Financial Responsibility Centers

• Financial responsibility centers are about apportioning accountability for financial results within an organization
• Formal management processes provide performance expectations and standards for evaluation
• Incentive or motivational contracts define the links between results and organizational incentives

Decentralization

• Companies are organized along lines of responsibility and may use a flattened hierarchy that emphasizes teams
• Centralized decision-making means decisions are made at the top level and lower managers implement them
• Decentralized decision-making empowers lower-level managers to make and implement decisions in their areas
• Decentralization provides better access to local information and more timely responses
• Decentralization allows central management to focus on central management
• It allows training and evaluation of segment managers, and enhances competition by exposing segments to market forces

Responsibility Centers

• A responsibility center is an organizational unit headed by a manager, responsible for specific inputs/outputs
• Responsibilities are expressed via physical units of output, and service characteristics like schedule attainment and customer satisfaction
• Responsibilities are expressed via quantities of inputs, and financial performance indicators
• Financial responsibility centers define manager's responsibilities at least partially financially
• Management control systems use one or a mix of four types of responsibility centers regardless of decentralization degree
• The four main types of responsibility centers are revenue, profit, expense/cost, and investment centers

Revenue Centers

• Revenue center managers are held accountable for generating revenues measured financially as outputs
• Examples include sales departments in commercial organizations and fundraising managers in non-profits
• There is no formal attempt to relate inputs (expenses) to outputs in revenue centers
• Most revenue center managers are accountable for some expenses like salaries and commissions
• Revenue centers are not profit centers, because costs are a tiny fraction of revenue, and not charged for goods sold

Expense/Cost Centers

• Expense/cost center managers are held accountable for expenses, a financial measure of input consumption
• Two types of expense / cost centers exist
• Standard cost centers (engineered expense centers) allow inputs to be measured monetarily
• Outputs can be measured physically
• A causal relationship between inputs and outputs are generally direct and stable
• Examples are manufacturing, warehousing, personnel administration and catering
• Managed cost centers (discretionary expense centers) have outputs difficult to measure
• The relationship between inputs and outputs is often not well known
• Examples are R&D, PR, HR, and marketing

Control in Expense and Cost Centers

• Engineered expense centers use standard cost vs. actual cost
• Compares the cost of inputs used vs. inputs expected
• Volume produced, quality and other production metrics are considered
• Discretionary expense centers ensure that managers adhere to budgeted expenditure levels while completing tasks successfully
• Subjective non-financial controls include quality of service as perceived and evaluated by users
• Personnel controls and benchmarking are also used

Profit Centers

• Profit center managers are held accountable for generating profits
• Profit is a financial measure of difference between revenues and costs
• Profit is comprehensive, incorporating many areas if performance
• Profit is unobtrusive: profit center managers make revenue/cost tradeoffs
• A key question is whether the manager has significant influence over both revenues and costs
• Organizations charge standard COGS to sales-focused entities
• Organizations assign revenues to cost-focused entities, which results in pseudo profit centers

Measuring Profitability

Investment Centers

• Investment center managers are held accountable for accounting returns (profits) on invested capital
• Measured by ROI, ROE, ROCE, and RONA
• Managers have to generate maximum profits from resources and invest when adequate returns are expected

Transfer Pricing

• Transfer price is the price charged by one subunit for a product or service to another subunit within the same organization
• Management control systems use transfer prices to coordinate subunits and evaluate performance
• Transfer prices provide economic signals for good managerial decisions
• Transfer prices provide information for evaluating profit centers and their managers
• Transfer prices move profits between firm locations for tax reasons
• Transfer prices should be sufficient to motivate the selling division without being too much for the buying division
• Transfer Prices create revenues for the selling subunit and costs for the buying subunit

Intermediate Product

• The product or service that gets transferred between subunits of an organization

Three Transfer Pricing Methods

• Market-based transfer prices involves top management using publicly available prices of similar products/services
• Cost-based transfer prices are when top management chooses a transfer price based on production costs of intermediate product
• Costs includes variable, fixed and full costs, and any markup
• Cost based pricing is useful when when market prices are unavailable, inappropriate, or too costly
• Negotiated transfer prices are when subunits of a firm are free to negotiate the transfer price between selves
• Negotiated transfer prices is used when market prices are volatile, and can bare resemblance to cost or market data
• Negotiated transfer prices represent outcome of bargaining between subunits

