Managerial Economics and Organizational Architecture, 5e

Managerial Economics and Organizational Architecture, 5e

Chapter 17: Divisional Performance Evaluation

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Managerial Economics and Organizational Architecture, 5e

Measuring Divisional Performance

Rewards are based on performance evaluations Must be consistent with decision rights granted to the unit manager Units can be characterized into five groups

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Managerial Economics and Organizational Architecture, 5e

Cost Centers
Manufacturing Assigned decision rights to produce a stipulated level of output

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Managerial Economics and Organizational Architecture, 5e

Cost Centers
Economic efficiency (minimize costs for given output) Technical efficiency (maximize output for given budget) Note: minimizing average cost does not yield profit-maximizing sales level

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Managerial Economics and Organizational Architecture, 5e

Expense Centers
Personnel, accounting Managers are given fixed budget and asked to maximize service/output Output is more subjectively measured than in 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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Managerial Economics and Organizational Architecture, 5e

Revenue Centers
Sales, distribution Managers compensated for selling a set of products Objective to maximize revenue for a given price 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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Managerial Economics and Organizational Architecture, 5e

Profit Centers
Combined cost and revenue centers Managers are given a fixed capital budget and allocated decision rights for input mix, product mix and selling prices Evaluated on difference between actual and budgeted accounting profits

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Managerial Economics and Organizational Architecture, 5e

Profit Centers
Firms must be wary of individual units maximizing profits at the expense of maximizing value of the whole firm. Complications
Selection of transfer price Overhead allocation

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Managerial Economics and Organizational Architecture, 5e

Investment Centers
Profit centers with decision rights over capital expenditures Evaluated on basis of return on capital
Return on assets
For the investment center the ratio of accounting net income to the total assets invested in the center

Economic value added

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Managerial Economics and Organizational Architecture, 5e

Transfer Pricing
Price paid for intra-organizational transfers of goods and services Choice determines both distribution of profits among units and overall profits If transfer prices are mis-measured, managers in various divisions will make inappropriate decisions

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Managerial Economics and Organizational Architecture, 5e

Transfer Pricing
The optimal transfer price for a product or service 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 price equal to MC
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Managerial Economics and Organizational Architecture, 5e

Profit-Maximizing Product Price

$

110
Firm profit = $500 Price (in dollars)

60

MC = $10 MR 10 Quantity
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D 22 Q

Managerial Economics and Organizational Architecture, 5e

Decentralized Firm transfer price

$ 110 Profits = $250 110 85 60 60 MC $ Profits = $125

Costs (in dollars)

10 5

MR 11 Quantity

MC Q 5 11

MR

D 22

Quantity Distribution division

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Manufacturing division

Managerial Economics and Organizational Architecture, 5e

Transfer-Pricing Methods
Market base Marginal cost Full cost Negotiated

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Managerial Economics and Organizational Architecture, 5e

Internal Accounting
The accounting system
Decision management requires estimates of future benefits and costs Backward-looking accounting systems support decision control

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Managerial Economics and Organizational Architecture, 5e

Internal Accounting
Tradeoffs between decision management and control
Accounting measures are not under the control of those being monitored Managers with decision making rights are often dissatisfied with financial measures for making operating decisions

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