11 Analysis of Decentralized Operations
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Learning Objectives
After studying Chapter 11, you will be able to:
• Describe the different types of responsibility centers.
• Discuss the advantages of decentralization.
• Evaluate a division manager’s performance using return on investment, residual income, and the economic
value added approach.
• Explain performance evaluation systems in service organizations.
• Discuss the advantages and disadvantages of alternative transfer pricing methods.
• Understand transfer pricing issues in the international arena.
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Chapter Outline
11.1 Review of Responsibility Centers
11.2 Advantages of Decentralization
11.3 Measurement of Financial Performance
Return on Investment
Residual Income
Economic Value Added
Ethical Concerns Relating to Performance Measures
11.4 Performance Evaluation Systems in Service Organizations
11.5 Intracompany Transactions and Transfer Pricing Problems
Desired Qualities of Transfer Prices and Policies
Transfer Prices
Evaluating Transfer Pricing Methods According to the Criteria
11.6 Maximizing International Profits: The Role of Transfer Prices
Minimizing Worldwide Taxes
Avoiding Financial Restrictions
Gaining Host Country Approval
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Dividing the Profit Pie: Whose Is Whose?
Shagari Petroleum Company is a large Nigerian oil company headquartered in Lagos.
The company has five operating divisions: Exploration & Production, Trading & Supply,
Gas Processing, Refining, and Marketing & Distribution. Each division is responsible for
generating a profit and for managing its investment in assets. Debates have raged among
division managers about who earned what profits since, in many cases, “Your revenues are
my costs.”
The Exploration & Production Division has the task of finding, developing, and producing
oil and gas reserves. Oil produced is sold to the Trading & Supply Division or to outside
customers, depending on who offers the best prices. Gas produced is sold to the Gas
Processing Division, petrochemical companies, or pipeline companies.
The Trading & Supply Division is responsible for meeting the crude oil needs of the Refining
Division. It purchases crude oil from the Exploration & Production Division and the open
market. Crude oil not sold to Refining is marketed overseas.
Although the Gas Processing Division may purchase gas from other companies, 90% of its
gas needs are met by the Exploration & Production Division. Processing results in liquid
petroleum gas products such as ethane, propane, and butane. These products are sold to the
Marketing & Distribution Division and to petrochemical companies.
The Refining Division has refineries in Kano, on the Niger River, and in Ibadan. The refineries
have the capability to produce a full range of petroleum products. Finished products are sold
either to the Marketing & Distribution Division or to an overseas wholesale market.
Marketing & Distribution sells to utilities and international resellers, plus industrial,
governmental, commercial, and residential customers. It buys its products from the Refining
and Gas Processing Divisions. If shortages occur, it may purchase from overseas wholesale
markets. The division sells a wide range of products. It owns a barge fleet, tanker trucks,
and some pipeline facilities for transporting the products. Other product shipments are
contracted with shipping companies.
Since the divisions each generate profits and have tremendous investments in assets,
Shagari Petroleum wants to develop an appropriate measure for evaluating the financial
performance of the divisions and their managers. Also, a transfer price policy should value
intracompany deals fairly.
One of the most striking characteristics of organizations over the past 30 years has been top
management’s desire to grow and yet retain the advantages of smallness. Companies have
decentralized operations to retain this element of smallness, to build “entrepreneurial spirit,”
and to motivate division managers to act as the heads of their “own” companies.
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Section 11.1 Review of Responsibility Centers
In contrast to a centralized company in which decision making is largely done by top manage-
ment, a decentralized company is one in which operating subunits (usually called divisions)
are created with definite organizational boundaries, each with managers who have decision-
making authority. Thus, responsibility for portions of the company’s profits can be traced to
specific division managers. Even though the amount of authority granted to these managers
varies among companies, the spirit of decentralization is clear—to divide a company into
elatively self-contained divisions and allow them to operate in an autonomous fashion.
This chapter discusses two problem areas common to evaluating divisional performance.
First, we discuss various evaluation measures and how these measures can be used. Then
we discuss criteria, approaches, and problems associated with transfer prices for goods and
services moving among divisions.
