Decentralization May 27, 2009 Chapter 10: Decentralization. Managers in large organizations have to delegate some decisions to those who are at the lower levels in the organization. This chapter explains how responsibility accounting systems and measures such as return on investment (ROI) and residual income are used to help control decentralized organizations.

Today’s Agenda Decentralization – what is it? Responsibility Centers Advantages and disadvantages Responsibility Centers Cost Centers Profit Centers Investment Centers Allocating costs equitably ROI & Residual Income

What is Decentralization? Decision making authority is spread throughout the organization Versus all decisions being made at the most senior level Large organizations need to decentralize decision making to at least to some extent Lower level employees are empowered

Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. A decentralized organization does not confine decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages of decentralization are as follows:   It enables top management to concentrate on strategy, higher-level decision-making, and coordinating activities. It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions. It enables lower-level managers to quickly respond to customers. It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions. It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance. Lower-level decision often based on better information. Lower-level managers can respond quickly to customers.

Decentralization in Organizations May be a lack of coordination among autonomous managers. Lower-level managers may make decisions without seeing the “big picture.” Disadvantages of Decentralization Lower-level manager’s objectives may not be those of the organization. The disadvantages of decentralization are as follows:   Lower-level managers may make decisions without fully understanding the “big picture.” There may be a lack of coordination among autonomous managers. The balanced scorecard can help reduce this problem by communicating a company’s strategy throughout the organization. Lower-level managers may have objectives that differ from those of the entire organization. This problem can be reduced by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company. It may be difficult to effectively spread innovative ideas in a strongly decentralized organization. This problem can be reduced through the effective use of intranet systems, which enable globally dispersed employees to electronically share ideas. May be difficult to spread innovative ideas in the organization.

Responsibility Centers In a Decentralized structure, organizations are divided into Responsibility Centers Allows tracking of performance of those who are making the decisions There are three types: Profit Center Measure on Profit & Loss, ROI Cost Center Measure on level of costs Investment Center Measure on ROI, for example

Responsibility Centers - Examples Investment Centers Cost Centers Part I. Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. Part II. The President and CEO as well as the Vice President of Operations manage investment centers. Part III. The Chief Financial Officer, General Counsel, and Vice President of Personnel all manage cost centers. Profit Centers ?

Segmented Reporting Each Responsibility Center may be segmented into logical units; eg, Regions Retail Outlets Business Divisions This is done to track performance at different levels It isolates performance – good and bad Costs must be fairly allocated Challenging to allocate common costs Note: Increasingly GAAP requires segmented reporting in certain cases

Allocating Costs to Business Segments Traceable Costs Costs that are directly traceable to the segment Eg, staff costs for the Western region These can be fixed or variable costs Common Costs Costs that are shared among all segments Eg, cost of centralized purchasing department These costs must be allocated in some manner acceptable to those whose performance is being measured

Measuring Performance Cost Centers Measured on level of costs against budget Profit Centers Measured on Profit & Loss against budget And possibly ROI Investment Centers Measured on ROI and Residual Income ROI provides incentive to invest for increasing levels of profitability Residual Income provides incentive to invest for increasing levels of income above a certain ROI threshold

Return on Investment (ROI) Formula Income before interest and taxes (EBIT) ROI = Net operating income Average operating assets An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as net operating income divided by average operating assets.   Net operating income is income before taxes and is sometimes referred to as EBIT (earnings before interest and taxes). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Net operating income is used in the numerator because the denominator consists only of operating assets. The operating asset base used in the formula is typically computed as the average of the assets between the beginning and the end of the year. Cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.

Average operating assets Improving ROI ROI = Net operating income Average operating assets Three ways to improve ROI: 1. Reduce expenses 2. Increase Revenue 3. Reduce Operating Assets

ROI – an example What is the Gross Margin? & GM %? What is Operating Income? Operating Income %? Calculate ROI

ROI – an example ROI is 19% Is that good? How can it be improved?

Return on Investment (ROI) Formula Net operating income Average operating assets Margin = Net operating income Sales Turnover = Sales Average operating assets Part I DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover. Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned. Part II Turnover is computed by dividing sales by average operating assets. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI. Part III So, we can restate the ROI equation as margin times turnover. ROI = Margin  Turnover

Calculating Residual Income ( ) ROI provides incentive to invest for increasing levels of profitability Residual Income provides incentive to invest for increasing levels of income above a certain ROI threshold

Calculating Residual Income Jack Company can invest Yuan 20 million in assets and expects it will generate Yuan 5 million per year in operating income The ROI threshold is 20% Should the company proceed with the investment?

Transfer Pricing Transfer pricing is required when one part of an organization transfers goods or services to another part A price needs to be determined in order to measure the performance of each group Transfer Prices can be determined in a number of ways Negotiated between the two departments Cost Fair Market Value In any case, the Transfer Price must be fair in order to maintain motivation and appropriately measure and reward managers

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