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 17-2 Managerial Economics and Organizational Architecture, 5e Cost Centers • Manufacturing • Assigned decision rights to produce a stipulated level of output 17-3 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 17-4 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” 17-5 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 17-6 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 17-7 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 17-8 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 17-9 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 17-10 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 17-11 Managerial Economics and Organizational Architecture, 5e Profit-Maximizing Product Price $ Price (in dollars) 110 Firm profit = $500 60 MC = $10 MR D 22 10 Q Quantity 17-12 Managerial Economics and Organizational Architecture, 5e Decentralized Firm transfer price $ $ Costs (in dollars) 110 Profits = $250 Profits = $125 110 85 60 MC 60 10 MR D MC 11 Q MR 11 D Q 22 Quantity Quantity Manufacturing division Distribution division 17-13 Managerial Economics and Organizational Architecture, 5e Transfer-Pricing Methods • • • • Market base Marginal cost Full cost Negotiated 17-14 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 17-15 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 17-16 ... 17-13 Managerial Economics and Organizational Architecture, 5e Transfer-Pricing Methods • • • • Market base Marginal cost Full cost Negotiated 17-14 Managerial Economics and Organizational Architecture, ... 17-2 Managerial Economics and Organizational Architecture, 5e Cost Centers • Manufacturing • Assigned decision rights to produce a stipulated level of output 17-3 Managerial Economics and Organizational. .. center • Economic value added 17-9 Managerial Economics and Organizational Architecture, 5e Transfer Pricing • Price paid for intra -organizational transfers of goods and services • Choice determines