CHAPTER SEVEN

Decentralization and Transfer Pricing

7.1. Decentralization

Decentralization is the delegation of decision-making authority to lower levels. In centralized

decision making, decisions are made at the very top level, and lower-level managers are
responsible for implementing these decisions. For decentralized decision making, decisions are
made and implemented by lower-level managers.

Reasons for decentralization include the following: access to local information, more timely
response, focusing of central management, exposure of segments to market forces, enhanced
competition, training, and motivation.

Advantages and Disadvantages of Decentralization

Decentralization involves spreading the decision-making throughout an organization instead of a

few making all of the decisions. Decentralization is a matter of degree. At one end of the
spectrum, a strongly decentralized organization has lower-level managers and employees making
decisions. At the other end of the spectrum, in other strongly decentralized organizations, these
managers have little freedom to make decisions. Most organizations fall somewhere between
these two extremes, and there is a current trend toward more decentralization.

Advantage of Decentralization

1. Top management is free to concentrate on higher-level problem-solving, company

strategy, higher-level decision-making and coordinating activities. Decentralization
allows top management to be free of the day-to-day "non-important" details of running a
company. Top management can focus on important financial decisions, recruiting,
training and maintaining a productive workforce, and positioning the company to be a
force within its industry.
2. Decentralization provides lower-level managers with crucial experience in making
decisions. Without this experience, they would not be prepared to act decisively when
they are promoted into higher-level positions. These so-called lower-level decisions
could center on who in a certain department is on what project team or which workers
work which shifts. These decisions are important but not as crucial as developing a
criteria for the hiring and dismissal of employees.

Disadvantage of Decentralization

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 1. Lower-level managers may make decisions without fully understanding the effects those
decisions could have on the organization as a whole. While top-level managers have less
information about local operations than lower-level managers, they normally have more
information about the company's philosophy and should have a better grasp of company
strategy. Lower-level managers are not always in a position to know the impact of their
decisions as top-level managers do.
2. Lower-level managers may have objectives and goals that differ from those of the
organization. Some lower-level managers may be more interested in increasing the sizes
of their departments than in increasing the profits of the company. Top-level managers
must have their eyes on the dollar and its impact on the company. Many lower-level
managers don't have to concern themselves with finances like their top-level brethren.
7.2. Responsibility Center

A responsibility center is a part or subunit of a company for which a manager has authority and
responsibility. The company's detailed organization chart is a logical source for determining
responsibility centers. The most common responsibility centers are the departments within a
company.

When the manager of a responsibility center can control only costs, the responsibility center is
referred to as a cost center. If a manager can control both costs and revenues, the responsibility
center is known as a profit center. If a manager has authority and responsibility for costs,
revenues, and investments the responsibility center is referred to as an investment center.

Responsibility centers are identifiable segments within a company for which individual
managers have accepted authority and accountability. Responsibility centers define exactly what
assets and activities each manager is responsible for.

How to classify any given department depends on which aspects of the business the department
has authority over.

Managers prepare a responsibility report to evaluate the performance of each responsibility

center. This report compares the responsibility center’s budgeted performance with its actual
performance, measuring and interpreting individual variances. Responsibility reports should
include only controllable costs so that managers are not held accountable for activities they have
no control over. Using a flexible budget is helpful for preparing a responsibility report.

1. Revenue centers

Revenue centers usually have authority over sales only and have very little control over costs. To
evaluate a revenue center’s performance, look only at its revenues and ignore everything else.

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Revenue centers have some drawbacks. Their evaluations are based entirely on sales, so revenue
centers have no reason to control costs. This kind of free rein encourages the concession manager
to hire extra employees or to find other costly ways to increase sales (giving away salty treats to
increase drink purchases, perhaps).

2. Cost centers

Cost centers usually produce goods or provide services to other parts of the company. Because
they only make goods or services, they have no control over sales prices and therefore can be
evaluated based only on their total costs.

One way for a cost center to reduce costs is to buy inferior materials, but doing so hurts the
quality of finished goods. When dealing with cost centers, you must carefully monitor the quality
of goods.

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 3. Profit centers

Profit centers are businesses within a larger business, such as the individual stores that make up a
mall, whose managers enjoy control over their own revenues and expenses. They often select the
merchandise to buy and sell, and they have the power to set their own prices.

Profit centers are evaluated based on controllable margin — the difference between controllable
revenues and controllable costs. Exclude all non-controllable costs, such as allocated overhead or
other indirect fixed costs, from the evaluation. The beautiful thing about running a profit center
is that doing so gives managers an incentive to do exactly what the company wants: earn profits.

Classifying responsibility centers as profit centers has disadvantages. Although they get
evaluated based on revenues and expenses, no one pays attention to their use of assets. This
scenario gives managers an incentive to use excessive assets to boost profits.

For managers, the upside of using more assets is the resulting increases in sales and profits.
What’s the downside? Well, nothing; managers of profit centers aren’t held accountable for the
assets that they use.

This flaw in the evaluation of profit centers can be addressed by carefully monitoring how profit
centers use assets or by simply reclassifying a profit center as an investment center.

