Performance Evaluation for Decentralized Operations

1. 0 24 Performance Evaluation for Decentralized Operations

2. 0 After studying this chapter, you should be able to: • List and explain the advantages and disadvantages of decentralized operations. • Prepare a responsibility accounting report for a cost center. • Prepare responsibility accounting reports for a profit center.

3. 0 After studying this chapter, you should be able to: • Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. • Explain how the market price, negoti-ated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business.

4. 0 24-1 Objective 1 List and explain the advantages and disadvantages of decentralized operations.

5. 0 24-1 Decentralized Operations Separating a business into divisionsor operating units and delegating responsibility to unit managers is called decentralization.

6. It allows managers to focus on acquiringexpertisein their areas of responsibility. Decentralizing decision making provides excellent training for managers. Decentralization helps managers create good customer relations by responding quickly to customers’ needs. Managers often become more creative in suggesting operating and product improvement. 0 24-1 Advantages of Decentralization

7. Decisions made by one manager may negatively affect the profitability of the entire company. A potential disadvantage is duplication of assets and costs in operating divisions (e.g., each manager of a product line might have a separate sales force and administrative staff ). 0 24-1 Disadvantages of Decentralization

8. 0 24-1 Responsibility Accounting In a decentralized business, an important function of accounting is to assist unit managers in evaluating and controlling their areas of responsibility, called responsibility centers.

9. 0 24-1 Responsibility accounting is the process of measuring and reporting operating data by responsibility centers. Three common types of responsibility centers are— • Cost Centers • Profit Centers • Investment Centers

10. Revenue – Cost Profit Revenue – Cost Profit Investment in assets 0 24-1 The three centers differ in their scope of responsibility, as shown below: Cost Center Profit Center Investment Center Cost 10

11. 0 24-2 Objective 2 Prepare a responsibility accounting report for a cost center.

12. 0 24-2 Responsibility Accounting for Cost Centers In a cost center, the unit manager has responsibility and authority for controlling the costs incurred.

13. 0 24-2 Responsibility Accounting Reports for Cost Centers (Continued) 13

14. 0 24-2 Responsibility Accounting Reports for Cost Centers from Manager, Plant A Budget Performance Report 14 (Continued)

15. 0 24-2 Responsibility Accounting Reports for Cost Centers To Vice President’s Budget Performance Report from Supervisor, Department 1, Plant A’s Budget Performance Report 15 (Continued)

16. 0 24-2 Responsibility Accounting Reports for Cost Centers To Manager, Plant A’s Budget Performance Report 16 (Concluded)

17. Example Exercise 24-1 Follow My Example 24-1 0 24-2 Nuclear Power Company’s costs were over budget by $24,000. The Power Company is divided into the North and South regions. The North Region’s costs were under budget by $2,000. Determine the amount that the South Region’s cost was over or under budget. $26,000 over budget ($24,000 + $2,000) For Practice: PE 24-1A, PE 24-1B 17

18. 0 24-3 Objective 3 Prepare responsibility accounting reports for a profit center.

19. 0 24-3 Responsibility Accounting for Profit Centers In a profit center, the unit manager has the responsibility and the authority to make decisions that affect both costs and revenues (and thus profits).

20. 0 24-3 Controllable revenues are revenues earned by the profit center. Controllable expenses are costs that can be influenced (controlled) by the decisions of the profit center managers.

21. 0 24-3 Service Department Charges Services provided by internal centralized service departments are often more efficient than services contracted with outside providers. An internal service cost is called a service department charge.

22. 0 24-3 22

23. 0 24-3 NEG Example NEG’s expenses for the year ended Decem-ber 31, 2008 for each service department are as follows: Purchasing $400,000 Payroll Accounting 255,000 Legal 250,000 Total $905,000 (Continued) 23

24. 0 24-3 NEG Example The activity base for each service depart-ment is a measure of the services performed. For NEG, the following applies: Purchasing Number of purchase requisitions Payroll Accounting Number of payroll checks Legal Number of billed hours (Continued)

25. $400,000 40,000 purchase requisitions = $10 per purchase requisition 0 24-3 NEG Example Service Usage Purchasing Theme Park Division 25,000 purchase requisitions Movie Production Division 15,000 Total 40,000 purchase requisitions (Continued) 25

26. $255,000 15,000 payroll checks = $17 per payroll check 0 24-3 NEG Example Service Usage Payroll Accounting Theme Park Division 12,000 payroll checks Movie Production Division 3,000 Total 15,000 payroll checks (Continued) 26

