2.4 Management Control in Decentralized Organizations

Question 1

What is….

1. Centralization? (3)
2. Decentralization? (4)

Answer 1

1. concentration of decision making authority only at the highest levels of organization || maximum constraints and minimum freedom
2. delegation of decision making authority to lower levels of the organization || the lower in the organization that authority is delegated the greater the decentralization || minimum contraints and maximum freedom

Question 2

What is segment autonomy?

Answer 2

• delegation of decision making power to managers of segments in an organization

Question 3

What are benefits (4) and costs (5) of decentralization?

Answer 3

Benefits:
- lower-level managers have the best information concerning local conditions
- promotes management skills which in turn helps ensure leadership continuity
- managers enjoy higher status from being independent and thus are better motivated
- frees up time for central managers

Costs:
- managers may make decisions that are not in the organizations best interests
- managers tend to duplicate services
- increasing costs of accumulating and processing information
- wasting time in negotiations
- innovative ideas are less likely to be shared

Question 4

What are success factors for decentralization?

1.
2.

Answer 4

• decentralization is more successful when an organizations segments are relatively independent of one another
• for decentralization to work, autonomy must be real, not just “lip service”

Question 5

Measures of Segment Performance | What is the Target here?
And what measures are there?

Target
1.
2.
3.

Answer 5

• goal congruence between segment manager and corporation
  1. income measures (net income, EBIT, EBITDA)
  2. Return on investment (ROI)
  3. economic profit

Question 6

Measure of Segment Performance | Income Measures (net income, EBIT, EBITDA)

What are advantages (2) and disadvantages (2)?

Answer 6

Advantages:
- available at any level of the organization for which a company can identify revenues and expenses
- easily adjustable for factors that are not in the control of the managers, e.g. impact of interest and taxes by using EBIT

Disadvantages:
- focus too narrowlly on income without considering the resources required to generate the income
- can provide misleading comparison

Question 7

Measures of Segment Performance | What is ROI (return on investment)?

1.
2.
3.

Answer 7

• more comprehensive measure of profitability that takes into account the investment required to generate income
• measure of income divided by the investment required to obtain that income (thus relative value)
• facilitates comparison of a unit´s performance with other segments

Question 8

What is the Value driver tree for ROI according to DuPont?

1.
2.
3.
4.

Answer 8

• allows for a better understanding of KPI formation
• identify measures to improve KPI
• used for benchmarking
• communication vehicle

Question 9

What are factors that have an Impact on the ROI Calculation when Valuating Assets?

1.
2.
3.

Answer 9

• historical vs current cost
• plant and equipment: net book value vs gross book value
• assets values: beginning value, ending value or average value

Question 10

What is…

1. net book value?
2. gross book value?

Answer 10

1. the original cost of an asset less any accumulated depreciation
2. original cost of an asset before deducting accumulated deoreciation

Question 11

What are the incentives arising from ROI?

1.
2.

Answer 11

• causes managers to consider both income and investment
• may still not align incentives for managers with goal of firm

Question 12

What is economic profit? What are the incentives from Economic Profit?

1.
2.
3.

Answer 12

• Economic Profit: amount by which NOPAT (after taxt unleveraged operating income) exceeds the cost of capital to generate that income
• economic profit aligns incentives for individual managers with the corporate goal (e.g. company has the goal to earn a return on investment greater than the cost of capital)
• managers evaluated based on economic profit have incentives to make an investment if, and only if, its return exceeds the corporate cost of capital and thus creating wealth for the corporation

Question 13

What is the formula for NOPAT?

Answer 13

operating profit * (1- tax rate)

Question 14

What are measures to increase the economic profit?

1.
2.
3.
4.

Answer 14

• increase in operating profit while cost of capital remains constant
• reduce capital costs without reducing operating profit
• profitable growth, i.e. invest in projects with positive economic profit contribution
• de-investment from activities with negative economic profit and repayment of existing credit lines or distributing to equity investors

Question 15

What is Transfer Pricing?

1.
2.
3.

Answer 15

• price that one segment charges another segment of the same organization for a product or service
• required when one segment of a company produces and sells an item to another segment
• revenue to the producing company and cost to the acquiring segment - the profit of the firm as a whole is not affected

Question 16

What is the purpose of Transfer Pricing?

1.
2.
3.

Answer 16

• the idea that decisions to improve segment performance should also increase performance of comapany as a whole
• it guides segment managers to make decisions regarding whether to buy or sell products inside or outside of the company
• it preserves segment autonomy in decentralized organizations

Question 17

What is the general rule for transfer pricing?

Answer 17

• transfer Price = outlay cost + opportunity cost

Question 18

Transfer Pricing: What are….

1. outlay costs?
2. opportunity costs?

Answer 18

1. amount the producing segment must pay to produce the product or service
2. contribution to profit that the producing segment forgoes by transferring the item internally

Question 19

What are the popular Transfer Pricing Systems?

1.
2.
3.

Answer 19

1. Market based transfer prices
2. cost based transfer prices (a. Variable costs or b. Full Cost (possibly plus profit))
3. negotiated transfer prices

Question 20

What is the idea of market based transfer prices?

1.
2.
3.

Answer 20

• using market price as transfer price (if there is a competitive market for the product)
• will lead in general to goal congruence because the market price = outlay cost plus opportunity cost
• deduction of avoidable costs (e.g. shipping or marketing) leads to “market price minus” transfer price

Question 21

What is the idea of Variable Cost Pricing amd Full Cost Pricing?

Answer 21

• VCP: appropriate when selling divisions forgoes no oppoertunity when it transfers the item internally (bc outlay cost = approx. VC)
• FCP: includes VC and also allocation of FC (an if included the profit markup) // it is implicitly assumed that the allocation is a good approximation of the opportunity cost

Question 22

What is the idea of Negotiated Transfer Prices? What do Critics say to this?

1.
2.
3.

Answer 22

• companies that are heavily committed to segment automony often allow managers to negotiate transfer prices
• open negotiations allow managers to make optimal decisions
• critics of negotiated prices say that it takes too much time and effort to negotiate, which is an activity that does not directly add to the profits of the company

Question 23

What is multinational Transfer Pricing?

1.
2.

Answer 23

• multinational companies use transfer pricing to minimize their worldwide taxes, duties and tariffs
• companies might also use transfer prices to avoid financial restricitions imposed by some governments, e.g. amount of dividend payments paid to foreign owners