1. Decentralization and Performance Evaluation

2. Presentation Outline The Concept of Decentralization
Types of Responsibility Centers
Evaluating Investment Centers with Return on Investment (ROI)
The Balanced Scorecard
Transfer Prices

3. I. The Concept of Decentralization
Decentralization Defined
Advantages/Disadvantages of Decentralization
Two Reasons for Evaluating Subunit Performance
Responsibility Accounting

4. A. Decentralization Defined
Firms that grant substantial decision making authority to the managers of subunits are referred to as decentralized organizations. Most firms are neither totally centralized nor totally decentralized.

5. B. Advantages/Disadvantages of Decentralization
Better information, leading to superior decisions.
Faster response to changing circumstances.
Increased motivation of managers
Excellent training for future top level executives.
Disadvantages
Costly duplication of activities.
Lack of goal congruence.

6. C. Two Reasons for Evaluating Subunit Performance
Identification of successful areas of operation and areas in need of improvement.
Influence over the behavior of managers.
Note that it is quite possible to have a good manager and a bad subunit.

7. D. Responsibility Accounting
Managers should only be held responsible for costs and revenues that they control.
In a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled.
(See Illustration 12-3 on p. 421)

8. Types of Responsibility Centers
Cost Centers
Profit Centers
Investment Centers

9. Cost Centers
A cost center is a subunit that has responsibility for controlling costs but not for generating revenues.
Most service departments (i.e., maintenance, computer) are classified as cost centers.
Production departments may be cost centers when they simply provide components for another department.
Cost centers are often controlled by comparing actual with budgeted or standard costs.

10. Profit Centers
A profit center is a subunit that has responsibility of generating revenue and controlling costs.
Profit center evaluation techniques include:
Comparison of current year income with a target or budget.
Relative performance evaluation compares the center with other similar profit centers.

11. Investment Centers
An investment center is a subunit that is responsible for generating revenue, controlling costs, and investing in assets.
An investment center is charged with earning income consistent with the amount of assets invested in the segment.
Most divisions of a company can be treated as either profit centers or investment centers.

12. Evaluating Investment Centers with Return on Investment (ROI)
The Components of ROI
Measuring ROI Income and Invested Capital
Problems with Using ROI
Residual Income (RI) as an Alternative to ROI

13. The Components of ROI or x
ROI has a distinct advantage over income as a measure of performance since it considers both income (the numerator) and investment (the denominator).
ROI =
Income
Invested capital or
ROI =
Income
Sales x
Invested capital
Profit Margin
Investment Turnover
The breakdown of the formula shows that managers can increase return by more profit and/or generating more sales for each investment dollar.

14. Measuring ROI Income and Invested Capital
Investment center income will be measured using net operating profit after taxes (NOPAT).
NOPAT should exclude nonoperating items such as interest expense and nonoperating gains and losses, net of the tax effect.
ROI Invested Capital
Invested capital is measured as total assets less noninterest bearing current liabilities.
Noninterest bearing current liabilities are deducted from total assets because they are a free source of funds and reduce the cost of the investment in assets.
See Illustration 12-4 on page 426

15. Problems with Using ROI
Investment in assets is typically measured using historical cost. ROI becomes larger as assets become depreciated. This may result in managers taking unnecessary delays in updating equipment.
Managers may turn down projects with positive net present values, simply because accepting the project results in a reduced ROI. In other words, projects may be turned down if they provide a return above the cost of capital but below the current ROI.

16. Residual Income (RI) as an Alternative to ROI
Residual Income = NOPAT – Required Profit
= NOPAT – Cost of Capital x Investment
= NOPAT – Cost of Capital x (Total Assets – Non-interest Bearing Current Liabilities)
Residual Income (RI) overcomes the underinvestment problem of
ROI since any investment earning more than the cost of capital will
increase residual income.

17. The Balanced Scorecard
The Balanced Scorecard Approach
The Balanced Scorecard Dimensions
How Balance is Achieved

18. A. The Balance Scorecard Approach
A problem with just assessing performance with financial measures is that such measures are backward looking.
The balanced scorecard approach also focuses on what managers are currently doing to create future shareholder value.

19. The Balanced Scorecard Dimensions
Financial Perspective
Is company achieving
financial goals?
Customer Perspective
Is company meeting
customer expectations?
Internal Process
Is company improving
critical internal processes?
Strategy
Learning and Growth
Is company improving
its ability to innovate?

20. How Balance is Achieved
Performance is assessed across a balanced set of dimensions
Quantitative measures (e.g., number of defects) are balanced with qualitative measures (e.g., rate of customer satisfaction).
There is a balance of backward-looking and forward-looking measures.

21. Transfer Prices Transfer Price Defined Market Prices as the Maximum
Variable Cost as the Minimum – Excess Capacity Exists
Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum – Excess Capacity Does Not Exist
Transfer Pricing and Income Taxes in an International Context

22. A. Transfer Price Defined
The price that is used to value internal transfers of goods and services within the same company is known as the transfer price.

23. Market Prices as the Maximum
The transfer price should not exceed what the acquiring division would have to pay for a similar good and given set of conditions on the outside market. If the outside market is cheaper, the good should be acquired outside the organization.

24. Variable Cost as the Minimum – Excess Capacity Exists
The supplying division should not set a transfer price that is lower than the variable cost of supplying the good and/or service to the requesting division. This may be less than the variable cost of serving an outside customer.

25. Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum – Excess Capacity Does Not Exist
The minimum transfer price will add a lost contribution margin on outside sales if the supplying division must turn away outside customers to provide the good and/or service to the requesting division.

26. Transfer Pricing and Income Taxes in an International Context
When income tax rates between countries differ significantly, a supplier in a lower rate country will want to charge the purchasing division a higher transfer price to lower taxable income for the purchaser in the higher rate nation, and vice versa.

27. Summary Decentralization and Responsibility Accounting
Cost, Profit, and Investment Centers
ROI
Residual Income
Balanced Scorecard
Transfer Pricing