c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Performance Evaluation for Decentralized Operations Chapter 23

Learning Objectives 1. Describe 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. 5. Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe the advantages and disadvantages of decentralized operations. 1

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Centralized and Decentralized Operations o In a centralized company, all major planning and operating decisions are made by top management.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Centralized and Decentralized Operations o In a decentralized company, managers of separate divisions or units are delegated operating responsibility. The division (unit) managers are responsible for planning and controlling the operations of their divisions.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Advantages of Decentralization o For large companies, it is difficult for top management to do the following:  Maintain daily contact with all operations  Maintain operating expertise in all product lines and services

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Advantages of Decentralization o Decentralized operations provide excellent training for managers. o Delegating responsibility allows managers to develop managerial experience early in their careers. (continued)

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Advantages of Decentralization o It helps a company retain managers. o As a result of working closely with customers, managers become more creative in suggesting operating and product improvements.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Disadvantages of Decentralization o A primary disadvantage is that decisions made by one manager may negatively affect the profits of the company. o Decentralization may result in duplicate assets and expenses.

A DVANTAGES AND D ISADVANTAGES OF D ECENTRALIZATION

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting o In a decentralized business, accounting assists managers in evaluating and controlling their areas of responsibility, called responsibility centers.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting o Responsibility accounting is the process of measuring and reporting operating data by responsibility centers. Three common types of responsibility centers are:  Cost centers  Profit centers  Investment centers

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Prepare a responsibility accounting report for a cost center. 2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Cost Centers o A cost center manager has responsibility for controlling costs. o Cost centers may vary in size from a small department to an entire manufacturing plant. o Cost centers may exist within other cost centers.

R ESPONSIBILITY A CCOUNTING FOR C OST C ENTERS

(continued) R ESPONSIBILITY A CCOUNTING FOR C OST C ENTERS

from Manager, Plant A Budget Performance Report (continued) R ESPONSIBILITY A CCOUNTING FOR C OST C ENTERS

from Supervisor, Department 1 — Plant A’s Budget Performance Report to Vice President’s Budget Performance Report (continued) R ESPONSIBILITY A CCOUNTING FOR C OST C ENTERS

to Manager, Plant A’s Budget Performance Report (concluded) R ESPONSIBILITY A CCOUNTING FOR C OST C ENTERS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Prepare responsibility accounting reports for a profit center. 3

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Profit Centers o A profit center manager has the responsibility and authority for making decisions that affect both costs and revenues and, thus, profits. o Profit centers may be divisions, departments, or products.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Profit Centers o Controllable revenues are revenues earned by the profit center. o Controllable expenses are costs that can be influenced (controlled) by the decisions of profit center managers.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges o Examples of service departments include the following:  Research and Development  Legal  Telecommunications  Information and Computer Systems  Facilities Management  Purchasing  Publications and Graphics  Payroll Accounting  Transportation  Personnel Administration

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges o Service department charges are indirect expenses to a profit center. o Services provided by internal centralized service departments are often more efficient than services contracted with outside providers. o Service department charges are allocated to profit centers based on the usage of the service by each profit center.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges o Nova Entertainment Group (NEG) has two operating divisions: Theme Park Division and Movie Production Division. o The revenues and direct operating expenses for the two divisions are shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Purchasing$400,000 Payroll Accounting255,000 Legal 250,000 Total$905,000 Service Department Charges o NEG’s service departments and the expenses they incurred for the year ended December 31, 2014, are as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. (continued) Service Department Charges o An activity base for each service department is used to charge service department expenses to the Theme Park and Movie Production divisions. The activity base for each service department is as follows:

Service Usage—Purchasing Theme Park Division 25,000 purchase requisitions Movie Production Division 15,000 Total40,000 purchase requisitions $400,000 40,000 purchase requisitions $10 per purchase requisition = $10 per purchase requisition (continued) Service Department Charges

Service Usage—Payroll Accounting Theme Park Division12,000 payroll checks Movie Production Division 3,000 Total15,000 payroll checks $255,000 15,000 payroll checks $17 per payroll check = $17 per payroll check (continued) Service Department Charges

Service Usage—Legal Theme Park Division 100 billed hours Movie Production Division 900 Total1,000 billed hours $250,000 1,000 hours $250 per hour = $250 per hour Service Department Charges

S ERVICE D EPARTMENT C HARGES

P ROFIT C ENTER R EPORTING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Profit Center Reporting o The income from operations is a measure of a manager’s performance. o In evaluating the profit center manager, the income from operations should be compared over time to a budget. However, it should not be compared across profit centers.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. 4

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Investment Centers o An investment center 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.

