1. Financial and Managerial Accounting
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Wild, Shaw, and Chiappetta
Fifth Edition
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 1

2. Decentralization and Performance Evaluation
Chapter 22
Decentralization and Performance Evaluation
This chapter describes responsibility accounting, measuring departmental performance, allocating common costs across department, and transfer pricing. It also explains financial and nonfinancial performance measures used to evaluate investment center performance.

3. 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.
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.
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4. Analytical Learning Objectives
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:
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.
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5. Procedural Learning Objectives
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:
P1: Prepare a responsibility report for a cost center.
P2: Allocate indirect expenses to departments.
P3: Prepare departmental income statements and contribution reports.
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6. Responsibility Accounting
Primary goals
Provide information for managers to use in performance evaluation of
departments.
To control costs and
expenses and assist
with evaluating
managers’
performance.
Most large companies are made up of subunits called departments. Top management is interested in the performance of each of the departments. To assist management in the performance evaluation of departments, a company can set up a responsibility accounting system to control costs and expenses and evaluate managers’ performance by assigning costs and expenses to the managers responsible for the costs. Responsibility accounting is sometimes referred to as departmental accounting.
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7. Information for Departmental EvaluationC1
Managers use this information to:
Control operations.
Appraise performance.
Allocate resources.
Plan strategy.
The accounting system provides information about resources used and outputs achieved.
All departments use resources to achieve a desired output. If our responsibility accounting system is properly designed and implemented, we can control operations, appraise performance, allocate resources, and plan strategy. One of top management’s objectives for this type of system is to be able to allocate more resources to those departments who are performing at the highest level or if a department is performing poorly, information about revenues or expenses can suggest useful changes.
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8. Information for Departmental EvaluationC1
The type of accounting information provided depends on whether the department is a . . .
Profit center
Cost center
Investment center
Financial information used to evaluate a department depends on whether it is evaluated as a profit center, cost center, or investment center. Profit centers are evaluated on the basis of profits. Profit center managers must generate revenues and control costs to sustain profits. Selling departments are often evaluated as profit centers. Cost center managers are evaluated on their ability to control costs. Investment center managers are evaluated on their use of center’s assets to generate income.
Evaluated on their use of center assets to generate income.
Evaluated on ability to generate revenues in excess of expenses.
Evaluated on ability to control costs.
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9. Responsibility Accounting
An accounting system that provides information . . .
Relating to the responsibilities of individual managers.
To evaluate managers on controllable items.
A responsibility accounting system uses the concept of controllable costs to evaluate a manager’s performance. Responsibility for controllable costs is clearly defined and performance is evaluated based on the ability to manage and control those costs.
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10. Controllable Costs C1
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
Managers should be evaluated on how well they manage controllable costs. A cost is controllable by a manager if the manager has the power to determine, or strongly influence, the amounts incurred. For example, production managers are generally considered to be responsible for the amount of material used in their departments, but not for the cost of insurance on the building in which the departments are located.
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11. Distinguishing between Controllable vs. Direct Costs
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.
Not all departmental direct costs are controllable by the department manager. For example, the department manager’s salary is directly traceable to the department, but the department manager does not control the salary. However, they can control or influence items such as the cost of supplies used in their department. Costs that are not controllable in the short run at lower levels in the organization, are likely to be classified as controllable costs at higher levels, especially if the time period is longer. When evaluating managers’ performances, we should use data reflecting their departments’ outputs along with their controllable costs and expenses.
When evaluating managers’ performances, we should use data reflecting their departments’ outputs along with their controllable costs and expenses.
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12. 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.
A responsibility accounting system makes use of organizational charts to determine lines of authority and levels of responsibility. It recognizes that control over costs and expenses belongs to several levels of management. The organization chart on this slide uses lines that connect the managerial positions and reflect channels of authority. For example, the department manager is responsible for controllable costs and expenses incurred in his/her department, but these same costs are subject to the overall control of the store manager.
