Managerial Accounting Wild and Shaw 2010 Edition McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 9Decentralization and Performance Evaluation

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Conceptual Learning ObjectivesC1: Explain departmentalization and the role of departmental accounting .C2: Distinguish between direct and indirect expenses.C3: Identify bases for allocating indirect expenses to departments.C4: Explain controllable costs and responsibility accounting.C5: Appendix 9A: Explain transfer pricing and methods to set transfer prices.C6: Appendix 9B: Describe allocation of joint costs across products.

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Analytical Learning ObjectivesA1: Analyze investment centers using return on total assets, residual income and balanced scorecard.A2: Analyze investment centers using profit margin and investment turnover.

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Procedural Learning Objectives

P1: Prepare departmental income statements.P2: Prepare departmental contribution reports.

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Departmental AccountingPrimary goalsC1

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Large complex businesses are divided into departments enabling managers to have a smaller effective span of control.Departmental AccountingC1

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Information forDepartmental Evaluation

Managers use this information to:Control operations.Appraise performance.Allocate resources.Plan strategy The accounting system provides information about resources used and outputs achieved.C1

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Information forDepartmental Evaluation The type of accounting information provided depends on whether the department is a . . .C1

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Information forDepartmental EvaluationInvestment CenterEvaluated on their use of center assets to generate income. C1

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Departmental Expense Allocation Direct expenses are incurred for the sole benefit of a specific department. Indirect expenses benefit more than one department and are allocated among departments benefited.C2

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Illustration of IndirectExpense Allocation Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies.C2

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Illustration of IndirectExpense Allocation Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies.C2

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Illustration of IndirectExpense Allocation Classic Jewelry pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies.C2

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Bases for AllocatingService Department Costs Service department costs are shared, indirect expenses that support the activities of two or more production departments.C3

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Service Department CostsQuestion ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly?a.$100,000b.$120,000c.$150,000d. $180,000C3

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Service Department CostsQuestion ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The assembly department has 100 employees and the packing department has 150 employees. What amount of cost is allocated to assembly?a.$100,000b.$120,000c.$150,000d. $180,000Assembly percentage = 100 (100 + 150) = 40%40% of $300,000 = $120,000C3

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Preparing DepartmentalIncome StatementsP1

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Departmental ExpenseAllocation SpreadsheetP1

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Departmental ExpenseAllocation SpreadsheetStep 1: Direct expenses are traced to service departments and sales departments without allocation.P1

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Departmental ExpenseAllocation SpreadsheetStep 2: Indirect expenses are allocated to both the service and the sales departments based on floor space occupied. Of a total of 12,000 square feet, the service departments occupy 1,500 square feet each, the hardware department occupies 4,050 feet, housewares 2,700, and appliances 2250. P1

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Departmental ExpenseAllocation SpreadsheetStep 3: The Service department total expenses (original direct expenses + allocated indirect expenses) from the two service departments are allocated to three remaining operating or sales departments. P1

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Departmental Income StatementsP1

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Departmental Income StatementP2

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Departmental Contribution to OHP2

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Financial Performance Evaluation MeasuresOne of the ways to evaluate investment center managers is to use a measure called return on investment (or return on assets.)The formula for ROI is as follows:

A1 Investment center net income Investment center average invested assetsROI =

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Financial Performance Evaluation MeasuresAnother measure of evaluating financial performance is by computing the investment centers residual income.A1 Investment Center - Target investment net income center net income Residual Income =

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Balanced ScorecardThe Balanced Scorecard is a system of performance measures, including non-financial measures. It Is used to assess company and division performance based on four perspectives:A1CustomerInternal processesInnovation and LearningFinancial

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Responsibility AccountingAn accounting system that provides information . . . C4

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Controllable Costs Costs are controllable if the manager has the power to determine, or strongly influence, the amounts incurred. A managers performance evaluation should be based on controllable costs.Im in controlC4

