CHAPTER 12

PERFORMANCE EVALUATION IN DECENTRALIZED ORGANIZATIONS

TRUE/FALSE

1. Decentralizing authority empowers employees at the higher levels.

LO1 False Decentralizing authority empowers employees at the lower levels.

2. Ensuring smooth succession is important for the survival of any company.

LO1 True

3. Decentralization worsens the problem of divergence between individual and organizational goals by
preventing lower-level managers from preparing to move to upper-level positions.
LO1 False Decentralization worsens the problem of divergence between individual and
organizational goals by giving control over organization resources to lower-level managers who are
far-removed from the top management of the firm.

4. Organizations use monitoring, performance evaluation, and incentive schemes to manage the cost
of delegating decisions.
LO1 True

5. Cost center managers are charged with minimizing the cost of producing a specified level of output
or the cost of delivering a specified level of service.
LO1 True

6. Production managers have little control over the volume of production.

LO2 True

7. The controllability principle is always the right approach for choosing performance measures.
LO2 False While intuitive, the controllability principle is not always the right approach for choosing
performance measures. Instead, we should rely on informativeness.

8. Most controllable measures are informative; however an informative measure is not necessarily
controllable.
LO2 True

9. A characteristic of an effective performance measure is that it yields maximum information about

the decisions or actions of the individual or organizational unit.
LO2 True

10. A characteristic of an effective performance measure is that it is easy to understand and

communicate.
LO2 True

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11. Cost center managers serve two roles in organizations achieving cost targets for a given level of
output in the short term, and making continuous improvements to increase revenue in the long
term.
LO3 False Cost center managers serve two roles in organizations achieving cost targets for a
given level of output in the short term, and making continuous improvements to cut costs in the
long term.

12. Organizations typically use budget variances to measure cost center performance in the long-run.
LO3 False In the short term, organizations typically use budget variances to measure cost center
performance.

13. Suma is a philosophy of continuous improvement that encourages and rewards employees who
constantly seek and suggest improvements to activities and business processes.
LO3 False Kaizen is a philosophy of continuous improvement that encourages and rewards
employees who constantly seek and suggest improvements to activities and business processes.

14. Cost centers for which there is a clear relation between inputs and outputs are termed discretionary
cost centers.
LO3 False Cost centers for which there is a clear relation between inputs and outputs are termed
engineered cost centers.

15. Firms often use profit before taxes to evaluate profits centers, computed as contribution margin less
traceable fixed costs.
LO3 True

16. Managers of investment centers enjoy little autonomy in decentralized organizations.

LO4 False Managers of investment centers enjoy considerable autonomy in decentralized
organizations.

17. Normally, we exclude interest and taxes from the calculation of an investment centers profit results
from its operations because profit center managers usually do not influence financial or tax-related
decisions.
LO4 True

18. Net book value is the original acquisition cost of plant and equipment less accumulated
depreciation.
LO4 True

19. The major criticism against ROI is that it is not an effective summary measure of business
profitability.
LO4 False A major criticism against ROI is that it fosters underinvestment.

20. Residual income represents the additional profit or value generated by an investment after meeting
the required rate of return.
LO4 True

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21. When intra-company transfers occur, a legally recognized sale takes place even though the divisions
are part of the same company.
LO5 False When intra-company transfers occur, no legally recognized sales takes place because
the divisions are part of the same company.

22. From the perspective of determining corporate pre-tax income, a transfer price does not serve any
useful purpose.
LO5 True

23. Divisional managers have a keen interest in the transfer price because their individual compensation
often depends on the profit reported by their division.
LO5 True

24. Setting effective transfer prices is relatively simply because division managers strategic and
economic considerations for the company as a whole are the same.
LO5 False Setting effective transfer prices is difficult because the buying and selling divisions often
do not agree on what constitutes a fair price.

25. A common approach to setting transfer prices is using cost-based transfer prices (including variable
and full cost).
LO5 True

26. The profit for a selling department in an inter-company transfer is the transfer price without
considering costs.
Appendix False The profit for a selling department in an inter-company transfer is the transfer
price less the cost of the transfer.

27. The minimum price that the selling division wants from an inter-company transfer is the cost of the
transfer plus the opportunity cost of the transfer.
Appendix True

28. The maximum amount the buying division in an inter-company transfer is willing to pay is
opportunity cost.
Appendix True

29. In an inter-company transfer, as long as the maximum price the buying division is willing to pay is
higher than the minimum price the selling division is willing to accept, both divisions will agree to
the internal transfer at any price between these two amounts.
Appendix True

30. In an inter-company transfer, if the maximum price the buying division is willing to pay is less than
the minimum price the selling division is willing to accept, both divisions will never agree to the
internal transfer.
Appendix True

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MULTIPLE CHOICE

31. Which of the following is a type of decision a regional manager would make?
A. Pricing.
B. Promotion.
C. Office management.
D. A and B only.
E. A, B and C are decisions a regional manager would make.
LO1 E