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13. Responsibility Accounting Performance Reports
Amount of detail varies according to level in organization.
The amount of detail in performance reports varies according to level in an organization. In general, lower-level managers receive detailed reports, but the level of detail decreases at higher levels. Top management receives reports that are highly summarized. If a problem arises, top management can request greater detail to look into the problem.
The vice president of operations receives summarized information from each store.
A store manager receives summarized information from each department.
A department manager receives detailed reports.
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14. Responsibility Accounting Performance Reports
To be of maximum benefit, responsibility reports should . . .
Be timely.
Be issued regularly.
Be understandable.
Compare budgeted and actual amounts.
A responsibility accounting system also involves performance reports. Responsibility performance reports should be timely, issued on a regular schedule, and presented in a usable, easily understood format to be of maximum benefit to managers. Since performance is being evaluated and reported, the responsibility report should include comparisons of budgeted costs and actual costs.
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15. Direct and Indirect Expenses
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.
Controllable costs. $$$
Uncontrollable costs. $$$
Direct expenses are costs that can be readily traced to one department because they are incurred for the sole benefit of that department. Direct expenses are often but not always, controllable costs. Indirect expenses cannot be traced to one department because they are incurred for the joint benefit of two or more departments. For example, if two departments are located in the same building, the cost of replacing the roof on the building benefits both departments. Since we cannot trace indirect expenses to individual departments, we must allocate them to departments on the basis of the relative benefits each department receives from the shared indirect expenses. Indirect expenses are typically considered uncontrollable because they are not within the manager’s control or influence.
On the next few slides, we’ll look at an example of indirect expense and how it is allocated among departments.
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16. Illustration of Indirect Expense Allocation
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.
Classic Jewelry, a retail store, has three departments in one store location, jewelry, watch repair, and china and silver. Janitorial services to clean the store cost $300 per month. Classic Jewelry allocates the $300 janitorial cost based on the square footage of each department.
First, we add the square footage in each department to get a total of 4,000 square feet. Then, we divide the square footage in each department by this total to get the allocation percentages. Last, we multiply the allocation percentages times the janitorial cost of $300 to get the amount allocated to each department.
Work through the computations for the jewelry department before checking your answers on the next slide.
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17. Illustration of Indirect Expense Allocation
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.
The allocation percentage for Jewelry is 2,400 square feet divided by 4,000 which equals 60 percent. Now, we multiply 60 percent times $300 to get the $180 that is allocated to jewelry.
Complete the table for the other two departments and then check your work using the next slide.
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18. Illustration of Indirect Expense Allocation
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.
How did you do on this exercise? We can check our work by adding the amounts allocated to each department. The total should be $300, the total amount of janitorial cost to allocate.
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19. Bases for Allocating Service Department Costs (Exhibit 22.3)
Service department costs are shared, indirect expenses that support the activities of two or more production departments.
The Classic Jewelry example used square footage as the allocation base. You can see examples of other common allocation bases on this slide.
Let’s look at a question using number of employees as the allocation base.
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20. Service Department Costs Question
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
Here’s your question. Try to work completely through the question before checking your answer on the next slide.
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21. Service Department Costs Question
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
We add the number of employees in each department to get a total of 250 employees. Then, we divide the number of employees in each department by this total to get the allocation percentage. The assembly allocation percentage is 100 employees divided by the 250 total, resulting in an allocation percentage of 40%. Last, we multiply the allocation percentage times the indirect cost of $300,000 to get the amount allocated to assembly, $120,000.
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22. Preparing Departmental Income Statements
Allocating costs to operating departments and preparing departmental income statements involve four steps:
Now that we have discussed direct expenses and the allocation of indirect expenses, we are ready to put our knowledge to work by preparing departmental income statements. These statements are the
primary tool for evaluating departmental performance. There are four steps to allocating costs to operating departments and preparing departmental income statements. They are: Step #1. Accumulating revenues and direct expenses by department.
