Ch12-Decentralization and Performance Evaluation

7/28/2019 Ch12-Decentralization and Performance Evaluation

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Managerial Accounting

by James JiambalvoChapter 12:

Decentralization and

PerformanceEvaluation

Slides Prepared by:

Scott PetersonNorthern State

University


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Objectives

1. List and explain the advantages anddisadvantages of decentralization.

2. Explain why companies evaluate theperformance of subunit managers.

3. Identify cost centers, profit centers,

and investment centers.4. Calculate and interpret return on

investment (ROI).


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Objectives(Continued)

5. Explain why using a measure of profit toevaluate performance can lead to

overinvestment and why using a measureof return on investment (ROI) can lead tounderinvestment

6. Calculate and interpret residual income

(RI) and economic value added (EVA).7. Explain the potential benefits of using a

Balanced Scorecard to assessperformance.


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Advantages of Decentralization

1. Better information leading to superiordecisions.

2. Faster response to changingcircumstances.

3. Increased motivation of managers.

4. Excellent training for future top levelexecutives.


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Advantages of Decentralization


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Disadvantages of

Decentralization

1. Costly duplication of activities.

2. Lack ofgoal congruence.
http://d/PPT/glossary.htmhttp://d/PPT/glossary.htm


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Why Companies Evaluate The

Performance of Subunits and

Subunit Managers

1. Decentralization naturally leads to evaluatesubunits and managers.

2. Companies evaluate performance ofsubunits and managers for two reasons:

a. Evaluation identifies successful operations

and areas needing improvement.b. Evaluating performance influences manager

behavior.


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Responsibility Accounting and

Performance Evaluation

1. Responsibility accounting holdsmanagers responsible for only costs and

revenues which they can control.

2. To implement responsibility accountingin a decentralized organization, costs

and revenues are traced to theorganizational level where they can becontrolled.


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Responsibility Accounting and

Performance Evaluation


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Cost Centers, Profit Centers,

and Investment Centers

1. Subunits are organizational units withidentifiable collections of related resources

and activities.2. A subunit may be a:

a. Departmentb. Subsidiaryc. Division.

3. Subunits are sometimes referred to asresponsibility centers and include costcenters, profit centers, and investment

centers.


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Cost Centers, Profit Centers,

and Investment Centers(Continued)

4. Subunits are also called responsibilitycenters.

5. Include:a. Cost centersb. Profit centersc. Investment centers.
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Cost Centers

1. Subunit that has responsibility forcontrolling costs but does not have

responsibility for generating revenue.

2. Examples: janitorial, computer service, andproduction departments.

3. Managerial goal: to provide services at areasonable cost to the company.

4. Evaluation: compare budgeted/standardcosts with actual costs.


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Profit Centers1. Subunit that has responsibility for generating

revenues as well as for controlling costs.

2. Examples: copier and camera divisions ofan electronics firm.

3. Managerial goal: to maximize profit(revenues expenses) for the division.

4. Evaluation: profit from the current year maybe compared with budget or previous yearsor compared with with other profit centers ona relative basis.


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Investment Centers

1. Subunit that has responsibility for:a. Generating revenuesb. Controlling costsc. Investing in assets

2. Managers of investment centers havecontrol over inventory, receivables,equipment purchases, etc...

3. Held responsible for generating some kindof return on them.


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Investment Centers(Continued)

4. Examples: Nordstrom, Inc. subunitFaconnable.

5. Managerial goal: to maximize return oninvestment.

6. Evaluation: rate of return (%) relative to a

benchmark/budget rate of return or relativeto other investment center rates of return.


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Evaluating Investment Centers

with ROI

1. ROI is one of the primary tools for evaluatingperformance of investment centers.

2. Calculated as follows: ROI = Income

Invested Capital

3. ROI focuses on income AND investment

4. Natural advantage over income (alone) as ameasure of performance.

5. Removes the bias of larger investment over

smaller investment.


