Introduction

• The primary distinction between centralized & decentralized

organization is the freedom of decision making by managers at many
levels

• At Centralized organization all activities & decisions coordinated by

top management

• At decentralized organization the decision-making authority

distributed various levels of the organization

Responsibility centers

• Decentralized organizations, where decision-making power is

distributed, often divide themselves into responsibility centers

• These centers, also known as strategic business units (SBUs), these

are specific subunits within the organization, such as departments or
divisions, Each center has clear responsibilities and goals

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 • There are four types of responsibility centers:

1. Cost Center: Responsible for managing costs, Examples include

production departments and maintenance teams, Their goal is to
minimize costs while maintaining output quality

2. Revenue Center: Focuses on generating revenue. Sales teams

and marketing departments are examples, Their success is
measured by their ability to increase sales

3. Profit Center: Responsible for both generating revenue and

controlling costs. They aim to maximize profits, Examples include
individual stores or product lines within a company.

4. Investment Center: Has the authority to make decisions about

investments, increase revenue & control cost, Example: Head
office

Controllability

• When evaluating a manager's performance, it's crucial to consider the

factors they can actually control.

• Controllable factors are those that the manager has the authority and
ability to influence

• Noncontrollable factors are those that the manager cannot change or

significantly impact.

• common costs as an example of factors that may not be controllable

by individual managers, These are costs shared across the organization

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common costs

• Common costs are expenses shared by two or more cost objects (e.g.,
departments, products, services)

• They are indirect costs because it's difficult to directly trace them to a
specific cost object, so it must be allocated

• Methods of Allocating Common Costs:

1. Cause-and-Effect Relationship: allocation should be based on a

direct relationship between the cost and the cost object, this
approach promotes fairness and improves acceptance of the
allocation by managers, Example: Use budgeted rates for
allocating variable costs based on actual output

2. Benefit Received: Costs are allocated based on the benefit that

organizational units or products receive, Example: Advertising
costs that are not tied to specific products may be allocated
based on the increase in sales achieved by different subunits

• Example: Let's say a company has three departments: Sales,

Marketing, and Production. They occupy a building with a monthly rent
of $10,000

• Allocating using standalone method

o Allocation based on proportionate basis

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 Sales Department Floor Space: 2,000 sq ft
Marketing Department Floor Space: 1,500 sq ft
Production Department Floor Space: 2,500 sq ft

• Calculate Percentage of Space Used:

Sales: (2,000 sq ft / 6,000 sq ft) x 100% = 33.33%
Marketing: (1,500 sq ft / 6,000 sq ft) x 100% = 25%
Production: (2,500 sq ft / 6,000 sq ft) x 100% = 41.67%

• Allocate Rent Based on Percentage:

Sales: 33.33% x $10,000 = $3,333
Marketing: 25% x $10,000 = $2,500
Production: 41.67% x $10,000 = $4,167

• Allocating using incremental methods

o Added additional cost equal to department cost

Sales cost = 5,000 then allocated rent cost is 5,000

Market cost = 3,000 then allocated rent cost is 3,000
Production cost = 2,000 then allocated rent cost is 2,000

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Headquarter Costs

• expenses incurred by the central administrative and support functions

of an organization. These costs are not directly associated with the
production or delivery of goods or services but are essential for the
overall operation of the business

• there are several reason to allocate headquarter costs to profit centers:

1. Awareness of support costs: Allocating costs reminds managers

that support functions exist and that they would have to bear
these costs if their departments were independent

2. Profitability reminder: The allocation highlights that profit

centers must cover a portion of the support costs.

3. Motivation for appropriate service usage: By allocating costs,

organizations aim to motivate departments to use central support
services effectively

Effects of Arbitrary Allocations

• Managers' morale may suffer when allocations depress operating

results.

• Dysfunctional conflict may arise among managers when costs

controlled by one are allocated to others

• Resentment may result if cost allocation is perceived to be arbitrary or

unfair

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Cost center & revenue center performance measures

• The most appropriate measures for cost center & revenue center is
variance analysis as Managers of cost and revenue centers primarily
influence one factor either costs or revenue, Variance analysis helps
identify the difference between actual performance and expected
performance, allowing managers to pinpoint areas where they can
improve.