27. $250,000 1,000 hours = $250 per hour 0 24-3 NEG Example Service Usage Legal Theme Park Division 100 billed hours Movie Production Division 900 Total 1,000 billed hours (Continued) 27

28. 0 24-3 Service Department Charges to NEG Divisions 28 (Concluded)

29. Example Exercise 24-2 0 24-3 The centralized legal department of Johnson Company has expenses of $60,000. The department has provided a total of 2,000 hours of service for the period. The East Division has used 500 hours of legal service during the period, and the West Division has used 1,500 hours. How much should it be charged for legal services? 29

30. Follow My Example 24-2 0 24-3 Manufacturing Division Service Charge for Legal Department: $15,000 = 500 billed hours x ($60,000/2,000 hours) Sales Division Service Charge for Legal Department: $45,000 = 1,500 billed hours x ($60,000/2,000 hours) 30 For Practice: PE24-2A, PE24-2B

31. 0 24-3 Profit Center Reporting The income from operations is a measure of a manager’s performance. In evaluating the profit center manager, the income from operations should be compared over time to a budget.

32. 0 24-3 Divisional Income Statement—NEG 32

33. Example Exercise 24-3 0 24-3 24-3 Using the data for the Johnson Company from Example Exercise 24-2 (click the button in the lower left-hand corner to go to EE 24-2; type “33” and press “Enter” to return to this slide), along with the data given below, determine the divisional income from operations for the East and West Divisions. East West DivisionDivision Sales $300,000 $800,000 Cost of goods sold 165,000 420,000 Selling expenses 85,000 185,000 33

34. Follow My Example 24-3 0 24-3 East Region West Region Revenue $300,000 $800,000 Operating expenses 250,000* 605,000** Income from operations before service department charges $ 50,000 $195,000 Service department charges 15,000 45,000 Income from operations $ 35,000 $150,000 *$165,000 + $85,000 **$420,000 + $185,000 34 For Practice: PE24-3A, PE24-3B

35. 0 24-4 Objective 4 Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center.

36. 0 24-4 Responsibility Accounting for Investment Centers In an investment center, the unit manager has the responsibility and the authority to make decisions that affect not only costs and revenues, but also the assets invested in the center.

37. 0 24-4 Divisional Income Statements—DataLink Inc. 37

38. 0 24-4 Rate of Return on Investment One measure that considers the amount of assets invested in an investment center is the rate ofreturn on investment (ROI) or rate of return on assets.

39. Rate of Return on Investment (ROI) Income from Operations Invested Assets = 0 24-4 Rate of return on investment is one of the most widely used measures for investment centers and is computed as follows: 39

40. 0 Revenues 24-4 40

41. Profit Margin 0 24-4 Profit Investment Turnover 41

42. Profit Margin 0 24-4 Profit margin is the ratio of of income from operations to sales Investment Turnover 42

43. Profit Margin 0 24-4 Investment turnover is the ratio of sales to invested assets Investment Turnover 43

44. 0 24-4 DuPont Formula Income from Operation Sales Sales Invested Assets x ROI = Investment Turnover Profit Margin 44

45. $ 70,000 $560,000 $560,000 $350,000 ROI = x 12.5% x 1.6 20% ROI = ROI = 0 24-4 DuPont’s Northern Division (ROI) Income from Operation Sales Sales Invested Assets x ROI = 45

46. $ 84,000 $672,000 $672,000 $700,000 ROI = x 12.5% x 0.96 12% ROI = ROI = 0 24-4 DuPont’s Central Division (ROI) Income from Operation Sales Sales Invested Assets x ROI = 46

47. $ 75,000 $750,000 $750,000 $500,000 ROI = x 10% x 1.5 15% ROI = ROI = 0 24-4 DuPont’s Southern Division (ROI) Income from Operation Sales Sales Invested Assets x ROI = 47

48. 0 24-4 DuPont’s Northern Division Proposal Assume that the revenues of the Northern Division could be increased by $56,000 through increasing advertising to $385,000.

49. Increase of $7,000 0 24-4 Projected Impact of Change Revenues ($560,000 + $56,000) $616,000 Operating expenses 385,000 Income from operations before service department charges $231,000 Service department charges 154,000 Income from operations $ 77,000 49

50. $ 77,000 $616,000 $616,000 $350,000 ROI = x 12.5% x 1.76 22% ROI = ROI = 0 24-4 DuPont’s Northern Division (ROI) Revised Income from Operation Sales Sales Invested Assets x ROI = 50