Performance Evaluation for Decentralized Operations

1. Performance Evaluation for Decentralized Operations Chapter 14

2. Learning Objectives After studying this chapter, you should be able to: • Describe the advantages and disadvantages of decentralized operations. • Prepare a responsibility accounting report for a cost center. • Prepare a responsibility accounting report for a profit center. • Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. • Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business.

3. Learning Objective 1 Describe the advantages and disadvantages of decentralized operations

4. Centralized and Decentralized Operations • Centralized business – all major planning and operating decisions are made by top management. • Decentralized business – separating a business into divisions and delegating responsibility to unit managers. • Divisions are structured around common functions, products, customers, or regions.

5. Decentralization • Advantages of Decentralization • Delegating authority to unit managers: • can result in better decisions because these managers anticipate and react to operating data more quickly. • allows managers to focus on their area of expertise. • provides excellent manager training. • Disadvantages of Decentralization • Decisions made by one manager may negatively affect the profitability of the entire organization. • Possible duplication of assets and costs in operating divisions.

6. Responsibility Accounting in Decentralized Operations • Responsibility accounting is the process of measuring/reporting operating data by responsibility center. • A responsibility center is the area for which a unit manager is responsible. Types of Responsibility Centers Investment Center Profit Center Cost Center

7. Learning Objective 2 Prepare a responsibility accounting report for a cost center

8. Responsibility Accounting for Cost Centers Exhibit 2: Cost Centers in a University Unit manager only has responsibility and authority for controlling costs.

9. Responsibility Accounting for Cost Centers Exhibit 3:Responsibility Accounting Reports for Cost Centers

10. Learning Objective 3 Prepare a responsibility accounting report for a profit center

11. Responsibility Accounting for Profit Centers • Unit manager has the responsibility and authority for controlling costs and generating revenues. • Focus is on controllable revenues and expenses. • We’ll illustrate profit center income reporting for the Tadpole Inc. Tadpole Inc. has two profit centers.

12. Service Departments • In addition to direct expenses, divisions may also have expenses for services provided by centralized service departments. • Examples include: • Research and development • Purchasing • Payroll Accounting • Information and Computer Systems • A profit center’s income needs to reflect the costs for any such services used.

13. Tadpole Inc., uses services provided by the Payroll Accounting service department Exhibit 4:Payroll Accounting Department Charges to Tadpole Inc.’s Theme Park and Photography Divisions

14. Allocating Service Charges • An activity base for each service department is used to charge service department expenses to profit centers. • The activity bases for the centralized services Tadpole Inc., are as follows:

15. Allocating Service Charges • Tadpole Inc., service usages: • Service department charge rates determine how much to allocate to each division. Service Department Expense Total Service Department Usage Service Department Charge Rate =

16. Service Department Allocations Exhibit 5:Service Department Charges to Tadpole Inc. Divisions

17. Divisional Income Statements Exhibit 6:Divisional Income Statements— Tadpole Inc.

18. Learning Objective 4 Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center

19. Responsibility Accounting for Investment Centers • Unit manager has responsibility and authority for controlling costs, generating revenues, and managing the assets invested in the center. • Income from operations is important, but so is the rate of return on investment and residual income. • We’ll use In-Touch Inc., a cellular phone company, to illustrate the accounting for investment centers.

20. Responsibility Accounting for Investment Centers In-Touch has three investment centers. The Central Division seems to be the most profitable. Exhibit 7:Divisional Income Statements— In-Touch Inc.

21. Rate of Return on Investment (ROI) • Measures profitability in terms of invested assets. Income from Operations Invested Assets ROI = • The Central Division is the least profitable when using ROI as the measure of profitability.

22. The DuPont Formula • An expanded ROI formula using two factors: • Ratio of income from operations to sales (often called the profit margin). • Ratio of sales to invested assets (often called the investment turnover). • ROI can be improved by increasing the profit margin or investment turnover.

23. The DuPont Formula Income from Operations Sales Sales Invested Assets × ROI = The ending result will be the same as the more basic ROI formula. But this method allows for greater analysis by separating profitability and investment turnover.

24. Margin Turnover Using DuPont Formula to Analyze In-Touch Divisions

25. Residual Income • Excess of income from operations over a minimum acceptable income from operations.

26. In-Touch’s Residual Income • Assuming a 10% minimum acceptable rate of return • The Northern Division has the highest residual income.

27. The Balanced Scorecard • Uses financial and nonfinancial data to evaluate a division. Exhibit 8:The Balanced Scorecard

28. Learning Objective 5 Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business

29. Transfer Pricing Exhibit 9:Commonly used Transfer Prices A transfer price is the price assigned when a good or service is transferred from one division to another within a company.

30. Three Transfer Pricing Approaches • Market Price Approach • Transfer price is the price at which the product or service transferred could be sold to outside buyers. • Negotiated Price Approach • Allows managers of decentralized units to negotiate among themselves as to the transfer price. • Must be less than market price, but more than the variable cost per unit. • Cost Price Approach • Cost is used to set transfer price. • Can use actual product cost, variable costs, or standards costs.

31. End of Chapter 14