R ESPONSIBILITY A CCOUNTING FOR I NVESTMENT C ENTERS DataLink Inc., a cellular phone company, has three regional divisions. These are shown in Exhibit 6.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Rate of Return on Investment o One measure that considers the amount of assets invested in an investment center is the rate of return on investment (ROI) or rate of return on assets. It is computed as follows: ROI = Income from Operations Invested Assets

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Rate of Return on Investment o The invested assets of DataLink’s three divisions are as follows:

Dupont Formula Income from Operations Sales Invested Assets x ROI = Profit Margin Investment Turnover Rate of Return on Investment

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Rate of Return on Investment o The profit margin and the investment turnover reflect the following underlying operating relationships of each division:  Profit margin indicates operating profitability by computing the rate of profit earned on each sales dollar.  Investment turnover indicates operating efficiency by computing the number of sales dollars generated by each dollar of invested assets.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. ROI = $ 70,000 $560,000 x $350,000 ROI = 12.5% x 1.6 Income from Operations Sales Invested Assets x ROI = 20% ROI = 20% Exhibit 6 from Exhibit 6 Rate of Return on Investment o DataLink’s Northern Division ROI

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. ROI = $ 84,000 $672,000 x $700,000 ROI = 12.5% x 0.96 Income from Operations Sales Invested Assets x ROI = 12% ROI = 12% Rate of Return on Investment o DataLink’s Central Division ROI

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. ROI = $ 75,000 $750,000 x $500,000 ROI = 10.0% x 1.5 Income from Operations Sales Invested Assets x ROI = ROI = 15% Rate of Return on Investment o DataLink’s Southern Division ROI

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. (continued) Rate of Return on Investment o Assume that the revenues of the Northern Division could be increased by $56,000 through increasing operating expenses, such as advertising, to $385,000.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Revenues ($560,000 + $56,000)$616,000 Operating expenses 385,000 Income from operations before service department charges$231,000 Service department charges 154,000 Income from operations$ 77,000 Increase of $7,000 (continued) Rate of Return on Investment o Projected Impact of Change

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. ROI = $ 77,000 $616,000 x $350,000 ROI = 12.5% x 1.76 Income from Operations Sales Invested Assets x ROI = 22% 22% (compared to the previous ROI of 20%) Rate of Return on Investment o DataLink’s Northern Division ROI Revised

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income o Residual income is the excess of income from operations over a minimum acceptable income from operations, as shown below:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income o Datalink Inc. establishes 10% as the minimum acceptable rate of return on divisional assets. The residual incomes for the three divisions are as follows:

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income o The major advantage of residual income as a performance measure is that it considers both the minimum acceptable rate of return, invested assets, and the income from operations for each division.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. The Balanced Scorecard o The balanced scorecard is a set of multiple performance measures for a company. o It normally includes performance measures for customer service, innovation and learning, and internal processes, as shown in Exhibit 7 (next slide).

T HE B ALANCED S CORECARD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. The Balanced Scorecard o Some common performance measures used in the balanced scorecard approach are shown below. (continued)

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. (continued) The Balanced Scorecard o Some common performance measures used in the balanced scorecard approach are shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. (continued) The Balanced Scorecard o Some common performance measures used in the balanced scorecard approach are shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. The Balanced Scorecard o Some common performance measures used in the balanced scorecard approach are shown below.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business. 5

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Transfer Pricing o When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Transfer Pricing o Three common approaches to setting transfer prices are as follows:  Market price approach  Negotiated price approach  Cost approach

T RANSFER P RICING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Market Price Approach o Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach o The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves on a transfer price. o The only constraint is that the transfer price be less than the market price, but greater than the supplying division’s variable costs per unit.

N EGOTIATED P RICE A PPROACH

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costs per Unit < Transfer Price < Market Price Income from Operations Exhibit 9 No Units Transferred (Exhibit 9) Exhibit 10 20,000 Units Transferred at $15 per Unit (Exhibit 10) Increase (Decrease) Eastern Division$200,000$300,000$100,000 Western Division 100, , ,000 Wilson Company$300,000$500,000$200,000 $10 < Transfer Price < $20 Negotiated Price Approach o Comparison of Exhibits 9 and 10

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Price Approach o Under the cost price approach, cost is used to set transfer prices. A variety of costs may be used in this approach, including the following:  Total product cost per unit  Variable product cost per unit

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Price Approach o If total product cost per unit is used, direct materials, direct labor, and factory overhead are included in the transfer price. o If variable product cost per unit is used, the fixed factory overhead cost is excluded from the transfer price.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Performance Evaluation for Decentralized Operations The End