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M i I d


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Measuring Income and

Invested Capital When

Calculating ROI

1. For ROI calculations, companies measureincome in a variety of ways:

a. Net income

b. Income before interest and taxes

c. Controllable profit

2. The text uses uses Net Operating ProfitAfter Taxes, NOPAT. This formula does nothold managers responsible for interest.


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What is NOPAT?

Net Income $3,900,000

Add Back:

Interest Expense 1,000,000

less tax savings (350,000)

NOPAT $4,550,000

M i I d


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Measuring Income and

Invested Capital When

Calculating ROI(Continued)

1. Invested capital is measured in a variety ofways.

2. In the text, invested capital is measured as:Total Assets - Noninterest-bearing currentliabilities

3. Examples of noninterest-bearing current

liabilities:a. Accounts payable

b. Income taxes payable

c. Accrued liabilities


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Problems With Using ROI1. Major problem with ROI: the denominator,

invested capital, is based on historical costs,

net of depreciation.2. As those assets become fully depreciated,

the invested capital denominator becomesextremely low and the ROI number quite

high.3. Managers may therefore be compelled to

put off purchases of new equipmentnecessary for long-term success. They

underinvest.


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Problems of Overinvestment

and Underinvestment: You Get

What You Measure

1. Managers of investment centers with highROIs may be unwilling to invest in assets

that will dilute their current ROI.

2. This will lead to underinvestment.

3. Conversely, evaluation in terms of profit can

lead to overinvestment.


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Residual Income (RI)1. Residual Income (RI): net operating profit

after taxes of an investment center in

excess of the profit required for the level ofinvestment.

2. RI = NOPAT - Cost of Capital x Investment

3. RI has the potential to solve both the

overinvestment and underinvestmentproblem because it compels investment inthe range between cost of capital andcurrent ROI.


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Residual Income (RI): Example1. Facts: NOPAT=$4,550,000, Invested

Capital=$65,000,000, cost of capital=10%.

2. Calculate residual income (loss):

3. RI = $4,550,000 (.10 x $65,000,000)

4. RI = ($1,950,000)

5. Negative residual value; not good!


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Solving The Overinvestment

and Underinvestment Problems1. What happens under RI when a project

comes along that will earn 11%?

a. The manager will make the investment:underinvestment problem solved!

2. What happens under RI when a project

comes along that will earn 9%?a. The manager will NOT make the

investment: overinvestment problemsolved!


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Economic Value Added (EVA)1. Economic Value Added, EVA, is a

performance measure developed by the

consulting firm Stern Stuart.

2. What is it? RI adjusted for accountingdistortions.

3. Primary distortion is related to research anddevelopment (R&D).
http://d/PPT/glossary.htm#Economic%20Value%20Added%20(EVA)http://www.sternstewart.com/http://www.sternstewart.com/http://d/PPT/glossary.htm#Economic%20Value%20Added%20(EVA)


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Economic Value Added (EVA)(Continued)

1. Under GAAP, R&D is expensedimmediately.

2. Under EVA, R&D is capitalized andamortized over a number of futureaccounting periods.

3. EVA has gained considerable attention inthe financial press.

4. EVA = NOPATadjusted

(Cost of Capital x

Investmentadjusted

)


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Using A Balanced Scorecard

To Evaluate Performance1. Problem with ROI and RI/EVA is that these

financial measures are ALL backward

looking.2. Balanced Scorecard is a set of performance

measures :

a. Financial perspectiveb. Customer perspective

c. Internal process perspective

d. Learning and growth


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Using A Balanced Scorecard

To Evaluate Performance(Continued)

3. Balanced Scorecard uses performancemeasures that are tied to the companys

strategy for success.4. Balance is a key factor using this technique.


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How Balance is Achieved in A

Balanced ScorecardBalance between qualitative and

quantitative, forward and backward

measures, and balanced companydimensions!

Performance is assessed across a

balanced set of dimensions. Quantitative measures are balanced with

qualitative measures. There is a balance of backward-looking and

forward-looking measures.


