© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 8 Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University Student Version These slides should be viewed using the presentation mode (left click your mouse on the icon). Performance Evaluation for Decentralized Operations Principles of Managerial Accounting 11e Reeve Warren Duchac

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 1 Describe the advantages and disadvantages of decentralized operations.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Centralized and Decentralized Operations  In a centralized company, all major planning and operating decisions are made by top management.  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. LO 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Advantages of Decentralization  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 LO 1  Decentralized operations provide excellent training for managers.  Delegating responsibility allows managers to develop managerial experience early in their careers.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Advantages of Decentralization  It helps a company retain managers.  As a result of working closely with customers, managers become more creative in suggesting operating and product improvements. LO 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Disadvantages of Decentralization  A primary disadvantage is that decisions made by one manager may negatively affect the profits of the company.  Decentralization may result in duplicate assets and expenses. LO 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Accounting  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 LO 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 2 Prepare a responsibility accounting report for a cost center.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Accounting for Cost Centers  A cost center manager has responsibility for controlling costs.  Cost centers may vary in size from a small department to an entire manufacturing plant.  Cost centers may exist within other cost centers. LO 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 3 Prepare responsibility accounting reports for a profit center.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Accounting for Profit Centers LO 3  A profit center manager has the responsibility and authority for making decisions that affect both costs and revenues and, thus, profits.  Profit centers may be divisions, departments, or products.  Controllable revenues are revenues earned by the profit center.  Controllable expenses are costs that can be influenced (controlled) by the decisions of profit center managers.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges  Service department charges are indirect expenses to a profit center.  Services provided by internal centralized service departments are often more efficient than services contracted with outside providers.  Service department charges are allocated to profit centers based on the usage of the service by each profit center. LO 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges LO 3 Nova Entertainment Group (NEG) has two operating divisions: Theme Park Division and Movie Production Division. The revenues and direct operating expenses for the two divisions are shown below. NEGNEG

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges LO 3 NEG’s service departments and the expenses they incurred for the year ended December 31, 2012, are as follows: Purchasing$400,000 Payroll Accounting255,000 Legal 250,000 Total$905,000 NEGNEG

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges LO 3 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: NEGNEG

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges LO 3 Service Usage—Purchasing Theme Park Division25,000 purchase requisitions Movie Production Division15,000 Total40,000 purchase requisitions $400,000 40,000 purchase requisitions = $10 per purchase requisition NEGNEG

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges LO 3 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 NEGNEG

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Charges LO 3 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 NEGNEG

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Profit Center Reporting  The income from operations is a measure of a manager’s performance.  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. LO 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 4 Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Accounting for Investment Centers  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. LO 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate of Return on Investment  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 LO 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. Rate of Return on Investment LO 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate of Return on Investment LO 4 ROI = $ 70,000 $560,000 x $350,000 ROI = 12.5% x 1.6 DataLink’s Northern Division ROI Income from Operations Sales Invested Assets x ROI = ROI = 20%

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate of Return on Investment LO 4 ROI = $ 84,000 $672,000 x $700,000 ROI = 12.5% x 0.96 DataLink’s Central Division ROI Income from Operations Sales Invested Assets x ROI = ROI = 12%

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate of Return on Investment LO 4 ROI = $ 75,000 $750,000 x $500,000 ROI = 10.0% x 1.5 DataLink’s Southern Division ROI Income from Operations Sales Invested Assets x ROI = ROI = 15%

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate of Return on Investment LO 4 Assume that the revenues of the Northern Division could be increased by $56,000 through increasing operating expenses, such as advertising, to $385,000.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 Projected Impact of Change Increase of $7,000 Rate of Return on Investment LO 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rate of Return on Investment LO 4 ROI = $ 77,000 $616,000 x $350,000 ROI = 12.5% x 1.76 Income from Operations Sales Invested Assets x ROI = 22% (compared to the previous ROI of 20%) DataLink’s Northern Division ROI Revised

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Residual Income  Residual income is the excess of income from operations over a minimum acceptable income from operations, as shown below: LO 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. LO 4 Residual Income

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Balanced Scorecard  The balanced scorecard is a set of multiple performance measures for a company.  It normally includes performance measures for customer service, innovation and learning, and internal processes. LO 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objective 5 Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used to decentralize segments of a business.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transfer Pricing  When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services.  Three common approaches to setting transfer prices are: 1. Market price approach 2. Negotiated price approach 3. Cost approach LO 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Market Price Approach  Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers. LO 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 5 Negotiated Price Approach  The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves on a transfer price.  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.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Price Approach  Under the cost price approach, cost is used to set transfer prices. A variety of costs may be used in this approach, including:  Total product cost per unit  Variable product cost per unit LO 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Price Approach  If total product cost per unit is used, direct materials, direct labor, and factory overhead are included in the transfer price.  If variable product cost per unit is used, the fixed factory overhead cost is excluded from the transfer price. LO 5

Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The End Performance Evaluation for Decentralized Operations