Performance Evaluation of Business Units PERTEMUAN XIII Dr Rilla Gantino, SE., AK., MM MM-FEB

  Performance Evaluation of Business Units PERTEMUAN XIII Dr Rilla Gantino, SE., AK., MM MM-FEB

KEMAMPUAN AKHIR YANG DIHARAPKAN

  Mahasiswa memahami tentang konsep penilaian kinerja bisnis melalui pemahaman tentang konsep desentralisasi

  Agenda

• Decentralization
• – Proft centers and proft computations
• – Transfer pricing
• National Youth Association • HCC Industries • Group problem solving

Decentralization and performance evaluation

  Performance evaluation becomes necessary when decision rights are delegated.

  Do owners evaluate

managerial inputs or outputs? Decentralization: Why?

• Environment • Information specialization
• Timeliness of response

• • Conservation of central management

  time
• Computational complexity
• Training of local managers
• Motivation of local managers

Responsibility centers:

• Standard cost centers - production variances
• Revenue centers - revenue variances
• Discretionary expense centers
• Proft centers - some measure of proft

• • Investment centers - some proftability

  measure (e.g., ROI or residual income)

Problems associated with decentralization:

• Goal congruence
• Externalities • Over-consumption of perquisites

Responsibility accounting:

  This refers to the various concepts and tools used by managerial accountants to measure the performance of people and departments in order to foster goal

Key concepts in responsibility accounting:

• Controllability • The controllability principle
• Controllability problems
• Traceability

Designing an accounting-based performance measure:

• Representing fnancial (and other) goals
• Choosing income and investment numbers

• • Choosing measures for income and

  investment numbers
• Choosing a target
• Choosing the timing of feedback

Proft centers:

  Proft center: A proft center is a unit for

which the manager has the authority to make

decisions on sources of supply and choices of

markets.

  Proft measurement: Variable contribution margin Controllable contribution Divisional contribution

John Daly

  Suppose that a year or more ago, John Daly, who owned the rights to produce a nifty new product, believed the product, Nifty, would be quite proftable if economical production facilities could be located. After much investigation, John located a small building on the edge of town that was reasonably cheap, even though it was actually somewhat larger than he needed.

John Daly continued:

  

The building contained 150,000 square feet of

usable space and cost $100,000 per year to

rent. John’s manufacturing operation required

about 75% of this space.

  In his frst year of operation, the company earned about $100,000 in operating income.

  John paid his manager a salary, but rewarded exceptional efort by sharing profts.

  What was operating income before facility

John Daly continued

  A friend of John’s had an idea for using the excess space in the facility and he asked John to fnance the operation. Once the friend had explained his idea, John agreed.

  New equipment was purchased, and the new product, New, was manufactured and sold, along with Nifty, during the second year of operation. There was no incremental increase in the cost of the facility or its maintenance.

John Daly continued

  

Once the costs that could be directly associated

with the new product were deducted, operating

profts had increased by $25,000. Nifty’s results were the same as in year one.

  Required: Suppose John wants to defne each product line as a proft center and split profts with his managers ffty-ffty. What operating proft would you compute for the two product lines? How much bonus would each manager receive?

  

Investment centers: ROI and

Residual Income Investment centers: The manager has been given maximum discretion for making short-run operating decisions on product mix, pricing and production methods, as well as the level and type of assets to be used.

  Income Income Sales ROI

•   Investment Sales Investment

Simple example: ROI

  The Division A manager earns $50,000 on his controllable investment of $350,000. His ROI is:

  $50,000 ROI 100 * % 14 . 3 % 

   $350,000

  What income number? What investment number?

Residual income

  Residual income is as close as an accountant comes to computing economic profit. It is operating income after paying all providers of capital.

  Residual income = Operating income - the cost of capital

  Cost of capital = demanded rate of return Simple example: Residual income

  Division A: Operating income $50,000

  Cost of capital (42,000) Residual income $ 8,000

  

The cost of capital in dollars is just the per dollar opportunity

Providers of capital demand 12% on average.

  This is the opportunity cost of their capital. Which performance measure is better? Simple example: The investors’ cost of capital remains 12% throughout.

Division A:Assets = $350,000

  Income = $50,000 ROI = 14.3%

  Suppose the division manager is considering investing $15,000 in an asset that will earn $2,000 in income.

  Decision 1: Will she take the investment? % 3 .

  13   $15,000 $2,000 ROI than less is return l Incrementa

  % 3 . 14 % 2 .

  14    $365,000 $52,000 ROI after Division

  Would the providers of capital want her to take it?

  Decision 2: Simple example

Suppose the division manager is considering disposing

of an asset with a book value of $20,000 which earns $2,500 in income during any accounting period. Will he dispose of the asset?

  $2,500 Asset' s ROI 12 . 5 %   _{Division ROI after} $20,000 _{   $330,000 $47,500 14 . 4 % 14 . 3 %}

  What do providers of capital want him to do?

