Managerial Accounting by James Jiambalvo Chapter 12: Decentralization and Performance Evaluation Slides Prepared by: Scott Peterson Northern State University

Objectives List and explain the advantages and disadvantages of decentralization. Explain why companies evaluate the performance of subunit managers. Identify cost centers, profit centers, and investment centers. Calculate and interpret return on investment (ROI).

Objectives (Continued) Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment Calculate and interpret residual income (RI) and economic value added (EVA). Explain the potential benefits of using a Balanced Scorecard to assess performance.

Advantages of Decentralization Better information leading to superior decisions. Faster response to changing circumstances. Increased motivation of managers. Excellent training for future top level executives.

Advantages of Decentralization

Disadvantages of Decentralization Costly duplication of activities. Lack of goal congruence.

Why Companies Evaluate The Performance of Subunits and Subunit Managers Decentralization naturally leads to evaluate subunits and managers. Companies evaluate performance of subunits and managers for two reasons: Evaluation identifies successful operations and areas needing improvement. Evaluating performance influences manager behavior.

Responsibility Accounting and Performance Evaluation Responsibility accounting holds managers responsible for only costs and revenues which they can control. To implement responsibility accounting in a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled.

Responsibility Accounting and Performance Evaluation

Cost Centers, Profit Centers, and Investment Centers Subunits are organizational units with identifiable collections of related resources and activities. A subunit may be a: Department Subsidiary Division. Subunits are sometimes referred to as responsibility centers and include cost centers, profit centers, and investment centers.

Cost Centers, Profit Centers, and Investment Centers (Continued) Subunits are also called responsibility centers. Include: Cost centers Profit centers Investment centers.

Cost Centers Subunit that has responsibility for controlling costs but does not have responsibility for generating revenue. Examples: janitorial, computer service, and production departments. Managerial goal: to provide services at a reasonable cost to the company. Evaluation: compare budgeted/standard costs with actual costs.

Profit Centers Subunit that has responsibility for generating revenues as well as for controlling costs. Examples: copier and camera divisions of an electronics firm. Managerial goal: to maximize profit (revenues – expenses) for the division. Evaluation: profit from the current year may be compared with budget or previous years or compared with with other profit centers on a relative basis.

Investment Centers Subunit that has responsibility for: Generating revenues Controlling costs Investing in assets Managers of investment centers have control over inventory, receivables, equipment purchases, etc... Held responsible for generating some kind of return on them.

Investment Centers (Continued) Examples: Nordstrom, Inc. subunit Faconnable. Managerial goal: to maximize return on investment. Evaluation: rate of return (%) relative to a benchmark/budget rate of return or relative to other investment center rates of return.

Evaluating Investment Centers with ROI ROI is one of the primary tools for evaluating performance of investment centers. Calculated as follows: ROI = Income Invested Capital ROI focuses on income AND investment Natural advantage over income (alone) as a measure of performance. Removes the bias of larger investment over smaller investment.

Evaluating Investment Centers with ROI (Continued) ROI breaks down into two components: Profit margin: Income Sales Investment turnover: Invested Capital

Measuring Income and Invested Capital When Calculating ROI For ROI calculations, companies measure “income” in a variety of ways: Net income Income before interest and taxes Controllable profit… The text uses uses Net Operating Profit After Taxes, NOPAT. This formula does not hold managers responsible for interest.

What is NOPAT? Net Income $3,900,000 Add Back: Interest Expense 1,000,000 less tax savings (350,000) NOPAT $4,550,000

Measuring Income and Invested Capital When Calculating ROI (Continued) Invested capital is measured in a variety of ways. In the text, invested capital is measured as: Total Assets - Noninterest-bearing current liabilities Examples of noninterest-bearing current liabilities: Accounts payable Income taxes payable Accrued liabilities

Problems With Using ROI Major problem with ROI: the denominator, invested capital, is based on historical costs, net of depreciation. As those assets become fully depreciated, the invested capital denominator becomes extremely low and the ROI number quite high. Managers may therefore be compelled to put off purchases of new equipment necessary for long-term success. They “underinvest.”

Problems of Overinvestment and Underinvestment: You Get What You Measure Managers of investment centers with high ROI’s may be unwilling to invest in assets that will dilute their current ROI. This will lead to “underinvestment.” Conversely, evaluation in terms of profit can lead to “overinvestment.”

Residual Income (RI) Residual Income (RI): net operating profit after taxes of an investment center in excess of the profit required for the level of investment. RI = NOPAT - Cost of Capital x Investment RI has the potential to solve both the overinvestment and underinvestment problem because it compels investment in the range between cost of capital and current ROI.

Residual Income (RI): Example Facts: NOPAT=$4,550,000, Invested Capital=$65,000,000, cost of capital=10%. Calculate residual income (loss): RI = $4,550,000 – (.10 x $65,000,000) RI = ($1,950,000) Negative residual value; not good!

