13 1 CHAPTER Performance Evaluation in the Decentralized

13 -1 CHAPTER Performance Evaluation in the Decentralized Firm

13 -2 Objectives 1. Define responsibility accounting, After studying this and describe four types of responsibility centers. chapter, you should 2. Tell why firms choose decentralize. be abletoto: 3. Compute and explain return on investment (ROI) and economic value added (EVA). 1. 4. Discuss methods of evaluating and rewarding managerial performance. 2. 5. Explain the role of transfer pricing in a decentralized firm.

13 -3 Responsibility accounting is a system that measures the results of each responsibility center according to the information managers need to operate their centers.

13 -4 Types of Responsibility Centers Cost center: A responsibility center in which a manager is responsible only for costs. Revenue center: A responsibility center in which a manager is responsible only for sales. Continued

13 -5 Types of Responsibility Centers Profit center: A responsibility center in which a manager is responsible for both revenues and costs. Investment center: A responsibility center in which a manager is responsible for revenues, costs, and investments.

13 -6 ACCOUNTING INFORMATION USED TO MEASURE PERFORMANCE Cost center Sales Capital Investment Other x x x Revenue center Direct cost only x Profit center x x Investment center x x

13 -7 Reasons for Decentralization 1. Ease of gathering and using local information 2. Focusing of central management 3. Training and motivating segment managers 4. Enhanced competition, exposing segments to market forces

13 -8 Return on Investment Operating income ROI = Average operating assets Beginning net book value + Ending net book value 2

13 -9 Comparison of ROI Electronics Divisions Medical Supplies Divisions 2003: Sales $30, 000 Operating income 1, 800, 000 Average operating assets 10, 000 ROI 18 % $1, 800, 000 $10, 000 $117, 000 3, 510, 000 19, 500, 000 18%

13 -10 Comparison of ROI Electronics Divisions Medical Supplies Divisions 2004: Sales $40, 000 Operating income 2, 000 Average operating assets 10, 000 ROI 20 % $2, 000 $10, 000 $117, 000 2, 925, 000 19, 500, 000 15%

13 -11 Margin and Turnover ROI = Margin x Turnover Operating Income Sales Average operating assets

13 -12 MARGIN AND TURNOVER COMPARISONS Electronics Division 2003 Margin Turnover ROI 6. 0% x 3. 0 18. 0% Medical Supplies Division 2004 2003 2004 5. 0% x 4. 0 20. 0% 3. 0% x 6. 0 18. 0% 2. 5% x 6. 0 15. 0%

Advantages of ROI 1. It encourages managers to focus on the relationship among sales, expenses, and investments. 2. It encourages managers to focus on cost efficiency. 3. It encourages managers to focus on operating asset efficiency. 13 -13

Disadvantages of ROI 1) It can produce a narrow focus on divisional profitability at the expense of profitability for the overall firm. 2) It encourages managers to focus on the short run at the expense of the long run. 13 -14

13 -15 Economic value added (EVA) is aftertax operating profit minus the total annual cost of capital. EVA = After-tax operating income – (Weighted average cost of capital x Total capital employed)

13 -16 There are two steps involved in computing cost of capital: 1. Determine the weighted average cost of capital (a percentage figure) 2. Determine the total dollar amount of capital employed

Weighted Average Cost of Capital 13 -17 Suppose that a company has two sources of financing: $2 million of long-term bonds paying 9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average cost of capital is computed as follows:

Weighted Average Cost of Capital Amount 13 -18 Percent x After-Tax Cost = Weighted Cost Bonds $2, 000 0. 25 0. 009(1 – 0. 4) =. 054 0. 0135 Equity 6, 000 0. 75 0. 06 + 0. 06 =. 120 0. 0900 Total $8, 000 0. 1035 Thus, the company’s weighted average is 10. 35 percent.

13 -19 EVA Example Suppose that Mahalo, Inc. , had after-tax operating income last year of $900, 000. Three sources of financing were used by the company: $2 million of mortgage bonds paying 8 percent interest, $3 million of unsecured bonds paying 10 percent interest, and $10 million in common stock, which was considered to be no more or less risky than other stocks. Mahalo, Inc. pays a marginal tax rate of 40 percent.

