The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin CHAPTER 9 Responsibility Accounting

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-2 Learning Objective LO1 To describe the concept of decentralization

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-3 An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-4 Decentralization Improves quality of decisions. Encourages upper-level management to concentrate on strategic decisions. Improves productivity. Develops lower-level managers. Improves performance evaluation. Advantages

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-5 Decision Making is Pushed Down Decentralization often occurs as organizations continue to grow. Decentralization

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-6 Learning Objective LO2 To describe the differences among cost, profit, and investment centers

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-7 Organization Chart Corporate headquarters – Panther Holding Company Lumber manufacturing division Home building division Furniture manufacturing division Wilson Carpet Company Selma Sopha Corporation Tables Incorporated Sales department Production department Planning department Accounting department Cutting department Assembly department Finishing department Responsibility Level

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-8 Learning Objective LO3 To prepare and use responsibility reports

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-9 Responsibility Reports  Prepare budgets for each responsibility center.  Prepare timely performance reports comparing actual amounts with budgeted amounts.  Measure performance of each responsibility center.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-10 Responsibility Reports

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-11 Responsibility Reports

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-12 Responsibility Reports

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-13 Responsibility Reports Panther Income Statement (Contribution Margin Format)

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-14 Learning Objective LO4 To relate management by exception to responsibility reports

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-15 Amount of detail varies according to level in an organization. Department manager receives detailed reports. Store manager receives summarized information from each department. Management by Exception

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-16 The vice president of operations receives summarized information from each unit. Management by exception Upper-level management does not receive operating detail unless problems arise. Amount of detail varies according to level in an organization. Management by Exception

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-17 Since the exercise of control may be clouded, managers are usually held responsible for items over which they have predominant rather than absolute control. I’m in control Controllability Concept Managers should only be evaluated on revenues or costs they control.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-18 To be of maximum benefit, responsibility reports should... Be timely Be issued regularly Be understandable Compare budgeted and actual amounts of controllable items Qualitative Reporting Features

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-19 Cost Center Profit Center Investment Center Evaluation Measures Profitability Return on investment (ROI) Residual income (RI) Cost control Quantity and quality of services Managerial Performance Measurement

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-20 Learning Objective LO5 To evaluate investment opportunities using return on investment

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-21 Return on Investment Return on investment is the ratio of income to the investment used to generate the income. Return on investment is the ratio of income to the investment used to generate the income. ROI = Operating Income Operating Assets

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-22 Return on Investment Panther Holding Company provides the following information for the company’s second level investment centers. Let’s calculate ROI

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-23 Return on Investment Lumber Manufacturing Home Building Furniture Manufacturing = = = $60,000 $300,000 $46,080 $256,000 $81,940 $482,000 = 20% = 18% = 17%

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-24 Measuring Operating Assets Using the book value of operating assets to calculate ROI will result in a higher ROI.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-25 Learning Objective LO6 To identify factors that affect return on investment

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-26 ROI = Operating Income Operating Assets Margin Turnover Factors Affecting ROI ROI = × Sales Operating Assets Operating Income Sales

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-27 The Lumber Manufacturing Division reported the following information: Operating Income$ 60,000 Sales$ 600,000 Sales$ 600,000 Operating Assets$ 300,000 Operating Assets$ 300,000 Let’s calculate ROI using the expanded equation. Factors Affecting ROI

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-28 ROI =.10 × 2 = 20% Factors Affecting ROI ROI = $60,000 $600,000 × $300,000 ROI = × Sales Operating Assets Operating Income Sales

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-29 Factors Affecting ROI Three ways to improve ROI  Increase Sales  Reduce Expenses  Reduce Operating Assets

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-30 The Lumber Manufacturing Division was able to increase sales to $660,000 which increased operating income to $79,200. There was no change in operating assets. The Lumber Manufacturing Division was able to increase sales to $660,000 which increased operating income to $79,200. There was no change in operating assets. Let’s calculate the new ROI. Factors Affecting ROI

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-31 The divisions ROI increased from 20% to 26.4%. Factors Affecting ROI ROI =.12 × 2.2 = 26.4% ROI = $79,200 $660,000 × $300,000 ROI = × Sales Operating Assets Operating Income Sales

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-32 ROI - A Major Drawback As division manager in Lumber Manufacturing, your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. As division manager in Lumber Manufacturing, your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager in Lumber Manufacturing, your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. As division manager in Lumber Manufacturing, your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager would you invest in this project?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-33 ROI - A Major Drawback As division manager, I wouldn’t invest in that project because it would lower my pay! Gee... I thought we were supposed to do what was best for the company!

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-34 Learning Objective LO7 To evaluate investment opportunities using residual income

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-35 Residual Income Operating Income – Investment charge = Residual income Operating Assets × Desired ROI = Investment charge Investment center’s cost of acquiring investment capital

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-36 Residual Income The Lumber Manufacturing Division currently earns $60,000 of operating income with the $300,000 of operating assets it controls. The Lumber Manufacturing Division currently earns $60,000 of operating income with the $300,000 of operating assets it controls. Panther has a 18% desired ROI. Panther has a 18% desired ROI. The Lumber Manufacturing Division currently earns $60,000 of operating income with the $300,000 of operating assets it controls. The Lumber Manufacturing Division currently earns $60,000 of operating income with the $300,000 of operating assets it controls. Panther has a 18% desired ROI. Panther has a 18% desired ROI. Let’s calculate residual income.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-37 Residual Income Panther’s desired return on investment. Operating income= $60,000 – Desired income = 54,000 = Residual income= $ 6,000 Operating assets = $300,000 × Desired ROI = 18% = Desired income = $ 54,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-38 Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-39 Responsibility Accounting and the Balanced Scorecard The balanced scorecard is a holistic approach to evaluating managers. Balanced Scorecard Multiple financial measures Multiple non-financial measures

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 9-40 End of Chapter 9