AC239 Unit 8 Chapter 24

Performance Evaluation for Decentralized Operations

In a decentralized company, managers of separate divisions or units are delegated operating responsibility. The division (unit) managers are responsible for planning and controlling the operations of their divisions.

Decentralized Operations

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1. Allows managers closest to the operations to make decisions

2. Provides excellent training for managers3. Allows managers to become experts in

their area of operation4. Helps retain managers5. Improves creativity and customer

relations

Advantages of Decentralization

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Exhibit 1Advantages and Disadvantages of Decentralized Operations

(continued)

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1. Decisions made by managers may negatively affect the profits of the company

2. Duplicates assets and expenses

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Disadvantages of Decentralization

Exhibit 1Advantages and Disadvantages of Decentralized Operations (continued)

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Responsibility Accounting

In a decentralized business, accounting assists managers in evaluating and controlling their areas of responsibility, called responsibility centers.

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Responsibility accounting is the process of measuring and reporting operating data by responsibility centers. Three common types of responsibility centers are—• Cost centers• Profit centers• Investment centers

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The area of responsibility for each center is shown below.

Cost Center Profit Center Investment Center

Cost Revenue– Cost Profit

Revenue– Cost Profit Investment in

assets

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Responsibility Accounting for Cost Centers

A cost center manager has responsibility for controlling the costs.

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Responsibility Accounting Reports for Cost Centers

(continued)

Exhibit 3

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from Manager, Plant A Budget Performance Report

(continued)

Responsibility Accounting Reports for Cost Centers (continued)

Exhibit 3

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To Vice President’s Budget Performance Report

from Supervisor, Department 1, Plant A’s Budget Performance Report

(continued)

Responsibility Accounting Reports for Cost Centers (continued)

Exhibit 3

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To Manager, Plant A’s Budget Performance Report

Responsibility Accounting Reports for Cost Centers (concluded)

Exhibit 3

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In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits).

Profit Center

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• Controllable revenues are revenues earned by the profit center.

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• Controllable expenses are costs that can be influenced (controlled) by the decisions of profit center managers.

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Service Department Charges

Services provided by internal centralized service departments are often more efficient than services contracted with outside providers. An internal service cost is called a service department charge.

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Payroll Accounting Department Charges to NEG’s Theme Park and Movie Production Divisions

Exhibit 4

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Service Department Charges to NEG Divisions

Exhibit 5

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An investment center manager has the responsibility and the authority to make decisions that affect not only costs and revenues, but also the assets invested in the center.

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Investment Center

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Exhibit 7 Divisional Income Statements—Datalink Inc.

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Rate of Return on Investment

One measure that considers the amount of assets invested in an investment center is the rate of return on investment (ROI) or rate of return on assets.

ROI =

Income from Operations

Invested Assets

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Income from Operations

SalesSales

Invested Assets×ROI =

DuPont Formula

Profit Margin

Profit Margin

Investment Turnover

Investment Turnover

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ROI =$ 70,000

$560,000×

$560,000

$350,000

ROI = 12.5% × 1.6

DataLink’s Northern Division (ROI)

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 20%

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ROI =$ 84,000

$672,000×

$672,000

$700,000

ROI = 12.5% × 0.96

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 12%

DataLink’s Central Division (ROI)

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ROI =$ 75,000

$750,000×

$750,000

$500,000

ROI = 10% × 1.5

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 15%

DataLink’s Southern Division (ROI)

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DataLink’s Northern Division Proposal

Assume that the revenues of the Northern Division could be increased by $56,000 through increasing advertising to $385,000.

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Revenues ($560,000 + $56,000) $616,000Operating expenses 385,000Income from operations before

service department charges $231,000Service department charges 154,000Income from operations $ 77,000

Projected Impact of Change

Increase of $7,000

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ROI =$ 77,000

$616,000×

$616,000

$350,000

ROI = 12.5% × 1.76

DataLink’s Northern Division (ROI) Revised

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 22%

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Example Exercise 24-4

Profit Margin, Investment Turnover, and ROI

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Campbell Company has income from operations of $35,000, invested assets of $140,000, and sales of $437,500. Use the DuPont formula to compute the rate of return on investment and show (a) the profit margin, (b) the investment turnover, and (c) the rate of return on investment.

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For Practice: PE 24-4A, PE 24-4B

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Follow My Example 24-4

Example Exercise 24-4 (continued)

a. Profit margin =$35,000

$437,500= 8%

b. Investment turnover =$437,500$140,000

= 3.125

c. Rate of return on investment =

8% × 3.125 = 25%

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Residual Income

Residual income is the excess of income from operations over a minimum acceptable income from operations.

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Northern Central SouthernDivision Division Division

Income from operations $70,000 $84,000$75,000Minimum acceptable income

from operations as a percent of invested assets:

$700,000 × 10% 70,000

$500,000 × 10% 50,000

Residual income $35,000 $14,000$25,000

$350,000 × 10% 35,000

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4 Example Exercise 24-5

Residual Income

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For Practice: PE 24-5A, PE 24-5B

The Wholesale Division of PeanutCo has income from operations of $87,000 and assets of $240,000. The minimum acceptable rate of return on assets is 12%. What is the residual income for the division?

Follow My Example 24-5

Income from operations $87,000Minimum acceptable income

from operations as a percent of assets ($240,000 × 12%) (28,800)

Residual income $58,200

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The balanced scorecard is a set of financial and nonfinancial measures that reflect multiple performance dimensions of a business.

The Balanced Scorecard

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Exhibit 8 The Balanced Scorecard

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Some common performance measures used in the balanced scorecard approach are shown below.

• Number of new products• Number of new patents• Number of cross-trained employees• Number of training hours• Number of ethics violations• Employee turnover

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Innovation and Learning

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Some common performance measures used in the balanced scorecard approach are shown below.

• Waste and scrap• Time to manufacture products• Number of defects• Number of rejected sales orders• Number of stockouts• Labor utilization

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Internal Processes

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Some common performance measures used in the balanced scorecard approach are shown below.

• Number of repeat customers• Customer brand recognition• Delivery time to customer• Customer satisfaction• Number of sales returns• Customer complaints

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Customer Service

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Some common performance measures used in the balanced scorecard approach are shown below.

• Sales• Income from operations• Return on investment• Profit margin and investment turnover• Residual income• Actual versus budgeted (standard) costs

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Financial

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When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services.

Transfer Pricing

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Three Methods of Transfer Pricing

1. Market price approach

2. Negotiated price approach

3. Cost price approach

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Income Statement—No Transfers Between Divisions

Exhibit 10

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Market Price Approach

Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers.

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The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves as to the transfer price.

Negotiated Price Approach

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Income Statements—Negotiated Transfer Price Exhibit 11

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Comparison of Exhibits 10 and 11

Income from Operations

No Units Transferred (Exhibit 10)

20,000 Units Transferred at $15 per Unit (Exhibit 11)

Increase (Decrease)

Eastern Division $200,000 $300,000 $100,000Western Division 100,000 200,000 100,000Wilson Company $300,000 $500,000 $200,000

Variable Costs per Unit < Transfer Price < Market Price

$10 < Transfer Price < $20

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Cost Price Approach

Under the cost price approach, cost is used to set transfer prices. Cost may refer to either total product cost per unit or variable cost per unit.

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