32. Which of the following is not a benefit of decentralization?

A. Permits timely decisions with the best available information.
B. Better coordination of decisions.
C. Trains future managers.
D. Empowers employees and increases job satisfaction.
LO1-Pretest-B

33. The benefits of decentralization include all of the following except:

A. It forces top levels of management to focus on individual units.
B. It empowers more employees at lower levels of management.
C. It allows for better and more timely decision making.
D. It trains future managers.
LO1-Self test-A

34. Which of the following is not a benefit of decentralization?

A. Trains future managers.
B. Simple to coordinate decisions.
C. Empowers employees and increases job satisfaction.
D. Permits timely decisions.
E. All of the above are benefits of decentralization.
LO1 B

35. Which of the following is not a cost of decentralization?

A. Might lead to an emphasis on local versus global goals.
B. Requires costly coordination of decisions.
C. Leads to improper decisions due to divergence between individual and organizational goals.
D. Fails to train future managers.
E. All of the above are costs of decentralization.
LO1 D

36. Which of the following is not a responsibility center?

A. Investment center.
B. Cost center.
C. Administrative center.
D. Profit center.
E. All of the above are responsibility centers.
LO1 C

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37. Which of the following is not an example of a cost center?

A. Plant maintenance.
B. Sears store.
C. Human resources.
D. Data processing.
E. General administration.
LO1 B

38. Which of the following is not an example of a profit center?

A. Production department of a manufacturing plant.
B. An individual product line at Proctor and Gamble.
C. A retail store.
D. All of the above are examples of profit centers.
E. None of the above is an example of a profit center.
LO2 A

39. What is the main focus for a manager of a profit center?

A. Maximizing revenues and minimizing costs.
B. Maximizing revenues.
C. Minimizing costs.
D. Maximize returns from invested capital.
LO2-Posttest-A

40. What does the informativeness principle state about the choice of performance measures that are
selected by a company?
A. A performance measure is informative if it is controllable by the manager.
B. A performance measure is informative if it is evaluated relative to other firms in the industry.
C. A performance measure is informative if it reflects the consequences of the actions taken by the
decision maker.
D. A performance measure is informative if it provides information about a managers effort, even
if the manager does not have control over it.
LO2-Post test-D

41. A production manager should be held accountable for:

A. Production delays.
B. Production delays and overall volume of production.
C. Changing prices.
D. Changing prices and overall volume of production.
E. Losses due to natural disasters.
LO2 A

42. Income statements prepared by segment are useful when they are prepared:
A. On a cash basis.
B. In a multi-step format.
C. On a contribution (cost behavior) basis.
D. On an accrual basis.
LO2- Self test-C

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43. The CFO of Infinity Systems is deciding which performance measures to use for one of the
companys investment centers. Which three measures will help insure the performance
measurement system is most effective?
A. The measures should align employee and organizational goals, be easy to communicate and
generate the largest amount of revenues.
B. The measures should be easy to measure, easy to understand, and must generate the largest
profits.
C. The measures should align employee and organizational goals, be easy to measure, and easy to
understand.
D. The measures should be easy to measure, easy to communicate, and hold managers responsible
for as little as possible.
LO2-Pretest-C

44. Which of the following is not a characteristic of effective performance measures?

A. Is easy to understand and communicate.
B. Is easy to measure.
C. Separates employee and organizational goals.
D. Yields maximum information about the decisions or actions of the individual or organizational
unit.
E. All of the above are characteristics of effective performance measures.
LO2 C

45. Ideally, the best performance measures:

A. Reflect the decision rights assigned to the individual/organizational unit.
B. Yield the maximum information about the decisions or actions of the individual/organizational
unit.
C. Have low measurement error.
D. Are easy to understand and communicate.
E. All of the above.
LO2 E

46. To make effective trade-offs among the attributes of performance measures, organizations often
use:
A. A combination of performance measures.
B. Only financial performance measures.
C. Avoid using more than one measure.
D. Select a single performance measure that possesses of the characteristics of an effective
performance measure.
E. None of the above.
LO2 A

47. Which of the following is not a role of a cost center manager in an organization?
A. To achieve cost targets for a given level of output in the short term.
B. Making continuous efficiency improvements to cut costs in the long term.
C. To achieve sales targets for a given level of output.
D. Neither A nor B are roles of a cost center manager.
LO3 C

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48. Which of the following does not describe Kaizen?

