Chapter 22 Performance Evaluation for Decentralized Operations Financial and Managerial Accounting 8th Edition Warren Reeve Fess © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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After studying this chapter, you should be able to: Objectives 1. List and explain the advantages and disadvantages of decentralized operations. 2. Prepare a responsibility accounting report for a cost center. 3. Prepare responsibility accounting reports for a profit center. 4. Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. After studying this chapter, you should be able to:

Objectives 5. Explain how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business.

Centralized and Decentralized Operations

Advantages of Decentralization It allows managers to focus on acquiring expertise in their areas of responsibility. Decentralizing decision making provides excellent training for managers. Delegation improves employee morale. Decentralization helps managers create good customer relations by responding quickly to customers’ needs. Managers become more creative in suggesting operating and product improvement.

Disadvantages of Decentralized Operations Decisions made by one manager may negatively affect the profitability of the entire organization. Assets and operating costs are duplicated (e.g., each division has its own administrative office staff).

Responsibility Centers Cost Centers Managers are held accountable for controlling costs. Profit Centers Managers are held accountable for costs and making decisions that impact revenues favorably.

Responsibility Centers Investment Centers Managers are held accountable for costs and revenues and are also held accountable for the efficient use of assets.

College of Engineering College of Arts and Sciences Responsibility Accounting for Cost Centers COST CENTERS IN A UNIVERSITY UNIVERSITY COLLEGE Dept. of Marketing College of Business College of Engineering College of Arts and Sciences Dept. of Accounting Dept. of Management

Responsibility Accounting for Cost Centers COST CENTERS IN A UNIVERSITY DEPARTMENT Department of Accounting

Cost Centers Budget Performance Report Supervisor, Department 1—Plant A For the Month Ended October 31, 2006 Over Under Budget Actual Budget Budget Factory wages $ 58,100 $ 58,000 $100 Materials 32,500 34,225 $1,725 Supervisory salaries 6,400 6,400 Power and light 5,750 5,690 60 Depreciation 4,000 4,000 Maintenance 2,000 1,990 10 Insurance, taxes 975 975 $109,725 $111,280 $1,725 $170 $109,725 $111,280 $1,725 $170 These totals are shown on the Manager, Plant A’s budget performance report (Slide 13).

Budget Performance Report For the Month Ended October 31, 2006 Cost Centers Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 Over Under Budget Actual Budget Budget Administration $ 17,500 $ 17,350 $150 Department 1 109,725 111,280 $1,555 Department 2 190,500 192,600 2,100 Department 3 149,750 149,100 650 $467,475 $470,330 $3,655 $800 Department 1 109,725 111,280 $1,555 From the Supervisor—Department 1, Plant A budget performance report (Slide 12).

Budget Performance Report For the Month Ended October 31, 2006 Cost Centers Budget Performance Report Manager, Plant A For the Month Ended October 31, 2006 Over Under Budget Actual Budget Budget Administration $ 17,500 $ 17,350 $150 Department 1 109,725 111,280 $1,555 Department 2 190,500 192,600 2,100 Department 3 149,750 149,100 650 $467,475 $470,330 $3,655 $800 $467,475 $470,330 $3,655 $800 This is shown on the Vice-President’s budget production report (Slide 15).

Cost Centers Note that “Over Budget” is a net figure. Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 Over Under Budget Actual Budget Budget Administration $ 19,500 $ 19,700 $ 200 Plant A 467,475 470,330 2,855 Plant B 395,225 394,300 $925 $882,200 $884,330 $3,055 $925 Plant A 467,475 470,330 2,855 Note that “Over Budget” is a net figure.

Cost Centers Budget Performance Report Vice-President, Production For the Month Ended October 31, 2006 Over Under Budget Actual Budget Budget Administration $ 19,500 $ 19,700 $ 200 Plant A 467,475 470,330 2,855 Plant B 395,225 394,300 $925 $882,200 $884,330 $3,055 $925 Each of the line items above is supported by a cost center report.

Responsibility Accounting for Profit Centers In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues.

Profit centers may be divisions, departments, or products.

