Bhakti Nagara Arifianto/1906456490 - 192 DK1

CH 10 – Decentralization: Responsibility Accounting, Performance Evaluation, and

Transfer Pricing

1. What is decentralization? Explain why firms choose to decentralize.

Decentralization is an approach of firms with multiple responsibility centers to manage
their diverse and complex activities by allowing managers at lower levels to make and
implement key decisions pertaining to their areas of responsibility. In shorter words, it is
the practice of delegating decision-making authority to the lower levels.
They’re some reasons firms choose to decentralize:
 Better access to local information
 Cognitive limitations
 More timely response
 Focusing of central management
 Training and evaluation of segment managers
 Motivation of segment managers
 Enhanced competition

2. What are margin and turnover? Explain how these concepts can improve the
evaluation of an investment center.
The two ratios of “Return of Investment formula”: Margin and Turnover.
Margin is the ratio of operating income to sales while turnover is found by dividing sales
by average operating assets.
Example of how these concepts can improve the evaluation of an investment center:
Consider there are two division Kantin BEI and Kantin BPKP

Kantin BPKP Kantin BEI Kantin BPKP Kantin BEI

Tahun 2018 Tahun 2018 Tahun 2019 Tahun 2019
Sales Rp160.000.000 Rp320.000.000 Sales Rp150.000.000 Rp420.000.000
Operating Income Rp10.000.000 Rp20.000.000 Operating Income Rp10.000.000 Rp25.000.000
Beginning Assets Rp35.000.000 Rp65.000.000 Beginning Assets Rp35.000.000 Rp95.000.000
Ending Assets Rp45.000.000 Rp95.000.000 Ending Assets Rp45.000.000 Rp65.000.000
Average operating assets Rp40.000.000 Rp80.000.000 Average operating assets Rp40.000.000 Rp80.000.000
Margin 6,25% 6,25% Margin 6,67% 5,95%
Turnover 4 4 Turnover 3,75 5,25
ROI 25,00% 25,00% ROI 25,00% 31,25%
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At the second year, Kantin BPKP generate more sales but having the same operating
income as previous year, while Kantin BEI generate more sales and more operating
income than previous year. Despite the declining margin at the second year (could be
because of increase in expenses or competitive pressures in its area), Kantin BEI
increased its rate of return. The increase resulted from an increase in the turnover rate that
more compensated for the decline in margin, indicating that it is using its operating assets
more effectively than Kantin BPKP and could generate more income despite having
lower margin.

3. What are the three benefits of ROI? Explain how each benefit can lead to improved
profitability.
They’re 3 benefit of using ROI to evaluate performance:
 Encourages investment center managers to focus on the relationship between
sales, expenses, and investment
ROI encourages managers to consider the interrelationship of income and investment.
 Encourages cost efficiency
The Manager of an investment center always has control over cost. Therefore, increasing
efficiency through judicious cost reduction is a common method of increasing ROI.
 Discourages excessive investment in operating assets
Division that have cut costs to the extent possible must focus on investment reduction.
For example, applying just in time system to reduce material and WIP inventory.

4. What is residual income? What is EVA? How does EVA differ from the general
definition of residual income? Can residual income or EVA ever be negative? What
is the meaning of negative residual income or EVA?
 Residual income is an alternative performance measurement to avoid manager who
tends to use ROI to turn down investments that are profitable for the company. It is
difference between operating income and the minimum rupiah return required on a
company’s operating assets.

RI = Operating income − (Minimum rate of return × Operating assets)

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 Another alternative is Economic Value Added (EVA). It is after-tax operating income

minus the total annual of capital. Over the long term, only those companies creating
capital or wealth can survive, therefore to adjust management compensation EVA
could encourage managers to use existing and new capital for maximum gain.

EVA = After-tax operating income – (Weighted average cost of capital × total capital employed)

 Both residual income and EVA could be negative. Negative in RI means the
operating income doesn’t fulfill the minimum rate of return from operating assets.
Negative in EVA means company destroying wealth by not generating an after-tax
operating income required for the cost of capital from total capital employed.

5. What is a transfer price? Briefly explain three common transfer pricing policies
used by organizations.
Transfer prices are the prices charged for goods produced by one division and
transferred to another as the output of one division can be used as input for another
division. The price charged affects the revenues of the transferring division and the costs
of receiving division. As the result, the profitability, ROI, and managerial evaluation of
both divisions are affected.

There are three common transfer pricing policies used by organizations:

1. Market Prices
If there is an outside market for the good to be transferred and the market is
perfectly competitive, this will be the correct transfer prices policy.

2. Negotiated Transfer Prices

In fact, perfectly competitive markets are rarely existed. In most cases, producers
can influence price. When imperfections exist in the market for the intermediate
produce, market price may no longer be suitable.

3. Cost-Based Transfer Prices

The standard costs should be used to avoid passing on the inefficiencies of one
division to another. Cost-based transfer prices consists of these forms:
a. Full-cost Transfer Pricing
b. Full-cost Plus Markup
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c. Variable-cost Plus Mixed Fee

Full-cost transfer pricing and full cost plus markup are simple and objective but
provide perverse incentives and distort performance measures, while Variable cost
plus fixed fee is useful if fixed fee is negotiable, and in other hand, variable cost is
selling division's opportunity cost if it is operating below capacity