Chapter 23 Performance Evaluation for Decentralized Operations Accounting

Chapter 23 Performance Evaluation for Decentralized Operations Accounting, 21 st Edition Warren Reeve Fess Power. Point Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electroni presentation is used with the permission of NVTech Inc.

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Objectives 1. List and explain the advantages and After of studying this disadvantages decentralized chapter, you should operations. be able to: accounting 2. Prepare a responsibility report for a cost center. 3. Prepare responsibility accounting reports for a profit center. 4. Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center.

Objectives 5. Explain how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business.

Centralized and Decentralized Operations

Advantages of Decentralization 1. It allows managers to focus on acquiring expertise in their areas of responsibility. 2. Decentralizing decision making provides excellent training for managers. 3. Delegation improves employee morale. 4. Decentralization helps managers create good customer relations by responding quickly to customers’ needs. 5. Managers become more creative in suggesting operating and product improvement.

Disadvantages of Decentralized Operations § Decisions made by one manager may negatively affect the profitability of the entire organization. § Assets and operating costs are duplicated (e. g. , each division has its own administrative office staff).

Responsibility Centers Cost Centers Managers are held accountable for controlling costs. Profit Centers Managers are held accountable for costs and making decisions that impact revenues favorably.

Responsibility Centers Investment Centers Managers are held accountable for costs and revenues and are also held accountable for the efficient use of assets.

Responsibility Accounting for Cost Centers COST CENTERS IN A UNIVERSITY College of Business COLLEGE Dept. of Marketing College of Engineering College of Arts and Sciences Dept. of Accounting Dept. of Management

Responsibility Accounting for Cost Centers COST CENTERS IN A UNIVERSITY DEPARTMENT Department of Accounting

Cost Centers Budget Performance Report Supervisor, Department 1—Plant A For the Month Ended October 31, 2006 Budget Actual Over Budget Under Budget Factory wages$ 58, 100 $ 58, 000 $100 Materials 32, 500 34, 225 $1, 725 Supervisory salaries 6, 400 Power and light 5, 750 5, 690 60 Depreciation 4, 000 Maintenance 2, 000 1, 990 10 Insurance, taxes 975 $111, 280 $1, 725$170 $109, 725 $111, 280 These totals are shown on the Manager, Plant A’s budget performance report (Slide 13).

Cost Centers Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 Budget Actual Over Budget Under Budget Administration $ 17, 500 $ 17, 350 $150 Department 111, 280 $1, 555 Department 1 1 109, 725 111, 280 Department 2 190, 500 192, 600 2, 100 Department 3 149, 750 149, 100 650 $467, 475 $470, 330 $3, 655 $800 From the Supervisor—Department 1, Plant A budget performance report (Slide 12).

Cost Centers Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 Budget Actual Over Budget Under Budget Administration $ 17, 500 $ 17, 350 $150 Department 1 109, 725 111, 280 $1, 555 Department 2 190, 500 192, 600 2, 100 Department 3 149, 750 149, 100 650 $467, 475 $470, 330 $800 $470, 330 $3, 655 This is shown on the Vice-President’s budget production report (Slide 16).

Cost Centers Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 Over Budget Actual Budget Administration Plant AA Plant B Under Budget $ 19, 500 $ 19, 700$ 200 467, 475 2, 855 467, 475 470, 330 2, 855 395, 225 394, 300 $925 $882, 200 $884, 330 $3, 055$925 Note that Over Budget is a net figure.

Cost Centers Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 Over Budget Actual Budget Administration Plant A Plant B Under Budget $ 19, 500 $ 19, 700$ 200 467, 475 470, 330 2, 855 395, 225 394, 300 $925 $882, 200 $884, 330 $3, 055$925 Each of the line items above is supported by a cost center report.

Responsibility Accounting for Profit Centers In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues.

Profit centers may be divisions, departments, or products.

Profit Centers NEG, a diversified entertainment company, has two profit centers: the Theme Park Division and the Movie Production Division. Revenues Operating expenses Theme Park Movie Production Division $6, 000 $2, 500, 000 2, 495, 000 405, 000

Profit Centers Charging Service Department Costs to Production Divisions Purchasing Department: $400, 000 (Activity base: number of purchase requisitions) Theme Park Division Movie Production Division: Total $400, 000 25, 000 purchase requisitions 15, 000 purchase requisitions 40, 000 = $10 per purchase requisition 40, 000 purchase requisitions

Profit Centers Charging Service Department Costs to Production Divisions Payroll Accounting: $255, 000 (Activity base: number of payroll checks) Theme Park Division Movie Production Division: Total $255, 000 15, 000 payroll checks 12, 000 payroll checks 3, 000 payroll checks 15, 000 = $17 per payroll check

Profit Centers Charging Service Department Costs to Production Divisions Legal Department: $250, 000 (Activity base: number of payroll checks) Theme Park Division 100 billed hours Movie Production Division: 900 billed hours Total 1, 000 $250, 000 1, 000 hours = $250 per hour

