Managerial Accounting by James Jiambalvo Chapter 10 Decentralization

Managerial Accounting by James Jiambalvo Chapter 10: Decentralization and Performance Evaluation Slides Prepared by: Scott Peterson Northern State University

Chapter 10: Decentralization and Performance Evaluation Chapter Themes: q Decentralized is all about pushing decision-making down to those in the best position to do it. q Responsibility should be commensurate with authority. q You get what you measure! Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI). More

Chapter 10: Decentralization and Performance Evaluation q q q Decentralized is all about pushing decision-making down to those in the best position to do it. Responsibility should be commensurate with authority. You get what you measure! Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Advantages of Decentralization 1. Better information leading to superior decisions. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Advantages of Decentralization 1. 2. Better information leading to superior decisions. Faster response to changing circumstances. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Advantages of Decentralization 1. 2. 3. Better information leading to superior decisions. Faster response to changing circumstances. Increased motivation of managers. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Advantages of Decentralization 1. 2. 3. 4. Better information leading to superior decisions. Faster response to changing circumstances. Increased motivation of managers. Excellent training for future top level executives. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Disadvantages of Decentralization 1. Costly duplication of activities. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Disadvantages of Decentralization 1. 2. Costly duplication of activities. Lack of goal congruence. [Note: goal congruence has to do with the compatibility of goals of the manager versus goals of the organization. ] Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Why Companies Evaluate the Performance of Subunits and Subunit Managers Decentralization leads naturally to the need to evaluate subunits and their managers. Companies evaluate the performance of subunits and subunit managers for two reasons. First, evaluation identifies successful operations and areas needing improvement. Second, evaluating performance influences manager behavior. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Responsibility Acocunting and Performance Evaluation In Chapter 5 the topic of responsibility accounting was introduced. Recall that this technique holds managers responsible for only those costs and revenues which they can control. Taken one step further, to implement responsibility accounting in a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled. (see chart) Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Responsibility Acocunting and Performance Evaluation Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Cost Centers, Profit Centers, and Investment Centers Subunits are organizational units with identifiable collections of related resources and activities. A subunit may be a department, a subsidiary, or a division. Subunits are sometimes referred to as responsibility centers and include cost centers, profit centers, and investment centers. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Cost Centers A cost center is a subunit that has responsibility for controlling costs but does not have responsibility for generating revenue. Examples: janitorial, computer service, and production departments. Managerial goal: to provide services at a reasonable cost to the company. Evaluation: compare budgeted/standard costs with actual costs. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Profit Centers A profit center is a subunit that has responsibility for generating revenues as well as for controlling costs. Examples: copier and camera divisions of an electronics firm. Managerial goal: to maximize profit (revenues – expenses) for the division. Evaluation: profit from the current year may be compared with budget or previous years or compared with other profit centers on a relative basis. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Investment Centers An investment center is a subunit that has responsibility for generating revenues, controlling costs, and investing in assets. Since managers of investment centers have control over inventory, receivables, equipment purchases and so on, it makes sense to hold them responsible for generating some kind of return on them. More Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Investment Centers Examples: Nordstrom, Inc. subunit Faconnable. Managerial goal: to maximize return on investment. Evaluation: rate of return (%) relative to a benchmark/budget rate of return or relative to other investment center rates of return. Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Evaluating Investment Centers with ROI One of the primary tools for evaluating the performance of investment centers is return on investment. ROI is calculated as follows: ROI = Income Invested Capital Since ROI focuses on income and investment, it has a natural advantage over income (alone) as a measure of performance. It removes the bias of larger investment over smaller investment. More Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Evaluating Investment Centers with ROI Some companies break ROI down into two components: profit margin and investment turnover as follows: Related Learning Objectives: n n Prof. Marg. Turnover n ROI = Income x Sales Inv. Capital n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Measuring Income and Invested Capital When Calculating ROI In calculating ROI, companies measure “income” in a variety of ways; net income, income before interest and taxes, controllable profit… The text uses the commonly used net operating profit after taxes, NOPAT. This formula does not hold managers responsible for interest. More Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Measuring Income and Invested Capital When Calculating ROI Further, invested capital is measured in a variety of ways In the text, invested capital is measured as total assets noninterest-bearing current liabilities (accounts payable, income taxes payable, and accrued liabilities). Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Problems with Using ROI A major problem with ROI is that the denominator, invested capital, is based on historical costs net of depreciation. As those assets become fully depreciated, the invested capital denominator becomes extremely low and the ROI number quite high. And to compound the problem, managers may therefore be compelled to put off purchases of new equipment necessary for long-term success. They “underinvest. ” Related Learning Objectives: n n List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunits and subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Problems of Overinvestment and Underinvestment: You Get What You Measure Additional problems with ROI exist. Managers of investment centers with high ROI’s may be unwilling to invest in assets that will dilute their current ROI. This will lead to underinvestment. Conversely, evaluation in terms of profit can lead to overinvestment. Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Evaluation in Terms of Profit Can Lead to Overinvestment As noted in Chapter 7, we would like managers to invest in assets that earn a return in excess of the cost of capital. Since “You Get What You Measure, ” managers may overinvest to grow profits (because their compensation package is based on total profits) even though the return on invested capital is less than the cost of capital. Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Evaluation in Terms of ROI Can Lead to Underinvestment Perhaps the solution to the overinvestment problem on the previous slide is to measure performance based on ROI. The problem here is that managers will have a tendency not to invest at less than their current ROI even if this reduced return is greater than the cost of capital. Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Other Measures Used in Evaluation An approach to solving the overinvestment and underinvestment problems involves use of residual income or a related method, economic value added. A new approach, the Balanced Scorecard, goes beyond financial measures to include multiple performance dimensions. Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Residual Income (RI) and Economic Value Added (EVA) Residual Income (RI) is the net operating profit after taxes of an investment center in excess of the profit required for the level of investment. Specifically: RI = NOPAT - Cost of Capital x Investment Related Learning Objectives: n n n RI has the potential to solve both the overinvestment and underinvestment problem because it compels investment in the range between cost of capital and current ROI. More Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Residual Income (RI) and Economic Value Added (EVA) Economic Value Added, EVA, is a performance measure developed by the consulting firm Stern Stuart. It is basically RI adjusted for “accounting distortions. ” A primary distortion is related to research and development (R&D). Under GAAP R&D is required to be expensed. Under EVA, R&D is capitalized and amortized over a number of future accounting periods. EVA has gained considerable attention in the financial press. Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Using a Balanced Scorecard to Evaluate Performance A problem with assessing performance with only financial measures, like profit, ROI, and RI/EVA, is that financial measures are “backward looking. ” Balanced Scorecard is a set of performance measures constructed for four dimensions of performance: 1. Financial 2. Customer 3. Internal processes 4. Innovation More Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Using a Balanced Scorecard to Evaluate Performance Balanced Scorecard uses performance measures that are tied to the company’s strategy for success. Balance is a key factor using this technique. More Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Using a Balanced Scorecard to Evaluate Performance Note how balance is achieved: n Performance is assessed across a balanced set of dimensions (financial, customer, internal processes, and innovation). n Quantitative measures are balanced with qualitative measures. n There is a balance of backward-looking measures More Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Using a Balanced Scorecard to Evaluate Performance Related Learning Objectives: n n n Explain why using a measure of profit to evaluate performance can lead to return on investment (ROI) can lead to underinvestment. Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Appendix A q q q q Transfer Pricing Market Price as the Transfer Price Market Price and Opportunity Cost Variable Cost as the Transfer Price Full Cost Profit as the Transfer Price Negotiated Transfer Prices Transfer Pricing and Income Taxes in an International Context Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Transfer Pricing In many cases, subunits “sell” goods or services to other subunits within the same company. For example in the automobile manufacturing industry, batteries manufactured in one division may be sold to other divisions which manufacture autos. Various approaches to pricing exist in practice: (1) market prices, (2) variable costs, (3) full cost plus profit, and (4) negotiated prices. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Market Price as the Transfer Price The transfer price in this method would be the same as between the subunit and any other customer at “arm’s length. ” The external market price is an excellent choice because the buying and selling divisions are treated as independent companies. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Market Price and Opportunity Cost Opportunity cost is the foregone benefit or increased cost of selecting one alternative over another. The selling division has a choice between selling to the related division or into an open market. The determining factor in deciding whether or not to sell to the related division is the impact to the firm (overall) of the decision, not one or the other of the divisions involved. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Variable Cost as the Transfer Price In some cases the transferred product is unique and is not sold in the open market. In this case variable cost may be a good transfer price. The main reason is that it conveys accurate opportunity cost information. And when not external market for the product exists, the opportunity cost of producing and selling the product is variable cost per unit. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Full Cost Plus Profit as the Transfer Price The problem with variable cost transfer pricing is that the selling division cannot earn a profit on production on the transferred product. Therefore, the price may not be acceptable to management of the selling company. So, many companies add a profit margin to the full cost of production and use this sum as the transfer price. The problem is that Full Cost Plus Profit may not measure the opportunity cost of producing the product. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Negotiated Transfer Prices One of the benefits of decentralization is that managers who are delegated decisionmaking responsibility tend to be highly motivated. To encourage autonomy, some companies allow managers to negotiate transfer prices. Again, the problem is that this price may not reflect the opportunity cost of producing and selling the product. More likely it will reflect the relative bargaining prowess of individual managers. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

Transfer Pricing and Income Taxes in an International Context Income tax rates vary significantly between countries. And when goods are transferred between countries, these tax situations may create incentives for relatively high or low transfer prices. All else equal, this creates a bias toward having high transfer prices when selling a product from a low tax country to a high tax country and having a low transfer price when selling a product from a high tax country to a low tax country. Related Learning Objectives: A 1. Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices.

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