A. Encourages and rewards employees who constantly seek and suggest improvements to activities
and business processes.
B. Is a philosophy of continuous improvement.
C. Involves comparing the effectiveness and efficiency of various activities and business processes
in a firm against the best practices in the industry.
D. None of the above statements describe Kaizen.
E. All of the above describe Kaizen.
LO3 C

49. A cost center for which there is a clear relation between inputs and outputs is referred to as a:
A. Discretionary cost center.
B. Budget center.
C. Engineered cost center.
D. Kaizen center.
E. None of the above.
LO3 C

50. Which of the following is not a performance measure used to evaluate a profit centers manager?
A. Customer satisfaction.
B. How well the manager utilizes funds made available to his/her division.
C. Employee turnover.
D. Market share.
E. All of the above are performance measures used to evaluate a profit centers manager.
LO3 B

51. Firms often view investment centers as:

A. Support activities.
B. Discretionary cost centers.
C. Stand-alone businesses.
D. Revenue centers.
E. None of the above.
LO3 C

52. Which of the following is not a popular measure of investment center performance?
A. Employee turnover.
B. Return on investment.
C. Residual income.
D. Economic value added.
E. None of the above.
LO4 A

53. When a company is attempting to increase return on investment (ROI) it should work to:
A. Decrease sales.
B. Decrease profits.
C. Increase costs.
D. Decrease operating assets.
LO4- Self test-D

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54. When measuring average operating assets, depreciable fixed assets may be included at any value
except:
A. Gross book value.
B. Net book value.
C. Current replacement value.
D. Original cost less estimated salvage.
LO4-Self test-D

55. The Gallagher Company is decentralized and has a required opportunity cost of capital of 20%. The
West division, whose current return on investment (ROI) is 15%, is considering an investment which
will earn a return of 18%. The East Division, whose current ROI is 25%, is considering an investment
which will earn a return of 22%. If the objective is to maximize ROI, each division will make the
following choice:
West East
A. Reject Accept
B. Accept Reject
C. Accept Accept
D. Reject Reject
LO4-Self test-B

56. Supercircuits is a decentralized company and has a required opportunity cost of capital of 15%. The
home computer division, whose current ROI is 10%, is considering an investment which will earn a
13% return. The gaming division, whose current ROI is 20%, is considering an investment which will
earn a 17% return. If the objective is to maximize residual income, each division will make the
following choice:
Computer Gaming
A. Reject Accept
B. Accept Reject
C. Accept Accept
D. Reject Reject
LO4-Self test-A

57. The Hoboken Company has two divisions, North and South. In July, contribution margin for North
was $126,000 and sales in the South division were $375,000 with a contribution margin ratio of 40%.
Traceable fixed costs for the divisions totaled $101,000. If net operating income was $69,000, then
total fixed costs must have been:
A. $106,000
B. $207,000
C. $282,000
D. $170,000
LO4-Self test-B

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58. The Brett Company has provided the following information for its two stores:
Store A Store B Total
Sales $700,000 $500,000 $1,200,000
Variable expenses 420,000 350,000 770,000
Contribution margin 280,000 150,000 430,000
Traceable fixed costs 80,000 50,000 80,000
Segment margin 200,000 100,000 300,000
Common fixed expenses 160,000
Net operating income $140,000
If Store B increases its sales by $50,000 with no change in fixed expenses the overall company net
income will:
A. Increase by $12,500.
B. Increase by $35,000.
C. Increase by $50,000.
D. Increase by $15,000.
LO4-self test-D

59. In 2013 the Yankee Company had average operating assets of $200,000. If the company reported a
return on investment of 50% then net operating income for 2013 must have been:
A. $100,000
B. $50,000
C. $400,000
D. $200,000
LO4-Self test-A

60. In 2013 the Porter Company reported the following information:

Sales $1,100,000
Average operating assets $600,000
Residual income $42,000
Return on investment 22%
The companys required rate of return was:
A. 11.3%
B. 33.3%
C. 15%
D. 29%
Lo4-Self test-C

61. The Greenberg Company reported average operating assets of $400,000 and sales of $1,200,000 in
2013. If the companys margin is 12%, their ROI must have been:
A. 24%
B. 36%
C. 33.3%
D. 40%
LO4-Self test-B

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62. The Allentown Company reported operating income of $25,000 for 2013. If average operating
assets for the year were $80,000 and the company had a required return of 12% the companys
residual income was:
A. $28,000
B. $22,000
C. $15,400
D. $6,600
LO4-Self test-C

63. The Grisham Company has reported the following information for 2013:
Net operating income after tax (NOPAT) $1,200,000
Invested capital $7,500,000
Current liabilities $980,000
Weighted average cost of capital 16%
The companys economic value added is:
A. $156,800
B. $220,000
C. $1,008,000
D. $851,200
LO4-Self Test-A

64. The Versa Company had the following results for 2013:
Net operating income $6,000
Turnover 3.5
ROI 15%
Versa Companys average operating assets were:
A. $140,000
B. $40,000
C. $490,000
D. $21,000
LO4-Self test-A

