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Division Performance Measurement

10. Division Performance Measurement. Prepared by Douglas Cloud Pepperdine University. Objectives. Explain some of the advantages and disadvantages of decentralization. Describe the commonly used measures of evaluating the performances of investment centers and their managers.

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Division Performance Measurement

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  1. 10 Division Performance Measurement Prepared by Douglas Cloud Pepperdine University

  2. Objectives • Explain some of the advantages and disadvantages of decentralization. • Describe the commonly used measures of evaluating the performances of investment centers and their managers. • Describe how performance evaluation methods can encourage managers to act against the best interests of the company. After reading this chapter, you should be able to: Continued

  3. Objectives • Describe variations in measuring income and investments. • Explain how evaluating a division is different from evaluating the manager of the division. • Explain the problems in developing transfer pricing policies. • Describe performance evaluation problems specific to multinational companies.

  4. Decentralization Decentralizationrefers to companies that give managers broad authority.

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

  6. 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. Managerial Accounting IssuesRelated 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.

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

  9. 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

  10. 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.

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

  12. Income Sales Sales Investment ROI = x Expanded ROI Formula Return on sales (ROS) Investment turnover

  13. Income Sales Sales Investment x ROI = $636 $7,151 $7,151 $6,390 x ROI = 8.9% x 1.12 ROI = 10.0% ROI = ROI Example Rockwell (in million)

  14. RI = Income – (investment x target ROI) 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.

  15. Required ROI is 10% Division ADivision B Investment $1,000,000$10,000,000 Division income $ 200,000 $ 1,500,000 (Investment x minimum ROI) 100,000 1,000,000 Residual income $ 100,000 $ 500,000 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.

  16. Required ROI is 18% Division ADivision B Investment $1,000,000$10,000,000 Division income $ 200,000 $ 1,500,000 (Investment x minimum ROI) 180,000 1,800,000 Residual income $ 20,000 $ (300,000 ) 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.

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

  18. Divisional profit: Current $300,000 From new project 75,000 Total divisional profit $375,000 Investment before new project $1,000,000 Additional investment for the project 300,000 Total investment $1,300,000 ROI Versus RI Division Q Example ($375,000 ÷ $1,300,000) 28.8%

  19. 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 200,000 Residual income $ 100,000

  20. 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 260,000 Residual income $ 115,000

  21. 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?

  22. $215,000 $2,100,000 $200,000 + $15,000 $2,000,000 + $100,000 = New ROI = ROI Versus RI New ROI = 10.2% The company should reject the investment, but the manager will accept because divisional ROI increases.

  23. Investment Bendan, Inc. (in millions of dollars) Division ABC Unallocated Total Investment Cash $ 20 $ 30 $ 60 $ 30 $ 140 Accounts receivable, net 60 80 90 230 Inventory 100 180 240 520 Prepaid expenses 10 10 20 20 60 Plant and equipment-- net of depreciation 200 320 440 60 1,020 Investments 10 --- --- 100 110 Total assets $400 $620 $850 $210 $2,080 Continued

  24. Investment Bendan, Inc. (in millions of dollars) Division ABC Unallocated Total Income Sales $100 $400 $700 $1,200 Variable costs 30 220 400 650 Contribution margin $ 70 $180 $300 $ 550 Direct fixed costs 30 90 140 260 Divisional profit $ 40 $ 90 $160 $ 290 Common fixed costs 60 Income $ 230

  25. Investment Bendan, Inc. (in millions of dollars) Company as a Whole ABC Computation of ROI: Profit of segment $ 40 $ 90 $160 $ 230 Investment in segment 400 620 850 2,080 ROI (profit/investment) 10 % 14.5 % 18.8 % 11.1 % Computation of RI: Profit of segment $ 40 $ 90 $160 $ 230 Required return (invest- ment x minimum return of 10%) 40 62 85 208 RI (profit – required return) $ 0 $ 28 $ 75 $ 22

  26. Investment Bendan, Inc. (in millions of dollars) Company as a Whole ABC Computation of ROI: Profit of segment $ 40$ 90$160$ 230 Total assets $400 $620 $850 $2,080 Divisional liabilities 60 170 310 540 Divisional investment $340 $450 $540 $1,540 Unallocated liabilities 730 Total investment $340 $450 $540 $ 810 ROI 11.8% 20.0% 29.6% 28.4% Continued

  27. Investment Bendan, Inc. (in millions of dollars) Company as a Whole ABC Computation of RI: Profit of segment $40 $ 90 $160 $ 230 Required return (invest- ment x minimum return of 10%) 34 45 54 81 RI $ 6 $45 $106 $149

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

  29. Transfer Pricing • Actual costs with or without a markup • Budgeted costs with or without a markup • Market-based prices • Incremental cost • Negotiated prices

  30. 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.

  31. 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.

  32. 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.

  33. 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.

  34. 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.

  35. Multinational CompaniesSpecial 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 Currency translation problems

  36. Chapter 10 The End

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