Market-Based Transfer Prices

• Optimal decisions are made when the market for an intermediate product is perfectly competitive.
• Optimal decisions are made when sub-unit interdependencies are minimal
• Optimal decisions are made when no additional costs or benefits to the company transacting internally rather than an external market
• Perfect competition exists when there is a homogenous product, buying prices equal to selling prices, and no individual buyer or seller
• Market based pricing allows goal congruence, it motivates management effort, and provides subunit autonomy

Minimum transfer price

• The minimum transfer price = Incremental cost per unit + opportunity cost per unit
• Incremental Cost is the additional cost of producing/ transferring the product/service
• Opportunity cost is the maximum contribution margin that gets forgone by the selling subunit if the product or service is transferred internally

Multi-National Transfer Pricing and Tax Considerations

• Transfer pricing often have tax implications
• Tax factors include income taxes, payroll taxes, custom duties, tariffs, sales taxes, value-added taxes, environment-related taxes, and other government levies
• Tax code requires prices for tangible and intangible property between a company and its foreign division be = price charges by 3rd party
• Tax codes gives "a room to wiggle"

ROI

• Return on investment is the ratio of income to the investment used to generate the income
• Return on assets (ROA) is where total assets is used as invested capital

Decomposing ROI

• ROI is decomposed into Net Income / Invested Capital
• ROI = (Net income / Sales) * (Sales / Invested Capital)

Margin and Turnover

• Margix x Turnover = ROI
• Margin = Income / Sales
• turnover = Sales / invested capital

Most popular metric

1. blends all ingredients of profitability into a single percentage
2. can be compared to other ROI

Ways to Improve ROI

• You must increase sales, reduce expenses and reduce assets
• ROI is accounting rate of return (ARR) or accrual accounting rate of return (AARR)

What's included in Investments

• Total Assets (ROI becomes ROA), is when total assets are used as invested capital
• Total Productive Assets excludes non-productive assets like construction-in-progress
• Net Operating Assets is total assets less current liabilities (basis used in EVA calculations
• Net Assets (total assets less total liabilities, or return on equity), so key is managers are evaluated on debt and equity level
• Only include assets that are under the manager's control

Accounting Issues With ROI

• Accounting policies (depreciation methods) affect income and investment
• Capitalization policies Affect Income and balance sheets
• Inventory Measurement Method Affects cost of sales and net income

Inventory

• The use of LIFO when prices rise then COGS will be highest, and inventory will be lowest
• the use of full costing when inventory level are increasing results in inventory increase
• disposition of standard cost variances (COGS, or COGS and EI) is a factor
• Gross Booker Value or subtracting deprecation for book value matters

Advantages of ROI

• ROI relates savings, expense and investment
• ROI encourages the company to focus on cost efficiency
• ROI encourages manages to focus on asset efficiency

Disadvantages of ROI

• ROI can produce a narrow focus
• ROI encourages focuses on short run and not long run

Reducing Expenses

• An opportunity to invest with 25%
• the role asks if you would invest if it reduced overall return and gave a great rate

Residual Income

• The accounting measures RI minus the dollar amount or required return
• If the imputed costs are costs recognized than RI is calculated
• Required Rate of Return TIMES the Investment is the Imputed cost of the investment

XYZ Company Exampla

• XYZ has opportunity to invest profit will be 25%
• Would the division make offer with -1 ROI: (no) -- ROI goes down -2 Residual Income (yes) -- RI comes out more.

Example . . that involves ABC Company

Rejects = reduces overall ROI Accept - Positive residual income

ROI Summary

• Problems with ROI, the company can be negative for some departments
• However if compared RI, it will grow in the departments

Economic Value Added

• Can not be compared to division of different size
• if a company gives capital but hurts divisions then RI
• Residual income encourages managers
• Residual income makes management makes investment
• The company has more invested capital
• The company has a EVA after tax and after capital
• If EVA is positive = creates wealth
• If EVA is negative = destroy capital

Economic Value Added (EVA)

• the EVA model is given "After-tax Operating Income-Weight Average
• use the average of capital, or the asset you should add