65. Quest Retail uses profit before taxes to evaluate its individual stores which are considered profit
centers. The following information is provided concerning the Southside store for 2013:
Contribution margin: $5,000,000
Traceable fixed costs: $2,000,000
Budgeted segment margin: $3,500,000
Last years segment margin: $2,900,000
How much are the variance from the budget and the variance from last year?
A. Budget: 14.29% U Last year: 3.45% F
B. Budget: 14.29% F Last year: 3.45% U
C. Budget: 16.67% U Last year: 3.33% F
D. Budget: 16.67% F Last year: 3.33% U
LO4-Pretest-A

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66. Stringer Co. compiled the following information from its financial records for its retail segment for
2013:
Sales revenue $ 6,700,000
Variable costs 4,000,000
Total assets 14,400,000
Traceable fixed costs 920,000
Income taxes 850,000
Calculate ROI for Stringer assuming the manager of the segment is able to significantly influence the
corporate tax burden.
A. 46.5%
B. 6.46%
C. 12.36%
D. 25.69%
LO4-Post test-B

67. How much will ROI change if the profit margin increases from 8% to 10%, the required rate of return
increases from 9% to 12%, and asset turnover stays the same at 2.1?
A. Increase of 4.2%
B. Increase of 2.0%
C. Increase of 3.0%
D. Decrease of 1.0%
LO4-Post test-A

68. Which of the following best describes residual income?

A. The revenue generated per each dollar of investment
B. The profit generated per each dollar of investment
C. The amount an investment generates above and beyond the required rate of return on
operating assets
D. The amount an investment must generate at the required rate of return
LO4-Post test-C

69. Tonal Company compiled the following information for the year ending December 31, 2013:
NOPAT $ 800,000
Sales 6,400,000
Net income 620,000
Invested capital 3,500,000
Current liabilities 340,000
Tonals expected rate of return is 12% and its WACC is 9.5% How much is EVA?
A. $300,200
B. $379,200
C. $499,800
D. $420,800
LO4-Post test-C

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70. Which of the following is not an option in deciding how to incorporate depreciable fixed assets in
measuring divisional investment?
A. Net book value.
B. Gross book value.
C. Transfer price.
D. Replacement cost of the asset.
E. Current value of the asset.
LO4 C

71. Which of the following describes ROI?

A. It fosters underinvestment.
B. It ignores future period considerations.
C. It is less suitable for evaluating long-term performance.
D. None of the above.
E. All of the above.
LO4 E

72. What does return on investment (ROI) measure?

A. The profit generated by a segment that exceeds the required rate of return
B. The revenue generated per dollar of investment by a segment
C. The profit generated per dollar of investment by a segment
D. The replacement value of assets invested in a division or segment
LO4-Pretest-C

73. Given a profit margin of 12%, total revenue of $410,000, an operating profit of $25,000, and an
asset turnover of 0.35, what is the ROI?
A. 6.1%
B. 2.5%
C. 5.1%
D. 4.2%
LO4-Pretest-D

74. Which of the following is not a disadvantage of residual income?

A. RI rankings depend crucially on the rate of return.
B. Magnitude of RI depends on the size of the investment
C. RI may generate rankings of investments that differ from rankings made using ROI.
D. RI can lead to underinvestment.
LO4-Pretest-D

75. Which of the following is the formula for ROI?

A. Profit Investment.
B. (Profit Sales) x (Sales Investment).
C. Profit margin x Asset Turnover.
D. None of the above.
E. All of the above.
LO4 E

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76. Gant Manufacturing Company has provided the following financial information:
Sales $400,000
Variable Expenses $250,000
Fixed Expenses $50,000
Investment in Fixed Assets $300,000
Required Rate of Return 5%
What is Gants residual income?
A. $80,000.
B. $95,000.
C. $100,000.
D. $85,000.
E. None of the above.
LO4 D

77. Which of the following is not a common approach to transfer pricing?

A. Variable cost-based transfer prices.
B. Full cost -based transfer prices.
C. Market-based transfer prices.
D. Negotiated transfer prices.
E. All of the above are common approaches to transfer pricing.
LOLO5 E

78. What belief does EVA reflect concerning the responsibility of managers?
A. Managers should be primarily responsible for investing in research and development.
B. Managers should be responsible for generating operating revenues and covering operating
costs.
C. Managers should be responsible for generating profits to cover both operating and capital costs.
D. Managers should be responsible for generating an acceptable profit margin.
LO5-Pretest-C

79. Which of the following is not a reason for using transfer pricing?
A. Pre-tax profits of a corporation will be larger.
B. Divisional income evaluation
C. Resource allocation among segments
D. Tax planning at the corporate level
LO5-Pretest-A

80. Which one of the following is not true about transfer pricing?
A. MNCs can transfer income from high-tax countries to low-tax countries.
B. Transfer prices can be cost-based or market-based.
C. An MNC entering a new foreign market may want to enable its subsidiary in a country to
compete effectively by charging a high transfer price.
D. Most countries have no restrictions on foreign currency exchange.
LO5-Post test-D

