Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition Wild, Shaw, and Chiappetta Fifth Edition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 22 Decentralization and Performance Evaluation

Conceptual Learning Objectives C1: Distinguish between direct and indirect expenses and identify bases for allocating indirect expenses to departments. C2: Appendix 22A: Explain transfer pricing and methods to set transfer prices. C3: Appendix 22B: Describe allocation of joint costs across products. 22-3

A1: Analyze investment centers using return on total assets, residual income, and balanced scorecard. A2: Analyze investment centers using profit margin and investment turnover. A3: Analyze investment centers using the balanced scorecard. A4: Compute cycle time and cycle efficiency, and explain their importance to production management. Analytical Learning Objectives 22-4

P1: Prepare a responsibility report for a cost center. P2: Allocate indirect expenses to departments. P3: Prepare departmental income statements and contribution reports. Procedural Learning Objectives 22-5

Provide information for managers to use in performance evaluation of departments. Provide information for managers to use in performance evaluation of departments. To control costs and expenses and assist with evaluating managers’ performance. To control costs and expenses and assist with evaluating managers’ performance. Primary goals Responsibility Accounting C1 22-6

Managers use this information to :  Control operations.  Appraise performance.  Allocate resources.  Plan strategy. The accounting system provides information about resources used and outputs achieved. Information for Departmental Evaluation C1 22-7

The type of accounting information provided depends on whether the department is a... Evaluated on ability to generate revenues in excess of expenses. Evaluated on ability to control costs. Profit center Cost center Information for Departmental Evaluation C Evaluated on their use of center assets to generate income. Investment center

An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items. C1 22-9

Costs are controllable if the manager has the power to determine, or strongly influence, the amounts incurred. A manager’s performance evaluation should be based on controllable costs. I’m in control Controllable Costs C

Direct costs are traced to departments, but may not be controllable by the department manager.  Example: Department managers usually have no control over their own salaries. Controllable costs are identified with a particular manager and a definite time period.  All costs are controllable at some level of management if the time period is long enough. Distinguishing between Controllable vs. Direct Costs C When evaluating managers’ performances, we should use data reflecting their departments’ outputs along with their controllable costs and expenses.

Responsibility Accounting Successful implementation of responsibility accounting may use organization charts with clear lines of authority and clearly defined levels of responsibility. It uses the concept of controllable costs to assign managers the responsibility for costs and expenses under their control. P

Amount of detail varies according to level in organization. A department manager receives detailed reports. A store manager receives summarized information from each department. Responsibility Accounting Performance Reports P The vice president of operations receives summarized information from each store.

To be of maximum benefit, responsibility reports should...  Be timely.  Be issued regularly.  Be understandable.  Compare budgeted and actual amounts. Responsibility Accounting Performance Reports P

Direct expenses are incurred for the sole benefit of a specific department. Indirect expenses benefit more than one department and are allocated among departments benefited. Direct and Indirect Expenses C Controllable costs. $$$ Uncontrollable costs. $$$

Classic Jewelry, a retail store, pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation P

Classic Jewelry, a retail store, pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation P

Classic Jewelry, a retail store, pays its janitorial service $300 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Illustration of Indirect Expense Allocation P

Service department costs are shared, indirect expenses that support the activities of two or more production departments. Bases for Allocating Service Department Costs (Exhibit 22.3) P

ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The Assembly Department has 100 employees and the Packing Department has 150 employees. What amount of cost is allocated to the Assembly Department? a.$100,000 b.$120,000 c.$150,000 d. $180,000 ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The Assembly Department has 100 employees and the Packing Department has 150 employees. What amount of cost is allocated to the Assembly Department? a.$100,000 b.$120,000 c.$150,000 d. $180,000 Service Department Costs Question P

ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The Assembly Department has 100 employees and the Packing Department has 150 employees. What amount of cost is allocated to the Assembly Department? a.$100,000 b.$120,000 c.$150,000 d. $180,000 ABCO allocates its $300,000 personnel cost to operating departments based on the number of employees in each department. The Assembly Department has 100 employees and the Packing Department has 150 employees. What amount of cost is allocated to the Assembly Department? a.$100,000 b.$120,000 c.$150,000 d. $180,000 Assembly percentage = 100 ÷ ( ) = 40% 40% of $300,000 = $120,000 Service Department Costs Question P

Preparing Departmental Income Statements P Accumulating revenues and direct expenses by department. 2.Allocating indirect expenses across departments 3.Allocating service department expenses to operating departments. 4.Preparing departmental income statements. Allocating costs to operating departments and preparing departmental income statements involve four steps:

Departmental Expense Allocation Spreadsheet (Exhibit 22.6) P

Departmental Expense Allocation Spreadsheet Step 1: Direct expenses are traced to service departments and sales departments without allocation. P

Departmental Expense Allocation Spreadsheet Of a total of 12,000 square feet, the service departments occupy 1,500 square feet each, the Hardware Department occupies 4,050 feet, Housewares 2,700, and Appliances 2,250. P3 1,500 ft 12,000 ft x $2,400 = $300 Step 2: Indirect expenses are allocated to both the service and the operating departments based on floor space occupied

Departmental Expense Allocation Spreadsheet P3 Step 3: The Service department total expenses (original direct expenses + allocated indirect expenses) from the two service departments are allocated to three remaining operating or sales departments