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Distinguishing Controllableand Direct Costs Direct costs are traced to departments, but may not be controllable by the department manager. Example: Department managers usually have no control over their own salaries. Controllable costs are identified with a particular manager and a definite time period.All costs are controllable at some level of management if the time period is long enough.C4

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Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with clear lines of authority and clearly defined levels of responsibility.C4

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Responsibility AccountingPerformance ReportsAmount of detail varies according to level in organization.A department manager receives detailed reports.A store manager receives summarized information from each department.C4

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Responsibility AccountingPerformance ReportsThe vice president of operations receives summarized information from each store. Management by exception: Upper-level management does not receive operating detail unless problems arise.Amount of detail varies according to level in organization.C4

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Responsibility AccountingPerformance Reports To be of maximum benefit, responsibility reports should . . .Be timely.Be issued regularly.Be understandable.Compare budgeted and actual amounts.C4

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Investment Center AnalysisWe can further examine investment center performance by splitting down return on investment into profit margin and investment turnover:

A2 ROI = Profit Margin X Investment TurnoverThis will provide further information on the performance of the unit.

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Profit MarginThe profit margin is the first component in the expanded equation and measures the income earned per dollar of sales.A2 Profit margin = Investment Center Net Income Investment Center Sales

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Investment TurnoverThe investment turnover measures how efficiently the company generates sales from its invested assets. It is used in the second half of the expanded ROI formula.

A2 Investment = Investment Center Sales Turnover Investment Center Average Assets

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End of Chapter 9

In presentations for each chapter in this text, we will provide you with sound to go along with the material on your screen. There will be sound on every slide you view. Please make sure your computer speakers are setup properly when viewing the material. Good luck and we hope you enjoy this new format.

This chapter describes decentralization performance measurement and managerial reports useful in directing a companys activities. It also describes responsibility accounting, transfer pricing, and allocating common costs across departments. In this chapter, you will learn the following conceptual objectives:C1: Explain departmentalization and the role of departmental accounting.C2: Distinguish between direct and indirect expenses.C3: Identify bases for allocating indirect expenses to departments.C4: Explain controllable costs and responsibility accounting.C5: Appendix 9A: Explain transfer pricing and methods to set transfer prices.C6: Appendix 9B: Describe allocation of joint costs across products.

In this chapter, you will learn the following analytical objectives:A1: Analyze investment centers using return on total assets.A2: Analyze investment centers using profit margin and investment turnover.

In this chapter, you will learn the following procedural objectives:P1: Prepare departmental income statements.P2: Prepare departmental contribution reports.

Most large companies are made up of subunits called departments. Top management is interested in the performance of each of the departments. To assist management in the performance evaluation of departments, we prepare departmental accounting reports. Each departmental accounting report emphasizes costs that are under the control of the departmental manager. Even the best managers can only do so much. It is necessary to divide businesses into smaller departments so a managers span of control is not too large.

