10-1 Division Performance Measurement Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 10

10-2  Explain some of the advantages and disadvantages of decentralization.  Describe the commonly used measures of evaluating the performances of investment centers and their managers.  Describe how performance evaluation methods can encourage managers to act against the best interests of the company. ObjectivesObjectives After reading this chapter, you should be able to: ContinuedContinued

10-3  Describe variations in measuring income and investments.  Explain how evaluating a division is different from evaluating the manager of the division.  Explain the problems in developing transfer pricing policies.  Describe performance evaluation problems specific to multinational companies. ObjectivesObjectives

10-4DecentralizationDecentralization Decentralization refers to companies that give managers broad authority.

10-5 Some Benefits of Decentralization Promotes better decision making Able to react quicker Increases motivation Prepares managers as future leaders of the company

10-6 Problems with Decentralization  Managers operating in nearly autonomous fashion might make decisions that harm the company.  Retailers are unhappy to buy from several divisions, instead of one.

10-7 Managerial Accounting Issues Related to Decentralization  The need to develop methods of evaluating performance that work to the benefit of the company as a whole.  The need to develop transfer prices that produce decisions in the best interest of the company.

10-8 Measures of Performance Income Return on Investment (ROI) Residual Income (RI) Three principal measures to measure divisions:

10-9 Measures of Performance Reasons income is unsatisfactory for measuring the performance of divisions:  In calculating net income, companies subtract interest and taxes, neither of which is normally under the control of divisional managers.  A division’s expenses usually include some charges for services provided by central headquarters. ContinuedContinued

10-10 Measures of Performance Reasons income is unsatisfactory for measuring the performance of divisions:  Factors that influence GAAP-based income do not necessarily apply to internal reports.  Income is not a comprehensive measure of success.

10-11 Return on Investment ROI = Divisional income Divisional investment ROI is the most frequently used criterion for divisional performance measurement.

10-12 Expanded ROI Formula ROI = Income Sales x Investment Return on sales (ROS) Investment turnover

10-13 ROI Example Rockwell (in million) ROI = Income Sales x Investment ROI = $636 $7,151 x $6,390 ROI = 8.9% x 1.12 ROI = 10.0%

10-14 Residual Income Residual income (RI) is the income a division produces in excess of the minimum required rate of return. RI = Income – (investment x target ROI) The profit that must be earned to satisfy the minimum requirement

10-15 A Residual Income Example Division A produces $200,000 income on an investment of $1,000,000, an ROI of 20 percent, while Division B earns $1,500,000 on an investment of $10,000,000, an ROI of 15 percent. Required ROI is 10% Division A Division B Investment$1,000,000$10,000,000 Division income$ 200,000$ 1,500,000 (Investment x minimum ROI) 100,000 1,000,000 Residual income$ 100,000$ 500,000

10-16 A Residual Income Example Division A produces $200,000 income on an investment of $1,000,000, an ROI of 20 percent, while Division B earns $1,500,000 on an investment of $10,000,000, an ROI of 15 percent. Required ROI is 18% Division A Division B Investment$1,000,000$10,000,000 Division income$ 200,000$ 1,500,000 (Investment x minimum ROI) 180,000 1,800,000 Residual income$ 20,000$ (300,000)

10-17 ROI Versus RI Using ROI to evaluate divisions can encourage them to reject good investments and accept poor investments.

10-18 ROI Versus RI Division Q Example Divisional profit: Current$300,000 From new project 75,000 Total divisional profit$375,000 Investment before new project$1,000,000 Additional investment for the project 300,000 Total investment$1,300,000 ($375,000 ÷ $1,300,000) 28.8%

10-19 ROI Versus RI Division Q Example Divisional investment$1,000,000 Minimum required ROI20% Division profit$ 300,000 Less minimum required 200,000 Residual income$ 100,000 Without New Project

10-20 ROI Versus RI Division Q Example Divisional investment$1,300,000 Minimum required ROI20% Division profit$ 375,000 Less minimum required 260,000 Residual income$ 115,000 With New Project

10-21 ROI Versus RI The Manager of Division Z of the same company expects income of $200,000 on an investment of $2,000,000 (10% ROI). How would the manager respond to an opportunity to increase income $15,000 by investing $100,000?