• performance measures should be based on cause-and-effect

relationship, The measure should reflect the impact of the manager's
actions (cause) on the desired outcome (effect).

• Performance measures can be non-financial in nature. For example:

Number of invoices processed per hour: This measures the efficiency
of a cost center like accounts payable.

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Profit center measures

• The segment margin approach is a method used in performance

measurement for profit centers, this method used the basis of
contribution margin but break out fixed cost into controllable fixed cost
& traceable fixed cost

• Segment Reporting is a method of analysis that breaks down a

company's performance into smaller, more manageable units called
"segments." These segments could be product lines, geographical areas

• Manufacturing Contribution Margin (MCM) refers to the portion of

sales revenue that remains after deducting all variable manufacturing
costs. It is a measure of the profitability of a company's manufacturing
operations, excluding fixed costs and non-manufacturing expenses.

• Contribution Margin (CM): This is the difference between sales revenue

and variable costs. It represents the amount of money available to cover
fixed costs and contribute to profit

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 • Controllable Fixed cost: Fixed costs that a manager has the authority
to influence or change, Example: Advertising Budgets, training,
Development Costs, Maintenance Costs, Department Overheads

• Short run performance margin: refers to the profit or contribution

generated by profit in the short term, after accounting for variable costs
and controllable fixed costs. equal contribution Margin mins
controllable fixed cost

• traceable fixed costs are fixed expenses that can be directly to

segment within an organization

• Segment margin: the net profit of the segment

key issues involved in determining segment profitability

• Cost Measurement:

o Under costing: This occurs when a product or unit uses a high

amount of resources but is reported as having low costs

o Over costing: This happens when a product or unit uses a low

amount of resources but is reported as having high costs

• Cost Allocation: Cost allocation involves assigning costs to the

appropriate products, business units, and customers.

• Investment Measurement: Investment measurement involves

calculating the cost of expanding production, developing new products,
or entering new markets

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Investment center performance measures

• The performance of investment center can by measure by:

1. Return on Investment (ROI)
2. Residual Income

Return on Investment (ROI)

• Measure how much profit is generated for every dollar invested

• Formula:

• Income of the business unit = Operating income

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benefits of using Return on Investment (ROI) as a performance measure:

1. Improve Projects: By analyzing ROI data, businesses can identify

areas where projects are not performing as expected.

2. Secure Funding: Positive ROI forecasts can be a powerful tool for

securing funding from investors or lenders

3. Comparative Analysis: ROI allows for easy comparison of

profitability and asset utilization across different business units
within a company

4. Discontinue Ineffective Products or Operations: ROI data can

be used to identify products or operations that are not generating a
sufficient return on investment

Limitation of ROI:
• Investment centers with high current ROIs may be not accept new
projects, even if those projects have a return higher than the center's
target ROI, This is because accepting a new project with a slightly lower
ROI than the current one would temporarily decrease the center's
overall average ROI.

• Example: An investment center has a current ROI of 8%, and its

investors expect a minimum return of 2%, If the center is presented with
a new project that offers a 6% return, they might reject it, this is
because accepting the 6% project would lower the center's overall
average ROI, even though 6% still exceeds the target return of 2%,

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Residual income
• Measures the excess of actual income earned over the required
minimum return on investment

• It calculates the income generated by an investment center above a

required minimum return on invested capital.

• Formula: Residual Income = Income of Business Unit - (Assets of

Business Unit * Required Rate of Return)

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ROI Vs RI
• ROI
▪ Measures the profitability of an investment as a percentage
▪ Limitation: Managers might be reluctant to invest in projects with
lower ROI than their current average, even if the project is still
profitable
• RI
▪ Measures the excess of actual income earned over the required
minimum return on investment

▪ Encourages managers to invest in projects that generate a return

higher than the required rate of return), even if it lowers their
individual ROI

Comparability Issues
▪ Inconsistency in Income Measurement: Different companies or even
different divisions within the same company might use different
definitions of income & assets for performance evaluation such as:
assets sharing , inventory cost flow methods

▪ Variations in Invested Capital Definition: The definition of invested

capital can also vary significantly, there is three common approaches to
defining invested capital
1. Total Assets Available: This includes all assets controlled by the
investment center, regardless of whether they are actively used.

