divisional performance evaluation

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Managerial Economic s and Organizational Architecture, 5e

Managerial Economics andOrganizational Architecture, 5e

Chapter 17: DivisionalPerformance Evaluation

McGraw-Hil l /IrwinCopy right 2009 by The McGraw-Hil l Comp anies, Inc. All Righ ts Reserved.


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Measuring Divisional Performance

Rewards are based on performanceevaluations

Must be consistent with decision rightsgranted to the unit manager

Units can be characterized into five

groups

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Cost Centers

Manufacturing

Assigned decision rights to produce astipulated level of output

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Cost Centers

Economic efficiency (minimize costs forgiven output)

Technical efficiency (maximize output forgiven budget)

Note: minimizing average cost does notyield profit-maximizing sales level

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Expense Centers Personnel, accounting

Managers are given fixed budget andasked to maximize service/output

Output is more subjectively measured thanin a cost center

Budgets may be benchmarked with those

of other firms Lack of charge back leads to overuse

Risk of empire building

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Revenue Centers

Sales, distribution

Managers compensated for selling a set ofproducts

Objective to maximize revenue for a givenprice or quantity and budget

May not be consistent with value

maximization Revenue maximized when MR=0

But MC may be greater than 0

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Profit Centers

Combined cost and revenue centers

Managers are given a fixed capital budgetand allocated decision rights for input mix,product mix and selling prices

Evaluated on difference between actualand budgeted accounting profits

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Profit Centers

Firms must be wary of individual unitsmaximizing profits at the expense ofmaximizing value of the whole firm.

Complications Selection of transfer price

Overhead allocation

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Investment Centers

Profit centers with decision rights overcapital expenditures

Evaluated on basis of return on capital

Return on assets

For the investment centerthe ratio of accountingnet income to the total assets invested in the

center Economic value added

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Transfer Pricing

Price paid for intra-organizational transfersof goods and services

Choice determines both distribution ofprofits among units and overall profits

If transfer prices are mis-measured,managers in various divisions will makeinappropriate decisions

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Transfer Pricing

The optimal transfer price for a product orservice is its opportunity cost

Often difficult to measure

Measurement Costless information

Opportunity cost is the marginal cost

Asymmetric information Managers may have incentives to hide true costs

and may charge monopoly price instead of priceequal to MC

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Profit-Maximizing Product Price

110

60

Price(indollars)

$

Firm profit = $500

MR

MC = $10

10 22

DQ

Quantity

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Decentralized Firm

transfer price

110

60

10

Costs(indollars)

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Quantity

DMRMC

Q

$

Profits = $250

Manufacturing division

$

110

85

60

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Quantity

DMRQ

MC

Profits = $125

Distribution division

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Internal Accounting

The accounting system

Decision management requires estimates offuture benefits and costs

Backward-looking accounting systemssupport decision control

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Internal Accounting

Tradeoffs between decision managementand control

Accounting measures are not under the

control of those being monitored

Managers with decision making rights areoften dissatisfied with financial measures for

making operating decisions

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divisional performance evaluation

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