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CHAPTER 16: Strategic Performance Measurement
CHAPTER
15
Performance Evaluation and Compensation
In Brief
When owners give managers authority to make decisions and guide operations, problems arise because owners’ and managers’ interests often
conflict. Owners use accounting information to measure performance, monitor managers’ actions, and motivate decisions that are in the
owners’ interest. Similarly, managers use accounting information to measure, monitor, and motivate the actions of employees. Before
managers or other employees can be held accountable for the results of their decisions and actions, their rights and responsibilities need to be
defined. Then return on investment, residual income, economic value added, or other measures can be used to gauge and reward
performance. In large organizations, resources may be transferred internally from one department to another. The prices set for these
transfers affect financial measures of performance. When these transfer prices are set appropriately, managers have incentives to increase the
value of the overall organization. However, transfer prices can encourage suboptimal decisions that may be beneficial at the local level, but
are not in the best interest of the global organization.
This Chapter Addresses the Following Questions:
•
•
Q1 What is agency theory?
Q2 How are decision-making responsibility and authority related to incentives and performance evaluation?
•
•
•
•
•
Q3 How are responsibility centers used to measure, monitor, and motivate performance?
Q4 How do return on investment, residual income, and economic value added affect managers’ incentives and decisions?
Q5 How is compensation used to motivate performance?
Q6 What prices are used for transferring goods and services within an organization?
Q7 How do transfer prices affect managers’ incentives and decisions?
NUCOR: A GROUP OF PEOPLE IN HEADLONG PURSUIT OF A SHARED PURPOSE*
N
ucor Corporation is one of the largest North American manufacturers of steel products. The company primarily uses mini-
mill technology, which recycles scrap steel as raw material. Nucor has been highly profitable for many years, although economic recession
led to losses during 2009. Its profits are affected significantly by changes in the demand for steel products, the price of scrap steel, energy
costs, competition from imports and substitute products, and capital investments. Nucor’s strategy focuses on technological and product
innovation, high quality, competitive pricing, efficient operations, and customer service. The company has no research and development
department and instead relies on innovations at the plant level. To motivate employees to work with management toward achievement of
strategic objectives, Nucor has adopted a unique approach to organizational structure and employee incentives.
The company’s organization structure is relatively flat, with only 5 layers from the CEO to frontline workers. In addition, each Nucor facility
operates autonomously, with a general manager responsible for all decisions. Employees at all levels are encouraged to participate in
decision making and to take actions proactively. Workers can halt production when problems arise, spend time with customers to learn more
about improving quality from the customer’s perspective, and travel to another plant to help solve a production problem or to learn new
methods.
To promote efficiency, innovation, and collaboration, about two thirds of employee pay is related to performance. Employees at all levels
earn lower wage rates than in other companies, but employees typically earn higher than average pay including bonuses. Examples of
performance measures include the following:
•
•
•
All employees: 10% of companywide operating profit distributed annually
Plant work groups: Weekly bonuses based on production volume
Plant managers: Bonuses based on companywide return on equity
•
CEO: Bonuses based on a three-year measure tied to return on equity, return on capital, and revenue growth relative to peer
companies
During 2009, Nucor faced new challenges as customer demand and selling prices dropped dramatically. Outside contractors were eliminated
so that employees could have at least some work beyond steelmaking, such as maintenance, janitorial services, and grounds keeping.
Although worker hours were cut back, Nucor maintained its policy of not laying off any employees.
In this chapter, we learn about the advantages and disadvantages of decentralized decision making, including incentive problems. We will
explore the ways that organizations assign responsibility and methods to develop internal prices when goods or services are transferred
between sub-units. We will also study the benefits and drawbacks of performance measures including return on investment, residual income,
and economic value added.
SOURCES: Nucor Corporation, “Nucor Reports Results for Third Quarter and First Nine Months of 2009,” press release, October 22, 2009;
Nucor Corporation, “Our Story,” available at www.nucor.com; N. Byrnes with M. Arndt, “The Art of Motivation,” Business Week, May 1,
2006; C. Helman, “Test of Mettle,” Forbes.com, November 5, 2009.
AGENCY THEORY
Q1 What is agency theory?
Agency theory is an analytical framework that examines potential conflicts between owners and managers and between managers and
employees; it suggests solutions to align the incentives. Agency problems arise when managers do not own firms. In for-profit firms, owners
often sell off part of the firm at some point in time, as the organization grows. Not-for-profit firms are often owned by organizations, such as
churches or governments. Within agency theory, the two types of information consumers are principals and agents. Principals hire agents to
make decisions for them and to act in their behalf. As shown in Exhibit 15.1, shareholders of a corporation are principals, and the chief
executive officer (CEO) is their agent. In not-for-profit organizations, stakeholders such as donors own the organization and hire the CEO.
As the top manager of an organization owned by shareholders or other stakeholders, the CEO makes decisions, plans strategies, and protects
the interests of the owners. At the same time, the CEO is a principal and the lower-level managers and employees are agents for both the
CEO and, in turn, the owners.
AGENCY COSTS
Problems arise when the goals of principals are not completely shared by their agents. For example, employees may exert insufficient effort,
or managers may waste organizational resources. The costs that arise when agents fail to act in the interest of principals are agency
costs. Exhibit 15.2 shows several types of agency costs, including the direct costs that occur when agents do not work in the principals’ best
interests, as well as costs incurred to monitor and motivate agent performance.
When organizations are small, principals minimize agency costs by personally overseeing agent behavior and performance. However, as
organizations grow larger, agent behavior is more difficult to observe, and agency costs tend to increase. To reduce agency costs,
organizations establish accounting systems to monitor and influence agent behavior. For example, public companies publish audited
financial statements, and employees are often paid bonuses for achieving profit goals. Thus, accounting information is used not only to
measure and monitor an organization’s activities, but also to measure, monitor, and motivate the performance of agents.
It is impossible to completely eliminate agency costs because agent behavior and decision making cannot be perfectly observed or measured.
Poor results might be caused by poor agent performance or by circumstances outside of the agent’s control. Similarly, favorable results
cannot be attributed to the agent’s performance alone. For example, the sales generated by a salesperson are partly a function of the effort
and skills of the salesperson and partly a function of the price and quality of the product, economic conditions, competition, customer tastes,
and so on.
ALTERNATIVE THEORIES OF MANAGER AND EMPLOYEE BEHAVIOR
Agency theory assumes that people are self interested, which compels organizations to develop systems to monitor effort and results to
control or reduce suboptimal behavior. Other theories of behavior do not make this assumption. For example, Simons’ levers of control
model is based on the ideas that people naturally want to exhibit positive behavior and that organizational systems create blocks that
encourage suboptimal behavior. According to Simons, beliefs systems lead to positive behavior by improving communication of
organizational core values and mission. Boundary systems promote proper behavior by reducing pressures and temptations. Diagnostic
control systems support achievement by clarifying resource needs and by helping managers and employees focus on clear targets. Interactive
control systems trigger learning by prompting organizational dialogue.1
EXHIBIT 15.1
Principals and Agents
EXHIBIT 15.2 Agency Costs
CHAPTER REFERENCE
Simons’ four levers of control are introduced in Chapter 1.
DECISION-MAKING AUTHORITY AND RESPONSIBILITY
Q2 How are decision-making responsibility and authority related to performance evaluation?
One way to reduce agency costs is to give specific decision-making authority to agents and then hold them responsible for the results of their
decisions. This idea lies behind the corporate form of business organization. Shareholders give managers authority to decide how
corporations’ resources are used. Then shareholders hold the managers responsible for creating shareholder value. Similarly, the authority for
decisions can be dispersed throughout an organization. To reduce agency costs, individual employees are held responsible for their
decisions, and limits are placed on their decision-making authority. For example, the maitre d’ in a restaurant is responsible for seating
people and has the authority to choose where customers sit. However, the maitre d’ has no responsibility for the menu items; the chef has the
authority to purchase food and to choose the items to be offered on the menu.
Many different approaches can be taken in assigning decision-making authority. Managers can also periodically restructure authority within
organizations. For example, Nucor Corporation allows frontline steelworkers to make decisions that in most companies would be restricted
to supervisors or plant managers. As the business environment becomes increasingly technical and competitive, the timeliness of decision
making becomes increasingly important to economic success. The need for more timely decision making often encourages managers to
reconsider how decision-making authority is assigned.
CENTRALIZED AND DECENTRALIZED ORGANIZATIONS
When managers make choices about locating decision-making authority, they are also making choices about the organization’s
structure. Organizational structure is the system within an organization that defines roles and responsibilities, flows of information, and
ability to influence the work of others. In organizations with centralized decision making, the right to make or authorize decisions lies
within top levels of management. In organizations with decentralized decision making, these rights are distributed to lower levels of
management. Nucor’s decision-making authority is highly decentralized, extending to frontline workers. In the current dynamic business
environment, many factors influence organizational structures, and changes in these structures are made over time.
GENERAL VERSUS SPECIFIC KNOWLEDGE
Knowledge is an important resource within organizations. The type of knowledge needed to make high-quality decisions affects the location
of authority within organizations. General knowledge, such as information about volume of sales or product prices when organizations sell
few products, is usually easy to transfer from one person to the next. Decisions based on general knowledge are likely to be centralized,
made primarily by the chief executive officer (CEO) and other top managers. Transferring the general knowledge needed for decision
making to an organization’s headquarters is relatively easy and, therefore, not very costly. Examples of centralized organizations include
small businesses where the owner makes most of the operating decisions and relies on a few employees to carry out those decisions. Large
businesses that produce few products, such as steel companies, are often centralized.