Movie Production Division Profit Centers NEG, a diversified entertainment company, has two profit centers: the Theme Park Division and the Movie Production Division. Theme Park Division Movie Production Division Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000

Profit Centers Charging Service Department Costs to Production Divisions Purchasing Department: $400,000 (Activity base: number of purchase requisitions) Theme Park Division 25,000 purchase requisitions Movie Production Division: 15,000 purchase requisitions Total 40,000 $400,000 40,000 purchase requisitions $10 per purchase requisition =

Charging Service Department Costs to Production Divisions Profit Centers Charging Service Department Costs to Production Divisions Payroll Accounting: $255,000 (Activity base: number of payroll checks) Theme Park Division 12,000 payroll checks Movie Production Division: 3,000 payroll checks Total 15,000 $255,000 15,000 payroll checks = $17 per payroll check

Charging Service Department Costs to Production Divisions Profit Centers Charging Service Department Costs to Production Divisions Legal Department: $250,000 (Activity base: number of payroll checks) Theme Park Division 100 billed hours Movie Production Division: 900 billed hours Total 1,000 $250,000 1,000 hours = $250 per hour

Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 25,000 purchase requisitions x $10 per purchase requisition 15,000 purchase requisitions x $10 per purchase requisition

Profit Centers 12,000 payroll checks x $17 per payroll check Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 12,000 payroll checks x $17 per payroll check 3,000 payroll checks x $17 per payroll check

Profit Centers 100 hours x $250 per hour 900 hours x $250 per hour Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 100 hours x $250 per hour 900 hours x $250 per hour

Profit Centers Purchasing $250,000 $150,000 Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2006 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total service department charges $479,000 $426,000

Income from operations before service department charges. Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division Movie Production Division Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000 Income from operations $3,505,000 $2,095,000 Income from operations before service department charges.

Income from operations $3,505,000 $2,095,000 Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2006 Theme Park Division Movie Production Division Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000 Income from operations $3,505,000 $2,095,000 Less service dept. charges: Purchasing $ 250,000 $ 150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total service department charges $ 479,000 $ 426,000 Income from operations $3,026,000 $1,669,000

Responsibility Accounting for Investment Centers In an investment center, the unit 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.

Divisional Income Statements For the Year Ended December 31, 2006 Investment Centers Datalink Inc. Divisional Income Statements For the Year Ended December 31, 2006 Northern Central Southern Division Division Division Revenues $560,000 $672,000 $750,000 Operating expenses 336,000 470,400 562,500 Income from operations before service dept. charges $224,000 $201,600 $187,500 Service department charges 154,000 117,600 112,500 Income from operations $ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Rate of return on investment 20% 12% 15% 20% 12% 15%

Rate of Return on Investment (ROI) Revenues

Rate of Return on Investment (ROI) Profit Profit Margin Investment Turnover

Rate of Return on Investment (ROI) The profit margin indicates the rate of profit on each sales dollar. The investment turnover indicates the rate of sales on each dollar of invested assets. Profit Margin Investment Turnover

Rate of Return on Investment (ROI) Income from operation Sales Sales Invested assets ROI = x ROI = $ 70,000 $560,000 x $350,000 ROI = 12.5% x 1.6 = 20%

Rate of Return on Investment (ROI) Income from operation Sales Sales Invested assets ROI = x Profit Margin Inventory Turnover

Income from operations $ 70,000 $ 84,000 $ 75,000 Northern Central Southern Division Division Division Profit Margin Income from operations $ 70,000 $ 84,000 $ 75,000 Revenues (Sales) $560,000 $672,000 $750,000 Profit margin 12.5% 12.5% 10.0% Investment Turnover Revenues (Sales) $560,000 $672,000 $750,000 Invested assets $350,000 $700,000 $500,000 Investment turnover 1.6 .96 1.5 Return on Investment (ROI) Income from operations $ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Rate of return on investment 20% 12% 15%

Minimum Acceptable Rate of Return on Assets – Income from Operations = Residual Income

Divisional Income Statements For the Year Ended December 31, 2006 Baldwin Company Divisional Income Statements For the Year Ended December 31, 2006 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 x 10% 35,000 $700,000 x 10% 70,000 $500,000 x 10% 50,000 Residual income $35,000 $14,000 $25,000

The balance scorecard is a set of financial and nonfinancial measures that reflect multiple performance dimensions of a business.

Innovation and Learning R&D investment R&D pipeline Skills and training Time to market Internal Process Customer Satisfaction Loyalty Perception Efficiency Quality Time Financial ROI Residual income Profit Cost Sales

Transfer Pricing

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

Benefits of Transfer Pricing 1. Divisions can be evaluated as profit or investment centers. 2. Divisions are forced to control costs and operate competitively. 3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

Commonly Used Transfer Prices 1. Market price approach sets the price at which the product transferred could be sold to outside buyers. 2. Negotiated price approach allows decentralized managers to agree (negotiate) among themselves. 3. Cost price approach (variable or full) uses a variety of cost concepts for setting the transfer price.

Commonly Used Transfer Prices Variable Cost per Unit $10 Full Cost per Unit $13 Market Price per Unit $20 Negotiated Price

Transfer Pricing—Negotiated Price Approach Assumptions 1. Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity. 2. Division N purchases 20,000 units of the same product at $20 per unit from an outside source. If the division managers agree on a price of $15 per unit, how much will each division’s income increase?

Chapter 22 The End