Performance Evaluation for Decentralized Operations

'ost 'enters
Budget Performance Report Supervisor, Department 1Plant A For the onth !nded Octo"er #1, $%%& Budget Actual Over Budget Under Budget

Factory wages Materials Supervisory salaries Power a ! lig"t $epreciatio Mai te a ce % sura ce, ta&es

$ 58,100 32,500 6,400 5,750 4,000 2,000 #75 $10#,725

$ 58,000 34,225 6,400 5,6#0 4,000 1,##0 #75 $111,280

$100 $1,725 60 10 $1,725 $1,725 $170

'ost 'enters
Budget Performance Report anager, Plant A For the onth !nded Octo"er #1, $%%& Budget Actual Over Budget Under Budget

'!(i istratio $epart(e $epart(e t t1 1 $epart(e t 2 $epart(e t 3

$ 17,500 10#,725 10#,725 1#0,500 14#,750 $467,475

$ 17,350 111,280 111,280 1#2,600 14#,100 $470,330

$150 $1,555 $1,555 2,100 $3,655 650 $800

'ost 'enters
Budget Performance Report anager, Plant A For the onth !nded Octo"er #1, $%%& Budget Actual Over Budget Under Budget

'!(i istratio $epart(e t 1 $epart(e t 2 $epart(e t 3

$ 17,500 10#,725 1#0,500 14#,750 $467,475

$ 17,350 111,280 1#2,600 14#,100 $470,330 $470,330

$150 $1,555 2,100 $3,655 $3,655 650 $800 $800

'ost 'enters
Budget Performance Report (ice)President, Production For the onth !nded Octo"er #1, $%%& Over Budget Actual Budget

Under Budget

'!(i istratio Pla Pla t t' ' Pla t )

$ 1#,500 467,475 467,475 3#5,225 $882,200

$ 1#,700 470,330 470,330 3#4,300 $884,330

$ 200 2,855 2,855 $3,055 $#25 $#25

*ote t"at +,ver )u!get- is a et .igure/

'ost 'enters
Budget Performance Report (ice)President, Production For the onth !nded Octo"er #1, $%%& Over Budget Actual Budget

Under Budget

'!(i istratio Pla t ' Pla t )

$ 1#,500 467,475 3#5,225 $882,200

$ 1#,700 470,330 3#4,300 $884,330

$ 200 2,855 $3,055 $#25 $#25

0ac" o. t"e li e ite(s a1ove is supporte! 1y a cost ce ter report/

Responsibility Accounting for Profit Centers

% a pro.it ce ter, t"e u it (a ager "as t"e respo si1ility a ! t"e aut"ority to (a2e !ecisio s t"at a..ect 1ot" costs a ! reve ues/

Profit centers (ay 1e !ivisio s, !epart(e ts, or pro!ucts/

Profit 'enters
*03, a !iversi.ie! e tertai (e t co(pa y, "as two pro.it ce ters4 t"e 5"e(e Par2 $ivisio a ! t"e Movie Pro!uctio $ivisio /
*heme Par+ Division $6,000,000 2,4#5,000 ovie Production Division $2,500,000 405,000

6eve ues ,perati g e&pe ses

Profit 'enters
7"argi g Service $epart(e t 7osts to Pro!uctio $ivisio s
Purchasing Department, -.%%,%%% 8'ctivity 1ase4 u(1er o. purc"ase re9uisitio s:
5"e(e Par2 $ivisio Movie Pro!uctio $ivisio 4 5otal 25,000 purc"ase re9uisitio s 15,000 purc"ase re9uisitio s 40,000

; -1% per purchase re/uisition 40,000 purc"ase re9uisitio s

$400,000

Profit 'enters
7"argi g Service $epart(e t 7osts to Pro!uctio $ivisio s
Pa0roll Accounting, -$11,%%% 8'ctivity 1ase4 u(1er o. payroll c"ec2s:
5"e(e Par2 $ivisio Movie Pro!uctio $ivisio 4 5otal 12,000 payroll c"ec2s 3,000 payroll c"ec2s 15,000