Some decisions require specific knowledge, that is, detailed information about particular processes, customers, or products—information
that is costly to transfer within the organization. Examples of specific knowledge are the technical details of the manufacturing or service
delivery processes and information gained over time from working with individual customers. When decision makers need specific
knowledge, they must either have the knowledge themselves or seek ways to obtain it. At Nucor, specific knowledge of customer
preferences is important to organizational success. Accordingly, plant managers are responsible for identifying customer needs and for
producing products at an appropriate quality and price to meet those needs.
TECHNOLOGY AND GLOBALIZATION
Technology has enhanced global communications and reduced the costs of business transactions so that organizations can more easily
operate in other countries. Accordingly, organizations have become increasingly multinational. When organizations expand to other
countries, managers within each country are likely to have specific knowledge of cultural and customer preferences. Decisions made at the
unit level are likely to be more timely and of higher quality because local decision makers best understand how to gather information
relevant to operations in that country.
CHOOSING A CENTRALIZED VERSUS DECENTRALIZED ORGANIZATIONAL STRUCTURE
Advantages and disadvantages for each type of organizational form are listed in Exhibit 15.3. Whether decision making within an
organization should be centralized or decentralized is not always a straightforward decision. Organizations often begin with centralized
decision making, then adopt a decentralized structure as they grow large. However, some large organizations find that a centralized approach
is best because it leads to greater alignment of decisions with the organizational vision and strategies.
EXHIBIT 15.3 Advantages and Disadvantages of Centralized and Decentralized Organizations
ORGANIZATIONAL STRUCTURE AND SPAN OF CONTROL
Once organizational structure and decision-making authority are established, responsibility for performance can be assigned to individuals
within an organization. The span of control refers to the scope of people or other resources over which an individual is given decisionmaking authority and is, therefore, held accountable. A span of control can range from narrow to wide. For example, a CEO with extensive
authority has a wide span of control, while a retail store clerk with little authority has anarrow span of control.
In general, individuals toward the top of an organization’s hierarchy have wide spans of control while individuals toward the bottom of the
hierarchy have narrow spans of control. As shown in Exhibit 15.4, overall organizational structure also influences the span of control. When
decision making is centralized, most employees have fairly narrow spans of control; the most flexibility in decision making is restricted to
top managers. When decision making is decentralized, employees throughout the organization have greater authority. The overall
hierarchical structure is shorter because fewer managers are needed; more employees report to a single manager (i.e., more employees and
other resources are under the span of control for each manager).
EXHIBIT 15.4 Span of Control and Organizational Structure
RESPONSIBILITY ACCOUNTING
Q3 How are responsibility centers used to measure, monitor, and motivate performance?
Accounting information is used in both centralized and decentralized organizations to measure, monitor, and reward performance. In
centralized organizations, information produced by the accounting system for decision making is used primarily by top managers who are
held responsible for both their effort and the quality of their decisions. Employees carry out tasks that result from these decisions and are
held responsible for their effort and compliance with top-down decisions. Therefore, individual and team efforts require close monitoring to
determine their contributions toward success. Managers use variance and productivity reports to gauge employee (individual and team)
efforts.
In decentralized organizations, decision making occurs throughout management levels and in the field. Employees in lower levels are held
responsible for their efforts and the quality of their decisions. Therefore, accounting systems are used to provide decision-making
information for all levels, from management to front-line employees. Broader accounting measures related to overall financial performance
are then used to measure and monitor performance.
Responsibility accounting is the process of assigning authority and responsibility to managers of subunits and then measuring and
evaluating their performance. under responsibility accounting, managers are usually held responsible only for factors within their span of
control. However, individuals may be held responsible for performance beyond their direct control. For example, Nucor rewarded plant
managers based on companywide return on equity, which included the performance of all plants. This reward system encourages plant
managers to share innovations and efficient practices.Responsibility centers are subunits (e.g., segments, divisions, departments) in which
managers are accountable for specific types of operating activities. Four common types of responsibility centers are cost centers, revenue
centers, profit centers, and investment centers. Exhibit 15.5 provides specific examples of each responsibility center and examples of
performance measures that are likely to be used in these centers.
EXHIBIT 15.5 Examples of Responsibility Centers and Performance Measures
COST CENTERS
In cost centers, managers are held responsible only for the costs under their control. Some cost centers provide support services that are
relatively easy to monitor because their outputs are measurable. Cost centers are also used for subunits that produce goods or services
eventually sold by others. Managers in these cost centers are responsible for producing their goods or services efficiently. In discretionary
cost centers, the output is not easily measurable in dollars or activities. Cost centers are found in for-profit, not-for-profit, and government
organizations.
Cost center managers are expected either to minimize costs for a certain level of output or to maximize output for a certain level of cost.
Cost center performance is measured and monitored several ways. Some organizations rely on cost budgets and variances. Measures of other
factors such as quality and timeliness of delivery are also relevant.
CHAPTER REFERENCE
Budgets are addressed in Chapter 10, and revenue and cost variances are addressed in Chapter 11.
REVENUE CENTERS
In revenue centers, managers are held responsible for the revenues under their control. Revenue centers frequently sell products from
manufacturing subunits. Managers are expected to maximize sales. If the manager in a revenue center is responsible for setting prices, gross
revenues can be used as a performance measure. If corporate headquarters, rather than the manager, sets prices, then managers’ performance
can be evaluated using a combination of sales volumes measured in units and sales mix. Many organizations treat their sales departments as
revenue centers and reward employees based on sales generated. In not-for-profit organizations, fundraising activities might be treated as a
revenue center.
PROFIT CENTERS
Managers in profit centers are held responsible for both revenues and costs under their control. Profit centers produce and sell goods or
services, and may include one or several cost centers. Profit center managers are responsible for decisions about inputs, product mix, pricing,
and volume of goods or services produced. Because profit centers include both revenues and costs, performance is typically measured using
some combination of revenue and cost measures. Not-for-profit organizations tend to use revenue and cost budgets and variances as
performance measures, although some focus managers’ attention on operating margins when performance is poor. For-profit organizations
use some measure of profits such as accounting earnings.
INVESTMENT CENTERS
Managers of investment centers are held responsible for the revenues, costs, and investments under their control. Investments include any
assets related to the investment center, such as fixed assets, inventory, intangible assets, and accounts receivable. Investment centers
resemble profit centers, where profitability is related to the assets used to generate the profits. Because investment centers include revenues,
costs, and investment, performance measures need to address all of these factors. Later in this chapter we will learn about three commonly
used measures: return on investment (ROI), residual income, and economic value added (EVA).
RESPONSIBILITY CENTERS, MANAGERS’ INCENTIVES, AND DIAGNOSTIC CONTROLS
Top managers use judgment to decide the best types of responsibility centers for the organization. The choices depend on the size of the
organization, the nature of operations, and the organizational structure and belief systems. Ideally, responsibility centers should reduce
agency costs by holding managers responsible for decisions over which they have authority. For example, accounting departments are often
viewed as cost centers because their managers have authority primarily over the use and cost of resources. Similarly, business segments are
generally treated as investment centers because segment managers have authority over revenues, costs, and investment.
Nevertheless, responsibility center accounting sometimes leads to suboptimal decision making. Asuboptimal decision is optimal for a
person, department, or business unit, but is suboptimal for the organization as a whole. Each type of responsibility center has a specific set of
agency problems. Managers in cost centers focus on minimizing costs and maximizing efficiency, which can lead to declines in quality and
delivery timeliness. In turn, sales could drop and the overall organization suffers. Similarly, revenue center managers, who are typically
rewarded for increasing revenues, may fail to consider product contribution margins and inappropriately emphasize less-profitable products.
These managers have incentives to offer discounts and generous payment terms that reduce overall profitability. In profit centers, managers
are encouraged to stress short-run profits by cutting maintenance, research and development, and advertising costs that benefit long-term
performance. Similarly in investment centers, managers may reduce investment to increase short-term results. Or, they may invest in
projects that are more or less risky than is appropriate for the organization. To address these agency problems, diagnostic control systems
typically include appropriate performance measures and incentive reward systems. Appropriate measures increase goal congruence,
creating agreement between the interests of individual managers and the organization as a whole.
INVESTMENT CENTER PERFORMANCE EVALUATION
Q4 How do return on investment, residual income, and economic value added affect managers’ incentives and decisions?
Investment centers are common in large decentralized organizations. Because managers are responsible for costs and revenues, as well as for
investments, the measures used for monitoring and motivating purposes typically include the return and the size of investment. Three
measures commonly used to evaluate investment center performance are:
•
•
•
Return on investment
Residual income
Economic value added
RETURN ON INVESTMENT
Return on investment (ROI) is the ratio of operating income to investment. Operating income is calculated as earnings before interest and
taxes (EBIT). Investment is usually measured as total assets. Sometimes nonoperating assets, such as investments in other companies or
property and equipment currently rented to other companies, are excluded from this calculation. When evaluating the entire company’s
performance, all assets would be included because owners want to evaluate their return based on the entire investment. But when evaluating
the performance of a subunit, judgment is used to determine which assets should be included. Any assets included should be under the
control of the managers being evaluated. For internal management, investment is sometimes measured as the average of beginning and
ending operating assets for several reasons. First, the measure is intended to capture operations over a period of time, not just at the end of
the time period. Second, the measure could be manipulated by temporarily decreasing investment at the time performance is measured. For
simplicity, the examples in this textbook use total rather than average assets.
ALTERNATIVE TERMS
Return on assets (ROI) is sometimes called accounting rate of return or accrual accounting rate of return (seeChapter 12).