Step #2. Allocating indirect expenses across departments
Step #3. Allocating service department expenses to operating departments. And lastly,
Step #4. Preparing departmental income statements.
Accumulating revenues and direct expenses by department.
Allocating indirect expenses across departments
Allocating service department expenses to operating departments.
Preparing departmental income statements.
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23. Departmental Expense Allocation Spreadsheet (Exhibit 22.6)
Here is the completed spreadsheet for a company called A-1 Hardware. The store has five departments. Two of them, General Office and Purchasing, are service departments, and the other three, Hardware, Housewares, and Appliances, are operating or selling departments. Let’s take an overall look at the spreadsheet, and then we will break it up by steps in the following slides. Here is an overview: The top portion of the spreadsheet allocates the direct expenses that each department incurs on their own. This information is accumulated in departmental expense accounts.
The second part of the spreadsheet allocates the indirect expenses based on an allocation base. The allocation bases are identified in the second column, and total expense amounts are reported in the third column.
The third part of the spreadsheet allocates the expenses of the two service departments, General Office and Purchasing, to the operating departments. You will notice that ALL of the direct and indirect costs of the service departments are eventually allocated to the three operating departments.
Let’s take a look at the steps in further detail.
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24. Departmental Expense Allocation Spreadsheet
Let’s break up the previous slide into smaller steps. On this slide, we see Step 1. Each department has direct expenses for salaries and supplies. In Step 1, we trace these direct expenses to the individual departments without allocation.
Step 1: Direct expenses are traced to service departments and sales departments without allocation.
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25. 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.
Now let’s take a look at the indirect expense allocation in Step 2. Each indirect expense is allocated based on a reasonable allocation basis. In this example, we will isolate the utilities expense and discuss how the $2,400 cost for utilities is allocated. In this example, utilities are allocated based on floor space. In this step, we allocate indirect expenses to both the service and the operating departments based on floor space occupied. The total floor space is 12,000 square feet. Both service departments occupy 1,500 square feet each, or 12.5% of the total for each service department. The Hardware Department occupies 4,050 square feet, or 33.75% of the total. The Housewares Department occupies 2,700 square feet, or 22.5% of the total. The Appliances Department occupies 2,250 square feet or 18.75% of the total. We allocate the indirect expenses by multiplying the allocation percentage for each department times the total indirect expenses. You should verify the numbers in the spreadsheet on your screen by working through the allocations for the remaining indirect expenses. For example, go back and recalculate the advertising expense based on relative sales percentages, and the insurance expense based on the value of insured assets to make certain you have an understanding of how expenses can be allocated.
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.
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26. Departmental Expense Allocation Spreadsheet
In Step 3, we total the expenses for the combined service departments and allocate the total to the operating departments. We will allocate the total expenses in the General Office Department based on sales of the three operating departments. $7,650 goes to the Hardware Department and $4,590 is allocated to the Housewares Department and $3,060 is allocated to the Appliances Department.
To begin the allocation, we add the sales for the three operating departments to get a total of $239,000. Then we divide the sales in each operating department by this total to get the allocation percentage. The Hardware Department’s allocation percentage is computed by dividing $119,500 by the $239,000 total. We get 50%. This means we allocate 50% of the general office expenses to the Hardware Department or $7,650. We repeat the steps for the Housewares and Appliances Departments. Again, you should verify the numbers in the spreadsheet on your screen by working through the allocations for the departments. The total expenses on the bottom line can then be used to prepare departmental income statements.
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.
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27. Departmental Income Statements (Exhibit 22.15)
Hardware
Housewares
Appliances
Dept.