11.1 Review of Responsibility Centers
Before discussing decentralization and performance measures, it is essential to review the
types of responsibility centers first introduced in Chapter 7. A responsibility center is any
organizational unit where control exists over costs or revenues. Managers of cost centers
have control over the incu
ence of cost but not over revenues. Cost centers are usually found
at lower levels of an organization but may include entire plants or even entire parts of an
organization, such as manufacturing or the controller’s office. In contrast, managers of profit
centers have control over both costs and revenues. These managers are responsible for gen-
erating revenues and for the costs incu
ed in generating those revenues.
In investment centers, managers control costs, revenues, and assets used in operations. The
investment involves plants and equipment, receivables, inventories, and, in some cases, pay-
ables traceable to the investment center’s operations. Companies or subsidiaries could be
investment centers or profit centers, depending on whether the corporate headquarters gives
investment responsibility to these levels. Investment responsibility is defined as authority to
uy, sell, and use assets.
Top management’s intent often determines the type of responsibility center. In a large com-
pany, a data processing center could be a cost center, either abso
ing its own costs or allocat-
ing its costs to users of the firm’s computer operations. As a profit center, it would be allowed
to charge a rate for data processing services it provides to internal users and be expected to
earn a profit on its operations. To create an investment center, the manager would be given
esponsibility to acquire equipment and update services from funds generated by its charges
for services provided. Often, organizational structures create natural cost, profit, or invest-
ment centers. But managerial intent is perhaps the most important factor in determining how
a decentralized unit will be viewed and managed.
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Section 11.2 Advantages of Decentralization
11.2 Advantages of Decentralization
Decentralization is the delegation of decision-making authority to lower management levels
in an organization. The degree of decentralization depends on the amount of decision-making
authority top management delegates to successively lower managerial levels. Advantages of
decentralizing include:
1. Motivated managers. Managers who actively participate in decision making are
more committed to working for the success of their divisions and are more willing to
accept the consequences of their actions, whether positive or negative.
2. Faster decisions. In a decentralized organization, managers who are close to the
decision point and familiar with the problems and situations are allowed to make
the decisions. Consequently, decisions can be made faster without moving data up
the organization and having a decision made by a manager far removed from the
action.
3. Enhanced specialization. Delegating authority permits the various levels of man-
agement to do those things each does best. For example, top management can
concentrate on strategic planning and policy development; middle management on
tactical decisions and management control; and lower management on operating
decisions.
4. Defined span of control. As an organization increases in size, top management has
more difficulty controlling the organization. Decentralizing the authority defines
more na
owly the span of control for each manager and thus makes the control
system more manageable.
5. Training. Experience in decision making at low management levels results in trained
managers who can assume higher levels of responsibility when needed.
To realize the full benefits of these advantages, top management must address the following
issues:
1. Competent people. Without competent people, the best policies
eak down; a lack
of control reduces the efficiency and effectiveness of operations.
2. Measurement system. The same measurement system should be used for all divi-
sions. Top management must develop policies that provide consistency in reporting
periods, methods of reporting, and methods of data collection.
3. Clear corporate goals. Left to themselves, division managers may work for their own
interests without consideration of benefits to the entire organization. Top manage-
ment needs to focus all managers’ efforts on corporate goals through planning and
incentive systems.
Formulating the best method for controlling and evaluating divisions is usually more complex
than any other single control activity within a company. Motivation, control, and managerial
ehavior are
oad topics and are far beyond the scope of this book.
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Section 11.3 Measurement of Financial Performance
11.3 Measurement of Financial Performance
In previous chapters, planning and control methods were discussed. We apply these to cost,
profit, and investment center evaluations. Cost controls used in cost centers are also relevant
for profit and investment centers. Revenue and profit measurements used in profit centers
are also applied to investment centers. Thus, we can build the following planning and control
structure:
Centers
Cost Profit Investment
Expense budgeting X X X
Flexible budgets X X X
Plan versus actual expense comparisons X X X
Standard cost variances X X X
Revenue and profit budgeting X X
Plan versus actual controllable contribution margin X X
Plan versus actual direct contribution margin X X
Asset utilization and rate of return target setting X
Plan versus actual asset utilization comparisons X
Plan versus actual rates of return comparisons X
It is rare that financial measures alone can evaluate the performance of a responsibility cen-
ter. Product or service quality, delivery reliability, market share, and responsiveness to cus-
tomers are all nonfinancial measures critical to the overall success of a firm