performance evaluation, variable costing, and decentralization management accounting: the...

Performance Evaluation, Variable

Costing, and Decentralization

Management Accounting: The Cornerstone for

Business Decisions

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning Objectives

1. Explain how and why firms choose to decentralize.

2. Explain the difference between absorption and variable costing. Prepare segmented income statements.

3. Compute and explain return on investment (ROI).

4. Compute and explain residual income and economic value added (EVA).

Learning Objectives

5. Explain the role of transfer pricing in a decentralized firm.

6. (Appendix) Explain the uses of the Balanced Scorecard and compute cycle time, velocity, and manufacturing cycle efficiency (MCE).

Comment on Decentralization and

Responsibility Centers◙ Companies organize around

responsibility centers◙ This is what organization charts

represent◙ Can become cumbersome for

decision making◙ Organizations can choose to

centralize or decentralize◙ Most organizations are a mix of

both

What are some reasons to decentralize?

1. It is easier to gather and use local information

2. It allows for focusing of central management

3. It provides training and motivation for segment managers

4. It enhances competition by exposing business segments to market forces

Illustrate Centralization Vs. Decentralization

Illustration of PepsiCo's Decentralized Divisions

Match Definitions

Cost Center

Revenue Center

A responsibility center in which the manager is only accountable for sales

A responsibility center in which the manager is accountable for both revenues and costs

Investment Center

Profit Center

A responsibility center in which the manager is accountable for revenues, costs and investments

A responsibility center in which the manager is only accountable for costs

Complete the Chart

What type of accounting information is use for measuring performance?

Capital

Center Cost Sales Investment Other

Cost

Revenue

Profit

Investment

XX X

X X

X X X X

Differentiate Between Product and Period

Costs

Complete Chart

How are product and period cost classified under absorption and variable costing? Insert the word “Product” or “Period” were appropriate

Costing Method

Absorption Variable

Direct materials Product Product

Direct labor Product Product

Variable overhead Product Product

Fixed overhead Product PERIOD

Selling expenses Period Period

Administrative expenses Period Period

How to compute inventory cost under absorption &

variable costing.During the most recent year, Fairchild

company had the following data associated with the product it makes.

Units in beginning inventory 0Units produced 12,000Units sold ($325 each) 10,000Variable costs per unit:

Direct materials $60Direct labor 90Variable overhead 60

Fixed costs:Fixed overhead per unit produced $25Fixed selling and administrative 100,000

11-1

REQUIRED:1. How many units are in ending inventory?

2. Using absorption costing, calculate the per-unit product cost. What is the value of ending inventory?

3. Using variable costing, calculate the per-unit product cost. What is the value of ending inventory?

Calculations:1. Units in ending inventory = Units in beginning

inventory + Units produced – Units sold

= 0 + 12,000 – 10,000 = 2,000

11-1

How to compute inventory cost under absorption &

variable costing.

How to compute inventory cost under absorption & variable

costing.11-1

2. Absorption costing 3. Variable costing

Direct materials $ 60 Direct materials $ 60

Direct labor 90 Direct labor 90

Variable overhead 60 Variable overhead 60

Fixed overhead 25 Unit product cost $ 210

Unit product cost $ 235

Value of ending inventory = 2,000 x $235 = $470,000

Value of ending inventory = 2,000 x $210 = $420,000

How to prepare income statements under

absorption & variable costing.

11-2

During the most recent year, Fairchild company had the following data associated with the product it makes.

Units in beginning inventory 0Units produced 12,000Units sold ($325) 10,000Variable costs per unit:

Direct materials $60Direct labor 90Variable overhead 60

Fixed costs:Fixed overhead per unit produced $25Fixed selling and administrative 100,000

REQUIRED:1. Calculate the cost of goods sold under absorption

costing2. Calculate the cost of goods sold under variable

costing3. Prepare an income statement under absorption

costing4. Prepare an income statement under variable costing

Calculation:1. Cost of goods sold = Absorption product cost x Units

sold= $235 x 10,000 = $2,350,000

2. Cost of goods sold = Variable product cost x Units sold= $210 x 10,000 = $2,100,000



11-2



11-2

3. Fairchild Company

Absorption-Costing Income Statement

Sales ($325 x 10,000) $3,250,000

Cost of goods sold 2,350,000

Gross Margin $ 900,000

Less: Selling & Administrative Expenses 100,000

Net income $ 800,000



11-24. Fairchild Company

Variable-Costing Income Statement

Sales ($325 x 10,000) $3,250,000

Less: Variable expenses:

Variable cost of goods sold 2,100,000

Contribution Margin $1,150,000

Less: Fixed expenses:

Fixed overhead $300,000

Fixed selling & administrative 100,000 400,000


Review the Relationships Between Production,

Sales & Income

IF THEN

1. Production > Sales Absorption net income > Variable net income

2. Production < Sales Absorption net income < Variable net income

3. Production = Sales Absorption net income = Variable net income

How to prepare a segmented income

statement.Audiomatronics, Inc., produces MP3 players and

DVD players in a single factory. The following information was provided for the following year.

MP3 Players DVD PlayersSales $400,000 $290,000Variable cost of good sold 200,000 150,000Direct fixed cost 30,000 20,000A 5% sales commission is paid for each of the two

product lines. Direct fixed selling and administrative expense was estimated to be $10,000 for the MP3 line and $15,000 for the DVD line.

Common fixed overhead for the factory was estimated at $100,000; common selling and administrative expense was estimated to be $20,000.

11-3

How to prepare a segmented income

statement.REQUIRED: Prepare a variable costing segmented income statement for Audiomatronics, Inc., for the coming year.