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81. Which of the following transfer price approaches is most appropriate for a short-term problem in
which the selling division has excess capacity?
A. Variable cost-based transfer prices.
B. Full cost-based transfer prices.
C. Market-based transfer prices.
D. Negotiated transfer prices.
E. None of the above.
LO5 A

82. Which of the following transfer prices, in theory, is the most sound because it provides the best
measure of the opportunity cost of inter-divisional transfers?
A. Variable cost-based transfer prices.
B. Full cost-based transfer prices.
C. Market-based transfer prices.
D. Negotiated transfer prices.
E. None of the above.
LO5 C

83. Which of the following transfer prices always results in both divisions voluntarily making the right
decisions from the perspective of the company as a whole?
A. Variable cost-based transfer prices.
B. Full cost-based transfer prices.
C. Market-based transfer prices.
D. Negotiated transfer prices.
E. None of the above.
LO5 C

84. Which of the following transfer prices gives divisions considerable autonomy?
A. Variable cost-based transfer prices.
B. Full cost-based transfer prices.
C. Market-based transfer prices.
D. Negotiated transfer prices.
E. None of the above.
LO5 D

85. The minimum price that the selling division wants from an inter-company transfer is:
A. The cost of the transfer plus the opportunity cost of the transfer.
B. The cost of the transfer less the opportunity cost of the transfer.
C. The normal selling price of the item plus the opportunity cost of the transfer.
D. The normal selling price of the item less the opportunity cost of the transfer.
E. The normal selling price.
Appendix A

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86. The maximum amount the buying division is willing to pay for an inter-company transfer is:
A. The cost of the transfer.
B. The cost of the transfer plus the opportunity cost of the transfer.
C. The cost of the transfer less the opportunity cost of the transfer.
D. The normal selling price of the item.
E. The opportunity cost of the transfer.
Appendix E

87. Given the following information, what is the maximum transfer price Division B should be willing to
pay Division A for its product?
Division A:
Production capacity 10,000 units
Selling price per unit $50
Variable production cost per unit $20
Variable selling cost per unit $5
Division B
Number of Division A units needed 2,000
Price per unit paid to outside supplier $32
A. $50
B. $20
C. $25
D. $32
E. None of the above.
Appendix D

88. Given the following information, what is the minimum transfer price Division A should be willing to
accept from Division B for its product?

Division A:
Production capacity 10,000 units
Selling price per unit $50
Variable production cost per $20
unit
Variable selling cost per unit $5
Division B
Number of Division A units 2,000
needed
Price per unit paid to outside $32
supplier
What is the maximum transfer price Division B should be willing to pay Division A for its
product?
A. $50
B. $20
C. $25
D. $32
E. None of the above.
Appendix C

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89. An electronics firm has two divisions, A and B. Division As annual sales are 2,500 units. The units
sell for $200 each and have variable product costs of $150 each. Division B would like to buy 100
units from Division A units, but has received a quote from an outside supplier of $160 per unit.
Suppose Division A has ample capacity to produce an additional 100 units with no effect on its sales
to outside customers. What is the effect on Division As profit if it sells the 100 units to Division B
for $160?
A. $16,000 increase.
B. $1,000 increase.
C. $5,000 increase.
D. $4,000 increase.
E. None of the above.
Appendix B

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Problems

1. As organizations grow, both the number and type of decisions owners and managers face increase
rapidly. Often, organizations have no other choice but to decentralize. The decision to decentralize
has both benefits and costs.

Required:

a. What is a decentralized organization?

b. List three benefits associated with decentralization.

c. List three costs associated with decentralization.

2. Although it is not possible to completely eliminate the costs of delegating decisions, organizations
take various measures to manage these costs. One method is to create organizational sub-units, or
responsibility centers.

Required:

a. List the three common types of responsibility centers and give an example of each.

b. For each responsibility center list the primary responsibilities of the manager.

3. Evaluating cost and profit centers is an essential part of an organizations process in a decentralized
environment.

Required:

a. How do organizations typically evaluate cost center performance in the short-term?

b. Discuss two long-term performance measures used to evaluate long-term reductions in cost.

c. What is the difference in engineered cost centers and discretionary cost centers?

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4. Watson Bicycle Manufacturing has provided the following information on the current years
activities. Watson uses the net book value to compute ROI.

Sales $100,000
Variable costs $30,000
Original costs of assets $200,000
Accumulated depreciation $70,000
Replacement costs of assets $170,000
Average investment $120,000
Net profit $45,000
Watsons minimum required return 30%

Required:

a. Calculate Watsons ROI.

b. Calculate Watsons residual income.

5. Most companies issue guidelines for setting transfer prices. However, they usually give some
autonomy to the division managers.

Required:

a. List three common approaches to setting transfer prices.

b. List one advantage and one disadvantage associated with each of the three approaches.

6. Mitchells Manufacturing Company has two divisions: Eastern and Western. The Eastern division
manufactures a digital camera with a selling price of $220, variable costs of $80 and allocated fixed
costs of $20 per unit. Western has asked to purchase 100 cameras. Eastern has ample capacity to
produce the 100 units. Western can purchase a camera of equal quality and features from an
outside supplier at $175 per unit.