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Service Department Purchasing $150, 000 Theme Park Division Movie Production Division $250, 000 25, 000 purchase 15, 000 purchase requisitions xrequisitions $10 x $10 per purchase requisition

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Service Department Purchasing $150, 000 Payroll accounting Theme Park Division Movie Production Division $250, 000 204, 000 51, 000 12, 000 payroll 3, 000 payroll checks x $17 checks per x $17 per payroll check

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Service Department Purchasing $150, 000 Payroll accounting Legal Theme Park Division Movie Production Division $250, 000 204, 000 51, 000 25, 000 225, 000 100 hours x $250 900 hours x $250 per hour

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Service Department Purchasing Payroll accounting Legal Total service department charges Theme Park Division Movie Production Division $250, 000 $150, 000 204, 000 51, 000 25, 000 225, 000 $479, 000 $426, 000

Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Revenues Operating expenses Income from operations Theme Park Division Movie Production Division $6, 000 2, 495, 000 $3, 505, 000 $2, 500, 000 405, 000 $2, 095, 000 Income from operations before service department charges.

Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division Revenues $6, 000 Operating expenses 2, 495, 000 Income from operations $3, 505, 000 Less service dept. charges: Purchasing $ 250, 000 Payroll accounting 204, 000 Legal 25, 000 Total service department charges $ 479, 000 Income from operations $3, 026, 000 Movie Production Division $2, 500, 000 405, 000 $2, 095, 000 $ 150, 000 51, 000 225, 000 $ 426, 000 $1, 669, 000

Responsibility Accounting for Investment Centers In an investment center, the unit 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.

Investment Centers Datalink Inc. Divisional Income Statements For the Year Ended December 31, 2006 Northern Division Central Division Southern Division Revenues $560, 000 $672, 000 $750, 000 Operating expenses 336, 000 470, 400 562, 500 Income from operations before service dept. charges $224, 000 $201, 600 $187, 500 Service department charges 154, 000 117, 600 112, 500 Income from operations $ 70, 000 20%$ 84, 000 12% $ 15% 75, 000 Invested assets $350, 000 Rate of return on investment 20% $700, 000 12% 15% $500, 000

Rate of Return on Investment (ROI) Revenues

Rate of Return on Investment (ROI) Profit Investment Turnover Profit Margin

Rate of Return on Investment (ROI) The investment turnover indicates the rate of sales on each dollar of invested assets. The profit margin indicates the rate of profit on each sales dollar. Investment Turnover Profit Margin

Rate of Return on Investment (ROI) Income from operation Sales ROI = x Sales Invested assets ROI = $ 70, 000 $560, 000 x $560, 000 $350, 000 ROI = 12. 5% x 1. 6 = 20%

Rate of Return on Investment (ROI) Income from operation Sales ROI = x Sales Invested assets Profit Margin Inventory Turnover

Profit Margin Northern Division Central Division Southern Division Income from operations $ 70, 000 $ 84, 000 $ 75, 000 Revenues (Sales) $560, 000 $672, 000 $750, 000 Profit margin Investment Turnover 12. 5% 10. 0% Revenues (Sales) Invested assets Investment turnover $560, 000 $672, 000 $750, 000 $350, 000 $700, 000 $500, 000 1. 6. 96 1. 5 Return on Investment (ROI) Income from operations Invested assets $ 70, 000 $ 84, 000 $ 75, 000 $350, 000 $700, 000 $500, 000 Rate of return on investment 20% 12% 15%

Income from Operations – Minimum Acceptable Rate of Return on Assets = Residual Income

Baldwin Company Divisional Income Statements For the Year Ended December 31, 2006 Northern Division Central Division Southern Division Income from operations Minimum acceptable income from operations as a percent of invested assets: $350, 000 x 10% $700, 000 x 10% $500, 000 x 10% $70, 000 $84, 000 $75, 000 Residual income $35, 000 $14, 000 $25, 000 35, 000 70, 000 50, 000

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

Innovation and Learning • • R&D investment R&D pipeline Skills and training Time to market Internal Process Customer • Satisfaction • Loyalty • Perception Financial • • • ROI Residual income Profit Cost Sales • Efficiency • Quality • Time

Transfer Pricing

Transfer Pricing When divisions transfer products or render services to each other, a transfer pricing is used to charge for the products or services

Benefits of Transfer Pricing 1. Divisions can be evaluated as profit or investment centers. 2. Divisions are forced to control costs and operate competitively. 3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

Commonly Used Transfer Prices 1. Market price approach sets the price at which the product transferred could be sold to outside buyers. 2. Negotiated price approach allows decentralized managers to agree (negotiate) among themselves. 3. Cost price approach (variable or full) uses a variety of cost concepts for setting the transfer price.

Commonly Used Transfer Prices Variable Cost per Unit $10 Full Cost per Unit $13 Negotiated Price Market Price per Unit $20

Chapter 22 The End