1. Division Performance Measurement
Chathuri Senarath

2. Decentralization
Decentralization refers to companies that give managers broad authority. 9 5

3. Some Benefits of Decentralization
Promotes better decision making
Able to react quicker
Increases motivation
Prepares managers as future leaders of the company 6 6 6 13

4. 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. 7

5. 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. 17 8

6. Measures of Performance
Three principal measures to measure divisions:
Income
Return on Investment (ROI)
Residual Income (RI) 7 8 9 18

7. 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.
Continued

8. 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.

9. Divisional investment
Return on Investment
ROI =
Divisional income
Divisional investment
ROI is the most frequently used criterion for divisional performance measurement. 19 10

10. Expanded ROI Formula ROI = Income Sales Investment Return on sales
(ROS)
Investment turnover 20 11

11. ROI Example Rockwell (in million) ROI = Income Sales Investment ROI =
$636
$7,151 x
$6,390
ROI =
8.9% x
ROI =
10.0%

12. The profit that must be earned to satisfy the minimum requirement
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

13. 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) , ,000,000
Residual income $ 100,000 $ ,000 23 14

14. 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) , ,800,000
Residual income $ ,000 $ (300,000 )

15. ROI Versus RI
Using ROI to evaluate divisions can encourage them to reject good investments and accept poor investments. 25 16

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

17. ROI Versus RI Division Q Example Without New Project
Divisional investment $1,000,000
Minimum required ROI 20%
Division profit $ 300,000
Less minimum required ,000
Residual income $ 100,000

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

19. 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?

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

21. Bendan, Inc. (in millions of dollars)
Investment
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
Continued

22. Bendan, Inc. (in millions of dollars)
Investment
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
Income $ 230

23. Bendan, Inc. (in millions of dollars)
Investment
Bendan, Inc. (in millions of dollars)
Company as a Whole
A B C
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 $ $160 $ 230
Required return (invest ment x minimum return of 10%)
RI (profit – required return) $ $ $ $ 22

24. The Subject of Evaluation—Division or Manager
Internal ranking
Historical comparisons
Industry averages
Budgets

25. Transfer Pricing Actual costs with or without a markup
Budgeted costs with or without a markup
Market-based prices
Incremental cost
Negotiated prices 34 18

26. Transfer Pricing
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. 35 19

27. Transfer Pricing
Budgeted Cost
This method does not reward the selling manager if costs go up, and actually encourages the selling manager to keep costs down. 36 20

28. Transfer Pricing
Market-Based Prices
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.

29. Transfer Pricing
Incremental Cost
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. 38 22

30. Transfer Pricing
Negotiated Prices
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. 39 23

31. 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 40 24