,

has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
 11-30

Quick Check 

Redmond Awnings, a division of Wrap-up Corp.,

has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000 Net operating income $60,000
Required return (15% of $300,000) (45,000)
d. $ 51,000 Residual income $15,000
 11-31

Quick Check 

If the manager of the Redmond Awnings

division is evaluated based on residual
income, will she want to make an investment
of $100,000 that would generate additional
net operating income of $18,000 per year?
a. Yes
b. No
 11-32

Quick Check 

If the manager of the Redmond Awnings

division is evaluated based on residual
income, will she want to make an investment
of $100,000 that would generate additional
net operating income of $18,000 per year?
a. Yes
Net operating income $78,000
b. No Required return (15% of $400,000) (60,000)
Residual income $18,000

Yields an increase of $3,000 in the residual income.

 11-33

Divisional Comparisons and

Residual Income
The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of
different sizes.
 11-34

Zephyr, Inc. - Continued

Recall the following Assume the following
information for the Retail information for the Wholesale
Division of Zephyr, Inc. Division of Zephyr, Inc.

Retail
Retail Wholesale
Wholesale
Operating
Operating assets
assets $$ 100,000
100,000 $$ 1,000,000
1,000,000
Required
Required rate
rate of
ofreturn
return ×× 20%
20% 20%
20%
Minimum
Minimum required
required return
return $$ 20,000
20,000 $$ 200,000
200,000

Retail
Retail Wholesale
Wholesale
Actual
Actual income
income $$ 30,000
30,000 $$ 220,000
220,000
Minimum
Minimum required
required return
return (20,000)
(20,000) (200,000)
(200,000)
Residual
Residual income
income $$ 10,000
10,000 $$ 20,000
20,000
 11-35

Zephyr, Inc. - Continued

The residual income numbers suggest that the Wholesale Division outperformed
the Retail Division because its residual income is $10,000 higher. However, the
Retail Division earned an ROI of 30% compared to an ROI of 22% for the
Wholesale Division. The Wholesale Division’s residual income is larger than the
Retail Division simply because it is a bigger division.
Retail
Retail Wholesale
Wholesale
Operating
Operating assets
assets $$ 100,000
100,000 $$ 1,000,000
1,000,000
Required
Required rate
rate of
ofreturn
return ×× 20%
20% 20%
20%
Minimum
Minimum required
required return
return $$ 20,000
20,000 $$ 200,000
200,000

Retail
Retail Wholesale
Wholesale
Actual
Actual income
income $$ 30,000
30,000 $$ 220,000
220,000
Minimum
Minimum required
required return
return (20,000)
(20,000) (200,000)
(200,000)
Residual
Residual income
income $$ 10,000
10,000 $$ 20,000
20,000
 11-36

Learning Objective 3

Compute delivery
cycle time,
throughput time,
and manufacturing
cycle efficiency
(MCE).
 11-37

Delivery Performance
Measures
Order Production Goods
Received Started Shipped

Process Time + Inspection Time

Wait Time + Move Time + Queue Time

Throughput Time

Delivery Cycle Time

Process time is the only value-added time.

 11-38

Delivery Performance
Measures
Order Production Goods
Received Started Shipped

Process Time + Inspection Time

Wait Time + Move Time + Queue Time

Throughput Time

Delivery Cycle Time

Manufacturing
Value-added time
Cycle =
Efficiency Manufacturing cycle time
 11-39

Quick Check 
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp hashas recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.20.2 days
days
What
What is
is the
the throughput
throughput time?
time?
a.
a. 10.4
10.4 days.
days.
b.
b. 0.2
0.2 days.
days.
c.
c. 4.1
4.1 days.
days.
d.
d. 13.4
13.4 days.
days.
 11-40

Quick Check 
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp hashas recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.20.2 days
days
What
What is
is the
the throughput
throughput time?
time?
a.
a. 10.4
10.4 days.
days.
b. 0.2 days.
Throughput days.
b. 0.2 time = Process + Inspection + Move + Queue
c.
c. 4.1
4.1 days.
days.= 0.2 days + 0.4 days + 0.5 days + 9.3 days
d.
d. 13.4
13.4 days.
days.= 10.4 days
 11-41