10-22 ROI Versus RI New ROI = $200,000 + $15,000 $2,000,000 + $100,000 = $215,000 $2,100,000 New ROI = 10.2% The company should reject the investment, but the manager will accept because divisional ROI increases.

10-23InvestmentInvestment Bendan, Inc. (in millions of dollars) Bendan, Inc. (in millions of dollars) Division A B C Unallocated Total Investment Cash$ 20$ 30$ 60$ 30$ 140 Accounts receivable, net Inventory Prepaid expenses Plant and equipment-- net of depreciation ,020 Investments Total assets$400$620$850$210$2,080 ContinuedContinued

10-24InvestmentInvestment Bendan, Inc. (in millions of dollars) Bendan, Inc. (in millions of dollars) Division A B C Unallocated Total Income Sales$100$400$700$1,200 Variable costs Contribution margin$ 70$180$300$ 550 Direct fixed costs Divisional profit$ 40$ 90$160$ 290 Common fixed costs 60 Income$ 230

10-25InvestmentInvestment Bendan, Inc. (in millions of dollars) Bendan, Inc. (in millions of dollars) A B C Company as a Whole Computation of ROI: Profit of segment$ 40$ 90$160$ 230 Investment in segment ,080 ROI (profit/investment)10%14.5%18.8%11.1% Computation of RI: Profit of segment$ 40$ 90$160$ 230 Required return (invest- ment x minimum return of 10%) RI (profit – required return)$ 0$ 28$ 75$ 22

10-26InvestmentInvestment Bendan, Inc. (in millions of dollars) Bendan, Inc. (in millions of dollars) A B C Company as a Whole Computation of ROI: Profit of segment$ 40$ 90$160$ 230 Total assets$400$620$850$2,080 Divisional liabilities Divisional investment$340$450$540$1,540 Unallocated liabilities 730 Total investment$340$450$540$ 810 ROI11.8%20.0%29.6%28.4% ContinuedContinued

10-27InvestmentInvestment Bendan, Inc. (in millions of dollars) Bendan, Inc. (in millions of dollars) A B C Company as a Whole Computation of RI: Profit of segment$40$ 90$160$ 230 Required return (invest- ment x minimum return of 10%) RI$ 6$45$106$149

10-28 The Subject of Evaluation— Division or Manager  Internal ranking  Historical comparisons  Industry averages  Budgets

10-29 Transfer Pricing Actual costs with or without a markup Budgeted costs with or without a markup Market-based prices Incremental cost Negotiated prices

10-30 Actual Cost These transfer prices are not wise because the selling manager has no incentive to keep costs down. Worse, a price that is actual costs plus a percentage markup gives the selling manager more profit the higher costs go. Transfer Pricing

10-31 This method does not reward the selling manager if costs go up, and actually encourages the selling manager to keep costs down. Budgeted Cost Transfer Pricing

10-32 Market-Based Prices Transfer Pricing This method is generally consider, the best. The biggest problem is that an outside market price may not exist. The transfer price may be less than the market price due to cost savings from selling internally.

10-33 Such prices are theoretically best from the company’s viewpoint when the selling division is operating below capacity. Incremental cost can be as low as the variable cost of the goods or services. Incremental Cost Transfer Pricing

10-34 This method allows managers to bargain with each other and alleviates some problems that arise with other methods. The manager with the better negotiating skills will tend to prevail. Negotiated Prices Transfer Pricing

10-35 Multinational Companies Special Problems Evaluating performance More complicated reporting needs Currency translation problems Little or no on-site supervision by the home-office managers Significant cultural and language barriers Transfer pricing Foreign taxes Currency translation problems

10-36 The End Chapter 10

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