Required:

a. What is the minimum transfer price the Eastern division would be willing to accept?

b. What is the maximum transfer price the Western division would be willing to pay?

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Problem solutions

1. Benefits and Costs of Decentralization (LO1)

a. A decentralized organization is one in which decision making is not limited to upper-level
executives, but authority is delegated to lower-level managers.

b. Benefits:
Permits timely decisions.
Tailors managerial skills and specializations to job requirements.
Empowers employees and increases job satisfaction.
Trains future managers.

c. Costs:
Might lead to an emphasis on local versus global goals.
Requires costly coordination of decisions.
Leads to improper decisions because of divergence between individual and
organization goals.

2. Responsibility Centers (LO2)

a. Types and examples:
Cost center examples include plant maintenance, data processing, human
resources, production, and general administration.
Profit center examples include product lines, division, regions, and retail stores.
Investment center examples include large independent divisions.

b. Responsibilities of managers:
Cost center:
o Minimize the cost of producing output.
o Minimize the cost of delivering a level of service.
o Improve the efficiency of operations by finding ways to cut costs and
minimize waste.

Profit center:
o Minimize costs.
o Maximize revenues.

Investment center:
o Maximize the returns from invested capital.
o Put the capital invested by owners and shareholders to the most profitable
use.

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3. Evaluating Cost and profit Centers (LO3)

a. In the short term, organizations typically use budget variances to measure cost center
performance.

b. Benchmarking is a process that involves comparing the effectiveness and efficiency of various
activities and business processes in a firm against the best practices in the industry. Such best
practices are not controllable by the decision maker, but still are useful performance measures.
For example, a firm may hold a manager accountable for achieving greater reductions in cycle
time than attained by immediate competitors.

Kaizen is a philosophy of continuous improvement. This initiative encourages and rewards

employees who constantly seek and suggest improvements to activities and business processes.
One way to implement continuous improvement is to hold managers accountable for achieving
performance reductions.

c. Engineered cost centers are cost centers for which there is a clear relation between inputs and
outputs. Discretionary costs centers are cost centers for which there is no clear relationship
between inputs and outputs.

4. Performance Measurement (LO4)

a. ROI = Profit Investment (net book value)
$45,000 $120,000 = 37.5%

b. Residual income = Profit (Required Return x Investment)

$45,000 (.30 x $120,000)
$45,000 - $36,000 = $9,000

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5. Transfer pricing (LO5)

a. Three common approaches:
Cost-based transfer prices
Market-based transfer prices
Negotiated transfer prices
b. Advantages and disadvantages:
Cost-based transfer prices. Advantage: appropriate for a short-term problem in
which the selling division has excess capacity. Disadvantage: there is no guarantee
that cost-based transfer prices will lead to the right quantity of transfers taking
place.
Market-based transfer prices. Advantage: most sound because the market price
provides the best measure of the opportunity cost of inter-divisional transfers. Also
always results in both divisions voluntarily making the right decisions from the
perspective of the company as a whole. Disadvantage: difficult to identify a market
price because there may be no ready market for the transferred goods or services.
Negotiated transfer prices: Advantage: gives divisions considerable autonomy and
if the managers behave rationally effective decisions will result. Disadvantage:
negotiations may be time-consuming and difficult because of the conflicting
interests of the managers.

6. Transfer pricing (Appendix)

a. The minimum amount Eastern should accept is $80.

b. The maximum amount Western should be willing to pay Easter is $175.

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Short Answer Questions

1. Why do firms decentralize?

2. List two benefits and two costs associated with decentralization.

3. What are the three common forms of responsibility centers we find in organizations?

4. What are the responsibilities of a cost center manager?

5. What are the responsibilities of a profit center manager?

6. What are the responsibilities of an investment center manager?

7. What are the two key principles of performance measurement?

8. List three characteristics of an effective performance measure.

9. How are cost center managers commonly evaluated?

10. What does the term kaizen mean?

11. How are profit center managers commonly evaluated?

12. Define ROI. List two advantages and two disadvantages of using ROI as a measure to evaluate
investment centers.

13. Define residual income. What is the difference between economic value added (EVA) and residual
income?

14. Why is transfer pricing necessary in organizations with multiple divisions?

15. What are the three common approaches to transfer pricing? List one advantage and one
disadvantage associated with each of these three approaches.

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Short Answer Solutions

1. (LO1) Firms decentralize because, as organizations grow, the number and types of decisions
that need to be made increase substantially. A single individual will not have the relevant expertise
and knowledge to make all of these decisions thus, firms delegate decision-making responsibility.