Quick Check 
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp hashas recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.20.2 days
days
What
What is
is the
the Manufacturing
Manufacturing Cycle
Cycle Efficiency
Efficiency
(MCE)?
(MCE)?
a.
a. 50.0%.
50.0%.
b.
b. 1.9%.
1.9%.
c.
c. 52.0%.
52.0%.
d.
d. 5.1%.
5.1%.
 11-42

Quick Check 
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp hashas recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.20.2 days
days
What
What is
is the
the Manufacturing
Manufacturing Cycle
Cycle Efficiency
Efficiency
(MCE)?
(MCE)? MCE = Value-added time ÷ Throughput time
a.
a. 50.0%.
50.0%. = Process time ÷ Throughput time
b.
b. 1.9%.
1.9%. = 0.2 days ÷ 10.4 days
c.
c. 52.0%.
52.0%. = 1.9%
d.
d. 5.1%.
5.1%.
 11-43

Quick Check 
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp hashas recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.20.2 days
days
What
What is
is the
the delivery
delivery cycle
cycle time
time (DCT)?
(DCT)?
a.
a. 0.5
0.5 days.
days.
b.
b. 0.7
0.7 days.
days.
c.
c. 13.4
13.4 days.
days.
d.
d. 10.4
10.4 days.
days.
 11-44

Quick Check 
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp hashas recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.20.2 days
days
What
What is
is the
the delivery
delivery cycle
cycle time
time (DCT)?
(DCT)?
a.
a. 0.5
0.5 days.
days.
b.
b. 0.7
0.7 days.
days. DCT = Wait time + Throughput time
c.
c. 13.4
13.4 days.
days. = 3.0 days + 10.4 days
d. = 13.4 days
d. 10.4
10.4 days.
days.
 11-45

Learning Objective 4

Understand how to
construct and use a
balanced scorecard.
 11-46

The Balanced Scorecard

Management
Management translates
translates its
its strategy
strategy into
into
performance
performance measures
measures that
that employees
employees
understand
understand and
and influence.
influence.

Financial Customer

Performance
measures
Internal Learning
business and growth
processes
 11-47

The Balanced Scorecard: From

Strategy to Performance
Measures
Performance Measures
Financial What are our
Has our financial
financial goals?
performance improved?

Customer What customers do Vision

we want to serve and
Do customers recognize that
how are we going to and
we are delivering more value? win and retain them? Strategy

Internal Business Processes What internal busi-

Have we improved key business ness processes are
processes so that we can deliver critical to providing
more value to customers? value to customers?

Learning and Growth

Are we maintaining our ability
to change and improve?
 11-48

The Balanced Scorecard:

Non-financial Measures
The balanced scorecard relies on non-financial measures
in addition to financial measures for two reasons:


 Financial
Financial measures
measures are are lag
lag indicators
indicators that
that summarize
summarize
the
the results
results of
of past
past actions.
actions. Non-financial
Non-financial measures
measures are
are
leading
leading indicators
indicators of
of future
future financial
financial performance.
performance.


 Top
Top managers
managers are
are ordinarily
ordinarily responsible
responsible forfor financial
financial
performance
performance measures
measures –– not
not lower
lower level
level managers.
managers.
Non-financial
Non-financial measures
measures are
are more
more likely
likely to
to be
be
understood
understood and
and controlled
controlled by
by lower
lower level
level managers.
managers.
 11-49

The Balanced Scorecard for

Individuals
The entire organization Each individual should
should have an overall have a personal
balanced scorecard. balanced scorecard.

AA personal
personal scorecard
scorecard should
should contain
contain measures
measures that
that can
can be
be
influenced
influenced by
by the
the individual
individual being
being evaluated
evaluated and
and that
that
support
support the
the measures
measures in in the
the overall
overall balanced
balanced scorecard.
scorecard.
 11-50

The Balanced Scorecard

A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.