ROI is used to evaluate investment center performance. It can be compared across sub-units within a single organization, among a group of
firms within an industry, and within a single organization across time.2 In addition, ROI can be decomposed into two components that
provide additional information about performance. ROI is decomposed by multiplying both the numerator and denominator by revenue and
then rearranging terms:
Because revenue divided by total assets represents investment turnover, and operating income divided by revenue represents the return on
sales, we can now rewrite the ROI formula as:
ROI = Investment turnover × Return on sales
The decomposition of ROI into investment turnover and return on sales is often referred to as DuPont analysis. The method originated at
the DuPont Company in the early 1900s so that results from a wider range of business activities could be compared. Investment
turnover is a measure of the sales generated by each dollar invested in operating assets. Return on sales (ROS) measures managers’
abilities to control the operating expenses related to sales. Focusing on these two measures encourages managers to improve profitability by
using assets more efficiently (i.e., by generating more revenue, reducing the investment in assets, or both) and by conducting operations
more efficiently (i.e., by controlling costs to provide greater profit for each dollar of revenue). An extended version of DuPont analysis is
sometimes used to evaluate performance at lower organizational levels, as discussed later in the chapter. Computer Wizards (Part 1)
demonstrates the use of ROI and DuPont analysis to evaluate alternatives for improving profitability.
ALTERNATIVE TERMS
The term asset turnover means the same as investment turnover. Similarly, the term profit margin ratio means the same as return on sales.
COMPUTER WIZARDS (PART 1)
RETURN ON INVESTMENT AND DUPONT ANALYSIS
Computer Wizards produces and sells computer monitors nationally and internationally. Jason Black is responsible for Ontario operations
and Cecilia Earnhart manages the New Jersey division. The top managers of Computer Wizards measure the performance of its divisions
using ROI.
Jason was recently hired from outside of the company to improve operations in the Ontario division. One of his objectives is to achieve an
ROI at least as high as the New Jersey division. Jason calculates the ROI of the two divisions and performs DuPont analysis as follows (all
amounts in U.S. dollars).
From this analysis, Jason learns that the Ontario division has lower performance in investment efficiency and operating efficiency, as well as
overall ROI. He decides to investigate options for improving the division’s profitability.
STRATEGIES FOR INCREASING ROI
The first option Jason investigates is to focus on increased sales. The Ontario division currently has idle capacity, and Jason would like to
emphasize a new group of products. He believes that current capacity can support an increase in sales of $600,000, without requiring
additional investment except for additional marketing costs. He estimates that operating income would increase by $60,000.
The second option is to reduce expenses. Jason believes that manufacturing costs could be reduced by as much as $100,000. He would
implement this plan using kaizen costing, that is, by organizing a team with members from marketing, accounting, and engineering to
analyze production activities and identify non-value-added activities that could be eliminated. Also, the products and manufacturing
processes could be redesigned to reduce the number of parts or processes.
CHAPTER REFERENCE
Kaizen costing was introduced in Chapter 13.
The third option is to reduce the investment in assets. Jason knows that internal processes are inefficient; inventory and work in process are
built up throughout different manufacturing areas. He would like to implement cellular production and just-in-time inventory practices.
These modifications would allow the division to sell a small building currently in use. Jason estimates that assets could be reduced by
$400,000.
Jason summarizes the effects on the Ontario division’s ROI for each option individually and combined, as follows.
Jason knows that increasing sales, reducing costs, and changing production processes are all worthy long-term goals, but it will take a year
or longer to see the results for all of these plans. He would prefer to increase ROI within a shorter time frame. Recently a competitor made
an offer to sell the Ontario division a component that is currently manufactured in-house. If Jason purchases the component, operating
earnings would decrease by $50,000. However, he could easily sell the small building because most of it houses the production facility for
the component. Investment turnover would be 3.1 times (the same as option 3), but return on sales would drop to 9% ($450,000 ÷
$5,000,000), and ROI would increase to 27%.
CHOOSING A PLAN OF ACTION
Jason decides to discuss his options with Renee Forsyth, the Director of Finance for Computer Wizards. All of the plans he is considering
require a great deal of time and effort. He believes that the strategies are sound, but is uncertain whether his expectations can be met. An
increase in sales depends in part on the continuing upswing of the economy. Cost reductions take time and concentrated effort on the part of
employees. Changing the manufacturing process could take several years because a new floor plan would have to be laid out, teams would
have to be established, and work would be disrupted while implementing the new lines. Furthermore, the employees might need several
months to work efficiently under the new system. The easiest choice is to outsource, and Jason knows that outsourcing would improve his
ROI in the short run. However, he believes that focusing on in-house manufacturing cost reductions would be a better strategy for Computer
Wizards in the long run. The company’s use of ROI to measure performance discourages this type of strategy, so Jason wonders whether a
different performance measure could be adopted that would better reward behavior to benefit the overall organization.
ROI AND MANAGERS’ INCENTIVES
A division’s ROI is easily compared with internal and external benchmarks and with other divisions’ returns on investment. Holding
managers responsible for some level of ROI reduces the tendency of managers to overinvest in projects. Another advantage of ROI is that its
components motivate managers to increase sales, decrease costs, and minimize asset investments.
However, ROI also discourages managers from investing in projects that reduce the division’s ROI, even though they improve the ROI for
the overall organization. Suppose Jason had an opportunity to invest $1,750,000 in a project that would generate sales of $2,500,000 and a
return on sales of 10% (same as the original assumptions), or $250,000 operating income per year. The division’s ROI including this
investment would be
Even though the investment reduces the division’s ROI, Computer Wizards forgoes $250,000 if the project is not undertaken. If the level of
risk and the return are comparable to projects from other divisions, Computer Wizards would prefer the benefits from this investment.
Another disadvantage of ROI is that it does not incorporate measures of risk. Managers can potentially increase ROI by investing in riskier
projects, which often have higher returns than less risky projects. If they are rewarded solely for increasing ROI, managers may undertake
risky projects without considering the added risk to the organization. This problem arises more often when managers’ time horizons are
short, for example, when they are planning to retire or move to another company. In such cases, managers often prefer immediate
improvements in performance measures.
Furthermore, when managers with short time horizons evaluate projects based on ROI, they might inappropriately cut costs that provide
long-term benefit for the organization. For example, they might cut research and development, maintenance, or employee training.
ROI is typically calculated using financial accounting assets and income. Under financial accounting rules, assets are recorded at their
original cost, and some intangible assets, such as brand name, are not recognized. These rules cause the investment in assets to be
understated, particularly when the value of assets, such as property, has increased or when a company has significant intangible assets.
Understatements in assets cause ROI and investment turnover to be overstated. In addition, financial accounting rules measure revenues and
costs in ways that can distort ROI. For example, overhead or support department costs might be allocated to a division using a method that
does not reflect the division’s use of resources. If the division’s costs are understated or overstated, ROI will be distorted.
Despite its drawbacks, ROI is widely used by businesses throughout the world. ROI is a common measure for any type of investment and
may be used in nontraditional ways. Managers analyze ROI for a diverse set of business initiatives and activities including marketing,
information technology, and human resources.3
RESIDUAL INCOME
Because of the disadvantages of ROI just described, many organizations prefer to use one or more types of residual income to measure
performance of subunits. Residual income measures the dollar amount of profits in excess of a required rate of return. Its general
calculation is as follows:
Residual income = Operating income − (Required rate of return × Average operating assets)
Operating income is measured as EBIT. Many organizations set a minimum return expectation for operations and new investments. Residual
income takes this expectation into consideration; it is the difference between actual operating income and the required income, given the
organization’s investment in operating assets and its required rate of return. The size of investment affects residual income less than ROI
because it is used only to value the dollar amount of expected return, not as a denominator. Compared to ROI, residual income is less
influenced by changes in investment. Organizations use a variety of residual income measures, such as cash value added.4 Below we learn
about economic value added, which is widely used.
CHAPTER REFERENCE
See Chapter 12 for a more complete discussion about determining the required rate of return.
ECONOMIC VALUE ADDED
Economic value added (EVA®) is a type of residual income that incorporates a number of adjustments.5 The basic EVA calculation follows:
Because managers have incentives to set a required rate of return that is too low, EVA uses theweighted average cost of capital (WACC).
WACC is calculated by analyzing all sources of invested funds, including both debt and equity financing (valued as the opportunity cost to
investors). It is the after-tax cost of all long-term financing for the company or division. With EVA, each division can use its actual cost of
capital, taking into consideration the industry and risk characteristics. Mini-case 15.37 provides an opportunity to explore calculations for
WACC.
To reduce the problems associated with financial accounting information, as discussed earlier for ROI, EVA attempts to use economic
values. The calculation of adjusted after-tax operating income begins with after-tax operating income instead of EBIT, which is consistent
with using the (after-tax) weighted average cost of capital and also gives managers incentives to reduce taxes. Then adjustments are made to
arrive at estimates of economic earnings and assets.
One purpose of adjusting financial accounting income and assets is to minimize suboptimal decision making. For example, research and
development costs, which must be recognized immediately as an expense under financial accounting practices, are often capitalized for EVA
calculations. This adjustment encourages managers to invest in research and development projects that have long-term value for the
organization. Similarly, long-term leases accounted for as operating leases on financial statements are often treated as capital leases for EVA
calculations. This adjustment reduces managers’ incentives to use operating leases to artificially understate the organization’s investment in
assets. They are then encouraged to make long-term asset acquisition decisions based on the best alternative for the organization, rather than
on their financial accounting treatment.
COMPUTER WIZARDS (PART 2)
COMPARING ALTERNATIVE INVESTMENT CENTER MEASURES
Jason consults with Renee, and they decide to investigate performance measures other than ROI. They decide to consider a basic residual
income measure and EVA. They collect the required information for calculations as follows (all amounts in U.S. dollars).
CALCULATING RESIDUAL INCOME AND EVA
Next, Jason and Renee calculate residual income and EVA for each division, as follows.