Combined
Sales
$ ,500
$ ,700
$ ,800
$ ,000
Cost of goods sold
73,800
43,800
30,200
147,800
Gross profit on sales
$ ,700
$ ,900
$ ,600
$ ,200
Operating expenses
Salaries expense
$ ,600
$ ,000
$ ,800
$ ,400
Depreciation expense
400
100
200
700
Supplies expense
300
600
Rent expense
4,860
3,240
2,700
10,800
Utilities expense
810
540
450
1,800
Advertising expense
500
1,000
Insurance expense
900
1,900
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
$ ,900
$ ,200
$ ,100
$ ,200
Net income (loss)
$ ,800
$ ,700
$ (500)
$ ,000
Step 4 – The departmental expense allocation spreadsheet, on the previous slide, can now be used to prepare performance reports for the company’s service and operating departments. In addition, the amounts in the operating department columns are used to prepare departmental income statements.
This slide shows the departmental income statements for the three operating departments- Hardware, Housewares, and Appliances. The information on sales and cost of goods sold came from their individual departmental records but the allocated direct and indirect expenses as well as the allocated service department costs, came directly from the departmental expense allocation spreadsheet.
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28. Departmental Income Statement
Hardware
Housewares
Appliances
Dept.
Combined
Sales
$ ,500
$ ,700
$ ,800
$ ,000
Cost of goods sold
73,800
43,800
30,200
147,800
Gross profit on sales
$ ,700
$ ,900
$ ,600
$ ,200
Operating expenses
Salaries expense
$ ,600
$ ,000
$ ,800
$ ,400
Depreciation expense
400
100
200
700
Supplies expense
300
600
Rent expense
4,860
3,240
2,700
10,800
Utilities expense
810
540
450
1,800
Advertising expense
500
1,000
Insurance expense
900
1,900
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
$ ,900
$ ,200
$ ,100
$ ,200
Net income
$ ,800
$ ,700
$ (500)
$ ,000
Direct
Let’s focus a little more on the operating expenses section of the departments’ income statements. Specifically, remember that these costs can be broken down into direct expenses, the yellow section, which includes: the salaries expense, depreciation expense, and supplies expense. All of the other expenses highlighted in pink of the slide are indirect expenses. By distinguishing between the two, we can now calculate the departmental contribution to overhead. This amount can be calculated by the three operating departments by taking the sales of the department and subtracting out all of the direct expenses of that department. We will show this on the next slide.
Indirect
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29. Departmental Contribution to Overhead (Exhibit 22.16)
Hardware
Housewares
Appliances
Dept.
Combined
Sales
$ ,500
$ ,700
$ ,800
$ ,000
Cost of goods sold
73,800
43,800
30,200
147,800
Gross profit on sales
$ ,700
$ ,900
$ ,600
$ ,200
Operating expenses
Direct expenses
Salaries expense
$ ,600
$ ,000
$ ,800
$ ,400
Depreciation expense
400
100
200
700
Supplies expense
300
600
Total direct expenses
16,300
7,300
8,100
31,700
Data from departmental income statements are not always best for evaluating each profit center’s performance, especially when indirect expenses are a large portion of total expenses and when weaknesses in assumptions and decisions in allocating indirect expenses can markedly affect net income. In these and other cases, we might better evaluate profit center performance using the departmental contribution to overhead, which is a report of the amount of sales less direct expenses. On this slide, each department’s direct expenses are highlighted in yellow. We then subtract these expenses from each department’s total gross profit. Their departmental contribution margin is shown in green. On the next slide, we will see that this dollar amount of contribution will be expressed as a percentage of sales.
Departmental contributions
to overhead
$ ,400
$ ,600
$ 9,500
$ ,500
Continued….
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30. 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 sales
24.6%
28.7%
19.9%
24.9%
On this slide, we again see the departmental contributions to overhead in green. In addition, at the very bottom of the report you will see that the contribution is expressed as a percentage of sales.
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31. 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:
One of the ways to evaluate investment center managers is to compute some key ratios. One of them is the investment center’s return on investment (ROI), also sometimes referred to as the return on assets. As you can see, the formula is computed by dividing the investment center’s net income by the amount of the average invested assets of the investment center.
