Decentralization and Performance Evaluation

Presentation Outline The Concept of Decentralization Types of Responsibility Centers Evaluating Investment Centers with Return on Investment (ROI) The Balanced Scorecard Transfer Prices

I. The Concept of Decentralization Decentralization Defined Advantages/Disadvantages of Decentralization Two Reasons for Evaluating Subunit Performance 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 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)

Types of Responsibility Centers Cost Centers Profit Centers Investment Centers

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.

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.

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.

Evaluating Investment Centers with Return on Investment (ROI) The Components of ROI Measuring ROI Income and Invested Capital Problems with Using ROI Residual Income (RI) as an Alternative to ROI

The Components of ROI or x 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 or ROI = Income Sales x 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.

Measuring ROI Income and Invested Capital 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

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.

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 – Non-interest Bearing Current Liabilities) Residual Income (RI) overcomes the underinvestment problem of ROI since any investment earning more than the cost of capital will increase residual income.

The Balanced Scorecard The Balanced Scorecard Approach The Balanced Scorecard Dimensions 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.

The Balanced Scorecard Dimensions Financial Perspective Is company achieving financial goals? Customer Perspective Is company meeting customer expectations? Internal Process Is company improving critical internal processes? Strategy Learning and Growth Is company improving its ability to innovate?

How Balance is Achieved Performance is assessed across a balanced set of dimensions 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.

Transfer Prices Transfer Price Defined Market Prices as the Maximum Variable Cost as the Minimum – Excess Capacity Exists Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum – Excess Capacity Does Not Exist 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.

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.

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.

Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum – Excess Capacity Does Not Exist The 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.

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 Centers ROI Residual Income Balanced Scorecard Transfer Pricing