Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 18 Organizational Design, Responsibility Accounting, and Evaluation of Divisional Performance

18-2 Learning Objective 1

18-3 Decentralized Organizations Decentralization - assigning of specific responsibilities to subunits of organizations. Decentralization - assigning of specific responsibilities to subunits of organizations. Goal congruence when subunit managers in the organization hold a common set of objectives. Goal congruence - when subunit managers in the organization hold a common set of objectives. Individual goal congruence - when a member’s personal goals are consistent with those of the organization as a whole. Individual goal congruence - when a member’s personal goals are consistent with those of the organization as a whole.

18-4 Goal Congruence and Performance Measurement Behavioral congruence Behavioral congruence - when individuals behave in the best interest of the organization regardless of their own goals. It is best for all concerned if the evaluation system used to measure a manager’s achievements result in at least behavioral congruence (if not goal congruence). Example: Overall company profitability.

18-5 Decentralized Organizations and Responsibility Accounting Responsibility accounting - a system of internal reporting tailored to specific organizational structures. It allows the aggregation of cost, profit and/or returns at the subunit levels, so that managers responsible for achieving results at each level can have their performance evaluated more appropriately.

18-6 Centralization versus Decentralization Centralized Centralized Decisions are handed down from the top echelon of management and subordinates carry them out. Centralized Centralized Decisions are handed down from the top echelon of management and subordinates carry them out. Decentralized Decentralized Decisions are made at divisional and departmental levels. Decentralized Decentralized Decisions are made at divisional and departmental levels.

18-7 Learning Objective 2

18-8 Benefits of Decentralization  Managers have specialized skills that permit them to manage their departments most effectively.  Their resulting autonomy provides a training opportunity for increased responsibility.  Managers with such authority exhibit positive motivation.  Delegation of tasks lightens the time burden on upper-level managers.  It also encourages timely responses to problem solving.

18-9 Costs of Decentralization  Local managers may narrow their focus to their own subunit’s performance.  Local managers may make decisions that are not congruent with the preferences of top management.  Some tasks or services may be duplicated among the decentralized subunits.

18-10 Learning Objective 3

18-11 Responsibility Accounting 1. Cost centers - responsible for the cost of a well defined activity. 2. Discretionary cost centers – responsible for the cost of an activity that is not well defined. 3. Revenue center – responsible for revenue attributed to the subunit. 4. Profit center – responsible for profit of a subunit. 5. Investment center – responsible for profit and the invested capital of a subunit.

18-12 Learning Objective 4

18-13 Performance Reports Shows the budgeted and actual amounts of key financial results tailored to the objectives of specific responsibility centers.

18-14 Shows the budgeted and actual amounts of key financial results tailored to the objectives of specific responsibility centers. Performance Reports Management by exception means that managers follow up on only the most significant variances between budgeted and actual results.

18-15 Budgets, Variance Analysis and Responsibility Accounting The flexible budget provides the benchmark against which actual revenues, expenses and profits are compared.

18-16 Activity-Based Responsibility Accounting Activity-based costing systems associate costs with the activities that drive those costs. The database created by an ABC system, coupled with nonfinancial measures of operational performance for each activity, enables management to employ activity-based responsibility accounting. Activity-based costing systems associate costs with the activities that drive those costs. The database created by an ABC system, coupled with nonfinancial measures of operational performance for each activity, enables management to employ activity-based responsibility accounting.

18-17 How Responsibility Accounting Affects Behavior Exchange information or assign blame? The system should identify the individual in the organization who is in the best position to explain each particular event or financial result. Can you help me understand the unfavorable cost variance? Sure, I’ll be glad to give you my input about the variance.

18-18 Learning Objective 5

18-19 Performance Measurement in Investment Centers Return on Investment (ROI) is the ratio of profits to investment in the assets that generate those profits. ROI = Income Invested capital

18-20 Performance Measurement in Investment Centers ROI = Income Invested capital ROI = × Sales revenue Invested capital Income Sales revenue or

18-21 Return on Investment The management of Matrix, Inc. is evaluating two investment proposals. 1. Project A will generate $150,000 in operating profits and require an investment of $600, Project B will generate operating profits of $500,000 and will require an investment of $2,500,000. Let’s calculate the ROI for these two projects. The management of Matrix, Inc. is evaluating two investment proposals. 1. Project A will generate $150,000 in operating profits and require an investment of $600, Project B will generate operating profits of $500,000 and will require an investment of $2,500,000. Let’s calculate the ROI for these two projects.

18-22 Return on Investment $150,000 ÷ $600,000 = 25% ROI If we can invest in only one project, we would select Project A. It has a higher ROI. If we can invest in only one project, we would select Project A. It has a higher ROI.

18-23 Return on Investment Matrix, Inc. provides the projected income statement for its investment in Project A. × Sales revenue Invested capital = ROI Income Sales revenue $150,000 $300,000× $300,000 $600,000 = ROI 50%50% = 25% ×

18-24 Learning Objective 6

18-25 Improving a Division’s ROI Decrease costs while maintaining the same sales level. Increase sales revenue with no change in costs. Decrease invested capital with no change in income. Decrease invested capital with no change in income. Caveat: None of these are easy to achieve!