Investment center net income Investment center average invested assets
ROI =
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32. Financial Performance Evaluation Measures
Another measure of evaluating financial performance is by computing the investment center’s residual income.
Another way to evaluate the investment center is by calculating residual income. The residual income is computed by taking the investment center’s actual net income and subtracting out the targeted or projected net income. To compute the target amount, the investment center’s target rate or “hurdle” rate is usually considered to be its cost of financing. The target income can be computed by taking the invested assets and multiplying by this hurdle rate. Unlike return on investment or assets, the residual income is usually expressed in dollars.
Investment center - Target investment net income center net income
Residual income =
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33. 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
We can further examine division performance by splitting return on investment into two components: profit margin and investment turnover. Profit margin is expressed as a percent, while investment turnover is interpreted as the number of times assets were converted into sales.
Review the expanded formula for return on investment. We will break each component down.
This will provide further information on the performance of the unit.
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34. Profit Margin A2
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
The profit margin is a measure of profitability and is computed by taking the investment center’s net income and dividing by the investment center’s sales. This is the first component of the expanded ROI formula.
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35. Investment Turnover A2
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.
The investment center turnover comprises the second half of the expanded ROI formula. The investment turnover measures how efficiently the company generates sales from its invested assets. It is computed by taking the investment center’s sales and dividing by the center’s average assets. The expanded measure of performance can aid management when considering further investments in divisions.
Investment = Investment center sales turnover Investment center average assets
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36. Balanced Scorecard A3
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:
Customer: What do customer’s think of us?
Internal processes: Which of our operations are critical to meeting customer needs?
Innovation and Learning: How can we improve?
Financial: What do our owners think of us?
Evaluating performance based solely on financial measures such as return on investment and residual income has limitations. So some companies also consider more nonfinancial measures. One of these measures that may be considered is a balanced scorecard. The balanced scorecard is a system of performance measures including nonfinancial measures. It asks managers to think of their company from four perspectives as shown in the slide above.
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37. Cycle Time and Cycle Efficiency
Manufacturing companies want to reduce the time to manufacture their products and to improve manufacturing efficiency.
Cycle time = Process time + Inspection time + Move time + Wait time
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.
Manufacturing companies commonly use nonfinancial measures to evaluate the performance of their production processes. For example, it is important for manufacturing companies to reduce the time to manufacture their products and to improve manufacturing efficiency. One method that measures that time element is the cycle time. To calculate cycle time, we add together the process, inspection, move, and wait time for a product.
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38. Cycle Time and Cycle Efficiency
Companies strive to reduce non-value-added time to improve cycle efficiency.
Cycle efficiency = Value–added time
Cycle time
Value-added time
Another common nonfinancial measure to evaluate the performance and efficiency of a manufacturer’s production processes is cycle efficiency. Cycle efficiency is the ratio of value-added time to total cycle time. We can see the formula on this slide. Companies strive to reduce non-value-added time to improve cycle efficiency. Process time is value-added time because it is the only activity in cycle time that adds value to the product from the customer’s perspective. The other three time activities are considered non-value added time because they add no value to the customer.
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.
Non-Value-added time
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39. 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.
Divisions in decentralized companies sometimes do business with one another. Determining the price that should be used to record transfers between these divisions is called transfer pricing. Transfer prices can be used in cost, profit, and investment centers. Since these transfers are not with customers outside the company, the transfer price has no direct impact on the company’s overall profits. However, transfer prices can impact performance evaluations and, if set incorrectly, lead to bad decisions.
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40. 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
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. To do this, management must decide how to allocate joint costs across products benefiting from these costs. If some products are sold and others remain in inventory, allocating joint costs involves assigning costs to both cost of goods sold and ending inventory. The two usual methods to allocate joint costs are the (1) physical basis and (2) the value basis.
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41. End of Chapter 22
Now that we have mastered some of the basic concepts and principles of relevant costing for managerial decisions, we are ready to put this knowledge to work.
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