2. (LO1) The benefits include (1) timely decisions, (2) tailoring managerial skills and
specializations to job requirements, (3) empowering employees, and (4) training future managers.
The costs include (1) an emphasis on local versus global goals, (2) requires coordination of decisions,
and (3) can lead to improper decisions because of a divergence between individual and
organizational goals.
3. (LO2) (1) Cost centers, (2) Profit centers, and (3) Investment centers

4. (LO2) Minimize the cost of producing a specified level of output or service.

5. (LO2) Both minimize costs and maximize revenues. That is, maximize profit

6. (LO2) Maximize the returns from invested capital, or to put the capital invested by owners and
shareholders of the organizations to the most profitable uses

7. (LO2) Controllability and informativeness

8. (LO2) An ideal performance measure (1) aligns employee and organizational goals, (2) yields
maximum information about the decision or actions of the individual or organizational unit, (3) is
easy to measure, and (4) is easy to understand and communicate.

9. (LO3) In the short-term, via budget variances. In the long-term, by techniques such as
benchmarking and kaizen

10. (LO3) Kaizen is a philosophy of continuous improvement

11. (LO3) By budget variances and comparing actual profit with past profit and industry profit.
Organizations also use revenue-oriented measures such as customer satisfaction and market share.
Additional cost-oriented measures might focus on employee turnover or process improvements

12. (LO4) ROI = return on investment = profit divided by investment. ROI is an effective summary
of business profitability it controls for size by expressing the return per investment dollar.
Consequently, it is easy to compare the performance of investment centers of different size. We
also can decompose ROI into smaller pieces, allowing managers to see how individual actions map
into overall profitability. The major criticism of ROI is that it can foster underinvestment. For
example, if current ROI is 20%, a manager may not invest in a project with an ROI of 18% even
though the firms cost of capital is 15%. It also favors divisions with older assets.

13. (LO4) Residual income = Profit (required return * Investment). Residual income represents
the additional profit or value generated by an investment after meeting the required rate of return.
Economic value added is a modified calculation of residual income it uses a weighted average cost
of capital and adjusts for the operating and capital costs of a business, including taxes.

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14. (LO5) Because multiple divisions often deal with each other in the normal course of business,
diverting a portion of their resources from external business to serve internal needs

15. (LO5) (1) Cost-based transfer prices, (2) market-based transfer prices, and (3) negotiated
transfer prices. Market based prices do best in evaluating opportunity costs and in preserving arms-
length transactions. But, the market may not exist. Negotiated transfer prices truly respect
autonomy but might be time consuming and tedious. Cost-based prices can be used under all
situations but defining what is the right cost and the right markup to use can lead to many disputes.

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Short Essays

1. Organizational experts say that decentralization co-locates knowledge and decision rights. What does this statement
mean? Is decentralization always beneficial? What are the costs associated with delegating decision making to lower
levels of an organization?

2. Some argue that decentralization results in maximizing profit division by division. It may not lead to profit
maximization at the overall firm level. Do you agree? Why or why not?

3. Why not simply evaluate the performance of all divisional managers based on the entire firms profit? That way, we
do not have to worry about divisional managers not acting in the firms best interests. Is this a reasonable argument?
Why or why not?

4. When evaluating investment centers, what are some of the disadvantages of using net book value to measure
investment?

5. Two divisions with exactly the same return on investment (ROI) can have different residual incomes (RI). Why?

6. Some argue that both ROI and RI motivate managers to focus on short-term performance, since both the measures are
calculated using operating performance (i.e., operating income). Yet, ROI is widely used as a performance measure.
Provide a brief discussion.

7. Explain why capacity utilization in a supplying division is such an important consideration when choosing a transfer
pricing policy.

8. A firm often obtains services from subsidiaries in which the firms key officers may hold minority ownership. What
incentive conflicts do such arrangements pose?

9. Discuss some problems that arise when pricing the transfer of intellectual property.

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Short Essay Solutions

1. (LO1) The phase co-locates knowledge and decision rights means giving the decision making
authority to individuals in the organization that have the requisite knowledge and information
to make the right decision. For example, decisions regarding material purchases in a
manufacturing company such as when to purchase, how much to purchase, which suppliers to
purchase from is best left to individuals dealing with the purchase function routinely. Similarly,
sales promotion decisions are best made by marketing personnel who have the best knowledge
of market conditions and consumer behavior. Decentralization of decision making is not always
beneficial because it might to lead decision makers at lower levels to choose actions that are in
their best interests and not necessarily in the best interests of the firm. It also requires
considerable coordination across all levels in the organization to ensure that all decisions are
properly coordinated.

2. (LO1) Yes. Decentralization promotes local maximization and not global maximization.
Each divisional manager is interested in casting his/her own performance in the best possible
light relative to other divisional managers. As long as divisional profit is used to evaluate
performance, each divisional manager has a natural incentive to find ways in which to increase
his/her own divisional profit even if the chosen ways might hurt other divisions.