18-26 Residual Income as a Performance Measure Residual income is defined as... The imputed interest rate should be the rate of return on investments of similar risk that are being forgone. Investment center’s profits – Investment center’s invested capital Imputed interest rate ×

18-27 Residual Income as a Performance Measure Using our original investment proposals and a imputed interest rate of 15%, let’s calculate the residual income. This time Project B looks much better.

18-28 Learning Objective 7

18-29 Comparing ROI and Residual Income Advantage: It uses percentages, which allow easy comparison with required returns. Disadvantage: Value of invested capital is measured in dollars of different purchasing power. Advantage: It facilitates goal congruence with its required rate of return Disadvantage: It is biased in favor of larger companies because it shows dollar results. ROI Residual Income Solution: Use both in evaluating investments.

18-30 Economic Value Added (EVA) as a Performance Measure All capital - debt or equity - has a cost. Cost of debt is equal to the interest payments made on the debt. Cost of debt is equal to the interest payments made on the debt. Cost of equity is the return the shareholders could obtain in price appreciation and dividends if they invested in a portfolio of companies about as risky as yours. Cost of equity is the return the shareholders could obtain in price appreciation and dividends if they invested in a portfolio of companies about as risky as yours.

18-31 Economic Value Added (EVA) Investment center’s after- tax operating profit EVA= – Weighted- average cost of capital × Investment center’s total assets Investment center’s current liabilities – Investment center current liabilities are subtracted from its total assets.

18-32 Weighted-Average Cost of Capital Cost of capital is the weighted average combination of the cost of debt and equity (WACC). After-tax cost of debt Market value of debt × Cost of equity Market value of equity × + Market value of debt Market value of equity x Weighted- average cost of capital =

18-33 Learning Objective 8

18-34 Measuring Investment Capital Three issues must be considered before we can properly measure the investment capital. Three issues must be considered before we can properly measure the investment capital. 1. Which asset value should be included in invested capital? 2. Should the assets be shown at historical or current cost? 3. Should we measure the investment at the beginning or end of period amount? Three issues must be considered before we can properly measure the investment capital. Three issues must be considered before we can properly measure the investment capital. 1. Which asset value should be included in invested capital? 2. Should the assets be shown at historical or current cost? 3. Should we measure the investment at the beginning or end of period amount?

18-35 Gross or Net Book Value Matrix, Inc. is considering an investment that is projected to produce operating profits of $25,000 before depreciation for the next three years. At the beginning of the first year Matrix will invest $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used. At the beginning of the first year Matrix will invest $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used. Matrix calculates ROI based on end-of-year asset values. Matrix calculates ROI based on end-of-year asset values. Let’s calculate ROI using both the gross and net book values. Matrix, Inc. is considering an investment that is projected to produce operating profits of $25,000 before depreciation for the next three years. At the beginning of the first year Matrix will invest $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used. At the beginning of the first year Matrix will invest $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used. Matrix calculates ROI based on end-of-year asset values. Matrix calculates ROI based on end-of-year asset values. Let’s calculate ROI using both the gross and net book values.

18-36 Gross or Net Book Value ($100,000 – $0) ÷ 10 = $10,000 per year $100,000 – $10,000 = $90,000 book value

18-37 Gross or Net Book Value $15,000 ÷ $90,000 = 16.67% $15,000 ÷ $100,000 = 15% The ROI increases each year under the net book value method even though no operating changes take place. The ROI increases each year under the net book value method even though no operating changes take place.

18-38 Current Value versus Historical-Cost Accounting Our previous example assumed no inflation. Let’s work with the same information and assume that the current replacement cost of the asset and profits before depreciation increase by 6% per year.

18-39 Historical Cost versus Current Cost $25,000 × 1.06 = $26,500

18-40 Historical Cost versus Current Cost Using historical cost and net book value, our ROI would be:

18-41 Historical Cost versus Current Cost Using current cost values, net operating profit would be: And ROI would be:

18-42 Beginning, Ending or Average Balance Using the average investment base provides acceptable results and discourages inappropriate investment decisions. If I purchase the asset early in the year, it will boost income for the entire year and impact ROI.

18-43 Return on Investment Allowing for the many possible variations of its components, ROI is the most commonly used measure of business-unit performance.

18-44 Nonfinancial Performance Measures The use of nonfinancial measures of performance in incentive plans is increasing. These measures help managers... 1.Focus on the drivers of profit, and 2.Recognize the time lags between nonfinancial and financial performance. The use of nonfinancial measures of performance in incentive plans is increasing. These measures help managers... 1.Focus on the drivers of profit, and 2.Recognize the time lags between nonfinancial and financial performance.

18-45 Performance Measurement in Nonprofit Organizations The goals of nonprofit organizations frequently are less clear-cut than those of for-profit enterprises. It may be difficult to have people within nonprofit organizations submit to the same types of controls as are often found in the business environment.

18-46 End of Chapter 18