All departments use resources to achieve a desired output. If our departmental accounting system is properly designed and implemented, we can control operations, appraise performance, allocate resources, and plan strategy. One of top managements objectives for this type of system is to be able to allocate more resources to those departments who are performing at the highest level or make changes to those who are operating poorly..We classify some operating departments as cost centers and others as profit centers. Cost centers are evaluated on their ability to control costs. Profit centers are evaluated on the basis of profits. Profit center managers must generate revenues and control costs to sustain profits.An investment center is responsible for all of the items mentioned in the cost and profit centers, but in addition they are also responsible for acquiring and utilizing assets.Direct expenses can be readily traced to one department. They are incurred for the sole benefit of one department. Indirect expenses cannot be traced to one department because they are incurred for the benefit of two or more departments. For example, if two departments are located in the same building, the cost of replacing the roof on the building benefits both departments. Since we cannot trace indirect expenses to individual departments, we must allocate them to departments on the basis of the relative benefits each department receives from the shared indirect expenses. Lets look at an example of indirect expense allocation. Classic Jewelry has three departments in one store location, jewelry, watch repair, and china and silver. Janitorial services to clean the store cost $300 per month. Classic Jewelry allocates the $300 janitorial cost based on the square footage of each department.First, we add the square footage in each department to get a total of 4,000 square feet. Then, we divide the square footage in each department by this total to get the allocation percentages. Last, we multiply the allocation percentages times the janitorial cost of $300 to get the amount allocated to each department.Work through the computations for the jewelry department before checking your answers on the next slide. The allocation percentage for jewelry is 2,400 square feet divided by 4,000 which equals 60 percent. Now, we multiply 60 percent times $300 to get the $180 that is allocated to jewelry.Complete the table for the other two departments and then check your work using the next slide.How did you do on this exercise? We can check our work by adding the amounts allocated to each department. The total should be $300, the total amount of janitorial cost to allocate.The Classic Jewelry example used square footage as the allocation base. You can see examples of other common allocation bases on this slide.Lets look at a question using number of employees as the allocation base.Heres your question. Try to work completely through the question before checking your answer on the next slide.We add the number of employees in each department to get a total of 250 employees. Then, we divide the number of employees in each department by this total to get the allocation percentage. The assembly allocation percentage is 100 employees divided by the 250 total, resulting in an allocation percentage of forty percent. Last, we multiply the allocation percentage times the indirect cost of $300,000 to get the amount allocated to assembly, $120,000.Now that we have discussed direct expenses and the allocation of indirect expenses, we are ready to put our knowledge to work by preparing departmental income statements. These statements are the primary tool for evaluating departmental performance. Before we prepare the departmental income statements, we must determine the expenses for each department using the three-step process that you see on your screen.Here is the completed spreadsheet for A-1 Hardware store that has five departments. Two of them, general office and purchasing, are service departments, and the other three, hardware, housewares, and appliances are operating or selling departments. Lets take an overall look at the spreadsheet, and then we will break it up by steps in the following slides. Here is an overview: Step one of the spreadsheet allocates the direct expenses that each department incurs on their own. This information is accumulated in departmental expense accounts.

The second part of the spreadsheet allocates the indirect expenses based on an allocation base.

The third part of the spreadsheet allocates the expenses of the two service departments, office and purchasing, to the operating departments. You will notice that ALL of the direct and indirect costs of the service departments are eventually allocated to the operating departments.