11-3

Calculation: MP3 Players DVD Players Total

Sales $ 450,000 $ 320,000 $ 770,000

Variable cost of goods sold (225,000) (160,000) (385,000)

Variable selling expense (22,500) (16,000) (38,500)

Contribution margin $ 202,500 $ 144,000 346,500

Less: direct fixed expenses:

Direct fixed overhead (30,000) (20,000) (50,000)

Direct sell & admin (10,000) (15,000) (25,000)

Segment margin $ 162,500 $ 109,000 $ 271,500

Less: common fixed expenses

Common fixed overhead (100,000)

Common sell & admin (20,000)


List Three Ways Investment Centers are

Evaluated

Match Definitions

ROI

Ave. Operating Assets

Sales / Average operating assets

Operating income / Sales

Turnover

Margin

Operating income / Average operating assets

(Beginning net book value + Ending net book value) / 2

How to calculate average operating assets, margin,

turnover & ROI.Celimar Company’s Eastern Division earned

operating income of $60,000 on Sales of $600,000. At the beginning of the year the net book value of the assets were $305,700, while at the end of the year they were $354,300.

REQUIRED: For the Eastern Division calculate:

1. Average operating assets2. Margin3. Turnover4. ROI

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Calculation:1. Average operating assets = (Beginning

assets + ending assets) / 2 = ($305,700 + $354,300) / 2 = $330,000

2. Margin = Operating income / Sales = $60,000 / $600,000 = 10% or 0.10

3. Turnover = Sales / Average operating assets = $600,000 / $330,000 = 1.82 times

4. ROI = Margin x Turnover = .10 x 1.82 = 18.2% or 0.182OR ROI = Operating income / Average operating assets = $60,000 / $330,000 = 18.2%

How to calculate average operating assets,

margin, turnover & ROI.11-4

What are three advantages of ROI?

1. It encourages managers to focus on the relationship among sales, expenses and investment, as should be the case for a manager of an investment center.

2. It encourages a manager to focus on cost efficiency.

3. It encourages a manager to focus on operating asset efficiency.

How to calculate residual income.

Celimar Company’s Eastern Division earned operating income of $60,000 on Sales of $600,000. At the beginning of the year the net book value of the assets were $305,700, while at the end of the year they were $354,300. Celimar requires a minimum rate of return of 12%.

REQUIRED: For the Eastern Division calculate:1.Average operating assets2.Residual incomeCalculation:1. Average operating assets = (Beginning assets +

ending assets) / 2 = ($305,700 + $354,300) / 2 = $330,000

2. Residual income = Operating income = - (Minimum rate of return x Average operating assets) = $60,000 – (0.12 x $330,000) = $60,000 - $39,600 = $20,400

11-5

How to calculate EVA.11-6

Sales $600,000

Cost of goods sold 330,000

Gross Margin $270,000

Less: Sell & Admin Exp. 210,000

Operating income $ 60,000

Less: Income taxes @30% 18,000

Net income $ 42,000

Celimar Company’s Eastern Division earned net income last year as shown in the following income statement:

Total capital employed equaled $330,000. Celimar’s actual cost of capital is 10%.

REQUIRED: Calculate EVA for Eastern Division

Calculation:EVA = After-tax operating income –

(Actual percentage cost of capital x Total capital employed)

= $42,000 – (10% x $330,000)= $42,000 - $33,000= $9,000

How to calculate EVA.11-6

Discuss Transfer Pricing

◙ This represents the charge Bravo Division pays Romeo Division for the use of Romeo Division’s output.

◙ It represents a complex issue.◙ It becomes an emotionally charged

issue since performance measurement is affected by the value established for the transfer price.

◙ A company can not make a profit from itself. Real profits come from selling to third parties.

Define the three ways to set transfer prices.

How to calculate transfer prices.

Omni, Inc., has a number of divisions, including Indigo Division, a producer of microcircuit boards and Lima Division a producer of controllers for heating and controlling manufacturers.

Indigo produces the bk-912 model that can be used by Lima Division in the production of its control systems for regulating heating and air conditioning systems. The market price of the bk-912 is $15 and the full cost is $8

REQUIRED:1. If Omni, Inc. has a transfer pricing policy that

requires transfer at full cost, what would the transfer price be? Do you suppose that Indigo and Lima would choose to transfer at that price?

11-7

2. If Omni, Inc. has a transfer pricing policy that requires transfer at market price, what would the transfer price be? Do you suppose that Indigo and Lima would choose to transfer at that price?

3. Now suppose that Omni, Inc., allows negotiated transfer pricing and that Indigo Division can avoid a $3 selling expense by selling to Lima Division. Which division sets the minimum transfer price, and what is it? Which division sets the maximum transfer price and what is it? Do you suppose that Indigo and Lima Divisions would choose to transfer somewhere in the bargaining range?

How to calculate transfer prices.11-7

Calculations:1. The full cost transfer price is $8. Lima

Division would be delighted with that price, but Indigo Division would refuse to transfer since $15 could be earned in the outside market.

2. The market price is $15. Both Indigo and Lima divisions would be willing to transfer at that price (since neither division would be worse off than if it bought/sold in the outside market).


3. Minimum transfer price = $15 - $3 = $12The price is set by Indigo Division, the selling division.Maximum transfer price = $15This price is the market price and is set by Lima Division, the buying division.

Yes, both divisions would be willing to a accept a transfer price within the bargaining range. Precisely what the transfer price would be depends on the negotiating skills of the Indigo and Lima Division managers.


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