Departmental Income Statements (Exhibit 22.15) HardwareHousewaresAppliances Dept. Combined Sales $ 119,500 $ 71,700 $ 47,800 $ 239,000 Cost of goods sold 73,800 43,800 30, ,800 Gross profit on sales $ 45,700 $ 27,900 $ 17,600 $ 91,200 Operating expenses 0 Salaries expense $ 15,600 $ 7,000 $ 7,800 $ 30,400 Depreciation expense Supplies expense Rent expense 4,860 3,240 2,700 10,800 Utilities expense ,800 Advertising expense ,000 Insurance expense ,900 Share of general office expense 7,650 4,590 3,060 15,300 Share of purchasing expenses 3,880 2,630 3,190 9,700 Total operating expenses $ 34,900 $ 19,200 $ 18,100 $ 72,200 Net income (loss) $ 10,800 $ 8,700 $ (500) $ 19,000 P

Departmental Income Statement HardwareHousewaresAppliances Dept. Combined Sales $ 119,500 $ 71,700 $ 47,800 $ 239,000 Cost of goods sold 73,800 43,800 30, ,800 Gross profit on sales $ 45,700 $ 27,900 $ 17,600 $ 91,200 Operating expenses Salaries expense $ 15,600 $ 7,000 $ 7,800 $ 30,400 Depreciation expense Supplies expense Rent expense 4,860 3,240 2,700 10,800 Utilities expense ,800 Advertising expense ,000 Insurance expense ,900 Share of general office expense 7,650 4,590 3,060 15,300 Share of purchasing expenses 3,880 2,630 3,190 9,700 Total operating expenses $ 34,900 $ 19,200 $ 18,100 $ 72,200 Net income $ 10,800 $ 8,700 $ (500) $ 19,000 P3 Indirect Direct 22-28

Departmental Contribution to Overhead (Exhibit 22.16) HardwareHousewaresAppliances Dept. Combined Sales $ 119,500 $ 71,700 $ 47,800 $ 239,000 Cost of goods sold 73,800 43,800 30, ,800 Gross profit on sales $ 45,700 $ 27,900 $ 17,600 $ 91,200 Operating expenses Direct expenses Salaries expense $ 15,600 $ 7,000 $ 7,800 $ 30,400 Depreciation expense Supplies expense Total direct expenses 16,300 7,300 8,100 31,700 Continued…. P3 Departmental contributions to overhead $ 29,400 $ 20,600 $ 9,500 $ 59,

Departmental Contribution to Overhead (Exhibit 22.16) Departmental contributions to overhead $ 29,400 $ 20,600 $ 9,500 $ 59,500 Indirect expenses: Rent expense 10,800 Utilities expense 1,800 Advertising expense 1,000 Insurance expense 1,900 Share of general office expense 15,300 Share of purchasing expenses 9,700 Total operating expenses $ 40,500 Net income $ 19,000 Contribution as percent of sales24.6%28.7%19.9%24.9% P

Financial Performance Evaluation Measures One of the ways to evaluate investment center managers is to use a measure called return on investment (or return on assets.) The formula for ROI is as follows: A1 Investment center net income Investment center average invested assets ROI = 22-31

Another measure of evaluating financial performance is by computing the investment center’s residual income. Financial Performance Evaluation Measures A1 Investment center - Target investment net income center net income Residual income = 22-32

Investment Center – Analysis We can further examine investment center performance by splitting down return on investment into profit margin and investment turnover: ROI = Profit margin X Investment turnover This will provide further information on the performance of the unit A2

Profit Margin The profit margin is the first component in the expanded equation and measures the income earned per dollar of sales. Profit margin = Investment center net income Investment center sales A2

Investment Turnover The investment turnover measures how efficiently the company generates sales from its invested assets. It is used in the second half of the expanded ROI formula. Investment = Investment center sales turnover Investment center average assets A2

Balanced Scorecard The balanced scorecard is a system of performance measures, including nonfinancial measures. It is used to assess company and division performance based on four perspectives: A3 1. Customer: What do customer’s think of us? 2. Internal processes: Which of our operations are critical to meeting customer needs? 3. Innovation and Learning: How can we improve? 4. Financial: What do our owners think of us? 22-36

Cycle Time and Cycle Efficiency Manufacturing companies want to reduce the time to manufacture their products and to improve manufacturing efficiency. A4 Process time: Time spent producing the product Inspection time: Time spent inspecting Move time: Time spent moving Wait time: Time that an order or job sits with no production applied to it Cycle time = Process time + Inspection time + Move time + Wait time

Cycle Time and Cycle Efficiency Companies strive to reduce non-value-added time to improve cycle efficiency. A4 Process time : Time spent producing the product Inspection time: Time spent inspecting Move time: Time spent moving Wait time: Time that an order or job sits with no production applied to it Cycle efficiency = Value–added time Cycle time Value-added time Non-Value-added time

Transfer Pricing C2 Determining the price that should be used to record transfers between divisions in the same company is called transfer pricing. These transactions are transfers within the same company. Transfer prices can be used in cost, profit, and investment centers

Joint Costs and Their Allocation Most manufacturing processes involve joint costs, which refer to costs incurred to produce or purchase two or more products at the same time. Joint costs are allocated among the joint products resulting from it. Two methods can be used: (1) Physical basis (2) Value basis C

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