Solving The Overinvestment and Underinvestment Problems What happens under RI when a project comes along that will earn 11%? The manager will make the investment: underinvestment problem solved! What happens under RI when a project comes along that will earn 9%? The manager will NOT make the investment: overinvestment problem solved!

Economic Value Added (EVA) Economic Value Added, EVA, is a performance measure developed by the consulting firm Stern Stuart. What is it? RI adjusted for “accounting distortions.” Primary distortion is related to research and development (R&D).

Economic Value Added (EVA) (Continued) Under GAAP, R&D is expensed immediately. Under EVA, R&D is capitalized and amortized over a number of future accounting periods. EVA has gained considerable attention in the financial press. EVA = NOPATadjusted – (Cost of Capital x Investmentadjusted)

Using A Balanced Scorecard To Evaluate Performance Problem with ROI and RI/EVA is that these financial measures are ALL “backward looking.” Balanced Scorecard is a set of performance measures : Financial perspective Customer perspective Internal process perspective Learning and growth

Using A Balanced Scorecard To Evaluate Performance (Continued) Balanced Scorecard uses performance measures that are tied to the company’s strategy for success. Balance is a key factor using this technique.

How Balance is Achieved in A Balanced Scorecard Balance between qualitative and quantitative, forward and backward measures, and balanced company dimensions! Performance is assessed across a balanced set of dimensions. Quantitative measures are balanced with qualitative measures. There is a balance of backward-looking and forward-looking measures.

How Balance is Achieved in A Balanced Scorecard

Appendix: Transfer Pricing Market Price as the Transfer Price Market Price and Opportunity Cost Variable Cost as the Transfer Price Full Cost Profit as the Transfer Price Negotiated Transfer Prices Transfer Pricing and Income Taxes in an International Context

Transfer Pricing Divisions often “sell” goods or services to other units within the same company. In the automobile manufacturing industry, batteries manufactured in one division may be sold to other divisions which manufacture autos. Market prices Variable costs Full cost plus profit Negotiated prices.

Market Price As The Transfer Price This method would be the same as with any other customer at “arm’s length.” The external market price is an excellent choice because the buying and selling divisions are treated as independent companies.

Market Price And Opportunity Cost Opportunity cost is the foregone benefit or increased cost of selecting one alternative over another. The selling division has a choice between selling to the related division or into an open market. The determining factor in deciding whether or not to sell to the related division is the impact to the firm (overall) of the decision.

Market Price And Opportunity Cost

Variable Cost As The Transfer Price In some cases the transferred product is unique and is not sold in the open market. Here, variable cost may be a good transfer price. Conveys accurate opportunity cost information. When no external market for the product exists, the opportunity cost of producing and selling the product is variable cost per unit.

Full Cost Plus Profit As The Transfer Price With variable cost transfer pricing, selling division cannot earn a profit The price may not be acceptable to management of the selling company. Many companies add a profit margin to the full cost of production. Full Cost Plus Profit may not measure the opportunity cost of producing the product.

Negotiated Transfer Prices Some companies allow managers to negotiate transfer prices. The problem is that this price may not reflect the opportunity cost of producing and selling the product. Reflects relative bargaining prowess of individual managers.

Transfer Pricing And Income Taxes In An International Context Income tax rates vary significantly between countries. When goods are transferred between countries, these tax situations may create incentives for relatively high or low transfer prices. Creates a bias toward having high transfer prices when selling a product from a low tax country to a high tax country and having a low transfer price when selling a product from a high tax country to a low tax country.

Quick Review Question #1 A profit center is responsible for all of the following except: Investing in long term assets. Controlling costs. Generating revenues. All of the above.

Quick Review Answer #1 A profit center is responsible for all of the following except: Investing in long term assets. Controlling costs. Generating revenues. All of the above.

Quick Review Question #2 What is the difference between RI and EVA? RI is a new concept. EVA makes adjustments for “accounting distortions.” RI excludes research and development as an expense. EVA includes a capital charge.

Quick Review Answer #2 What is the difference between RI and EVA? RI is a new concept. EVA makes adjustments for “accounting distortions.” RI excludes research and development as an expense. EVA includes a capital charge.

Quick Review Question #3 Return on Investment (ROI) is calculated as: Sales / Total assets. Gross margin / Invested capital. Investment center income / Invested capital. Income / Sales.

Quick Review Answer #3 Return on Investment (ROI) is calculated as: Sales / Total assets. Gross margin / Invested capital. Investment center income / Invested capital. Income / Sales.

Quick Review Question #4 Investment center income is $864,000. Investment turnover is 2. ROI is 24%. Sales is? $8,000,000 $7,200,000 $6,000,000 $3,600,000

Quick Review Answer #4 Investment center income is $864,000. Investment turnover is 2. ROI is 24%. Sales is? $8,000,000 $7,200,000 $6,000,000 $3,600,000 Instructor: Solution is as follows: .24x = (864,000/x) * 2

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