Residual income Ontario = $500,000 − (10% × $2,000,000) = $300,000
Residual income New Jersey = $60,000 − (10% × $200,000) = $40,000
EVA Ontario = $310,000 − [7.2% × ($2,000,000 − $20,000)] = $167,440
EVA New Jersey = $35,000 − [10% × ($200,000 − $5,000)] = $15,500
ANALYZING THE RESULTS OF ALTERNATIVE PERFORMANCE MEASURES
Jason and Renee create a table to compare various performance measures for the two divisions. In addition to ROI, residual income, and
EVA, they include operating income and return on sales because these measures are often discussed during management meetings.
Jason and Renee examine the rankings of the two divisions using these five measures. Under ROS and ROI, the New Jersey division (11%
and 30%) appears to perform better than the Ontario division (10% and 25%). But when comparing EBIT, residual income, and EVA, the
Ontario division outperforms the New Jersey division. They recognize that size has an effect on these three measures. The New Jersey
division is only 10% of the size of the Ontario division but its return on that investment is 5 percentage points greater than Ontario’s (30%
compared to 25%), which suggests that the New Jersey division’s assets are being used more efficiently. Both divisions are performing well
above the hurdle rate of 10%, however. ROS measures cost efficiency relative to revenues produced. New Jersey has a higher ROS, which
suggests that it has lower costs per dollar of revenue. EBIT and ROS do not include information about investment and ROS does not include
information about costs. Therefore, Renee recommends using ROI and EVA as performance measures. Jason suggests that Renee also
consider nonfinancial performance measures to evaluation performance. He believes that increasing customer satisfaction should increase
financial performance because repeat and new customers will increase revenues. Renee agrees that by focusing on customer satisfaction, any
potential customer-related problems are likely to be discovered sooner, and will give the measure further consideration.
RESIDUAL INCOME, EVA, AND MANAGERS’ INCENTIVES
All residual income measures, including EVA, improve goal congruence compared to ROI. Managers are not penalized for investing in
projects that have acceptable rates of return, but which are lower than current project returns. Instead, they are motivated to invest in projects
that exceed the rate of return used to calculate residual value—i.e., that are expected to add value to the organization as a whole.
Compared to a generic residual value, EVA has three advantages. First, when WACC is used for the “hurdle” rate of return, it more closely
aligns managers’ incentives with shareholders. Under the general residual income measure, senior managers from each subunit might
determine their own required rate of return. They have incentives to set a required rate of return that is too low, in turn encouraging
investment in less profitable projects. They may also invest in less risky projects and forego riskier projects that would be profitable for the
overall organization.
Second, because values more closely represent the economic value of operating income and total assets with EVA, the likelihood of
suboptimal decisions is reduced. When residual income is calculated using financial statement values, it suffers from the same earningsrelated problems as ROI.
Third, EVA adjustments are personalized to each organization. For example, an adjustment to capitalize research and development costs is
only useful for organizations that invest heavily in research and development. EVA adjustments provide specific incentives that increase
goal congruence.
However, residual income measures including EVA have their own problems. Because they are absolute dollar values, larger subunits are
more likely to have larger residual incomes. As a result, managers find it difficult to compare performance across units. A disadvantage they
share with ROI is that residual income measures usually increase as investment and costs decrease (holding sales constant). Therefore,
managers may cut costs such as maintenance or employee training that likely have long-term benefits for the organization. In addition,
managers may forego investment projects that are expected to generate negative short-term residual income, even when the expected net
present value (see Chapter 12) is positive.
A major drawback of EVA relative to other measures is the complexity and potentially large number of adjustments (160 or more). The
adjustments are not only time-consuming, but they might not be well understood by managers. Accordingly, some analysts recommend
making only a few key adjustments.
MOTIVATING PERFORMANCE WITH COMPENSATION
To reduce agency costs, organizations use compensation contracts that provide incentives for agents to increase the value of the
organization. These contracts include cash-based bonuses, stock options, and other types of bonuses based on stock prices.
BONUS SYSTEM INCENTIVES
Q5 How is compensation used to motivate performance?
As organizations increase in size, more sophisticated incentive packages are required to align the goals of employees and owners.
Compensation contracts can be based on accounting earnings; other financial measures such as ROI, residual income, and EVA; and
nonfinancial measures such as customer satisfaction or defects rates.
Compensation contracts often include a base salary and bonuses. In the largest U.S. corporations, bonuses typically make up 50% or more of
the total compensation for top executives. Bonuses may be a combination of cash, stock, stock options (options to buy stock in the future at a
set price), and deferred compensation (salary or bonuses paid in the future, often after retirement). For professional, technical, and
managerial employees, incentive pay and bonuses represent as much as 10% of salary.6
CHAPTER REFERENCE
Chapter 16 provides more details about nonfinancial measures.
A wide variation exists in compensation packages among executives. For example, the average compensation of the CEOs of the largest 500
U.S. companies was $11.4 million in 2008. The largest compensation went to Larry Ellison, CEO of Oracle, who received a $1 million
salary plus $544 million from exercising stock options. One of the lowest-paid was Warren Buffett, CEO of Berkshire Hathaway, who
received $100,000 in salary and no bonus.7 Besides salary and bonuses, CEOs received benefits such as financial planning, personal and
home security, and personal use of corporate aircraft.8
To protect shareholders, executive compensation is usually set by a committee of the board of directors. Ideally, the compensation
committee consists of directors who are considered outsiders, with no formal connections to the management team. Bonuses are sometimes
limited to some fraction of accounting earnings. In addition, shareholders may have the ability to vote periodically on compensation
contracts. However, considerable evidence suggests that management compensation is not in fact independently determined, but rather that
top managers influence the decisions made by the compensation committee.
USING BUDGETS TO MONITOR AND REWARD PERFORMANCE
Budgets give managers authority over the use of an organization’s resources. Accordingly, it seems reasonable to hold managers responsible
for meeting budget benchmarks. However, when budget variances are used in performance evaluation, a number of challenges arise for
managers being evaluated as well as for managers conducting the evaluation. Exhibit 15.6 provides examples of these challenges. Notice
that most of these problems relate to holding managers responsible for results when they lack control over factors that affect their variances.
The investment center performance measures we learned about in this chapter (ROI, residual income, and EVA) can also be tied to budgets
and variances. Exhibit 15.7 illustrates a budget variance analysis for residual income. Individuals responsible for different aspects of
performance can readily understand how their performance affects overall performance. When used as part of a performance evaluation
system, this type of analysis is likely to increase goal congruence throughout an organization.
CHAPTER REFERENCE
Budgets are addressed more fully in Chapter 10. Variance analysis and behavioral implications are addressed inChapter 11.
PERFORMANCE MEASURE TARGETS
As organizations develop their operating plans and budgets, targets (i.e., preset goals) are often set for performance measures. These budgets
and targets are often used to establish bonus payments. For example, stock bonuses granted to Paul Stebbins, CEO of World Fuel Services,
depended on annual net income growth and three-year earnings-per-share growth. Targets for William Hickey, CEO of Sealed Air, included
ten specific goals including diluted earnings per share, net profit, return on assets, safety, and manufacturing quality. Blake Nordstrom,
President of Nordstrom, receives a stock bonus if total shareholder return is positive and above average among retail peer companies.9 As
discussed at the beginning of the chapter, Nucor awards weekly bonuses to plant employees based on achieving production volume goals.
CHAPTER REFERENCE
Chapter 14 describes the relationship between inventories and income, and presents alternative income calculations that reduce suboptimal
incentives.
EXHIBIT 15.6 Challenges in Appropriately Assigning Decision Rights
EXHIBIT 15.7 Extended Residual Income Analysis with Budget Variances
RISK OF BIASED DECISIONS
Regression to the Mean
Regression to the mean refers to the statistical tendency for observations in a series of data to move from the extremes toward the mean. In
sports statistics, fans understand that players will perform exceedingly well in a particular game, but their performance in the next game may
not attain the same high level. Because of this tendency, baseball batting averages over a year are better predictors than end-of-season
performance for the next year’s average. It is easy for individuals to overlook the regression to the mean effect in day-to-day decision
making. For example, when an organization is performing exceedingly well in a particular year, managers tend to set high goals and
standards for the next year. These goals may lead to false assumptions about the future period and inappropriate planning. An example of the
regression to the mean phenomenon was the drop in housing prices in the late 2000s. Although home values had increased at unprecedented
rates in many locations, many homeowners, investors, mortgage lenders, and other financial experts ignored the likelihood of a regression
toward the mean. Managers need to incorporate knowledge of these statistical tendencies into their plans for the future through budgets and
other forward-looking analyses.
BUDGET AND VARIANCE ADJUSTMENTS
Because managers’ budgets often include items not under their control, the following adjustments can be made when budgets are used to
measure managers’ performance.
•
•
•
•
Use a flexible budget to determine expected revenues based on budgeted prices and actual volumes.
Use a flexible budget to determine expected variable costs based on budgeted variable cost rates and actual volumes.
Remove allocated costs that are not controllable by managers in the departments receiving allocations.
Update costs for any anticipated price changes in direct materials, direct labor, and overhead-related resources.
LONG-TERM VERSUS SHORT-TERM INCENTIVES
For many years, U.S. compensation practices were criticized because they were based on accounting earnings. In addition to the problems
already described, managers could also reduce the level of investment in assets such as equipment, thereby reducing depreciation expense
and, in turn, increasing accounting earnings. However, the reduced investment negatively affects future earnings if sales are forgone because
of either limited capacity or increases in maintenance and downtime costs for old equipment that should have been replaced. In addition,
manufacturers sometimes increase revenues by forcing their customers to carry large inventories. These types of actions may increase shortterm earnings, but often have negative effects on long-term earnings potential.
CHAPTER REFERENCE
Chapter 14 describes the relationship between inventories and income, and presents alternative income calculations that reduce suboptimal
incentives.
