Decentralization, Segment Reporting and Transfer Pricing

Decentralization and Segment Reporting:

When an organization grows beyond a few people, it becomes impossible for the top manager to make decisions about everything.

Managers have to delegate decisions to some degree to those who are at lower levels in the organization. However the degree to which decisions are delegated varies from organization to organization.

Decentralization in organizations:

A decentralized organization is one in which decision making is not confined to a few top executives but rather is throughout the organization, with managers at various levels making key operating decisions relating to their sphere of responsibility. Decentralization is a matter of degree, since all organizations are decentralized to some extent out of necessity. At one extreme, a strongly decentralized organization is one in which even the lowest-level managers and employees are empowered to make decisions. At the other extreme, in a strongly decentralized organization, lower-level managers have little freedom to make decisions. Click here to read full article about definition, advantages and disadvantages of decentralization.

Traceable and common fixed costs:

The most puzzling aspect of segmented income statements is probably the treatment of fixed costs. While preparing segmented income statements the fixed cost is divided into tow parts on is traceable fixed cost and other is common fixed cost. Only traceable fixed costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments. Click here to read full article for definition, examples and explanation of traceable and common fixed costs.

Segment reporting and profitability analysis-segmented income statements:

A different kind of income statement is required for evaluating the performance of a profit or investment center. This income statement should emphasize on the segment rather than the performance of the company as a whole. A contribution margin  format income statement is used to evaluate the performance of different segments. In a contribution margin format income statement cost of goods sold consists only of the variable manufacturing costs. Click here to read full article.

Hindrances/Problems to Proper Cost Assignment in Segmented Reporting:

For segment reporting to accomplish its intended purposes, costs must be properly assigned to segments. If the purpose is to determine the profits being generated by particular segment or division, then all of the costs attributable to that division or segment–and only those costs–should be assigned to it. Unfortunately, three practices greatly hinder proper cost assignment:

  1. Omission of some costs in the assignment process.
  2. The use of inappropriate methods for allocating costs among segments of a company.
  3. The assignment of costs to segments when they are really common costs. Click here to continue

Segmented Financial Information on External Reports:

The Financial Accounting Standards Board (FASB) now requires that companies in the united states include segmented financial and other data in their annual reports and that the segmented reports prepared for external users must use the same method and definitions that the companies use in internal segmented reports that are prepared to aid in making operating decisions. This is a very usual requirement. Click here to continue reading.

Return on Investment (ROI) for Measuring Managerial Performance:

In a truly decentralized company, segment managers are given a great deal of autonomy. Profit and investment centers are virtually independent businesses, with their managers having about the same control over decisions as if they were in fact running their own independent firms. With this autonomy, fierce competition often develops among managers, with each striving to make his or her segment the “best” in the company. Competition between investment centers is particularly keen for investment funds.  How do managers in corporate headquarters go about deciding who gets new investment funds as they become available and how do these managers decide which investment centers are most profitability using the funds that have already been entrusted to their care?  One of the most important ways of making these judgments is to measure the rate of return that investment managers are able to generate on their assets. This rate of return is called the return on investment (ROI). Click here to read full article.

Controlling and Improving Rate of Return on Investment:

Return on investment is normally used to judge the managerial performance in an investment center. Managers therefore try to control and improve the ROI of their investment center. Click here to read full article.

Return on Investment (ROI) and Balanced Scorecard:

Simply exhorting managers to increase return on investment (ROI) is not sufficient. Managers who are told to increase return on investment (ROI) will naturedly wonder how this is to be accomplished. Generally speaking, ROI can be increased by increasing sales, decreasing costs, and/or decreasing investments in operating assets. However it may not be obvious to managers how they are supposed to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. Click here to continue reading

Criticism, Disadvantages or Limitations of Return on Investment (ROI):

Although the return on investment is widely used in evaluating performance, it is not a perfect tool. It is not without criticism. Click here to continue reading.

Residual Income-Another Method to Measure Managerial Performance:

Residual income is the net operating income that an investment center earns above the minimum required return on its operating assets. Residual income is another approach to measuring an investment center’s performance. Economic Value Added (EVA) is an adoption of residual income that has recently been adopted by many companies. Under EVA, companies often modify their accounting principles in various ways. For example funds used for research and development are often treated as investment rather than as expenses under EVA. These complications are best dealt with in more advanced courses. Here we will focus on the basics and will not draw any distinction between residual income and EVA. Click here to read full article.

Limitations, Criticism or Disadvantage of Residual Income Method:

The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. You would expect larger divisions to have more residual income than smaller divisions, not necessarily because they are better managed but simply because they are bigger. Click here to continue.

Transfer Pricing:

Definition of Transfer pricing:

A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. For example, most companies in the oil industry have a petroleum refining and retail sales divisions that are usually evaluated on the basis of return on investment (ROI) or residual income method.

The petroleum refining division processes crude oil into gasoline, kerosene, and other end products. The retail sales division takes gasoline and other products from the refining division and sells them through the company’s chain of service stations. Each product has a price for transfers within the company. Suppose the transfer price for the gasoline is $0.80 a gallon. Then the refining division gets credit for $0.80 a gallon of revenue on its segment report and the retailing division must deduct $0.80 a gallon as an expense on its segment report. Clearly the refining division would like the transfer price as high as possible, whereas the retailing division would like the transfer price to be as low as possible. However, the transaction has no direct effect on the entire company’s reported profit. It is like taking money out of one pocket and putting it into the other.

Managers are intensively interested in how transfer prices are set, since transfer prices can have a dramatic effect on the apartment profitability of a division. Three common approaches are used to set transfer prices.

  1. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
  2. Set transfer prices at cost using variable or full (absorption) cost
  3. Set transfer prices at the market price

Divisional Autonomy and Sub optimization:

How much autonomy should be granted to divisions in setting their own transfer prices and in making decisions concerning whether to sell internally or to sell outside? Should the divisional heads have complete authority to make these decisions, or should top corporate management step in if it appears that a decision is about to be made that would result in sub optimization? For example, if the selling division has idle capacity and divisional managers are unable to agree on a transfer price, should top corporate management step in and force a settlement? Click here to continue reading.

International Aspects of Transfer Pricing:

The objective of transfer pricing change when multinational corporations involved and the goods and services being transferred cross international borders. The objective of international transfer pricing focus on minimizing taxes, duties, and foreign exchange risks, along with enhancing a company’s competitive position and improving its relations with foreign governments. Click here to continue.

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