4. Investment centers

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You could call investment centers the luxury cars of responsibility centers because they feature
everything. Managers of investment centers have authority over and are held responsible for
revenues, expenses, and investments made in their centers. Return on investment (ROI) is often
used to evaluate their performance.

To improve return on investment, the manager can either increase controllable margin (profits)
or decrease average operating assets (improve productivity).

Using return on investment to evaluate investment centers addresses many of the drawbacks
involved in evaluating revenue centers, costs centers, and profit centers. However, classification
as an investment center can encourage managers to emphasize productivity over profitability to
work harder to reduce assets (which increases ROI) rather than to increase overall profitability.

 ROI is the most common measure of investment SBU financial performance

 The higher the percentage, the better the indicated financial performance
 When the value of the firm’s ownership interest is used for investment, return on
investment often is called return on equity (ROE)
 The two components of ROI create a more complete picture of management performance
(goals should be set related to both measures)
 Return on sales (ROS) or profit margin, a firm’s profit per sales dollar, measures the
manager’s ability to control expenses and increase revenue to improve profitability.
 Asset turnover (AT), the amount of dollar sales achieved per dollar of investment,
measures the manager’s ability to increase sales from a given level of investment.

Example

CompuCity sells computers, software, and books in three locations, Boston, South Florida, and
the Midwest. The company’s profits declined in the Midwest last year.

Required: Determine ROI for each year?

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Solution

$8,000 Income/$200,000 Sales $200,000 Sales/$50,000 Investment

4.00% ROS x 4.00 AT

 Overall ROI has fallen from 14.4% in 2006 to 13.5% in 2007, mainly due to a decline
in overall ROS
 The drop in ROS is due to the sharp decline in ROS for the computer unit
 Software is the most profitable unit, as measured by ROI

7.3. Transfer Price

Transfer pricing is the setting of the price for goods and services sold between controlled (or
related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a
parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price.
Legal entities considered under the control of a single corporation include branches and
companies that are wholly or majority owned ultimately by the parent corporation. Certain
jurisdictions consider entities to be under common control if they share family members on their
boards of directors. Transfer pricing can be used as a profit allocation method to attribute a
multinational corporation's net profit (or loss) before tax to countries where it does business.
Transfer pricing results in the setting of prices among divisions within an enterprise.

In principle, a transfer price should match either what the seller would charge an independent,
arm's length customer, or what the buyer would pay an independent, arm's length supplier. While
unrealistic transfer prices do not affect the overall enterprise directly, they become a concern for
government taxing authorities when transfer pricing is used to lower profits in a division of an
enterprise located in a country that levies high income taxes and raise profits in a country that is
a tax haven that levies no (or low) income taxes.

Transfer pricing is the major tool for corporate tax avoidance, also referred to as Base Erosion
and Profit Shifting (BEPS).

Transfer Pricing Objectives

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The objectives of transfer pricing are the same as those for evaluating the performance of SBUs:

 To motivate managers
 To provide an incentive for managers to make decisions consistent with the firm’s goals
 To provide a basis for fairly rewarding managers

Specific international issues include:

 Minimization of customs charges

 Minimize total (i.e., worldwide) income taxes
 Currency restrictions
 Risk of expropriation (government seizure)

Transfer pricing methods

 Variable cost (standard or actual), with or without a mark-up for “profit”

 Full cost (standard or actual), with or without a markup for “profit”
 Market price (perhaps reduced by any internal cost savings realized by the selling
division)
 Negotiated price between buyer and selling units, perhaps with a provision for arbitration

Choosing a Transfer Pricing Method

Firms can use two or more methods, called dual pricing, one method for the buying unit and a
different one for the selling unit. From top management’s perspective, there are three
considerations in setting the transfer price:

 Is there an outside supplier?

 Is the seller’s variable cost less than the market price?
 Is the selling unit operating at full capacity?

Before deciding on transfer pricing

 Is there an outside supplier?
If so we must compare the inside seller’s variable costs to the outside seller’s price

 Is the seller’s variable cost less than the market price?

If it is, so we must consider the utilization of capacity in the inside selling unit
 Is the selling unit operating at full capacity?
If it is, so we must consider the contribution of the selling unit’s outside sales relative to the
savings from selling inside.

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Example: High Value Computer (HVC) Company
Key assumptions:
 Manufacturing unit can buy the x-chip inside or outside
 x-chip can sell inside or outside
 x-chip unit is at full capacity (150,000 units)
 One x-chip is needed for each computer manufactured

Other Information:
 Unit selling price of computer = $850
 Variable manufacturing costs (excluding x-chip) = $650
 Variable unit manufacturing cost of x-chip = $60
 Price of x-chip sold to outside supplier = $95
 Outside supplier price of x-chip = $85
 Variable cost to make the outside chips compatible = $5
 Variable selling cost for HVC to sell its chip = $2

Solution

Option 1: X-Chip Unit Sells to Outside Supplier

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Option 2: X-Chip Unit Sells Inside

The firm benefits more from Option 1

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