$255,000 15,000 payroll c"ec2s

; -12 per pa0roll chec+

Profit 'enters
7"argi g Service $epart(e t 7osts to Pro!uctio $ivisio s
3egal Department, -$1%,%%% 8'ctivity 1ase4 u(1er o. payroll c"ec2s:
5"e(e Par2 $ivisio 100 1ille! "ours Movie Pro!uctio $ivisio 4 #00 1ille! "ours 5otal 1,000

$250,000 1,000 "ours

; -$1% per hour

Profit 'enters
4ova !ntertainment 5roup Service Department 'harges to 4!5 Divisions For the 6ear !nded Decem"er #1, $%%& *heme Par+ Division ovie Production Division

Service Department

Purc"asi g

$250,000

$150,000

$1,%%% purchase 11,%%% purchase re/uisitions 7 re/uisitions -1% 7 -1% per purchaseper purchase re/uisition re/uisition

Profit 'enters
4ova !ntertainment 5roup Service Department 'harges to 4!5 Divisions For the 6ear !nded Decem"er #1, $%%& *heme Par+ Division ovie Production Division

Service Department

Purc"asi g Payroll accou ti g

$250,000 204,000

$150,000 51,000

1$,%%% pa0roll #,%%% pa0roll chec+s 7 -12 chec+s per 7 -12 per pa0roll chec+ pa0roll chec+

Profit 'enters
4ova !ntertainment 5roup Service Department 'harges to 4!5 Divisions For the 6ear !nded Decem"er #1, $%%& *heme Par+ Division ovie Production Division

Service Department

Purc"asi g Payroll accou ti g <egal

$250,000 204,000 25,000

$150,000 51,000 225,000

1%% hours 7 -$1% 8%% hours 7 -$1% per hour per hour

Profit 'enters
4ova !ntertainment 5roup Service Department 'harges to 4!5 Divisions For the 6ear !nded Decem"er #1, $%%& *heme Par+ Division ovie Production Division

Service Department

Purc"asi g Payroll accou ti g <egal 5otal service !epart(e t c"arges

$250,000 204,000 25,000 $47#,000

$150,000 51,000 225,000 $426,000

4ova !ntertainment 5roup Divisional 9ncome Statements For the 6ear !nded Decem"er #1, $%%&
*heme Par+ Division ovie Production Division

6eve ues ,perati g e&pe ses % co(e .ro( operatio s

$6,000,000 2,4#5,000 $3,505,000

$2,500,000 405,000 $2,0#5,000

% co(e .ro( operatio s before service department charges.

4ova !ntertainment 5roup Divisional 9ncome Statements For the 6ear !nded Decem"er #1, $%%&
*heme Par+ Division ovie Production Division

6eve ues ,perati g e&pe ses % co(e .ro( operatio s <ess service !ept/ c"arges4 Purc"asi g Payroll accou ti g <egal 5otal service !epart(e c"arges % co(e .ro( operatio s

$6,000,000 2,4#5,000 $3,505,000 $ 250,000 204,000 25,000 t $ 47#,000 $3,026,000

$2,500,000 405,000 $2,0#5,000 $ 150,000 51,000 225,000 $ 426,000 $1,66#,000

Transfer Pricing

5ra s.er Prici g

="e !ivisio s tra s.er pro!ucts or re !er services to eac" ot"er, a transfer pricing is use! to c"arge .or t"e pro!ucts or services

)e e.its o. 5ra s.er Prici g

1/ $ivisio s ca 1e evaluate! as profit or investment ce ters/ 2/ $ivisio s are forced to control costs a ! operate co(petitively/ 3/ %. !ivisio s are per(itte! to 1uy co(po e t parts w"erever t"ey ca .i ! t"e 1est price 8eit"er i ter ally or e&ter ally:, tra s.er prici g will allow a co(pa y to ma imize its profits/

Transfer Pricing
> 'oncept ,) ? *ransfer price is defined as the value placed on transfer of goods or services among t:o or more profit centers; ? For selling profit center, the transfer price is ma<or determinant of its revenue and hence its profits; ? For "u0ing profit center, the transfer price is ma<or determinant of the e7penses incurred and hence its profit; ? *he price of inter divisional sales affects the selling divisional sales and "u0ing divisional cost; ? *ransfer price is fundamentall0 an attempt to simulate e7ternal mar+et condition :ithin the organi=ation; ? *:o divisions can "e made completel0 independent of each other;
MICS-HJB 22

