1. To guide divisional executives in making decisions. 2. To guide top management in making decisions. 3. To enable top management to appraise the performance of divisional management. There is, of course, a fundamental distinction between the use of profit figures to guide decisions and their use to appraise management. Decision-making looks to the future, appraisal looks to the past. Decision-making can, therefore, at its best, make only limited use of profit figures. Expected earnings are really of interest to the decision-maker and reported earnings are only helpful to the extent that they have predictive value. Appraisal of past performance is quite a different matter, for reported earnings have more direct relevance here. Other reasons for scepticism in the use of reported profit figures even for appraisal purposes have, however, been suggested earlier. Whatever can be said to indicate that any one variant of reported earnings is better than another for decision-making or appraisal purposes must be accepted subject to all these important reservations. With this point established, it will be argued that the most suitable income figure for use in appraising the performance of divisional management, and also for use by divisional executives in guiding their decisions, is controllable residual income before taxes, arrived at in the manner indicated in Exhibit VII. To guide top management in its decisions relating to a division, the most appropriate figure seems to be net residual income. Whether this should be taken before or after taxes depends very much on how the tax charge to divisions is computed. More will be said about this shortly. It is almost a self-evident proposition that, in appraising the performance of divisional management, no account should be taken of matters outside the division's control. These executives are to be judged on their conduct of affairs, not on the conduct of others, even when the latter has a bearing on the success of the divisional enterprise. It is mainly for this reason that, in spite of the difficulties involved, it is worth while to try to measure controllable residual income, free of all cost elements which are completely beyond the division's control. The same figure is also the most appropriate one for use by divisional management to guide its decisions, as far as historical information ever can be used to guide decisions. Indeed, as between controllable residual income and net residual income, the first is the only one which could sensibly be used at the divisional level. Net residual income is arrived at after deducting noncontrollable items which, for the most part, will have been incurred by the head office for the division-advertising expenditure, where divisions do not handle their own advertising, will serve as an example. Although these expenditures will be reported to the division for inclusion in its statements, the division may know little about the way the figures were arrived at. This would certainly be true, too, of incremental central expenses where these were charged to a division. It follows that divisional managers would know little about how these noncontrollable expenses might react to any decisions they might take. For that reason, net residual income is less useful as a guide to divisional decision-making than is controllable residual income. Turning now to corporate as distinct from divisional decisions, it must be noted that some corporate decisions relating to a division are concerned with men-the promotion or transfer of a DGM, for example. The principle so far established applies to those decisions which follow, in part, from an appraisal of managerial performance. In these cases, only controllable performance should be taken into account. For other corporate decisions, such as new investment or a withdrawal of funds from the division, the important thing is the success or failure of the divisional venture, not of the men who run it. All information relating to the venture, whether it refers to matters within the control of the division or to matters handled by the head office for the division, should be taken into account. This requires that top management examine net residual income even though this figure may provide only background information for most of the decisions with which top management will be concerned. New investment decisions will be based on forecasts relating to projects, as will abandonment decisions. These forecasts call for special studies rather than routine reports of the earnings of a whole division. The function of the routine reports in the area of decision-making will most likely be to stimulate questions, as a result of which the special studies will be made. Routine reports can never take the place of special studies: indeed, the principal value of the reports will often be to suggest the need for such studies. Page Chapter IV. Some Specific Problems of Divisional Profit Measurement___ Rules for depreciation accounting_- LIFO and Divisional Profit Measurement_ 85 86 90 93 95 98 Direct Costing-- 100 Why use direct costing?--- 102 Exhibit IX. (a) Divisional income statement for August and Sep- 103 107 Exhibit XI. Operating statements with inventory valued at normal 108 ExhibitXII. Operating statments with inventory valued at direct The Reconciliation of Direct Costing and Absorption Costing....... 109 111 Exhibit XIII. Reconciliation of operating profits under direct costing and absoprtion costing--- 113 Other Conflicts Between Accounting for Tax Purposes and Accounting for 114 The Allocation of Income Taxes to Divisions__ 116 Exhibit XIV. (Illustration, method of allocating taxes)_. 121 Computing Divisional Investment.. Chapter V. Evaluating Divisional Performance by Return on Investment and Residual Income___ 1. Total assets, net assets or fixed assets plus net current assets?__ 2. Fixed assets at cost, not bok value or appraised value?___ 123 128 129 132 134 136 138 139 6. What should be included in net income for rate of return pur- 148 7. Divisional return on investment-before tax or after tax?---Rate of Return on What? A Summary_ 149 149 Using the Rate of Return__ 151 Figure 6. Relationship of Factors Affecting Return on Invest- Exhibit XIX. (Illustration, divisional sales forecast) --- 167 169 170 Theoretical Basis of the "Market Price" Rule for Transfer Pricing- 171 Extension of the analysis-More than one consuming division___ 172 174 The Difficulty of Determining Market Price-- Transfer Prices in an Imperfect Market-The Marginal Cost Rule__ 177 178 181 Relative Neglect of the Marginal Cost Rule in Practice__ 183 184 186 Figure 7. (Graphic suggestion of continuous and discon- 186 "Shadow Prices" as Transfer Prices__ Exhibit XXIII. (Illustration, Division B's production of two Exhibit XXIV. (Illustration, company decision on how much of Page 187 188 189 191 A Recommended Procedure_ Intracompany Services_-_ Inventory Valuation and the Transfer Problem_. Interdivisional Market Relationships--- Interdivisional Transfers and Government Contracts_. The Intermediate Product Has a Competitive Market... Figure 8(a). (Illustration, graph.). 198 205 206 207 209 Appendix A to Chapter XI. A Graphic Treatment of the Theory of 212 212 213 215 Imperfectly Competitive Market for the Final Product_ Figure 9(a). (Illustration, graph.). Competing Demands for the Intermediate Product_ Transfer Prices in an Imperfect Market-the Marginal Cost Rule 224 Figure 12. (Illustration, graph). 225 Figure 13. (Illustration, graph). 227 Appendix B to Chapter VI. Computation of the Optimal Program for the Product-Mix Problem and of the Implicit Prices of the Trans- Appendix C to Chapter VII. A Case Study in Budgetary Control of 247 Exhibit XXV. Statement of income__. 249 Exhibit XXVI. Statement of income and return on investment by 251 Exhibit XXIX. Statement of income, budget year 19- Exhibit XXVII. Net sales and gross profit by product lines---- 252 253 254 255 Exhibit XXXIV. Research and development by products, related Exhibit XXXI. Profit improvement summary (product group). 256 257 258 259 260 261 262 263 264 Exhibit XXXVII. Cost saving (obsolescense) capital budget pro- Exhibit XXXVIII. New product line property budget proposal, 266 268 |