DECENTRALIZATION AND PERFORMANCE EVALUATION © itaesem/iStockphoto CHAPTER 10

10 THE SUM OF THE PARTS… ► Three years of losses for Centex Yarns’ Nylon Fibers Division ► How long will management let this go on? ► What information would help Monica make her case?

CENTRALIZED VERSUS DECENTRALIZED ORGANIZATIONS Unit 10.1 Unit 10.2Unit 10.3 © Tomwang112 / iStockphoto Unit

10 DECENTRALIZATION ► Pushes decision making and responsibility down the organization chart to lower level managers ► Requires a way to evaluate the decentralized managers and the segments of the business they manage ► Runs along a continuum

10 THE DECENTRALIZATION CONTINUUM CENTRALIZED DECENTRALIZED Decision making authority is at the top Decision making authority is delegated to lower level managers Where do you want to be?

10 EFFECTS OF DECENTRALIZATION ADVANTAGES ► Better information for operational decisions ► More timely information for operational decisions ► Develops decision making skills for future ► Gives top managers time to focus on strategic planning DISADVANTAGES Conflict between operational decisions and corporate strategy Duplicated work effort across units Reduced communication between units Increased potential for errors as managers learn to make decisions

10 RESPONSIBILITY ACCOUNTING ► An organization is divided into operating units, where managers have decision making authority ► Unit managers are evaluated only on those items under their control Costs Profits Investments (assets)

10 COST CENTER ► Manager has control over only the costs incurred by the center ► No control over revenue or investment in assets ► Goal is to minimize costs while providing an acceptable service level or product quality ► Compare actual results to flexible budget

10 PROFIT CENTER ► Manager has control over both revenues and costs for the center ► No control over investment in assets ► Goal is to maximize unit’s profit ► Actual profit compared to flexible budget

10 INVESTMENT CENTER ► Manager is responsible for revenues, costs and investment in assets ► Goal is to maximize returns through ROI or residual income

10 CENTEX YARNS’ DECENTRALIZED STRUCTURE

SEGMENT EVALUATION Unit 10.1 Unit 10.2 Unit 10.3 © Tomwang112 / iStockphoto Unit

10 WHAT IS A SEGMENT? ► A part of the organization that management wishes to evaluate ► No “correct” way to divide an organization

10 ONE WAY TO SEGMENT CENTEX YARNS Does this format help Centex Yarns’ managers decide what to do with the Nylon Fibers Division? Polyester Fibers Division Rope Division Nylon Fibers Division Total Revenue$10,600,000$6,725,000 $8,650,000$25,975,000 Cost of goods sold 7,638,550 4,011,800 6,959,750 18,610,100 Gross profit2,961,4502,713,200 1,690,2507,364,900 S&A expenses 2,332,450 1,309,200 1,790,250 5,431,900 Operating income$ 629,000$1,404,000 $ (100,000)$ 1,933,000

10 SEGMENT MARGIN INCOME STATEMENT Now how does the Nylon Fibers Division look? Polyester Fibers Division Rope Division Nylon Fibers DivisionTotal Revenue$10,600,000$6,725,000 $8,650,000$25,975,000 Variable COGS5,543,0002,368,0004,414,00012,325,000 Variable S&A 1,334, , ,000 2,873,000 Contribution margin3,723,0003,708,0003,346,00010,777,00 Traceable fixed COGS1,685,0001,382,0002,208,0005,275,000 Traceable fixed S&A 236, , , ,000 Segment margin$ 1,802,000$2,152,000$ 865,0004,819,000 Common fixed expenses 2,886,000 Net operating income$ 1,933,000

10 Textile Yarns Group Industrial Yarns Group Nylon Fibers Division Revenue$6,055,000$2,595,000 $8,650,000 Variable COGS3,168,4001,245,6004,414,000 Variable S&A 683, , ,000 Contribution margin2,203,6001,142,4003,346,000 Traceable fixed COGS744,400415,2001,159,600 Traceable fixed S&A 191,100 81, ,000 Segment margin$1,268,100$ 645,300 1,913,400 Common fixed expenses 1,048,400 Net operating income$ 865,000 WATCH OUT… $2,208,000 in Traceable Fixed Costs to Nylon Fibers Division are now part traceable and part common

RETURN ON INVESTMENT Unit 10.1Unit 10.2 Unit 10.3 © Tomwang112 / iStockphoto Unit

10 RETURN ON INVESTMENT ► What return did a manager earn on the assets that he had control over? ► Return is a measured as net operating income for that segment ► The net operating income is compared to the operating assets assigned to that segment

10 RETURN ON INVESTMENT CALCULATION Operating Income (or segment margin) Average Operating Assets INCOME BEFORE INTEREST AND TAXES CASH, A/R, INVENTORY, PPE, AND OTHER PRODUCTIVE ASSETS

