Performance Evaluation for Decentralized Operations 24 Performance Evaluation for Decentralized Operations Student Version

Describe the advantages and disadvantages of decentralized operations. 1 Describe the advantages and disadvantages of decentralized operations. 24-2

Decentralized Operations 1 Decentralized Operations In a decentralized company, managers of separate divisions or units are delegated operating responsibility. The division (unit) managers are responsible for planning and controlling the operations of their divisions.

1 Responsibility accounting is the process of measuring and reporting operating data by responsibility centers. Three common types of responsibility centers are— Cost centers Profit centers Investment centers

Prepare a responsibility accounting report for a cost center. 2 Prepare a responsibility accounting report for a cost center. 24-5

Responsibility Accounting for Cost Centers 2 Responsibility Accounting for Cost Centers A cost center manager has responsibility for controlling the costs.

Prepare responsibility accounting reports for a profit center. 3 Prepare responsibility accounting reports for a profit center. 24-7

3 Profit Center In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits).

Service Department Charges 3 Service Department Charges Services provided by internal centralized service departments are often more efficient than services contracted with outside providers. An internal service cost is called a service department charge.

3 NEG Example NEG’s expenses for the year ended Decem-ber 31, 2010 for each service department are as follows: Purchasing $400,000 Payroll Accounting 255,000 Legal 250,000 Total $905,000 (continued)

Purchasing Number of purchase requisitions 3 The activity base for each service depart-ment is a measure of the services performed. For NEG, the following applies: Purchasing Number of purchase requisitions Payroll Accounting Number of payroll checks Legal Number of billed hours (continued)

40,000 purchase requisitions 3 Service Usage Purchasing Theme Park Division 25,000 purchase requisitions Movie Production Division 15,000 Total 40,000 purchase requisitions $400,000 40,000 purchase requisitions = $10 per purchase requisition (continued)

3 Service Usage Payroll Accounting Theme Park Division 12,000 payroll checks Movie Production Division 3,000 Total 15,000 payroll checks $255,000 15,000 payroll checks = $17 per payroll check (continued)

3 Service Usage Legal Theme Park Division 100 billed hours Movie Production Division 900 Total 1,000 billed hours $250,000 1,000 hours = $250 per hour (continued)

4 Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. 24-15

4 Investment Center An investment center 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.

4 Revenues Profit $$$ Profit Margin Investment Turnover

Profit margin is the ratio of income from operations to sales 4 Profit margin is the ratio of income from operations to sales Profit Margin Investment Turnover

Investment turnover is the ratio of sales to invested assets 4 Investment turnover is the ratio of sales to invested assets Investment Turnover

Rate of Return on Investment 4 Rate of Return on Investment One measure that considers the amount of assets invested in an investment center is the rate of return on investment (ROI) or rate of return on assets. Income from Operations Invested Assets ROI =

Income from Operations 4 DuPont Formula Income from Operations Sales Sales Invested Assets ROI = × Profit Margin Investment Turnover

DataLink’s Northern Division (ROI) 4 DataLink’s Northern Division (ROI) Income from Operations Sales Sales Invested Assets ROI = × ROI = $ 70,000 $560,000 × $350,000 ROI = 12.5% × 1.6 ROI = 20%

DataLink’s Central Division (ROI) 4 DataLink’s Central Division (ROI) Income from Operations Sales Sales Invested Assets ROI = × ROI = $ 84,000 $672,000 × $700,000 ROI = 12.5% × 0.96 ROI = 12%

DataLink’s Southern Division (ROI) 4 DataLink’s Southern Division (ROI) Income from Operations Sales Sales Invested Assets ROI = × ROI = $ 75,000 $750,000 × $500,000 ROI = 10% × 1.5 ROI = 15%

DataLink’s Northern Division Proposal 4 DataLink’s Northern Division Proposal Assume that the revenues of the Northern Division could be increased by $56,000 through increasing advertising to $385,000.

Projected Impact of Change 4 Projected Impact of Change Revenues ($560,000 + $56,000) $616,000 Operating expenses 385,000 Income from operations before service department charges $231,000 Service department charges 154,000 Income from operations $ 77,000 Increase of $7,000

DataLink’s Northern Division (ROI) Revised 4 DataLink’s Northern Division (ROI) Revised Income from Operations Sales Sales Invested Assets ROI = × ROI = $ 77,000 $616,000 × $350,000 ROI = 12.5% × 1.76 ROI = 22%

4 Residual Income Residual income is the excess of income from operations over a minimum acceptable income from operations.

4 Income from operations $70,000 $84,000 $75,000 Northern Central Southern Division Division Division Income from operations $70,000 $84,000 $75,000 Minimum acceptable income from operations as a percent of invested assets: $350,000 × 10% 35,000 $700,000 × 10% 70,000 $500,000 × 10% 50,000 Residual income $35,000 $14,000 $25,000

5 Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business. 24-30

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

5 Market Price Approach Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers.

Negotiated Price Approach 5 Negotiated Price Approach The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves as to the transfer price.

5 Cost Price Approach Under the cost price approach, cost is used to set transfer prices. Cost may refer to either total product cost per unit or variable cost per unit.