Transfer Pricing
Profit Centre Input
Money Cost Input are related to Output

Output EC RC
Money Profit

Production

Marketing

Business Unit

Buying cost

Selling cost Selling cost Variable cost i!ed cost Profit "argin Buying cost Variable cost i!ed cost

MICS-HJB

23

*ransfer Pricing
> O"<ectives , ? 9t should provide each segment :ith the relevant information re/uired to determine the optimum trade > off "et:een compan0 cost and revenue; ? 9t should induce goal congruent decisions; ? Decisions regarding division and compan0 @ ? 9t should help measure the economic performance of individual profit centers; ? *he s0stem should "e eas0 to administer;

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*ransfer Pricing
> echanism of *ransfer Pricing , ? *ransfer price, means the value placed on a transfer of goods or services in transaction; ? *he FU4DA !4*A3 PR94'9P3! is that the transfer price should "e similar to the price that :ould "e charged if the product :ere sold to out side customers or purchased from out side supplier; ? Ahen profit center of an organi=ation "u0 product from and sell to one other, t:o decision are to "e carried out and revie:ed periodicall0; > Sourcing Decision , Should the compan0 produce the product inside the compan0 or purchase it from an out side vendor B > *ransfer Price Decision , 9f produced inside, at :hat price should "e the product transferred to ne7t centre B ? 9t starts from simple to e7tremel0 comple7 depending upon the nature of "usiness;

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*ransfer Pricing
> *he 9deal situation ,
? *ransfer price :ill induce goal congruence if all the conditions listed "elo: e7ist; ? 'ompetent People , anagers interested in long run and short run performance and staff involved in negotiation and ar"itration of transfer price; ? 5ood Atmosphere , *he0 should perceive that it is a mechanism; ? ar+et Price , 9t should "ased on :ell esta"lished mar+et price, :hich reflects same conditions li+e /uantit0, /ualit0, deliver0 time, etc; ? Freedom to Source , Bu0ing manager should have freedom to "u0 from out side and selling manager should have freedom to sell out side; ? Full of 9nformation , anagers must have all information a"out the alternatives and cost; ? 4egotiation , Smooth mechanism for contract "et:een "usiness units;

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*ransfer Pricing
> 5"e 7o strai ts o Sourci g 4
? % actual all t"ese co !itio s are ot prese t t"e (a@or s"ort .alls are 4 ? 3imited ar+et , ar+et for "u0ing or selling is limited due to several reasons; > !7istence of internal capacit0 limit the development of e7ternal sales; > 9f compan0 is sole producer of a differentiated product no out side source e7ists; > 9f compan0 has developed significant facilities, it does not allo: to use out side sources unless out side selling price approaches the compan0Cs varia"le cost; ? !7cess or Shortage of 'apacit0 , > 9f selling unit can not sell all it can produce is e7cess capacit0; *he profit can not "e optimi=e if "u0ing unit purchase from out side suppliers; > 9f "u0ing unit can not o"tain product it re/uires from out side :hile selling unit is selling it out side is shortage of capacit0; Out put of "u0ing unit constrained;

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*ransfer Pricing
> ethod of 'alculating *ransfer Prices ,
? B0 availa"le 'ompetitive Price , ? Pu"lished mar+et price; ? ar+et price "0 DB9DE ? 9f selling profit centre sells product in out side mar+et, it can replicate the price; ? 9f "u0ing profit centre purchase similar product from out side mar+et, it can replicate the price; ? 'ost Base *ransfer Price , ? *he 'ost Basis > usual "asis of standard cost; ? *he Profit ar+ up > consideration of profit;
> Percentage of cost, no account of capital re/uired; > Batter "ase is percentage of investment "ut there are t:o pro"lems, one is historical cost and other is level of profit; Standard cost is to "e considered;
MICS-HJB 28

*ransfer Pricing
> ethod of 'alculating *ransfer Prices , ? Upstream Fi7ed 'ost and Profit , ? Agreement Among Business Units ? *:o > Step Pricing ? Profit Sharing ? *:o Sets of Prices

