Chapter 12Decentralization and Performance

Evaluation

Presentation Outline

I. The Concept of Decentralization

II. Types of Responsibility Centers

III. Evaluating Investment Centers with Return on Investment (ROI)

IV. The Balanced Scorecard

V. Transfer Prices

I. The Concept of Decentralization

A. Decentralization Defined

B. Advantages/Disadvantages of Decentralization

C. Two Reasons for Evaluating Subunit Performance

D. Responsibility Accounting

A. Decentralization Defined

Firms that grant substantial decision making authority to the managers of subunits are

referred to as decentralized organizations. Most firms are neither totally centralized

nor totally decentralized.

B. Advantages/Disadvantages of Decentralization

Advantages Better information,

leading to superior decisions.

Faster response to changing circumstances.

Increased motivation of managers

Excellent training for future top level

executives.

Disadvantages Costly duplication of

activities. Lack of goal congruence.

C. Two Reasons for Evaluating Subunit Performance

Identification of successful areas of operation and areas in need of

improvement.Influence over the behavior of managers.

Note that it is quite possible to have a good manager and a bad subunit.

D. Responsibility Accounting

Managers should only be held responsible for costs

and revenues that they control.

In a decentralized organization, costs and

revenues are traced to the organizational level where

they can be controlled.(See Illustration 12-3 on p.

421)

II. Types of Responsibility Centers

A. Cost Centers

B. Profit Centers

C. Investment Centers

A. Cost Centers A cost center is a subunit that

has responsibility for controlling costs but not for

generating revenues. Most service departments (i.e., maintenance, computer) are classified as cost centers.

Production departments may be cost centers when they

simply provide components for another department.

Cost centers are often controlled by comparing actual with budgeted or

standard costs.

B. Profit Centers

A profit center is a subunit that has responsibility of generating revenue and

controlling costs. Profit center evaluation

techniques include: Comparison of current year income with a target or budget.

Relative performance evaluation compares the center with other

similar profit centers.

C. Investment Centers

An investment center is a subunit that is responsible for

generating revenue, controlling costs, and

investing in assets. An investment center is charged with earning income consistent with the amount of assets invested in the segment.

Most divisions of a company can be treated as either profit centers or investment centers.

III. Evaluating Investment Centers with Return on

Investment (ROI)

A. The Components of ROIB. Measuring ROI Income and Invested

CapitalC. Problems with Using ROI

D. Residual Income (RI) as an Alternative to ROI

A. The Components of ROI

ROI has a distinct advantage over income as a measure of performance since it considers both income (the numerator) and investment (the denominator).

ROI = Income

Invested capital

ROI = Income

Salesx

Sales

Invested capital

Profit Margin Investment Turnover

The breakdown of the formula shows that managers can increase return by more profit and/or generating more sales for each

investment dollar.

B. Measuring ROI Income and Invested Capital

ROI Income Investment center income

will be measured using net operating profit after taxes

(NOPAT). NOPAT should exclude nonoperating items such as

interest expense and nonoperating gains and

losses, net of the tax effect.

ROI Invested Capital Invested capital is measured

as total assets less noninterest bearing current

liabilities. Noninterest bearing current

liabilities are deducted from total assets because they are a free source of funds and

reduce the cost of the investment in assets.

See Illustration 12-4 on page 426

C. Problems with Using ROI

Investment in assets is typically measured using historical cost. ROI becomes larger as assets become depreciated. This may result in managers taking unnecessary delays in

updating equipment.Managers may turn down projects with positive net present

values, simply because accepting the project results in a reduced ROI. In other words, projects may be turned down if they provide a return above the cost of capital but below

the current ROI.

D. Residual Income (RI) as an Alternative to ROI

Residual Income = NOPAT – Required Profit

= NOPAT – Cost of Capital x Investment

= NOPAT – Cost of Capital x (Total Assets – Noninterest Bearing Current Liabilities)

Residual Income (RI) overcomes the underinvestment problem ofROI since any investment earning more than the cost of capital will

increase residual income.

IV. The Balanced Scorecard

A. The Balanced Scorecard Approach

B. The Balanced Scorecard Dimensions

C. How Balance is Achieved

A. The Balance Scorecard Approach

A problem with just assessing performance with financial measures is that

such measures are backward looking.

The balanced scorecard approach also focuses on

what managers are currently doing to create future shareholder value.

B. The Balanced Scorecard Dimensions

Financial PerspectiveIs company achieving

financial goals?

Financial PerspectiveIs company achieving

financial goals?

Internal ProcessIs company improving

critical internal processes?

Internal ProcessIs company improving

critical internal processes?

Customer PerspectiveIs company meeting

customer expectations?

Customer PerspectiveIs company meeting

customer expectations?

Learning and GrowthIs company improvingits ability to innovate?

Learning and GrowthIs company improvingits ability to innovate?

Strategy

C. How Balance is Achieved

Performance is assessed across a balanced set of dimensions (see Illustration 12-10 on p. 437).

Quantitative measures (e.g., number of defects) are balanced with qualitative measures (e.g., rate

of customer satisfaction).There is a balance of backward-looking and

forward-looking measures.

V. Transfer Prices

A. Transfer Price Defined

B. Market Prices as the Maximum

C. Variable Cost as the Minimum – Excess Capacity Exists

D. Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum

– Excess Capacity Does Not Exist

E. Transfer Pricing and Income Taxes in an International Context

A. Transfer Price Defined

The price that is used to value internal transfers of goods and services

within the same company is known as

the transfer price.

B. Market Prices as the Maximum

The transfer price should not exceed what the

acquiring division would have to pay for a similar

good and given set of conditions on the outside

market. If the outside market is cheaper, the

good should be acquired outside the organization.

C. Variable Cost as the Minimum – Excess Capacity Exists

The supplying division should not set a transfer price that is lower than

the variable cost of supplying the good and/or service to the

requesting division. This may be less than the

variable cost of serving an outside customer.

D. Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum – Excess

Capacity Does Not ExistThe minimum transfer price

will add a lost contribution margin on

outside sales if the supplying division must

turn away outside customers to provide the good and/or service to the requesting division.

E. Transfer Pricing and Income Taxes in an International Context

When income tax rates between countries differ

significantly, a supplier in a lower rate country will

want to charge the purchasing division a

higher transfer price to lower taxable income for

the purchaser in the higher rate nation, and

vice versa.

Summary

Decentralization and Responsibility Accounting

Cost, Profit, and Investment CentersROI

Residual IncomeBalanced ScorecardTransfer Pricing