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How Balance is Achieved in A

Balanced Scorecard


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Appendix: Transfer Pricing1. Transfer Pricing

2. Market Price as the Transfer Price

3. Market Price and Opportunity Cost

4. Variable Cost as the Transfer Price

5. Full Cost Profit as the Transfer Price

6. Negotiated Transfer Prices

7. Transfer Pricing and Income Taxes in anInternational Context


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Transfer PricingDivisions often sell goods or services to other

units within the same company. In the

automobile manufacturing industry, batteries

manufactured in one division may be sold to

other divisions which manufacture autos.

1. Market prices

2. Variable costs

3. Full cost plus profit

4. Negotiated prices.


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Market Price As The Transfer

Price1. This method would be the same as with any

other customer at arms length.

2. The external market price is an excellentchoice because the buying and sellingdivisions are treated as independent

companies.


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Market Price And Opportunity

Cost1. Opportunity cost is the foregone benefit or

increased cost of selecting one alternative

over another.2. The selling division has a choice between

selling to the related division or into an open

market.3. The determining factor in deciding whether

or not to sell to the related division is theimpact to the firm (overall) of the decision.


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Market Price And Opportunity

Cost


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Variable Cost As The Transfer

Price1. In some cases the transferred product is

unique and is not sold in the open market.

2. Here, variable cost may be a good transferprice.

3. Conveys accurate opportunity cost

information.4. When no external market for the product

exists, the opportunity cost of producing andselling the product is variable cost per unit.


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Full Cost Plus Profit As The

Transfer Price1. With variable cost transfer pricing, selling

division cannot earn a profit

2. The price may not be acceptable tomanagement of the selling company.

3. Many companies add a profit margin to the

full cost of production.4. Full Cost Plus Profit may not measure the

opportunity cost of producing the product.


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Negotiated Transfer Prices1. Some companies allow managers to

negotiate transfer prices.

2. The problem is that this price may notreflect the opportunity cost of producing andselling the product.

3. Reflects relative bargaining prowess ofindividual managers.

Transfer Pricing And Income


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Transfer Pricing And IncomeTaxes In An International

Context1. Income tax rates vary significantly between

countries.

2. When goods are transferred betweencountries, these tax situations may createincentives for relatively high or low transferprices.

3. Creates a bias toward having high transferprices when selling a product from a low taxcountry to a high tax country and having alow transfer price when selling a product from

a high tax country to a low tax country.


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Quick Review Question #11. A profit center is responsible for all of

the following except:

a. Investing in long term assets.

b. Controlling costs.

c. Generating revenues.

d. All of the above.


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Quick Review Answer #11. A profit center is responsible for all of

the following except:

a. Investing in long term assets.

b. Controlling costs.

c. Generating revenues.

d. All of the above.


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Quick Review Question #22. What is the difference between RI and

EVA?

a. RI is a new concept.

b. EVA makes adjustments for accountingdistortions.

c. RI excludes research and developmentas an expense.

d. EVA includes a capital charge.


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Quick Review Answer #22. What is the difference between RI and

EVA?

a. RI is a new concept.

b. EVA makes adjustments for accountingdistortions.

c. RI excludes research and developmentas an expense.

d. EVA includes a capital charge.


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Quick Review Question #33. Return on Investment (ROI) is calculated

as:

a. Sales / Total assets.

b. Gross margin / Invested capital.

c. Investment center income / Invested

capital.d. Income / Sales.


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Quick Review Answer #33. Return on Investment (ROI) is calculated

as:

a. Sales / Total assets.

b. Gross margin / Invested capital.

c. Investment center income / Invested

capital.d. Income / Sales.


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Quick Review Question #44. Investment center income is $864,000.

Investment turnover is 2. ROI is 24%.

Sales is?a. $8,000,000

b. $7,200,000

c. $6,000,000d. $3,600,000


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Quick Review Answer #44. Investment center income is $864,000.

Investment turnover is 2. ROI is 24%.

Sales is?a. $8,000,000

b. $7,200,000

c. $6,000,000d. $3,600,000


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Documents

Ch12-Decentralization and Performance Evaluation