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*ransfer Pricing
> ethod of 'alculating *ransfer Prices , ? Upstream Fi7ed 'ost and Profit , > *ransfer price can create a significant pro"lem in an integrated compan0; > *he profit centre selling product out side ma0 not a:are a"out the upstream fi7ed cost and profit included; > 9f a:are, ma0 "e reluctant to reduce its o:n profit to compan0Cs optimi=ed profit; ? Agreement Among Business Units , > A mechanism :here representative of "u0ing and selling unit meet to periodicall0 and decide on the profit :ith significant upstream fi7ed cost;
MICS-HJB 30

*ransfer Pricing
> ethod of 'alculating *ransfer Prices ,
? *:o > Step Pricing ,
> Another :a0 is, to include t:o charges, that is standard varia"le cost for each unit sold and periodic charges ? monthl0 @ :hich is e/ual to related :ith facilities reserved for the "u0ing unit; > !7ample , Unit ) F is transferring product A to Unit > 6 !7pected monthl0 sales to "usiness unit 6 1%%% units (aria"le cost per unit 1 Rs onthl0 fi7ed cost assigned to product $%%%% Rs 9nvestment in :or+ing capital and facilities 1$%%%%% Rs 'ompetitive return on investment per 0ear 1% G *ransfer price calculation , (aria"le cost per unit 1 Rs Fi7ed cost per unit ? $%%%% H 1%%% @ . Rs Profit per unit ?? %;1% I?1$%%%%% H 1$ @@ H 1%%% @ $ Rs *otal 11 Rs
MICS-HJB 31

*ransfer Pricing
> ethod of 'alculating *ransfer Prices ,
> > > > 9f 1%%% units are transferred amount is 11I1%%% 11%%% Rs 9f .%%% units are transferred amount is 11I.%%% ..%%% Rs 9f &%%% units are transferred amount is 11I&%%% &&%%% Rs; *his is normal calculation, t:o > step pricing method as doing some thing different; > For 1%%% unit
? onthl0 fi7ed cost ? Return on investment ? %;1%I? 1$%%%%% H 1$ @ ? (aria"le cost ? 1 I 1%%% @ ? *otal $%%%% Rs 1%%%% Rs $1%%% Rs 11%%% Rs 1%%%% Rs &%%%% Rs

> For .%%% unit

? #%%%% J ? 1 I .%%% @

> For &%%% unit

? #%%%% J ? 1 I &%%% @

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*ransfer Pricing
> ethod of 'alculating *ransfer Prices ,
> Under t:o > step pricing method, compan0Cs varia"le cost for product ) A is identical to Unit ) 6; Unit > 6 can ta+e short ) term corrective action; 9t is also having information of up stream fi7ed cost an profit relating to product > A :hich can "e use for long > term action; > *he monthl0 charge for fi7ed coast and profit should negotiated periodicall0; > Assigning cost to individual product is not difficult; > anufacturing unit performance is not affected "0 sales volume; > *here could "e a conflict "et:een the interest of manufacturing unit and compan0 in case of capacit0 limited; > ethod is similar to Dta+e or pa0E

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*ransfer Pricing
> ethod of 'alculating *ransfer Prices ,
? Profit Sharing ,
> 9f t:o > step pricing method not feasi"le, a profit sharing is used; > *he product is transferred at standard varia"le cost; > Profit is contri"uted after selling the product; ? Selling price > (aria"le manufacturing cost > ar+eting cost @ > Applica"le :ere demand is not stead0;

? *:o Sets of Prices ,

> 9t is used :hen there are fre/uent conflicts "et:een "u0ing and selling unit and can not resolve "0 an0 other method; > anufacturing unit revenue is credited at the out side selling price; > Bu0ing unit charged to a total standard cost; > Difference is charged to head office and eliminated at the time of "usiness unit statement is consolidated;
MICS-HJB 34

7o((o ly Bse! 5ra s.er Prices

1/ !ar"et price approach sets t"e price at w"ic" t"e pro!uct tra s.erre! coul! 1e sol! to outsi!e 1uyers/ 2/ #egotiated price approach allows !ece traliAe! (a agers to agree 8 egotiate: a(o g t"e(selves/ #; Cost price approach $variable or full% uses a variety o. cost co cepts .or setti g t"e tra s.er price/