To focus managers more on the long term, many companies in the United States increased the use of stock-based compensation. Stock
options, in particular, became popular during the 1980s and 1990s. Compensation tied to the value of stock was viewed as a way to
encourage managers and other employees to focus on increasing the long-term value of the company. However, company stock prices are
sensitive to changes in earnings. Some managers engaged in unethical or illegal activities to boost reported income so that stock prices
would remain stable or increase. Earnings manipulation was a significant problem during the early 2000s; many large U.S. corporations and
their accounting firms came under scrutiny from the Securities and Exchange Commission.
INTERNATIONAL EXECUTIVE COMPENSATION
In the past, compensation practices outside of the United States often focused on factors other than stock price. In France and Germany, for
example, CEO and top management rewards were sometimes tied to the average salary of all employees because the board of directors
included labor union representation. These types of contracts provide incentives to increase the wages of all employees. However, in the
early 2000s European companies, which were struggling to attract and retain highly skilled and talented people, began using stock options
for top and mid-level managers. Chinese companies were prohibited from granting stock options until 2003.10
Disagreement exists about whether executive pay in international companies is converging with that of the U.S. However, high executive
pay seems to be more controversial outside of the U.S., suggesting that at least some pay differences are likely to persist in the foreseeable
future. On average, U.S. CEOs are paid considerably more than CEOs in other countries. In 2005, only four countries paid their CEOs more
than 50% of U.S. pay (Switzerland, France, Germany, Italy, and the United Kingdom). Average 2005 CEO pay in Swedish companies was
about 44% of that for U.S. CEOs, and the proportion of compensation in the form of short-term and long-term non-salary pay was much
lower than in the U.S. In contrast, German CEOs receive fairly large bonuses payments. Potential factors influencing international variations
in CEO pay include differences in corporate laws, litigation, shareholder voting requirements, regulation of new stock issuances, public
disclosure requirements, tax laws, labor laws, stock exchange listing rules, financial accounting rules for employee stock options, and
cultural differences.11
FOCUS ON ETHICAL DECISION MAKING
Bailouts and Bonuses
During 2009, public furor erupted over bonuses for executives and employees at financial institutions. During the worldwide financial crisis,
many U.S. financial institutions and other companies had received “bailout” funds from the Troubled Asset Relief Program (TARP).
Analysts estimated that three of the institutions–Goldman Sachs, Morgan Stanley, and JPMorgan Chase’s investment banking unit–
planned to pay executive bonuses of $29.7 billion in bonuses, up 60% from 2008 (Fitzgerald, 2009).
According to a December 2009 poll, two-thirds of Americans held an unfavorable view of financial executives. More than half believed that
financial institution managers were only out for themselves and that the government should not have bailed out their organizations. Threequarters believed that firms that received TARP support should not pay bonuses, and 39% believed that bonuses should not be paid even if
the institutions repaid the TARP funds (Fitzgerald, 2009).
The U.S. government responded to bonus problems by restricting the form of employee pay at four recipients of TARP support (American
International Group, Citigroup, General Motors, and GMAC). However, the restrictions limited the way compensation could be paid
(salary versus bonus and long-term versus short-term) rather than restricting the total amount of pay (Solomon and Holzer, 2009). In
contrast, the British government imposed a 50% “super tax” on bank bonuses above £25,000. Proponents believed the new tax would force
financial institutions to make harder choices between bonuses payments and the rebuilding of financial capital. Opponents argued that the
tax would cause financial experts to leave London and move to Switzerland, the United States, or other countries (Murphy, 2009).
Unlike top executives at other financial institutions, John Mack, CEO at Morgan Stanley, recommended that the board of directors pay him
no 2009 bonus. Some analysts praised Mack for exhibiting restraint and responding to political and public pressure. Other analysts criticized
him for “sending the wrong signal to bankers and traders who believe their hard work should be rewarded” (Baer and Guerrera, 2009).
SOURCES: A. Fitzgerald, “Raging Against the Street,” Business Week, December 21, 2009, p. 22; D. Solomon and J. Holzer, “U.S. News:
Treasury Restricts Pay at Four Firms,” The Wall Street Journal (Eastern Edition), December 12, 2009, p. A4; M. Murphy, “City
Limits,” Financial Times, December 14, 2009, p. 6; and J. Baer and F. Guerrera, “M Stanley Chief Mack to Forgo Bonus,” Financial Times,
December 19, 2009, p. 17.
ETHICS OF COMPENSATION PRACTICES
Should governments interfere in the pay practices of financial institutions and other companies? What are the arguments for and against
government intervention? Should it matter whether:
•
•
•
An organization has received governmental “bailout” support?
An organization has repaid the “bailout” support?
Bonuses are to be paid to top executives versus other employees?
TRANSFER PRICE POLICIES
Q6 What prices are used for transferring goods and services within an organization?
When one unit relies on other units within an organization for goods or services, a problem arises that affects the measurement of financial
performance. Suppose Porcelain & More, a kitchen and bath fixtures manufacturer, operates with three profit centers: fixtures, sinks, and
tubs. Sinks and tubs are sold as kits that include fixtures. In their kits, the sink and tub profit centers use the faucets and handles produced by
the fixture profit center. Thus, these fixtures are transferred from one department to the other two departments, and the fixtures need to be
priced appropriately. A transfer price is the price used to record revenue and cost when goods or services are transferred between
responsibility centers in an organization.
TRANSFER PRICES AND CONFLICTS AMONG MANAGERS
When compensation is tied to the financial performance of subunits, managers tend to overlook their contribution to the entire organization
and focus instead on how decisions affect their subunit’s financial performance. Conflicts arise among managers, leading to suboptimal
operating decisions.
Q7 How do transfers prices affect managers’ incentive and decisions?
Suppose that Division A manufactures widgets and sells 1,000 units to Division B, which then sells them on the external market for $25
each. The Division managers are discussing a transfer price policy and analyze three different methods: variable cost at $15 per unit,
variable cost plus a portion of fixed costs at $20 per unit, and market price at $25 per unit. Their analysis is shown in the following chart.
Based on each division’s contribution margin, the manager of Division A would prefer to use the market price as transfer price, while the
manager of Division B would prefer variable cost. After negotiation, the two managers agree to use the transfer price of $20 to split the
contribution from the sales of widgets. However, a few months later, the manager in Division B finds a supplier who can provide the widgets
at $18 each and decides to buy externally. When the two managers analyze the new results (shown below), they find that Division B is better
off, while the entire organization is worse off by $3,000. Transfer prices based on market prices often encourage managers to make
suboptimal decisions.
SETTING AN APPROPRIATE TRANSFER PRICE
The perfect transfer price would be the opportunity cost of transferring goods and services internally. If external demand is zero and the
selling division has excess capacity, the transfer price would be the variable cost. This price is the minimum price the selling division would
typically be willing to accept from an outside buyer when it has excess capacity. However, if capacity is limited and goods or services can be
sold externally, then the opportunity cost would be the market price. To sell internally, the department forgoes an external sale and,
therefore, should charge the market price.
Although the opportunity cost is the best transfer price policy, it is rarely used because the price would vary with capacity. Most managers
prefer stable transfer prices across time. In addition, selling managers may regard a price equal to variable cost as unfair when excess
capacity exists, because the purchasing department receives credit for the entire contribution margin for products that are essentially
manufactured by both departments. Therefore, other transfer price polices are typically used.
The following methods are often used for setting transfer price policies in manufacturing and service organizations.
•
•
•
•
•
Cost based
Activity based
Market based
Dual rate
Negotiated
Cost-Based Transfer Prices Cost-based transfer prices are based on the cost of the good or service transferred. Cost can be computed in
different ways, ranging from variable costs to fully allocated costs. If a product has no external market because it is a subcomponent of
another product, some type of cost-based transfer price is commonly used.
Suppose that the fixtures department of Porcelain & More usually produces about 40,000 sets of fixtures and incurs about $200,000 in
manufacturing overhead cost during an accounting period. The average fixed cost per unit would be $5 ($200,000 ÷ 40,000 units). Under a
full production cost transfer price policy, Porcelain & More could set a transfer price of $15 ($10 variable cost + $5 fixed cost). This transfer
price allows each department to split the contribution margin that arises when fixtures are sold as part of sink and tub kits.
Cost-based transfer prices present several disadvantages. When products have an external market and departments are profit centers, the
transfer price affects decisions about transferring internally or purchasing externally. This situation can lead to suboptimal decisions, such as
the purchase of units from external providers shown in the earlier widgets example. In addition, when transfer prices include allocated fixed
costs, managers in selling departments do not have as much incentive to reduce fixed costs. They can pass the responsibility for allocated
fixed costs to another department through the transfer pricing policy.
Activity-Based Transfer Prices A variation of cost-based transfer prices is the use of activity-based transfer prices. Here, the purchasing
unit is charged for the unit-level, batch-level, and possibly some product-level costs for products transferred, plus an annual fixed fee that is
a portion of the facility-level costs. Suppose the tubs department at Porcelain & More plans to buy enough fixtures internally so that it uses
20% of fixture’s capacity. Under activity-based transfer pricing, the tubs department could pay for the unit and batch costs of each fixture
and also pay 20% of the fixtures department facility-level costs. By making this lump-sum payment, the tubs department essentially reserves
some of the fixture department’s capacity for units it will purchase internally.
An advantage of activity-based transfer pricing is that the purchasing department has an incentive to accurately project the number of units it
will purchase internally. This accuracy enhances an organization’s planning abilities. Suppose managers in the fixtures department believe
that external sales will be forgone by selling 20% of their fixtures to the tub department. Because they receive a fixed price from the tub
department, they know ahead of time that they need to increase capacity to accommodate external sales. They can more easily plan for these
changes.
However, because of uncertainty in demand, organizations may sometimes need to reallocate capacity to attain the highest contribution. In a
changing business environment, departments should be allowed to subcontract with each other so that the departments with the best
opportunities are using most of the capacity.