If we improve Another desired

Then
one performance performance measure
measure . . . will improve.

The balanced scorecard lays out concrete

actions to attain desired outcomes.
 11-51

The Balanced Scorecard and

Compensation
Incentive compensation should be linked to

balanced scorecard performance

measures.
 11-52

The Balanced Scorecard ─

Jaguar Example
Profit
Financial
Contribution per car

Number of cars sold

Customer
Customer satisfaction
with options

Internal
Business Number of Time to
options available install option
Processes

Learning Employee skills in

and Growth installing options
 11-53

The Balanced Scorecard ─

Jaguar Example
Profit

Contribution per car

Number of cars sold

Customer satisfaction Results

with options Satisfaction
Increases
Strategies
Increase Number of Time to
Options options available install option Time
Decreases

Increase Employee skills in

Skills installing options
 11-54

The Balanced Scorecard ─

Jaguar Example
Profit

Contribution per car

Results
Cars sold
Number of cars sold Increase

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option

Employee skills in
installing options
 11-55

The Balanced Scorecard ─

Jaguar Example
Profit
Results
Contribution per car Contribution
Increases

Number of cars sold

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option Time
Decreases

Employee skills in
installing options
 11-56

The Balanced Scorecard ─

Jaguar Example Results
Profit Profits
Increase
If number
Contribution per car Contribution
of cars sold Increases
and contribution
Cars Sold
per car increase, Number of cars sold Increases
profit should
increase. Customer satisfaction
with options

Number of Time to
options available install option

Employee skills in
installing options
Transfer Pricing
Appendix 11A

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 11-58

Key Concepts/Definitions
A transfer price is the price
charged when one segment of
a company provides goods or
services to another segment of
the company.

The fundamental objective in

setting transfer prices is to
motivate managers to act in the
best interests of the overall
company.
 11-59

Three Primary Approaches

There are three primary

approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the
selling division; and
3. Transfers at market price.
 11-60

Learning Objective 5

Determine the
range, if any, within
which a negotiated
transfer price should
fall.
 11-61

Negotiated Transfer Prices

A negotiated transfer price results from discussions
between the selling and buying divisions.
Range of Acceptable
Transfer Prices
Advantages of negotiated transfer prices:
Upper limit is
1. They preserve the autonomy of the determined by the
buying division.
divisions, which is consistent with
the spirit of decentralization.
2. The managers negotiating the
transfer price are likely to have much
better information about the potential
costs and benefits of the transfer
than others in the company. Lower limit is
determined by the
selling division.
 11-62

Grocery Storehouse – An
Example
Assume the information as shown with respect
to West Coast Plantations and Grocery Mart
(both companies are owned by Grocery
Storehouse).
West Coast Plantations:
Naval orange harvest capactiy per month 10,000 crates
Variable cost per crate of naval oranges $ 10 per crate
Fixed costs per month $ 100,000
Selling price of navel oranges on the outside
market $ 25 per crate
Grocery Mart:
Purchase price of current naval oranges $ 20 per crate
Monthly sales of naval oranges 1,000 crates
 11-63

Grocery Storehouse – An
Example
The selling division’s (West Coast Plantations) lowest acceptable transfer
price is calculated as:
Variable cost Total contribution margin on lost sales
Transfer Price  +
per unit Number of units transferred

Let’s calculate the lowest and highest acceptable

transfer prices under three scenarios.
The buying division’s (Grocery Mart) highest acceptable transfer price is
calculated as:
Transfer Price  Cost of buying from outside supplier
If an outside supplier does not exist, the highest acceptable transfer price
is calculated as:
Transfer Price  Profit to be earned per unit sold (not including the transfer price)
 11-64

Grocery Storehouse – An
Example
If West Coast Plantations has sufficient idle capacity (3,000 crates) to
satisfy Grocery Mart’s demands (1,000 crates), without sacrificing
sales to other customers, then the lowest and highest possible
transfer prices are computed as follows:

Selling division’s lowest possible transfer price:

 $ -
Transfer Price $10 + = $ 10
1,000

Buying division’s highest possible transfer price:

Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable

transfer prices is $10 – $20.
 11-65

Grocery Storehouse – An
Example
If West Coast Plantations has no idle capacity (0 crates) and must
sacrifice other customer orders (1,000 crates) to meet Grocery Mart’s
demands (1,000 crates), then the lowest and highest possible transfer
prices are computed as follows:

Selling division’s lowest possible transfer price:

( $25 - $10) × 1,000
Transfer Price  $ 10 + = $ 25
1,000

Buying division’s highest possible transfer price:

Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, there is no range of

acceptable transfer prices.
 11-66

Grocery Storehouse – An
Example
If West Coast Plantations has some idle capacity (500 crates) and
must sacrifice other customer orders (500 crates) to meet Grocery
Mart’s demands (1,000 crates), then the lowest and highest possible
transfer prices are computed as follows:

Selling division’s lowest possible transfer price:

( $25 - $10) × 500
Transfer Price  $ 10 + = $ 17.50
1,000

Buying division’s highest possible transfer price:

Transfer Price  Cost of buying from outside supplier = $ 20

Therefore, the range of acceptable

transfer prices is $17.50 – $20.00.
 11-67

Evaluation of Negotiated Transfer

Prices
If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices within which
both the selling and buying divisions would have
higher profits if they agree to the transfer.

If managers are pitted against each other rather

than against their past performance or
reasonable benchmarks, a noncooperative
atmosphere is almost guaranteed.

Given the disputes that often accompany the

negotiation process, most companies rely on
some other means of setting transfer prices.
 11-68

Transfers at the Cost to the Selling

Division
Many companies set transfer prices at either
the variable cost or full (absorption) cost
incurred by the selling division.
Drawbacks of this approach include:
1. Using full cost as a transfer price
can lead to suboptimization.
2. The selling division will never
show a profit on any internal
transfer.
3. Cost-based transfer prices do not
provide incentives to control
costs.
 11-69

Transfers at Market Price

A market price (i.e., the price charged for an
item on the open market) is often regarded as
the best approach to the transfer pricing
problem.
1. A market price approach works
best when the product or service
is sold in its present form to
outside customers and the
selling division has no idle
capacity.
2. A market price approach does
not work well when the selling
division has idle capacity.
 11-70

Divisional Autonomy and

Suboptimization The principles of
decentralization suggest
that companies should
grant managers autonomy
to set transfer prices and
to decide whether to sell
internally or externally,
even if this may
occasionally result in
suboptimal decisions.
This way top management
allows subordinates to
control their own destiny.
Service Department Charges
Appendix 11B

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 11-72

Learning Objective 6

Charge operating
departments for
services provided by
service
departments.
 11-73

Service Department Charges

Operating Service
Departments Departments

Do not directly
Carry out central
engage in
purposes of
operating
organization.
activities.
 11-74

Reasons for Charging Service

Department Costs
Service department costs are charged to operating
departments for a variety of reasons including:

To
To provide
provide operating
operating
To
To encourage
encourage departments
departments with
with
operating
operating departments
departments more
more complete
complete cost
cost
to
to wisely
wisely use
use service
service data
data for
for making
making
department
department resources.
resources. decisions.
decisions.

To
To help
help measure
measure the the To
To create
create an
an incentive
incentive
profitability
profitability of
of for
for service
service
operating
operating departments
departments to to
departments.
departments. operate
operate efficiently.
efficiently.
 11-75

Transfer Prices
The
The service
service department
department charges
charges
considered
considered inin this
this appendix
appendix can
can bebe
viewed
viewed as
as aa transfer
transfer price
price that
that is
is
charged
charged for
for services
services provided
provided byby
service
service departments
departments to to operating
operating
departments.
departments.
Service
Departments
$ Operating
Departments
 11-76

Charging Costs by Behavior

Whenever possible,
variable and fixed
service department costs
should be charged
separately.
 11-77

Charging Costs by Behavior

Variable service
department costs should be
charged to consuming departments
according to whatever activity
causes the incurrence
of the cost.
 11-78

Charging Costs by Behavior

Charge
Charge fixed
fixed service
service department
department costs
costs to
to
consuming
consuming departments
departments inin predetermined
predetermined
lump-sum
lump-sum amounts
amounts that
that are
are based
based on
on the
the
consuming
consuming department’s
department’s peak-period
peak-period or
or
long-run
long-run average
average servicing
servicing needs.
needs.

