Decentralization and Decentralization and Performance EvaluationPerformance Evaluation

Decentralization and Performance Evaluation

• Responsibility Centers• Costs and benefits of

decentralization• Return on Investment• Residual Income

Decentralization and Performance Evaluation

• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income

Responsibility Centers

• Cost Centers

• Revenue Centers

• Profit Centers

• Investment Centers

Responsibility Centers include:

Responsibility Centers

• Cost Centers

– A cost center is a segment whose manager is

responsible for costs but not for revenues.

• Revenue Centers

• Profit Centers

• Investment Centers

Responsibility Centers

• Cost Centers

• Revenue Centers

– Revenue center managers are mostly responsible

for generating sales, not for the cost of goods sold.

• Profit Centers

• Investment Centers

Responsibility Centers

• Cost Centers

• Revenue Centers

• Profit Centers

– Profit center managers are responsible for revenues

as well as costs. These costs may include indirect

costs.

• Investment Centers

Responsibility Centers• Cost Centers

• Revenue Centers

• Profit Centers

• Investment Centers

– Investment center managers are responsible not

only for revenues and costs, but also for the

investment required to generate profits.

Responsibility Centers

Levi Strauss

San Francisco

Levi Strauss

Canada

Levi Strauss

U.S.A.

Levi Strauss

Europe

Dockers Jeans

Factories Warehouses

Sales offices

Investment Centers

Profit Centers

Cost Centers

Revenue Centers

Responsibility Centers

• Cost Centers– report of costs

• Revenue Centers– report of sales

• Profit Centers– Divisional income statement

• Investment Centers– Return on Investment

What reports are used to evaluate these responsibility center managers?

Decentralization and Performance Evaluation

• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income

Responsibility Centers

• Takes advantage of knowledge and expertise within the organization.

• Autonomy can be an intrinsic reward.

• Places fewer demands on top management.

Benefits of Decentralization:

Responsibility Centers

• Loss of Control.

• Goal Congruence.

Costs of Decentralization:

Decentralization and Performance Evaluation

• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income

ROI and Residual IncomeProjectLevel

Measure

DivisionLevel

Measure

Ratio: I RR ROI

DollarReturns: NPV R.I .

Where

IRR = Internal Rate of Return

ROI = Return on Investment

NPV = Net Present Value

R.I. = Residual Income

Return on Investment (ROI)

Examples of ROI that you may have seen:

ROE = Return on Equity

ROA = Return on Assets

These are usually employed at a firm-wide level for financial statement analysis. In cost accounting, we are usually more interested in ROI calculations for a part of the firm (e.g., a division).

ROI = Some Measure of InvestmentSome Measure of Income

Return On Investment (ROI)

ROI = Divisional Investment

= Operating Profit

Division Revenuesx Divisional Revenues

Divisional Investmt

Operating Profit

= Return on Sales x Turnover Ratio

Return On Investment (ROI)

ADVANTAGES:ROI is a measure of profitability that is independent of the size of the division.

DISADVANTAGES:Can encourage divisional managers to reject good investments.

ROI = Division Investment

Operating Profit

Decentralization and Performance Evaluation

• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income

Residual Income (RI)

ADVANTAGES:

Some argue that Residual Income comes very close to what investors care about.

RI = Profits - (Hurdle Rate x Investment)

This hurdle rate usually should be equal to or greater than the cost of capital.

E.V.A. (Economic Value Added) is a type of Residual Income calculation.

Measurement IssuesIncome:

Residual Income should exclude interest on debt.

Both RI and ROI might include some allocated corporate costs.

Investment:

Always includes identifiable assets.

Can also include some allocated corporate assets.Fixed assets might be stated at Original Cost Original cost less accumulated depreciation (book value) Current replacement cost

Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:

Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000

The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.

What is the residual income for the Fish Division?

Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:

Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000

The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.

What is the residual income for the Fish Division?

operating income - (average investment x cost of capital)= $60,000 - ($400,000 x 18%)= $60,000 - $72,000= ($12,000)

Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:

Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000

The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.

What is the return on investment (ROI) for the Turkey Division?

Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:

Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000

The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.

What is the return on investment (ROI) for the Turkey Division?

operating income ÷ average operating assets= $50,000 ÷ $250,000 = 20%

Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:

Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000

The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.

A project with a return of $36K on an investment of $200K exists. If divisions are evaluated based on residual income, which divisions would accept the project?

Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:

Turkey FishNet Operating Income $ 50,000 $ 60,000Average Operating Assets $250,000 $400,000

The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.

A project with a return of $36,000 on an investment of $200,000 exists. If divisions are evaluated based on residual income, which divisions would accept the project?

$36,000 - ($200,000 x 18%) = $0.Both Turkey division and Fish division are indifferent.