Lets take a look at the steps in further detail.Lets take a look at step 1. Each department has direct expenses for salaries and supplies. In Step One, we trace these direct expenses to the individual departments without allocation. They are accounted for in separate general ledger accounts.Now lets take a look at the indirect expense allocation in step 2. Each indirect expense is allocated based on a reasonable allocation basis. In this example, we will isolate the utilities expense and discuss how the $2,400 cost for utilities is allocated. In this example, utilities are allocated based on floor space. In this step, we allocate indirect expenses to both the service and the sales departments based on floor space occupied. The total floor space is 12,000 square feet. Both service departments occupy 1,500 square feet each, or twelve point five percent of the total for each service department. The hardware department occupies 4,050 square feet, or thirty three point seven five percent of the total. The housewares department occupies 2,700 square feet, or twenty two point five percent of the total. The appliances department occupies 2,250 square feet or eighteen point seven five percent of the total. We allocate the indirect expenses by multiplying the allocation percentage for each department times the total indirect expenses. You should verify the numbers in the spreadsheet on your screen by working through the allocations for the remaining indirect expenses. For example, go back and recalculate the advertising expense based on relative sales percentages, and the insurance expense based on the value of insured assets to make certain you have an understanding of how expenses can be allocated.In Step Three, we total the expenses for the combined service departments and allocate the total to the operating departments. We will allocate the total expenses in the general office department based on sales of the three sales departments, one hundred nineteen thousand five hundred dollars for the Hardware Department and seventy one thousand seven hundred dollars for the Housewares Department and forty seven thousand eight hundred dollars for the Appliances Department. To begin the allocation, we add the sales for the three sales departments to get a total of two hundred thirty nine thousand. Then we divide the sales in each sales department by this total to get the allocation percentage. The Hardware departments allocation percentage is computed by dividing one hundred nineteen thousand five hundred dollars by the two hundred thirty nine thousand dollars total. We get fifty percent. This means we allocate 50% of the general office expenses to the Hardware Department. We repeat the steps for the Housewares and Appliances Departments Again, you should verify the numbers in the spreadsheet on your screen by working through the allocations for the departments. The total expenses on the bottom line can then be used to prepare departmental income statements.. Step 4 The amounts from the previous step can now be carried over to create proper Departmental Income Statements showing the proper allocation of costs. We can now take the data and further break it down into direct expenses and indirect expenses. The salaries expense and depreciation expense and supplies expense are direct to each department. All of the other expenses highlighted in pink of the slide are indirect expenses. By distinguishing between the two, we can now calculate the departmental contribution to overhead. This amount can be calculated by the three operating departments by taking the sales of the department and subtracting out all of the direct expenses of that department. We will show this on the next slide.In this last step of computing departmental contributions, you can see that the direct expenses are subtracted from sales to compute the Departmental contributions to overhead. These are shown on the green line. In addition, at the very bottom of the report you will see that the contribution is expressed as a percentage of sales. One of the ways to evaluate investment center managers is to compute some key ratios. One of them is the investment centers return on investment (ROI), also sometimes referred to as the return on assets. As you can see the formula is computed by dividing the investment centers net income by the amount of the average invested assets of the investment center. Another way to evaluate the investment center is by calculating residual income. The residual income is computed by taking the investment centers actual net income and subtracting out the targeted or projected net income. To compute the target amount, the investment centers target rate or hurdle rate is usually considered to be its cost of financing. The target income can be computed by taking the invested assets and multiplying by this hurdle rate. Unlike return on investment or assets, the residual income is usually expressed in dollars. Evaluating performance based solely on financial measures such as return on investment and residual income has limitations. So some companies also consider more non-financial measures. One of these measures that may be considered is a balanced scorecard. The balanced scorecard is a system of performance measures including non-financial measures. It asks managers to think of their company from four perspectives as shown in the slide above.A responsibility accounting system uses the concept of controllable costs to evaluate a managers performance. Responsibility for controllable costs is clearly defined and performance is evaluated based on the ability to manage and control those costs. Managers should be evaluated on how well they manage controllable costs. A cost is controllable by a manager if the manager has the power to determine, or strongly influence, the amounts incurred. For example, production managers are generally considered to be responsible for the amount of material used in their departments, but not for the cost of insurance on the building in which the departments are located. Not all departmental direct costs are controllable by the department manger. For example, the department managers salary is directly traceable to the department, but the department manager does not control the salary. Costs that are not controllable in the short run at lower levels in the organization are likely to be classified as controllable costs at higher levels, especially if the time period is longer.A responsibility accounting system makes use of organizational charts to determine lines of authority and levels of responsibility.The amount of detail in performance reports varies according to level in an organization. In general, lower-level managers receive detailed reports, but the level of detail decreases at higher levels. Top management receives reports that are highly summarized. If a problem arises, top management can request greater detail to look into the problem. This procedure is known as management by exception because top management only gets involved in detailed operations if a problem (exception) arises. Responsibility performance reports should be timely, issued on a regular schedule, and presented in a usable, easily understood format to be of maximum benefit to managers. Since performance is being evaluated and reported, the responsibility report should include comparisons of budgeted costs and actual costs.We can further examine division performance by splitting return on investment into two components: profit margin and investment turnover. By doing so we can further investigate what has transpired in the unit being evaluated.Review the expanded formula for Return on investment. We will break each component down.The profit margin is a measure of profitability and is computed by taking the investment centers net income and dividing by the investment centers sales. This is the first component of the expanded ROI formula.The investment center turnover comprises the second half of the expanded ROI formula. The investment turnover measures how efficiently the company generates sales from its invested assets. It is computed by taking the investment centers sales and dividing by the centers average assets. The expanded measure of performance can aid management when considering further investments in divisions.