Market-Based Transfer Prices Market-based transfer prices are based on competitors’ prices or on the supply-and-demand relationship.
They are appropriate under a restrictive set of conditions. These conditions include the presence of a highly competitive market for the
intermediate product so that the selling department can sell as much as it wants to outside customers, and the purchasing department can buy
as much as it wants from outside suppliers, all without affecting the price. These conditions are rarely met. However, when they are, the
market price provides an objective value for intermediate products. The problem with market-based transfer prices is that information about
underlying costs is not revealed, and this lack of information encourages suboptimal decision making, as illustrated in the widget example.
Dual Rate Transfer Prices Dual rate transfer prices allow the selling department to be credited for the market price and the purchasing
department to be charged the variable cost. When financial statements are consolidated at the end of the accounting period, adjustments are
made so that overall organizational profit is accurately reported. This method provides appropriate information and incentives when the
selling department has excess capacity. Also, it is most similar to a policy that uses an opportunity cost for the transfer price. A disadvantage
of the method is that it overstates profitability at the subunit level, and managers may believe that the organization as a whole is more
profitable than it actually is.
Negotiated Transfer Prices Negotiated transfer prices are based on an agreement reached between the managers of the selling and
purchasing departments. This method ensures that both managers have full information about costs and market prices and that the transfer
price provides appropriate incentives. A disadvantage of this method is that it usually requires more time because both managers prefer more
contribution margin. Managers’ time is valuable to the organization for other responsibilities, and negotiation time may not be a high priority
for the organization as a whole.
COMPUTER WIZARDS (PART 3)
NEGOTIATED TRANSFER PRICES
The Ontario division of Computer Wizards produces computer monitors. These monitors are sold on the open market for $110 each or the
New Jersey division uses them as part of a complete computer package. When the monitor is transferred internally, the entire computer
package has a contribution margin of $415 each. The organization currently uses market price plus shipping as a transfer price. Jason is
happy with this transfer price, but Cecelia has asked Renee to consider changing the policy, because her division shows lower earnings than
it should. She would prefer to purchase monitors from Jason, but often purchases less-expensive and lower-quality monitors from an
external vendor to improve her division’s earnings.
The Ontario division has capacity to produce 10,000 monitors per month and usually operates at 70% of capacity. The following data pertain
to production at this level.
If a monitor is sold on the open market, the customer pays the shipping cost. The cost of shipping a monitor from Ontario to New Jersey is
about $10 each.
The Ontario division is currently operating at 50% of its capacity, substantially below normal. Jason would like to sell more monitors
internally to help cover fixed costs. Both managers contact Renee, who tells them to negotiate a policy that is fair to both divisions. Jason
would like to set a transfer price that is below the market price but above the variable cost, so that some of the fixed costs are covered by
internal transfers. Cecelia would prefer to pay only the variable cost plus the shipping charge, because the Canadian division’s fixed costs
will not change if production increases, and workers would be idle part of the time without the internal transfers.
After negotiating for several weeks, the two managers go back to Renee for help. Renee has laid out the following information based on a
selling price for the computer package of $950.
Renee explains that, from Computer Wizard’s perspective, the contribution margin on monitors sold externally is $65 ($110 − $45). When
the monitor is transferred internally, the relevant cost to Computer Wizards is $45, the variable cost. The relevant contribution margin for the
computer package is $415 ($950 − $490 − $45). When Cecelia purchases a monitor externally for $110, the contribution margin is $350
($950 − $490 − $110). Therefore, corporate headquarters would prefer internal transfers over purchases from outside vendors.
Renee suggests that Cecelia pay Jason a flat amount to help cover fixed costs and also pay the variable cost for each monitor transferred.
Jason agrees to this policy as long as the division operates with excess capacity. However, he points out that when the division lacks enough
capacity to fill both external and internal orders, he will sell externally and forgo internal transfers to increase profits for the Ontario
division.
Renee calculates the difference in the company-wide contribution margin when transferring monitors internally versus purchasing them
externally at $65 ($415 − $350). This difference happens to be the same as the contribution margin for the Ontario division when monitors
are sold externally. Therefore, Jason and Cecelia are indifferent to whether sales take place internally or externally when the Ontario division
is at capacity. Meanwhile, both managers agree that developing a transfer price policy that suits not only both divisions but also the overall
organization is more difficult than it first appeared.
ADDITIONAL TRANSFER PRICE CONSIDERATIONS
The preceding section addressed the incentives of managers for transfer prices between operating units. The following additional factors
affect the choice of transfer prices.
INTERNATIONAL INCOME TAXES
For organizations that do business internationally, the taxable location of profit is affected by transfer price policies. An organization with
subsidiaries located in high-tax and low-tax countries could potentially charge a high transfer price in the low-tax countries so that most of
the contribution margin arises where taxes are lowest. To restrict firms’ abilities to shift income in this manner, income tax regulations
typically stipulate the use of market-based transfer prices. The details of international tax regulation are complex and beyond the scope of
this textbook.
Q7 How do transfer prices affect managers’ incentive and decisions?
TRANSFER PRICES FOR SUPPORT SERVICES
Many organizations set transfer prices for support services. Their objective is to motivate efficient use and cost-effective production of
internal support services such as accounting, printing, human resources, and purchasing. When support departments provide services without
charge to user departments, the user departments tend to use the support services inefficiently. In turn, inefficient use tends to encourage
support departments to grow unnecessarily large. Transfer prices can encourage more efficient use of support services.
Transfer prices are often based on fully allocated costs and therefore include allocations of fixed support department costs and allocations
from other support departments. As a result, the transfer prices can be high. High transfer prices can encourage user departments to
outsource the support services. As we learned in the widget example, outsourcing is not always beneficial to the organization as a whole.
Outsourcing can cause internal services to be duplicated, resulting in excess capacity and inefficient use of resources.
SETTING TRANSFER PRICES FOR INTERNAL SERVICES
Because top managers prefer to have support services used efficiently, they want to set transfer prices that motivate this behavior. The best
transfer price policy is an opportunity cost approach. Each department is charged an amount that reflects the value of any opportunities
forgone by not using the service for its next best alternative use.
CHAPTER REFERENCE
See Chapter 8 for more details about allocating service department costs.
Suppose that Computer Wizards’ production and assembly equipment needs routine maintenance to prevent downtime during regular hours
of operation. The maintenance department schedules its repair and maintenance time during lunch hours and at the end of each production
shift. Currently, the maintenance department is operating close to capacity. Other departments need to schedule nonroutine tasks, such as
painting walls and repairing damaged flooring, well in advance. If a department wants maintenance personnel to hang pictures in an office,
the value of the opportunity forgone might be the cost of hiring a contractor to provide routine maintenance on equipment or to paint walls.
However, if the maintenance department has extra capacity and workers are idle part of the time, the opportunity cost of hanging pictures
would be zero.
Implementing a transfer price policy based on opportunity costs is problematic because opportunities change over time with changes in
demand and capacity. In addition, finding and valuing alternative uses for some services can be difficult. Therefore, organizations use
transfer price policies for internal services similar to those used for transferring goods. Cost-based transfer prices range from variable costs
to fully allocated costs. Market-based transfer prices are set at amounts that would be paid if the service were outsourced.
Some organizations establish a price per job for each task, keep prices low on jobs they want to have performed internally, and set prices
high on jobs that are considered unnecessary or inappropriate. Suppose the managers of Computer Wizards believe that the maintenance
personnel should not be hanging pictures. They could set the transfer price for hanging pictures high enough to discourage other departments
from asking the maintenance department to perform this service.
TRANSFER OF CORPORATE OVERHEAD COSTS
Another type of transfer price occurs when corporate overhead costs are allocated to other responsibility centers. Managerial performance
rewarded based on accounting profits can stimulate much discussion between corporate headquarters and profit center managers about
whether allocating overhead costs is appropriate, and whether the allocation plan and allocation bases are appropriate. Under responsibility
accounting, managers should be held accountable only for costs that they control. Because they have little or no control over corporate costs,
they should not be held responsible for those costs in performance evaluations.
Many organizations do allocate corporate headquarters costs, however. Sometimes these are considered a corporate tax and are allocated
based on revenues or profitability. In this manner, subunits operating under optimal circumstances absorb more overhead than subunits with
poor results because of economic or industry conditions that are not under managers’ control.
SUMMARY
Q1 What Is Agency Theory?
Principals and Agents
Principals hire agents to make decisions for them and to act in their behalf.
Agency Costs
Costs that arise when agents fail to act in the interest of principals:
•
•
•
•
•
Losses from poor decisions
Losses from incongruent goals
Monitoring costs
Goal alignment costs
Contracting costs
Reducing Agency Costs
To measure, monitor, and motivate performance:
•
•
•
•
•
Assign responsibility for decision making
Link decision-making authority to performance measurement
Use income-based measures to assess performance
Motivate performance with compensation schemes
Establish prices for the transfer of goods and services within an organization
Alternative Theory
Simons’ levers of control
Q2 How Are Decision-Making Responsibility and Authority Related to Incentives and Performance Evaluation?
Centralized and Decentralized Organizations
Advantages and disadvantages: See Exhibit 15.3.
Span of Control
General Versus Specific Knowledge
Decision authority is related to the type of knowledge within an organization.
Q3 How Are Responsibility Centers Used to Measure, Monitor, and Motivate Performance?
Types of Responsibility Centers
•
•
•
•
Cost centers
• Discretionary cost centers
Revenue centers
Profit centers
Investment centers
Suboptimal Decisions
Issues
•
•
Reduce agency costs by holding managers responsible for the decisions over which they have authority
Measuring performance at the responsibility center level can lead to suboptimal decisions
Q4 How Do Return on Investment, Residual Income, and Economic Value Added Affect Managers’ Incentives and Decisions?
