1. Decentralization, Profitability and ROI
April 26, 2010
Decentralization, Profitability and ROI
Chapter 10: Decentralization.
Managers in large organizations have to delegate some decisions to those who are at the lower levels in the organization. This chapter explains how responsibility accounting systems and measures such as return on investment (ROI) and residual income are used to help control decentralized organizations.

2. Today’s Agenda Decentralization – what is it? Responsibility Centers
Advantages and disadvantages
Responsibility Centers
Cost Centers
Profit Centers
Investment Centers
Allocating costs equitably
ROI & Residual Income

3. What is Decentralization?
Decision making authority is spread throughout the organization
Versus all decisions being made at the most senior level
Large organizations need to decentralize decision making to at least to some extent
Lower level employees are empowered

4. Decentralization in Organizations
Benefits of
Decentralization
Top management
freed to concentrate
on strategy.
Lower-level managers
gain experience in
decision-making.
Decision-making
authority leads to
job satisfaction.
A decentralized organization does not confine decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages of decentralization are as follows:
It enables top management to concentrate on strategy, higher-level decision-making, and coordinating activities.
It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions.
It enables lower-level managers to quickly respond to customers.
It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions.
It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance.
Lower-level decision
often based on
better information.
Lower-level managers can respond quickly to customers.

5. Decentralization in Organizations
May be a lack of
coordination among
autonomous
managers.
Lower-level managers
may make decisions
without seeing the
“big picture.”
Disadvantages of
Decentralization
Lower-level manager’s
objectives may not
be those of the
organization.
The disadvantages of decentralization are as follows:
Lower-level managers may make decisions without fully understanding the “big picture.”
There may be a lack of coordination among autonomous managers. The balanced scorecard can help reduce this problem by communicating a company’s strategy throughout the organization.
Lower-level managers may have objectives that differ from those of the entire organization. This problem can be reduced by designing performance evaluation systems that motivate managers to make decisions that are in the best interests of the company.
It may be difficult to effectively spread innovative ideas in a strongly decentralized organization. This problem can be reduced through the effective use of intranet systems, which enable globally dispersed employees to electronically share ideas.
May be difficult to
spread innovative ideas
in the organization.

6. Responsibility Centers
In a Decentralized structure, organizations are divided into Responsibility Centers
Allows tracking of performance of those who are making the decisions
There are three types:
Profit Center
Measure on Profit & Loss, ROI
Cost Center
Measure on level of costs
Investment Center
Measure on ROI, for example

7. Responsibility Centers - Examples
Investment Centers
Cost Centers
Part I.
Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.
Part II.
The President and CEO as well as the Vice President of Operations manage investment centers.
Part III.
The Chief Financial Officer, General Counsel, and Vice President of Personnel all manage cost centers.
Profit Centers ?

8. Segmented Reporting
Each Responsibility Center may be segmented into logical units; eg,
Regions
Retail Outlets
Business Divisions
This is done to track performance at different levels
It isolates performance – good and bad
Costs must be fairly allocated
Challenging to allocate common costs
Note: Increasingly GAAP requires segmented reporting in certain cases

9. Allocating Costs to Business Segments
Traceable Costs
Costs that are directly traceable to the segment
Eg, staff costs for the Western region
These can be fixed or variable costs
Common Costs
Costs that are shared among all segments
Eg, cost of centralized purchasing department
These costs must be allocated in some manner acceptable to those whose performance is being measured

10. Measuring Performance
Cost Centers
Measured on level of costs against budget
Profit Centers
Measured on Profit & Loss against budget
And possibly ROI
Investment Centers
Measured on ROI and Residual Income
ROI provides incentive to invest for increasing levels of profitability
Residual Income provides incentive to invest for increasing levels of income above a certain ROI threshold

11. Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)
ROI =
Net operating income
Average operating assets
An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as net operating income divided by average operating assets.
Net operating income is income before taxes and is sometimes referred to as EBIT (earnings before interest and taxes). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.
Net operating income is used in the numerator because the denominator consists only of operating assets.
The operating asset base used in the formula is typically computed as the average of the assets between the beginning and the end of the year.
Cash, accounts receivable, inventory,
plant and equipment, and all other
assets held for operating purposes.

12. Average operating assets
Improving ROI
ROI =
Net operating income
Average operating assets
Three ways to improve ROI:
1. Reduce expenses
2. Increase Revenue
3. Reduce Operating Assets

13. ROI – an example What is the Gross Margin? & GM %?
What is Operating Income?
Operating Income %?
Calculate ROI

14. ROI – an example
ROI is 19%
Is that good?
How can it be improved?

15. Return on Investment (ROI) Formula
Net operating income
Average operating assets
Margin =
Net operating income
Sales
Turnover =
Sales
Average operating assets
Part I
DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover.
Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned.
Part II
Turnover is computed by dividing sales by average operating assets. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI.
Part III
So, we can restate the ROI equation as margin times turnover.
ROI =
Margin  Turnover

16. Calculating Residual Income( )
ROI provides incentive to invest for increasing levels of profitability
Residual Income provides incentive to invest for increasing levels of income above a certain ROI threshold

17. Calculating Residual Income
Jack Company can invest Yuan 20 million in assets and expects it will generate Yuan 5 million per year in operating income
The ROI threshold is 20%
Should the company proceed with the investment?

18. Transfer Pricing
Transfer pricing is required when one part of an organization transfers goods or services to another part
A price needs to be determined in order to measure the performance of each group
Transfer Prices can be determined in a number of ways
Negotiated between the two departments
Cost
Fair Market Value
In any case, the Transfer Price must be fair in order to maintain motivation and appropriately measure and reward managers

19. Tutorial