7o((o ly Bse! 5ra s.er Prices

(aria"le 'ost per Unit -1%

Full 'ost per Unit -1#

ar+et Price per Unit -$%

4egotiated Price

*ransfer Pricing4egotiated Price Approach

Assumptions 1/$ivisio M pro!uces a pro!uct wit" a varia1le cost o. $10 per u it/ $ivisio M "as u use! capacity/ 2/$ivisio * purc"ases 20,000 u its o. t"e sa(e pro!uct at $20 per u it .ro( a outsi!e source/ %. t"e !ivisio (a agers agree o a price o. $15 per u it, "ow (uc" will eac" !ivisio Cs i co(e i creaseD

Responsibility Accounting for &nvestment Centers

% a i vest(e t ce ter, t"e u it (a ager "as t"e respo si1ility a ! t"e aut"ority to (a2e !ecisio s t"at a..ect ot o ly costs a ! reve ues 1ut also t"e assets i veste! i t"e ce ter/

9nvestment 'enters
Datalin+ 9nc; Divisional 9ncome Statements For the 6ear !nded Decem"er #1, $%%& 4orthern Division 'entral Division Southern Division

6eve ues ,perati g e&pe ses % co(e .ro( operatio s 1e.ore service !ept/ c"arges Service !epart(e t c"arges % co(e .ro( operatio s % veste! assets 6ate o. retur o i vest(e t

$560,000 336,000 $224,000 154,000 $ 70,000

$672,000 470,400 $201,600 117,600 $ 84,000

$750,000 562,500 $187,500 112,500 $ 75,000

$350,000 $700,000 $500,000 20E 12E 15E 20E 12E 15E

6ate o. 6etur o % vest(e t 86,%:

Revenues

6ate o. 6etur o % vest(e t 86,%:

Profit Profit argin

9nvestment *urnover

6ate o. 6etur o % vest(e t 86,%:

5"e profit margin i !icates t"e rate o. pro.it o eac" sales !ollar/

5"e investment turnover i !icates t"e rate o. sales o eac" !ollar o. i veste! assets/

9nvestment *urnover

Profit argin

6ate o. 6etur o % vest(e t 86,%:

6,% ; % co(e .ro( operatio Sales 6,% ; $ 70,000 $560,000 &

Sales & % veste! assets

$560,000 $350,000

6,% ; 12/5E & 1/6 ; $%G

6ate o. 6etur o % vest(e t 86,%:

6,% ; % co(e .ro( operatio Sales

Sales & % veste! assets

Pro.it Margi

% ve tory 5ur over

Profit

argin

4orthern Division

'entral Division

Southern Division

% co(e .ro( operatio s 6eve ues 8Sales: Profit margin 9nvestment *urnover 6eve ues 8Sales: % veste! assets 9nvestment turnover Return on 9nvestment ?RO9@ % co(e .ro( operatio s % veste! assets Rate of return on investment

$ 70,000 $560,000 12/5E $560,000 $350,000 1/6 $ 70,000 $350,000 20E

$ 84,000 $672,000 12/5E $672,000 $700,000 /#6 $ 84,000 $700,000 12E

$ 75,000 $750,000 10/0E $750,000 $500,000 1/5 $ 75,000 $500,000 15E

9ncome from Operations

>

inimum Accepta"le Rate of Return on Assets

Residual 9ncome

Bald:in 'ompan0 Divisional 9ncome Statements For the 6ear !nded Decem"er #1, $%%& 4orthern Division 'entral Division Southern Division

% co(e .ro( operatio s Mi i(u( accepta1le i co(e .ro( operatio s as a perce t o. i veste! assets4 $350,000 & 10E $700,000 & 10E $500,000 & 10E 6esi!ual i co(e

$70,000 $84,000 $75,000

35,000 70,000 50,000 $35,000 $14,000 $25,000

5"e balance scorecard is a set o. .i a cial a ! o .i a cial (easures t"at re.lect (ultiple per.or(a ce !i(e sio s o. a 1usi ess/

9nnovation and 3earning

> > > > 6F$ i vest(e t 6F$ pipeli e S2ills a ! trai i g 5i(e to (ar2et

'ustomer
> Satisfaction > <oyalty > Perceptio

Financial
> > > > > 6,% 6esi!ual i co(e Pro.it 7ost Sales

> 0..icie cy > Guality > 5i(e

9nternal Process

5"e 0 !