2. Total Assets Employed: This excludes idle assets like vacant land

3. Working Capital Plus Other Assets: This approach focuses on

the capital provided by both long-term investors and short-term
creditors.

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 • Performance evaluation for multinational companies effected by the
following:
1. Expropriation: It refers to the seizure of a company's assets by a
foreign government, This is typically done for a public purpose
which reduce the total assets of the company

2. Repatriation: This refers to the process of converting funds held

in a foreign currency into the company's home currency and
transferring them back to the home country.

3. Tariffs: Taxes imposed on imported goods

4. Inflation: The risk that the purchasing power of a currency will

decline over time

5. Exchange Rate: The risk that the value of a foreign currency will
fluctuate, affecting the profitability of international transactions.

6. Political Risk: The risk of losses due to actions of governments,

such as changes in tax laws, environmental regulations, or
expropriation of assets

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Balance scorecard
• The balanced scorecard is a strategic performance management tool
that helps organizations track their progress toward achieving their
strategic goals, It does this by looking at performance from four key
perspectives:

1. Financial Perspective: This perspective focuses on how the

company creates value for its shareholders. Key metrics include
revenue growth, profitability, return on investment, and cash flow.

2. Customer Perspective: This perspective focuses on how the

company is perceived by its customers. Key metrics include
customer satisfaction, market share, customer retention

3. Internal Business Processes Perspective: This perspective

focuses on the internal processes that drive customer
satisfaction and value creation. Key metrics include process
efficiency, quality control, and innovation

4. Learning and Growth Perspective: This perspective focuses on

the capabilities of the organization to improve and innovate, Key
metrics include employee satisfaction, employee training, and
investment in technology.

Key Performance indicators “KPI’S”

• metrics used to evaluate an organization's progress toward achieving its

strategic goals that used for each balance score card

• KPI’s including financial measures & Non-financial measures

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Examples on KPI’s
• Financial KPIs: Revenue growth, Profitability (net income, gross
margin), Return on investment (ROI), Cash flow, Earnings per share
(EPS), …..

• Customer stratification KPIs: Customer satisfaction scores, customer

churn rate (Customer leave the company) , Net Promoter Score
(customer recommendation),Market share, ….

• Internal process KPIs: Defect rates, Cycle time, Product Quality,

Number of injury claims

• Learning & Growth KPIs: Employee turnover rate, Employee

satisfaction, Training completion rates

SWOT Analysis
• SWOT Analysis is used to identify Key Performance Indicators (KPIs) for
a firm which consists of :
1. Strengths: Internal capabilities that give a firm an advantage
2. Weaknesses: Internal limitations that may hinder performance
3. Opportunities: External factors the firm can capitalize on
4. Threats: External challenges that could harm the firm.

• Identifying KPIs through SWOT: A firm uses SWOT analysis to assess

its internal and external environment. The insights gained help in
pinpointing the most relevant KPIs.

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PEST Analysis
• PEST Analysis is used to identify Key Performance Indicators (KPIs) by
analyzing the external environment of an organization

• PEST stands for:

o Political Factors
o Economic Factors
o Social Factors
o Technological Factors

• PEST analysis helps organizations understand external factors that can

impact their performance. These factors inform the creation of relevant
KPIs

common problems in implementing the Balanced Scorecard

1. Using too many measures: When companies try to track an excessive
number of metrics, it can dilute the focus on the most critical KPIs

2. Failing to evaluate personnel on non-financial as well as financial

measures: The Balanced Scorecard emphasizes a holistic view of
performance. If companies only evaluate employees based on financial
metrics, they may overlook important contributions in areas like
customer satisfaction, innovation, and employee development

3. Including measures that will not have long-term financial benefits:

Some companies include measures that may seem relevant but don't
ultimately contribute to long-term financial success

4. not understanding that subjective measures (such as customer

satisfaction)