Return on Investment (ROI)
DuPont Analysis:
Residual Income
Economic Value Added (EVA)
Advantages and Disadvantages
ROI is easier to compare across subunits, but motivates suboptimal decisions, both in long-term investment and short-term cost cutting
Residual Income provides more appropriate investment incentives than ROI, but is not comparable across subunits
EVA minimizes suboptimal decision-making incentives, but is complex to calculate and not comparable across subunits.
Goal Congruence
Q5 How Is Compensation Used to Motivate Performance?
Bonus System Incentives
Examples of performance measures:
•
•
•
•
•
•
ROI
Residual income
EVA
Operating income or growth in income
Cost savings
Revenue growth
Using Budgets to Monitor and Reward Performance
Performance Measure Targets
Motivating Long-Term Versus Short-Term Performance
Q6 What Prices Are Used for Transferring Goods and Services Within an Organization?
Ideal Transfer Price
•
Opportunity cost
Effect of Seller’s Capacity
Alternatives
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Cost-based transfer price
Activity-based transfer price
Market-based transfer price
Dual rate transfer price
Negotiated transfer price
Q7 How Do Transfer Prices Affect Managers’ Incentives and Decisions?
Uses
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•
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Assign cost to goods and services transferred internally for financial reporting and income taxes
Motivate efficient use of support services
Allocate corporate overhead costs
Incentive Issues
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Conflicts among managers
Suboptimal decision making
Managers should not be held responsible for costs over which they have no control
International income taxes
KEY TO SYMBOLS
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This question requires students to extend knowledge beyond the applications shown in the textbook.
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This question requires the ability to identify problems involving business risks, ethical dilemmas, or uncertainties.
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This question requires the ability to identify problems and also explore perspectives, biases, strengths and weaknesses, etc.
This question requires the ability to identify and explore problems and also prioritize among competing alternatives.
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This question requires the ability to identify, explore, and prioritize and also envision ways to address ongoing risks and
opportunities.
See Appendix 1A for more information about identifying, exploring, prioritizing, and envisioning skills.
SELF-STUDY PROBLEMS
Q4
Self-Study Problem 1 ROI, Residual Income, EVA
Outdoor Express is a large manufacturer of recreational equipment. Performance of the Camping division is measured as an investment
center because the managers make all decisions about investments in operating equipment and space. Following is financial information for
the Camping division:
Average operating assets
$2,000,000
Current liabilities
500,000
Operating income
300,000
Camping division’s required rate of return is 12%, but Outdoor Express’s weighted average cost of capital is 9%, and the tax rate is 30%.
REQUIRED:
•
•
•
•
A. Calculate return on investment for the Camping division.
B. Calculate residual income for the Camping division.
C. Calculate EVA for the Camping division.
D. Briefly discuss the advantages and disadvantages of each method.
Solution to Self-Study Problem 1
A.
B.
C.
D. ROI and residual income motivate managers to reduce costs and investment, whereas EVA provides incentives to invest as long as the
return is equal to or greater than the required rate of return. In addition, ROI and residual income do not include taxes, so no incentive is
provided for managers to minimize taxes. EVA can be adjusted for intangibles such as leases and R&D spending. Therefore, it can be
designed to minimize managers’ abilities to artificially improve the performance measure. Also, see the summary on page 604.
Q6, Q7
Self-Study Problem 2 Transfer Price, Excess versus Full Capacity, Outsourcing
The Kansas division of Aeronautic Controls (AC) produces a digital thermometer. The thermometer can be sold on the open market for $180
each, or it can be used by the Texas division in the production of a temperature control gauge that has a unit contribution margin of $140
(given that the digital thermometer is transferred at variable cost plus shipping).
The Kansas division is currently operating at 70% of its capacity of 2,000 digital thermometers per month. Following are average costs per
unit at this level of capacity:
If a digital thermometer is sold on the open market, the customer pays the shipping cost. The cost of shipping a digital thermometer from
Kansas to Texas is $15.
REQUIRED:
•
•
•
•
A. What is the best transfer price for AC overall if a digital thermometer is transferred to Texas and the Kansas division is operating at
70% of capacity?
B. What is the best transfer price for AC overall if a digital thermometer is transferred to Texas, but the Kansas division is operating at
full capacity and the digital thermometer could have been sold on the open market?
C. Suppose the Texas division can purchase a substitute for the digital thermometer from an outside supplier for $100 (including
shipping costs). Under ordinary circumstances, what single transfer price would motivate the managers of both divisions to act in AC’s
interests at either excess or full capacity?
D. What are the potential problems with the transfer price identified in part (C)? Explain.
Solution to Self-Study Problem 2
A. When the Kansas division has excess capacity (30% in the problem), the transfer price should be the variable cost of $75 (direct materials
of $50 plus supplies of $10 and shipping of $15).
B. If the Kansas division could sell all of its thermometers on the open market, the transfer price should be the market price of $180 plus $15
shipping = $195.
C. First consider the contribution margin for each division from the perspective of the entire organization. Selling the temperature control
gauge results in a contribution margin of $140 per unit. Selling the digital thermometers results in a contribution margin of $105 ($180 −
$75 thermometer variable cost). When Kansas has excess capacity, the total contribution margin is $245 ($140 + $105).
For each unit produced with a digital thermometer from an outside supplier, the Texas division’s contribution margin is reduced by $25
($100 − $75) from $140 to $115. However, from the perspective of the entire organization, the contribution margin is $115 from Texas plus
$105 from Kansas, or $220 in total. If the internal transfer takes place, the contribution margin is only $140. Therefore, transfers should take
place only when Kansas has excess capacity. To motivate this behavior, the transfer price should be equal to or greater than $75and equal to
or less than $100. Setting the transfer price at $90 + $10 shipping would give Texas incentive to purchase inside if Kansas had capacity, but
purchase outside if Kansas had no capacity because the transfer price would be the same with either purchase. In addition, Kansas would
have incentive to sell to the external market when possible because the contribution margin of $105 on external sales is greater than the $35
($90 − $65) contribution margin for internal sales.
D. The Texas division might find an external vendor that could produce the digital thermometer at a cost less than the transfer price, but that
would decrease AC’s overall contribution margin. In addition, the Texas division could forgo special orders that would have a positive
contribution margin for AC if the division uses the internal transfer price to determine whether to accept the order.
KEY TERMS
For each of these terms, write a definition in your own words. For starred terms, list at least one example that is different from the ones
given in this textbook.
Activity-based transfer price (p. 600)
*Agency costs (p. 584)
Agency theory (p. 584)
*Agent (p. 584)
Centralized decision making (p. 586)
*Cost-based transfer price (p. 600)
*Cost center (p. 589)
Decentralized decision making (p. 586)
*Discretionary cost center (p. 589)
Dual rate transfer price (p. 601)
Economic value added (EVA) (p. 593)
*General knowledge (p. 586)
*Goal congruence (p. 590)
*Investment center (p. 589)
Investment turnover (p. 591)
Market-based transfer price (p. 601)
Negotiated transfer price (p. 601)
Organizational structure (p. 586)
*Principal (p. 584)
*Profit center (p. 589)
*Regression to the mean (p. 597)
Residual income (p. 593)
Responsibility accounting (p. 588)
*Responsibility center (p. 588)
Return on investment (ROI) (p. 590)
Return on sales (p. 591)
*Revenue center (p. 589)
Span of control (p. 587)
*Specific knowledge (p. 586)
*Suboptimal decision (p. 589)
Transfer price (p. 599)
QUESTIONS
15.1
15.2
15.3
Explain how return on investment (ROI) is calculated and how it can be decomposed into two financial measures.
Explain how and why the use of ROI for performance evaluation can cause managers to make decisions that could be
harmful to an organization in the long run.
Explain how residual income is calculated, and define required rate of return in your own words.
15.4
Explain why the use of residual income for performance evaluation provides better incentives, in some ways, than ROI,
but still causes managers to make some decisions that could be harmful to an organization in the long run.
15.5
Explain the differences between general and specific knowledge. Give an example of an industry where knowledge is
quite general and an example of an industry that requires specific knowledge.
15.6
Explain why organizational form may vary if specific knowledge versus general knowledge is needed for decision making.
15.7
Describe agency costs and give several examples of them.
15.8
Explain how EVA differs from residual income.
15.9
Identify the four different types of responsibility centers and explain the general objectives of each.
15.10
An organization’s plant in Tennessee manufactures a product that is shipped to a branch in Oregon for sale. Does it make
any difference which branch (each is a profit center) is charged for the cost of transportation? Explain.
15.11
A national corporation, Fast Print, decided to expand into several developing countries. The corporation has been
managed under a centralized organizational form, but is considering changing to a decentralized form. List the
advantages and disadvantages of making this change.
15.12
15.13
Suppose transfer prices are set at market prices and a manager who previously purchased internally begins to purchase
externally. Explain what it means to say that the outsourcing decision might have been suboptimal.
Describe as many different methods for setting transfer prices as you can.
15.14
Explain how the span of control relates to responsibility accounting.
15.15
Describe the restrictions that are often imposed on transfer prices by income tax regulations.
EXERCISES
15.16
Q1, Q2, Q3,
Q4, Q5
REQUIRED:
Responsibility centers, agency theory, and performance measures Your brother recently bought a
small business with several coffee carts located around the city. Two workers share responsibility for
each cart. All beverages are prepared using identical recipes and ingredients, but the baked goods and
other items sold by each cart are chosen by the employees who operate the carts each day. Your
brother asked your advice in determining how best to compensate the employees. He thinks he should
give them bonuses when costs are contained, and pay them a flat salary otherwise.
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•
•
•
15.17
Q4
A. What type of responsibility center is each cart?
B. Explain how agency theory relates to your brother’s situation.
C. List several financial performance measures that might be relevant for measuring employee
performance.