Weighted Average Cost of Capital Amount 13 -20 Weighted Percent x After-Tax Cost = Cost Mortgage bonds $ 2, 000 0. 133 Unsecured bonds 3, 000 0. 200 Common stock 10, 000 0. 667 Total $15, 000 Weighted average cost of capital 0. 048 0. 006 0. 060 0. 012 0. 120 0. 080 0. 098

13 -21 EVA Example Mahalo’s EVA is calculated as follows: After tax operating income Less: Cost of capital EVA $900, 000 784, 000 $116, 000

Behavioral Aspects of EVA 13 -22 A number of companies have discovered that EVA helps to encourage the right kind of behavior from their divisions in a way that emphasis on operating income alone cannot. The underlying reason is EVA’s reliance on the true cost of capital.

Behavioral Aspects of EVA In many companies, the responsibility for investment decisions rests with corporate management. As a result, the cost of capital is considered a corporate expense. If a division builds inventories and investment, the cost of financing that investment is passed along to the overall income statement and does not show up as a reduction from the division’s operating income. 13 -23

13 -24 Incentive Pay for Managers Why would managers not provide good service? There are three reasons: 1. They may have low ability 2. They may prefer not to work as hard as needed 3. They may prefer to spend company resources on perquisites

13 -25 Incentive Pay for Managers Perquisites are a type of fringe benefit given to managers over and above a salary. § A nice office § Use of a company car or jet § Expense accounts § Paid country club memberships

13 -26 Transfer Pricing The value of a transferred good is revenue to the selling division and cost to the buying division. This value is called transfer pricing.

13 -27 Transfer Pricing Transfer pricing affects both transferring divisions and the firm as a whole through its impact on-(1) divisional performance measures (2) firmwide profits (3) divisional autonomy

13 -28 Opportunity Cost Approach This approach identifies the minimum and maximum price that a selling division would be willing to accept and the maximum price that a buying division would be willing to pay. minimum transfer price is the transfer price that The maximum would leave the selling buying division no no worse off ifif the an goods were sold to an internal division than ifthan the if input were purchased from an internal division good were sold to an external party(ceiling). (floor). the good were purchased externally

The Transfer Pricing Illustration Tyson Manufacturers produces small appliances. The Small Parts Division produces parts used by the Small Motors Division. The parts also are sold to other manufacturers and wholesalers. 13 -29

The Transfer Pricing Illustration 13 -30 The Small Motors Division is operating at 70 percent capacity. A request is received for 100, 000 units of a certain model at $30 per unit. A component for this motor can be supplied by the Small Parts Division. The transfer price is $8 despite the Small Parts Division only experiencing a cost of $5 per unit.

The Transfer Pricing Illustration Using the $8 transfer price, the total cost is $31 per unit, calculated as follows: Direct materials Transferred-in component Direct labor Variable overhead Fixed overhead Total cost $10 8 2 1 10 $31 13 -31

The Transfer Pricing Illustration 13 -32 The Small Motors Division is operating at 70 percent capacity, so the $10 fixed cost is not relevant. Recalculating the cost-Direct materials Transferred-in component Direct labor Variable overhead Total cost $10 8 2 1 $21 The Small Motors Division can pay the Small Parts Division $8 per unit and still make a substantial contribution to the overall profitability of the Division.

13 -33 Negotiated Transfer Prices When imperfections exist in competitive markets for the intermediate product, market price may no longer be suitable.

13 -34 Negotiated Transfer Prices In this case, negotiated transfer prices may be a practical alternative. Opportunity costs can be used to define the boundaries of the negotiation set.

13 -35 Disadvantages of Negotiated Transfer Prices 1. A division manager who has private information may take advantage of another divisional manager. 2. Performance measures may be distorted by the negotiated skills of managers. 3. Negotiation can consume considerable time and resources.

13 -36 Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and accurate performance evaluation.

13 -37 Chapter Thirteen The End

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