Managerial Accounting Part - Evaluation and reward system

When subunit managers in the organization hold a common set of objectives.

When individuals behave in the best interest of the organization regardless of their own goals.

It is best for all concerned if the evaluation system used to measure a manager's achievements result in at least behavioral congruence (if not then goal congruence). Example: overall company profitability.

Responsibility accounting is a system of dividing an organization into similar units. These units may be in the form of divisions, segments, departments, branches, product lines and so on. Each department consists of individuals who are responsible for particular tasks or managerial functions they need to accomplish.

Responsibility accounting represents a method of measuring the performances of various divisions of an organization. Collects planned and actual accounting information about the inputs and outputs of responsibility centers.

Centralized: Process where the concentration of decision making is in a few hands. Decisions are handed down from the top priority of management and subordinates carry them out.

Decentralized: Decisions are made at divisional and departemental levels.

The level of centralization and decentralization will depend upon the amount of authority delegated to the lowest level.

• Managers have specialized skills that permit them to manage their departments most effectively
• Their resulting autonomy provides a training opportunity for increased responsibility
• Managers with such authority exhibit positive motivation
• Delegation of tasks relieves the time burden on upper-level managers
• It also encourages timely responses to problem solving

• Local managers may narrow their focus to their own subunit's performance
• Local managers may make decisions that are not congruent with the preferences of top management
• Some tasks or services may be duplicated among the decentralized subunits

1. Cost centers: responsible for the cost of a well defined activity
2. Discretionary cost centers: responsible for the cost of an activity that is not well defined
3. Revenue center: responsible for revenue attributed to the subunit
4. Profit center: responsible for profit of a subunit
5. Investment center: responsible for profit and the invested capital of a subunit.

• Decrease costs while maintaining the same sales level
• Decrease invested capital with no change in income
• Increase sales revenue with no change in costs

ROI: 

• Advantage: It uses percentages, which allow easy comparison with required returns
• Disadvantage: Value of invested capital is measured in dollars of different purchasing power

Residual Income:

• Advantage: If facilitates goal congruence with its required rate of return
• Disadvantage: It is biased in favor of larger companies because it shows dollar results

Solution: Use both in evaluating investments.

A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit.

This measure was devised by Stern Steward. Economic value added attempts to capture the true economic profit of a company.

• Cost of debt is equal to the interest payments made on the debt
• Cost of equity is the return the shareholders could obtain in price appreciation and dividends if they invested in a portfolio of companies about as risky as yours

1. Which asset value should be included in invested capital
2. Should the assets be shown at historical or current cost
3. Should we measure the investment at the beginning or end of period amount

The amount charged when one division of an organization sells goods or services to another division. The exchange is internal and does not affect the organization's total sales or profit.

If the divisions are evaluated on profitability, the transfer price can have an impact on the reported performance of each division.

The value placed on the goods being transferred between divisions should encourage the divisions to complete the transfers, if that is in the organization's best interest- while allowing them to retain their autonomy.

In decentralized organizations, the managers of profit and investment centers often have considerable autonomy in deciding whether to accept or reject orders and whether to buy from inside or outside the organization.

The goal in setting the transfer price is to provide incentives for each division manager to act in the company's best interest.

1. The company has no excess capacity
2. The company has excess capacity

Transfer price = outlay cost + opportunity cost

1. If the transfer price is set at market price, the producing division should have the option to either produce goods for internal transfer or sell in the external market
2. The buying division should be required to purchase goods from inside its organization if the producing divison's goods meet the product specifications

In some companies, division managers negotiate the price at which transfers will be made: 

• Negotiations can lead to disagreement and competition between participating division managers
• Although negotiating skill is a valuable managerial skill, it should not be the only or dominant factor in evaluating a division.

When a company does not use market prices or negotiated prices to determine transfer price, it usually turns to cost-based transfer-pricing. The cost-based transfer price may be based upon:

• Unit-level cost
• Absorption cost

When using this approach, the producing divison is not allowed to show any contribution margin on the transferred products or services. Under such conditions, the producing division has no positive incentive to produce and transfer products or services efficiently.

Some companies avoid this problems by setting the transfer price at standard unit-level cost plus a markup.

Absorption cost is equal to the product's unit-level cost plus an assigned portion of the higher-level cost (batch-level,product-line-level, customer-level,facility-level cost)

Transfer prices should not be based on actual costs because such a practice would allow an inefficient producing division to pass its excess production costs on to the buying division via the transfer price.

A dual transfer pricing system charges the buying division for the cost of the transferred product (however the cost might be determined) and credits the selling division with the cost plus some profit allowance.

Since tax rates are different in different countries,companies have incentives to set transfer prices that will increase revenues in low-tax countries and increase costs in high-tax countries.

Service industry firms and nonprofit organizations use transfer pricing when services are transferred between responsibility centers.

Balanced scorecards are performance measurement systems or business models that tie together knowledge of strategy, processes, activities and operational and strategic performance measures.

An incentive system communicates strategy, motivates employees,and reinforces achievement of organizational goals.

1. Financial performance: How should we appear to our shareholders?
2. Business and production process performance: At what business practices must we excel?
3. Customer performance: How should we appear to our customers?
4. Learning and growth performance: How should we sustain our ability to change and improve?

• Encourages all employees to consider the impacts of their decisions on profitability
• Appears to work in various types of organizations

• choosing and validating measures
• training and interpretation activities
• managing many measures at once

Pay for performance means that at leat some portion of a manager's income is not guaranteed but depends on measure's of organizational performance.

An effective incentive system should motivate employees to achieve the organization's goals and objectives nd reward them if they do.

Incentives work best when individuals see a strong link between their actions and performance results. Many companies reward division managers for both business unit and companywide performance.

1. Absolute or relative performance
2. Formula-based or subjective performance
3. Financial or nonfinancial performance
4. Narrow or borad responsibility of performance
5. Current or deferred rewards
6. Salary,bonus or stock rewards

Rewards can be given later if sustained performance is desired (cash or stock rewards payable at the end of several years):

• They encourage managers to stay for a while
• They help managers focus on the long term (as long as it is not too far away)

1. Cash bonuses- the most liquid and immediate
2. Stock awards- usually not redeemable right away
3. Stock appreciation rights- confer a bonus to employees based on increases in stock price for a predetermined number of shares
4. Stock options- give an individual the right to purchase a number of shares at a specified price over a specified time period

A mismatch of executive pay and firm performance has been widely observed in many types of organizations. In some cases, the mismatch is the result of poorly designed incentive systems that generate high rewards even when stockholders lose money.

Expectancy theory (from applied psychology) and agency theory (from financial economics).

An employee contracts with an employer to perform certain work, and the employer want to be sure that the work is duly and well performed. So incentive plans must: 

• Motivate the employee to work
• Align the employee's goals with the employer's

Investment center is a division within a business much like a cost or profit center. The only difference is that the performance of manager is measured based on the ROI of the division or the residual income.