3. (LO2) The problem with this argument is that each manager cannot control actions of the
other managers, and the impact of their actions on the firms profit. Thus, it is possible that even
though the division is doing extremely well, its manager may not receive commensurate reward
if the firm as a whole is not doing well because of the actions of other managers.

4. (LO4) When the net book value is used to measure investment, the assets age becomes a
factor. As the asset becomes older, the accumulated depreciation increases and the net book
value decreases. Consequently, ROI often is higher for older assets. As a result, managers may
have less of an incentive to undertake timely asset replacement decisions.

5. (LO4) Consider the following example. Division A has an income of $10,000 on an investment
of $100,000. Division B has an income of $100,000 on an investment of $1,000,000. Assume that
the require rate of return is 8%.
The ROI for both the divisions is 10%. But the residual income for Division A is $2,000 (=$10,000
(8% $100,000)), and the residual income for Division B is $20,000 (=$100,000 (8%
$1,000,000)). Why? This is because the residual income is sensitive to project size. All else equal,
larger investments will have higher residual incomes.

6. (LO4) Yes, both ROI and RI are short-term performance measures. ROI is widely used because
it is easy to compute and is well understood. As we learned in the chapter, ROI can be
conveniently decomposed into profitability and asset turnover ratios. By evaluating the trends in
these ratios, one can make reasonable assessments of the firms future. Also, ROI is but one of
several measures that analysts and outsiders employ to evaluate the firms performance and its
future potential.

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7. (LO5) When the supplying division is fully utilized, any transfer to the buying division is
diverting capacity away from profitable use of its capacity. Unless the firm can earn a great
profit by diverting capacity, it does not make sense to transfer. In a decentralized environment
in which both the buying and selling divisions are acting as profit centers, the transfer price must
compensate the selling division for lost profit. The buying division will be willing to do so only if
it is still able to make a profit for itself. In this case, the company as a whole is better off because
the selling divisions capacity will have been put to the most profitable use!

8. (LO5) In such instances, there is a natural incentive for the firms management to provide
business to its subsidiaries even if the same services can be obtained from other sources for
lower prices and at better quality.

9. (LO5) Intellectual property is inherently difficult to price. It is very much unlike a typical
product which has a certain definite determinable life, and whose cost of production is
determinable to a fair degree of accuracy. On the other hand, the life of intellectual property is
difficult to estimate. Sometimes new technologies emerge suddenly rendering the intellectual
property totally worthless immediately. On the other hand, some intellectual property has
indefinite lives. Another problem is that the dissemination of intellectual property is not easily
controllable. The acute problem of piracy in the software industry is a good example.

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Exercises
1. Karl Krader oversees a staff of over 200 persons and a budget of close to a million dollars per year.
He is responsible for the upkeep of all buildings and equipment at a large university. However, any
reconstruction project is budgeted and administered separately. Karls responsibilities include
selection and evaluation of personnel, negotiating with suppliers, choosing the kinds of
landscaping, and so on. Karls services, however, are not priced out to the user departments or to
individual units within the university.

Required:
a. Should Karl be evaluated as a profit center or a cost center?
b. How should the university evaluate Karls performance?
2. The Production Department of Advent Cordless Phones is a cost center. The following table provides
budgeted and actual cost information for the most recent year.
Budget Actual
Production volume (units) 175,000 200,000
Total variable costs $7,875,000 $9,450,000
Total fixed costs 1,200,000 $1,350,000

Required:
Evaluate the performance of the Production Department.

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Exercise Solutions

1. (LO1)
a. We believe that Karl should be evaluated as a cost center. While he provides a useful and visible
service, there is no direct impact on revenue. Further, he does not influence prices or determine
the level of output. His job is to keep up the buildings to specified quality levels within allowed
costs. This is a central characteristic of a cost center.

b. The university should use a mix of financial and non-financial measures. Relying on financial
measures alone is not advisable because Karl can always postpone maintenance to come in
below budgeted expenditures. However, we do need to make sure that the budget is not over-
spent by a lot. Non-financial measures such as time to respond to complaints and general score
on upkeep seem useful as a way to make sure that Karl is providing the desired service quality.

2. (LO3) The data pertain to an engineered cost center. That is, volume affects total cost. We
need to construct a flexible budget and perform cost variance analysis. We have:

Flexible
Budget Actual
budget*

Production volume (units) 175,000 200,000 200,000

Total variable costs $7,875,000 $9,000,000 $9,450,000

Total fixed costs 1,200,000 1,200,000 $1,350,000

* As we know from Chapter 8, the flexible budget adjusts costs for the actual volume of operations. Thus,
we have ($7,875,000/175,000) 200,000 = $9,000,000. Fixed costs do not change.

After adjusting for volume, the efficiency variance is $450,000 U and the fixed cost spending
variance is $150,000 U. While some of the cost over-runs might be legitimately attributed to the
higher volume (e.g., poorer quality materials, more supervisors hired etc), the increase is significant
and warrants investigation. Overall, the data reflect considerable cause for concern.

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