Management accounting -- Chapter 10

Decentralization -- the delegation of freedom to make decisions. The lever in the organization that this freedom exists, the greater decentralization
segment autonomy -- the delegation of decision-making power to managers of segments of an organization
incentives -- those informal and formal performance-based rewards that enhance managerial effort toward organizational goals
agency theory -- a theory that deals with contracting between an organization and the managers that hires to make decisions on its behalf
return on investment (ROI) -- a measure of income or profit divided by the investment required to obtain that income or profit
return on sales -- income divided by revenue
capital turnover -- revenue divided by invested capital
residual income (RI) -- after-tax operating income less a capital charge
capital charge -- Company's cost of capital Times amount of investment
cost of capital -- what a firm must pay to acquire more capital, whether or not it actually has to acquire more capital
economic value added (EVA) -- equals adjusted after-tax operating income minus the cost of invested capital multiplied by the adjusted average invested capital
Gross book value -- the original cost of an asset before deducting accumulated depreciation
net book value -- the original cost of an asset less any accumulated depreciation
transfer price -- the price that one segment of an organization charges another segment of the same organization for product or service
dysfunctional decision -- any decision that is in conflict with organizational goals
management by objectives (MBO) -- the joint formulation by a manager and his or her superior of a set of goals and plans for achieving the goals for a forthcoming period

As companies grow, the ability of managers to effectively plan and control becomes more and more difficult because top managers are further removed from day-to-day operations. One approach to effective planning and control in large companies is to decentralize decision-making. This means that top management gives mid and lower level managers the freedom to make decisions that impact the subunits performance. The more that decision-making is delegated, the greater the decentralization. Often, the subunit manager is most knowledgeable of the factors that management should consider in the decision-making process.

Top management must design and management control system so that it motivates managers to act in the best interests of the company. This is done through the choice of responsibility centers in the appropriate performance measures and rewards. The degree of decentralization does not depend on the type of responsibility center chosen. For example, a cost center manager in one company may have more decision-making authority than does a profit center manager in a highly centralized company.

It is generally a good idea to link managers rewards to responsibility center results. Top management should use performance measures for the responsibility center that promote goal congruence. However, linking rewards to results creates risks for the manager. The greater the influence of uncontrollable factors on a managers reward, the more risk the manager bears.
It is typical to measure the results of investment centers using a set of performance measures that include financial measures such as return on investment (ROI), residual income, or economic value added (EVA). ROI is any income measure divided by the dollar amount invested and is expressed as a percentage. Residual income, or economic value added, is after-tax operating income less a capital charge based on the capital invested (cost of capital). It is an absolute dollar amount.

The way an organization measures invested capital determines the precise motivation provided by ROI, RI, or EVA. Managers will try to reduce assets or increased liabilities that accompany includes in their divisions investment base. They will adopt more conservative assets replacement policies if the company uses net book value rather than Gross book value in measuring the assets.

In large companies with many different segments, one segment often provides products or services to another segment. The siding on the amount the selling division should charge the buying division for these transfers is difficult. Companies use various types of transfer pricing policies. The overall purpose of transfer prices is to motivate managers to act in the best interests of the company, not just the segment.

As a general rule, transfer prices should approximate the outlay cost plus opportunity cost. Each type of transfer price has its own advantages and disadvantages. Each has a situation where it works best, and each can lead to dysfunctional decisions in some instances. Cost based prices are readily available, but if a company uses actual cost, the receding segment manager does not know the cost in advance, which makes cost planning difficult. When a competitive market exists for the product or service, using market-based transfer prices usually leads to goal congruence and optimal decisions. When idle capacity exists in the segment providing the product or service, the use of variable cost as the transfer price usually leads to goal congruence.

Multinational organizations often use transfer prices as a means of minimizing worldwide income taxes, import duties, and tariffs.

Regardless of what measures a management control system uses, when used to evaluate managers they should focus on only the controllable aspects of the measures. MBO can focus attention on performance compared to expectations, which is better than a valuations based on absolute profitability.