  Residual income: Decision

  evaluation measure is residual income. Will the manager choose to invest in a new assets that makes $2,000 per year and costs $15,000?

  What is the current residual income? $8,000 New residual income: $52,000 controllable cont.

  (43,800) new cost of capital Residual income: Decision

  residual income dispose of an asset with annual earnings of $2,500 and a book value of $20,000?

  New residual income$47,500 controllable cont.

  (39,600) new cost of capital $ 7,900 new residual income

Compare divisons: ROI and residual income

  Division A Assets: $350,000 Contrib: $50,000 ROI: 14.3%

  Division B Assets: $250,000 Contrib: $37,500 ROI: 15%

  Which division is more profitable? What rate of return does the larger division make on its additional assets?

  Proft centers: HCC

Industries

• Participatory budgeting

• • Setting budget performance targets

• Risk sharing and risk setting
• Communicating using the budget
• There are no actual calculations to do for HCC Industries • Pay attention to the probabilities

  Proft centers and transfer pricing:

  TRANSFER PRICE A PRICE CHARGED BY ONE SEGMENT OF AN ORGANIZATION FOR A PRODUCT OR SERVICE THAT IT SUPPLIES TO ANOTHER SEGMENT OF THE ORGANIZATION.

Objectives of transfer pricing schemes:

• • Encourage managers to make decisions

  that are in the organization’s best interest.
• Provide information for evaluation of business units and managers.
• Minimize tax obligations (we will ignore) Constraint: The scheme chosen should require little intervention by top management.

The unifying principle is opportunity cost:

  The general transfer pricing rule: T = VC + OC

  VC = OUTLAY COSTS INCURRED TO THE POINT OF TRANSFER; USUALLY APPROXIMATED BY STANDARD VARIABLE COST

  OC = OPPORTUNITY COST TO THE FIRM (I.E., CONTRIBUTION FOREGONE = CM)

  Note that CM = SP - VC, so VC + OC = SP - the market price

Transfer pricing: Crossville Company

  

At practical capacity, the Fabricating Division of Crossville Company has facilities

to produce 8,000 units per month. Each unit requires five direct labor hours. The

Assembly Division has forwarded a requisition for 8,000 units to the Fabricating Division. Since Crossville uses a market-based transfer pricing system, contribution margin using a $50 market price would be $168,000. Georges, Inc., a competitor, also sells the units for $50. The receipt of this requisition from Assembly upset the Fabricating manager as he had just been approached by an outside buyer with a rush order for 5,000 units at a $56 unit selling price.

  Top management’s initial reaction is to reject the offer.

  Crossville Company

  B. What is the minimum transfer price required by the selling division, Fabricating? $53.75, the immediate average market price

  

C. What is the maximum transfer price required by the

buying division?

  $50, the price it would pay to Georges

  Crossville Company

  Buying Division Selling Division

  

$50 or less $53.75 or more Crossvillle Company

  Which of the following circumstances will lead to goal congruence between the managers and the overall firm? Why? 1. The policy enforced is market price transfers.

  Will the managers agree to transfer? No, the Fabrication manager sells outside.

  Is the transfer in the best interest of the company?

  Crossville Company

  Is the transfer in the best interest of the company? Minimize costs:

  Internal transfer: Relevant cost of product = $53.75 Note: $168,000 / 8,000 = $21 = CM/unit Therefore, VC = $29 per unit External transfer: Fab: ($53.75) - 29 = ($24.75)

  Assy: $50.00 Relevant cost of product = $25.25 Crossville Company 2. Fabricating has adequate idle capacity.

  This means that there is no meaningful market price for the items that would be transferred.

  Internal transfer: Fab’s outlay cost = $29 Assy’s outlay cost = $0 External transfer Fab’s outlay cost = $0 Assy’s outlay cost = $50

  What price will the Fabrication manager ask?

  Crossville Company

  3. Fabricating is forced to transfer product in lieu of selling 5,000 units outside.

  Fabrication manager gets $50 Assembly manager pays $50 Internal transfer: $53.75 relevant cost External transfer: $24.25 relevant cost

  The managers will act against the company’s best interest.

Negotiated market-based prices:

• • Some form of outside market for the

  intermediate product.
• Sharing of all market information among the negotiators.

• • Freedom to buy or sell outside. This

  provides the necessary discipline to the bargaining process.

• • Support and occasional involvement

Its limitations:

• Time consuming
• Leads to confict within frms
• It makes the measurement of divisional proftability sensitive to the negotiating skills of managers.
• It requires the time of top management to oversee and mediate.
• It may lead to a suboptimal level of

  NYA • Transfer pricing.

• Reward functions are as follows:
• – Total points = 300
• – Your fraction of the 300 points:

  Your team’s margin/Overall corporate margin

• These points will be used to award class participation credit.