Are based on amounts of

Should not vary from
capacity each consuming
period to period.
department requires.
 11-79

Should Actual or Budgeted Costs

Be Charged?

Budgeted variable
and fixed service department
costs should be charged to
operating departments.
 11-80

Sipco: An Example
Sipco has a maintenance department and two operating
departments: Cutting and Assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixed
maintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:

Allocate maintenance costs to the two operating departments.

 11-81

Sipco: End of the Year

Actual hours
 11-82

Sipco: End of the Year

Actual hours

Percent of peak-period capacity.

 11-83

Quick Check 
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:

Percent of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500
 11-84

Quick Check 

How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the end
end of of the
the
year?
year?
a.
a. $121,200
$121,200
b.
b. $254,400
$254,400
c.
c. $139,500
$139,500
d.
d. $117,000
$117,000
 11-85

Quick Check 

How
How much
much ambulance
ambulance service
service cost
cost will
will be
be
allocated
allocated to
to Mercy
Mercy Hospital
Hospital at
at the
the end
end of of the
the
year?
year?
a.
a. $121,200
$121,200
b.
b. $254,400
$254,400
c.
c. $139,500
$139,500
d.
d. $117,000
$117,000
 11-86

Pitfalls in Allocating Fixed

Costs

Allocating fixed
costs using a variable
allocation base.
 11-87

Pitfalls in Allocating Fixed

Costs

Using sales
dollars as an
allocation base. Result
Sales of one department
influence the service
department costs
allocated to other
departments.
 11-88

Autos R Us – An Example
Autos
Autos RR Us
Us has
has one
one service
service department
department andand three
three
sales
sales departments,
departments, New New Cars,
Cars, Used
Used Cars,
Cars, and
and Car
Car
Parts.
Parts. The
The service
service department
department costs
costs total
total $80,000
$80,000
for
for both
both years
years in
in the
the example.
example.
Contrary
Contrary to
to good
good practice,
practice, Autos
Autos R R Us
Us allocates
allocates the
the
service
service department
department costs
costs based
based on
on sales.
sales.
 11-89

Autos R Us – First-year
Allocation
Departments
New Used Parts Total
Sales by department $ 1,500,000 $ 900,000 $ 600,000 $ 3,000,000
Percentage of total sales 50% 30% 20% 100%
Allocation of service
department costs $ 40,000 $ 24,000 $ 16,000 $ 80,000

$1,500,000 ÷ $3,000,000 50% of $80,000

In
In the
the next
next year,
year, the
the manager
manager of of the
the New
New Cars
Cars department
department
increases
increases sales
sales byby $500,000.
$500,000. Sales
Sales inin the
the other
other departments
departments
are
are unchanged.
unchanged. Let’s Let’s allocate
allocate the
the $80,000
$80,000 service
service department
department
cost
cost for
for the
the second
second year
year given
given the
the sales
sales increase.
increase.
 11-90

Autos R Us – Second-year
Allocation

Departments
New Used Parts Total
Sales by department $ 2,000,000 $ 900,000 $ 600,000 $ 3,500,000
Percentage of total sales 57% 26% 17% 100%
Allocation of service
department costs $ 45,714 $ 20,571 $ 13,715 $ 80,000

$2,000,000 ÷ $3,500,000 57% of $80,000

IfIf you
you were
were the
the manager
manager of of the
the New
New Cars
Cars department,
department, would
would
you
you be
be happy
happy with
with the
the increased
increased service
service department
department
costs
costs allocated
allocated to to your
your department?
department?
 11-91

End of Chapter 11B