D. List one nonfinancial measure that might be important to the success of this business.
Residual income, ROI, and EVA The following selected data pertain to Brannard Company’s
Construction Division for last year.
Sales
$2,000,000
Variable costs
$1,200,000
Traceable fixed costs
$200,000
Average invested capital (assets)
$3,000,000
Current liabilities
$200,000
Required rate of return
15%
Marginal tax rate
36%
Weighted average cost of capital
12%
REQUIRED:
1.
Calculate the residual income.
2. Calculate the return on investment.
3.
Calculate the economic value added.
15.18
Q4
Cumulative Exercise (Chapter 3): ROI, residual income, breakeven point, contribution margin
(CPA) Oslo Company’s industrial photo-finishing division, Rho, incurred the following costs and
expenses in the last period.
During the period, Rho produced 300,000 units of industrial photo prints, which were sold for $2.00 each.
Oslo’s investment in Rho was $500,000 and $700,000 at the beginning and end of the year, respectively.
Oslo’s weighted average cost of capital and required rate of return is 15%.
REQUIRED:
1.
Determine Rho’s return on investment for the year.
2. Compute Rho’s residual income (loss) for the year.
3. How many industrial photo print units did Rho have to sell during the year to break even?
4.
What was Rho’s contribution margin for the year?
15.19
EVA for segments Following is information for the Fulcrum Company’s three business segments
Q4
located in Europe.
Fulcrum’s applicable tax rate for the segments is 30%, and its weighted average cost of capital for each
segment is 10%.
REQUIRED:
Determine the segment with the highest EVA.
15.20
Q4, Q6, Q7
ROI, transfer prices, taxes, employee motivation Fowler Electronics produces color plasma screens
in its Windsor, Ontario, plant. The screens are then shipped to the company’s plant in Detroit, Michigan,
where they are incorporated into finished televisions. Although the Windsor plant never sells plasma
screens to any other assembler, the market for them is competitive. The market price is $750 per
screen.
Variable costs to manufacture the screens are $350. Fixed costs at the Windsor plant are $2,000,000 per
period. The plant typically manufactures and ships 10,000 screens per period to the Detroit plant. Taxes in
Canada amount to 30%, of pretax income. The Canadian plant has total assets of $20,000,000.
The Detroit plant incurs variable costs to complete the televisions of $110 per set (in addition to the cost of
the screens). The Detroit plant’s fixed costs amount to $4,000,000 per period. The 10,000 sets produced each
period are sold for an average of $2,500 each. The U.S. tax rate is 45% of pretax income. The U.S. plant has
total assets of $30,000,000.
REQUIRED:
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•
•
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A. Determine the return on investment for each plant if the screens are transferred at variable
cost.
B. Determine the return on investment for each plant if the screens are transferred at market
price.
C. To reduce taxes, will Fowler prefer a transfer price based on cost or market price? Explain.
D. Will the top managers in each plant prefer to use cost or market price as the transfer price?
Explain.
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15.21
Q6, Q7
E. What method could be used to resolve potential conflict over the transfer price policy?
Choice of transfer price The following information relates to a new computer chip that Hand Held has
developed for its new cell phone that contains a personal organizer:
The variable costs of the Cell Phone Division will be incurred whether it buys from the Chip Division or from
an outside supplier.
REQUIRED:
1.
What is the highest price that the managers of the Cell Phone Division would want to pay the
Chip Division for the chip? Explain.
2. If the Chip Division is working at full capacity and cannot produce additional units, what transfer
price for the chip would be best for the company as a whole? Explain.
3.
If the Chip Division is not operating at capacity and has no prospect of reaching capacity, what is
the lowest price its managers would typically be willing to sell chips to the Cell Phone Division?
15.22
Residual income, solve for unknown A business segment reports income of $50,000, residual income
of $(10,000), and total assets of $400,000.
REQUIRED:
Calculate the minimum return required by management.
15.23
ROI, solve for unknowns Data for three business units is shown below.
REQUIRED:
Determine the unknowns indicated by letters (A) through (I).
15.24
Minimum transfer price, capacity, contribution margins Nexa’s Division A produces a product that
can be sold for $200 or transferred to Division B as a component for its product. Division B can buy the
part from another suppler at $180. In the current period, Division B purchased 1,000 units from
Division B. Data on a per-unit basis follows:
The variable cost in Division B does not include the cost of the component provided by Division A or the
outside supplier.
REQUIRED:
1.
Calculate the minimum transfer price if Division A is operating at capacity.
2. Calculate the minimum transfer price if Division A is operating below capacity.
3. Calculate the effect on the company’s contribution margin if Division A has excess capacity and
Division B buys 1,000 units from the outside supplier.
4. Calculate the contribution margin for the company for 1,000 units if Division A is required to sell
to Division B when there is no excess capacity.
5. Calculate the contribution margin for the company if Division A is at capacity and sells 1,000
units to the external market and Division B purchases 1,000 units from an outside supplier.
6. Is it more profitable for the company to require Division A to transfer units to Division B?
Explain.
7.
If there are no outside suppliers and Division A is operating at capacity, is the company better off
to have Division A sell externally or internally? Show your calculations.
15.25
Q2, Q5
Span of control, general and specific knowledge, performance measures Barnett’s is a boutique
clothing store serving high-income customers. The store has two departments: women’s and men’s.
Each salesperson receives a base salary plus commissions on net sales (sales to customers less returns)
and has the authority to resolve customer problems including:
•
•
REQUIRED:
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•
Returning or exchanging merchandise
Holding sale merchandise for individual customers
A. To be effective, do the salespeople require general knowledge, specific knowledge, or both?
B. What are the pros and cons of giving salespeople the authority to resolve customer
•
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15.26
Q6, Q7
problems?
C. Does each sales associate seem to have a wide, moderate, or narrow span of control?
Discuss.
D. Suppose the store owner is considering adopting a bonus plan. Discuss the advantages and
disadvantages of each of the following measures as a basis for salesperson bonuses:
1. Total store sales
2. Department sales
3. Store gross margin
4. Department gross margin
5. Store earnings before interest and taxes (EBIT)
Choice of transfer price, fairness to managers [Note: This problem is based on transfer prices and
incentives for a real company. However, the name of the company and the data are fictional.]
Prem International has two large subsidiaries, Oil and Chemical. Oil is an oil-refining business, and its main
product is gasoline. Chemical produces and sells a variety of chemical products.
Chemical owns a polystyrene processing plant next to Oil’s refinery. The polystyrene plant was built at the
same time that Oil built a benzene plant at the refinery. Benzene is the raw material needed by Chemical to
produce polystyrene. Chemical’s managers believe they can sell 100 million pounds of polystyrene per year,
which is less than full capacity. Following are Chemical’s expected revenues and costs for the polystyrene
plant (volume is measured using weight in pounds rather than using a liquid measure such as gallons because
weight is not affected by temperature):
Oil can operate at full capacity and sell all of the gasoline it produces. Following are Oil’s expected revenues
and costs for the production of gasoline:
Per Pound
Selling price
$0.16
Costs: Crude oil
$0.06
Variable production costs
0.02
Fixed production costs
0.07
For every pound of benzene that Oil produces, it will forgo selling a pound of gasoline. However, 100 million
pounds per year would be only a small portion of total volume at the refinery. Following are Oil’s expected
revenues and costs for the production of benzene (these costs include the costs of refining the crude oil):
REQUIRED:
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•
•
•
•
15.27
Q6, Q7
A. On a company-wide basis, should Prem International produce polystyrene this year? Why or
why not?
B. What is the maximum price that Chemical’s managers would be willing to pay for benzene?
C. Would Chemical’s managers be willing to pay the maximum transfer price calculated in part
(B)? Why or why not?
D. What is the minimum price that Oil’s managers would be willing to receive for benzene?
E. Would Oil’s managers be willing to receive the minimum transfer price calculated in part
(D)? Why or why not?
F. What transfer price might be fair to the managers of both subsidiaries? Explain.
Transfer price, sale to outside versus inside customer (CPA) Ajax division of Carlyle Corporation
produces electric motors, 20% of which are sold to the Bradley division of Carlyle and the remainder to
outside customers. Carlyle treats its divisions as profit centers and allows division managers to choose
their sources of sale and supply. Corporate policy requires that all interdivisional sales and purchases
be recorded at variable cost as transfer price. Ajax division’s estimated sales and standard cost data for
the year, based on its full capacity of 100,000 units are as follows:
Ajax has an opportunity to sell the 20,000 units to an outside customer at a price of $75 per unit on a
continuing basis. Bradley can purchase its requirements from an outside supplier for $85 per unit.
REQUIRED:
Assuming that Ajax division desires to maximize its gross margin, should Ajax accept the new customer
and drop its sales to Bradley for the year? Why or why not?
PROBLEMS
15.28
Q4
ROI, residual income, comparing measures The following financial data are for the evaluation of
performance for Midwest Mining:
Average operating assets
$500,000
Net operating income
$65,000
Minimum required rate of return
10%
Midwest Mining currently uses return on investment to evaluate investment center managers. An accounting
intern from the local university suggested to the controller that residual income may be a better performance
measure.
REQUIRED:
•
•
•
15.29
Q3, Q4
REQUIRED:
Lease versus buy decision, ROI, residual income, EVA, manager incentives Refer to the
information in Problem 15.28. The manager of Midwest Mining is considering a new project. She can
buy or lease equipment that will reprocess tailings from old mines to remove any traces of gold left
behind by the original separating processes. The purchase price of the equipment is $150,000. The cost
to lease is $2,000 per month. She estimates the return (incremental revenues minus incremental
expenses, including lease cost) to be $40,000 per year. She knows that purchasing the equipment will
increase the value of average operating assets. If she leas…