5. Trying to achieve improvements in all areas at all times

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Transfer Pricing

• which is the internal pricing system used when one division of a

company sells goods or services to another division within the same
company

• In decentralized organizations, each division acts more independently.,

a division should charge another division the same price it would
charge an external customer, This encourages divisions to act in their
own best interests, but Sometimes the interests of the selling division
might not align with the best interests of the company, For example, if
Division A can sell its products to an external customer at a higher
price, it might be not need to give a discount to Division B, However, in
some cases it might be advantageous for the company as a whole if
Division A sells to Division B at a lower price

Transfer price methodologies

Variable Cost:

• When a selling division has excess production capacity, it might be

beneficial to set the transfer price for internal sales at the variable cost
of production. This means the selling division only covers its direct
variable costs (like raw materials and direct labor)

• Benefits: Utilizes Excess Capacity: By selling internally at variable cost,

the company can utilize its unused production capacity, improving
overall efficiency and potentially reducing fixed costs per unit.

• The seller to have incentive it must identify price slightly higher than
variable cost to cover some of fixed cost

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Full (Absorption) Cost
• this method includes all manufacturing costs in the transfer price
• Advantages of Using Full Cost No Loss for the Selling Division By using
full cost, the selling division is guaranteed to not incur a loss on the
internal sale. This provides an incentive for the selling division to agree
to the transfer.
• Disadvantage of using full cost is Because the selling division can pass
all costs (including fixed costs) to the buying division, there is little
incentive for the selling division to control its production costs.

Market Price

• Market price refers to the price at which similar goods or services are
sold in the open market.

• If the selling division can sell all its output to external customers at the
market price, there's no reason to offer a lower price to an internal
division.

Negotiation

• In a negotiated transfer price, the selling and buying divisions within a

company negotiate the price for the internal transaction. This allows for
flexibility and takes into account the specific circumstances and needs
of each division.

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factors and considerations in choosing a transfer pricing policy within an
organization:

Goal Congruence:
• The primary objective is to ensure that the transfer price aligns with the
overall goals of the company, This means the pricing strategy should
motivate all divisions to work together to achieve the company's
objectives, such as maximizing profitability and efficiency.

Segmental Performance:
• Transfer prices should allow each division to recover its costs and
generate a fair return on its investments

• The selling division should not be penalized for selling internally

Negotiation
• If the purchasing division has the option to buy from external suppliers,
it should be allowed to negotiate the transfer price to not incurred
greater cost by purchasing within the company

Capacity
• When the selling division has excess capacity, internal sales can be
beneficial to utilize those resources.

• if the selling division is operating at full capacity and selling to external

customers at a profit, it shouldn't be forced to supply internal divisions
at a lower price

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Cost structure
• If the selling division has excess capacity and can sell internally at a
price above its variable cost, it should accept the internal order as it
contributes towards covering fixed costs.

Tax Issues
• Transfer pricing can have significant tax implications, especially for
multinational companies, such as: income taxes, sales taxes, …

• Examples:

o Income Taxes: Transfer prices can significantly impact the

income taxes paid by different divisions or subsidiaries of a
company. If the transfer price is set too high, it can increase the
profits of the selling division and reduce the profits of the buying
division, potentially leading to higher taxes for the selling division.
Conversely, a low transfer price can shift profits to the buying
division, which may have a lower tax rate.

o Sales Taxes: Sales taxes are Imposed on the sale of goods and
services. Transfer prices can affect the amount of sales tax paid
by the company as a whole.

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Dual Pricing
• In dual pricing, the selling and buying units within a company record the
transfer at different prices

• For the Seller: The selling division records the transfer at the usual
market price that would be charged to an external customer This
boosts their reported profits.

• For the Buyer: The buying division records the purchase at the variable
cost of production This lowers their costs and improves their reported
profitability

• Benefits for the Firm: Improved Performance Reports Both the selling
and buying divisions appear more profitable due to the dual pricing
scheme.

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 • Limitation

o is Reduced Profit for the Company The overall profit for the
company by using dual pricing is lower than the sum of the profits
reported by the individual segments

o The selling division is assured of a high price, so there's less

motivation to control costs.

o The buying division benefits from a low price, reducing their

incentive to source more cost-effectively.

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