10 CENTEX YARNS’ DIVISIONAL ROI S Polyester Fibers Division Rope Division Nylon Fibers Division Segment Margin$1,802,000$2,152,000$ 865,000 Average Assets$8,153,000$8,406,250$2,703,000 ROI

10 THE DUPONT MODEL Net operating income Sales revenue Average operating assets x MARGIN TURNOVER

10 THE DUPONT MODEL- NYLON FIBERS $865,000 $8,650,000 $2,703,000 x MARGIN TURNOVER ROI = 10% X 3.2 = 32%

10 HOW DO WE IMPROVE ROI? ► Increase Sales (to increase turnover) ► Reduce Expenses (to increase margin) ► Reduce Assets (to increase turnover) Net operating income Sales revenue Average operating assets x

10 AN ISSUE WITH ROI The Nylon Fibers division has been generating a 32% ROI, well above the corporate goal of 15%. A new project comes along with a 25% ROI. Will Monica choose to invest in this project? Probably not, since the division’s ROI will fall

RESIDUAL INCOME AND EVA ® Unit 10.1Unit 10.2Unit 10.3 Unit 10.4 © Tomwang112 / iStockphoto104.

10 RESIDUAL INCOME ► Companies typically have a minimum return they require on asset investments ► Any income earned in excess of that minimum is “residual income” ► Any project with a positive residual income is beneficial to the company as a whole, even though it may lower an individual segment’s ROI

10 CALCULATION OF RESIDUAL INCOME Operating Assets xRequired Rate of Return Required Return Actual Return -Required Return Residual Income

10 CENTEX YARNS’ DIVISIONAL RESIDUAL INCOME Polyester Fibers Division Rope Division Nylon Fibers Division Assets$8,153,000$8,406,250$2,703,000 × Required rate of return 15% Minimum required income$1,222,950$1,260,938$ 405,450 Segment Margin$1,802,000$2,152,000$ 865,000 - Minimum required income 1,222,950 1,260, ,450 Residual income$ 579,050$ 891,062$ 459,550

10 ECONOMIC VALUE ADDED (EVA) ► A variation of residual income that measures “economic profit” ► Residual income calculates using the weighted average cost of capital (WACC) rather than management’s desired rate of return EVA = Net operating profit – (Invested capital × WACC)

10 FOUR STEPS TO CALCULATE EVA ► Calculate net operating profit ► Calculate invested capital ► Calculate weighted average cost of capital (WACC) ► Calculate EVA

10 NYLON FIBERS DIVISION EVA ► Net operating profit $865,000 – ($865,000×30%) = $605,500 ► Invested Capital $2,703,000 assets - $600,000 current liabilities = $2,103,000 ► Weighted average cost of capital (6% ×40%) + (12% ×60%) = 9.6% ► EVA $605,500 – ($2,103,000 ×9.6%) = $403,612

TRANSFER PRICING APPENDIX © Tomwang112 / iStockphoto A 10

10 INTERMEDIATE PRODUCTS Centex Nylon Fibers Division Centex Rope Division Product manufactured by one division and used as a raw material in another division Requires a transfer price

10 MARKET-BASED TRANSFER PRICE Centex Nylon Fibers Division External Customer Centex Rope Division Transfer price = $25 per reel Market price = $25 per reel

10 COST-BASED TRANSFER PRICE Centex Nylon Fibers Division Centex Rope Division No external market exists. Nylon Fibers Division’s cost to produce is $16 per reel. Transfer price = $16 per reel

10 COST-PLUS TRANSFER PRICE Centex Nylon Fibers Division Centex Rope Division No external market exists. Nylon Fibers Division’s cost to produce is $16 per reel. 20% profit margin required. Transfer price = $19.20 per reel ($16 × 1.2)

10 NEGOTIATED TRANSFER PRICE Centex Nylon Fibers Division Centex Rope Division No external market exists. Nylon Fibers Division’s cost to produce is $16 per reel. Managers from both divisions negotiate a transfer price. Transfer price = ?

10 MINIMUM TRANSFER PRICE ► Transfer price should be set to generate the greatest benefit possible to the organization as a whole ► Depends on whether excess production capacity exists Minimum price = Variable cost to produce/sell + CM forgone

10 CAPACITY EFFECTS ON TRANSFER PRICE ► Excess capacity exists Transferred units do not require giving up existing contribution margin Minimum transfer price = variable cost to produce/sell ► No excess capacity exists Normal sales will have to be reduced to provide the transferred units, resulting in lost contribution margin Minimum transfer price = variable cost to produce/sell plus the normal contribution margin per unit