Decentralization and Performance Evaluation in Managerial Accounting

1. Cornerstones of Managerial Accounting, 5e

2. Chapter 12:Performance Evaluation and Decentralization Cornerstones of Managerial Accounting, 5e

3. Decentralization and Responsibility Centers • A company is organized along lines of responsibility. • Most companies use a more flattened hierarchy that emphasizes teams. • Firms with multiple responsibility centers usually choose one of two decision-making approaches to manage their diverse and complex activities: centralized or decentralized. LO-1

4. Decentralization and Responsibility Centers (cont.) • In centralized decision making, decisions are made at the very top level, and lower level managers are charged with implementing these decisions. • Decentralized decision making allows managers at lower levels to make and implement key decisions pertaining to their areas of responsibility. The practice of delegating decision-making authority to the lower levels of management in a company is called decentralization. LO-1

5. Centralization and Decentralization LO-1

6. Divisions in the Decentralized Firm • Decentralization involves a cost-benefit trade-off. • As a firm becomes more decentralized, it passes more decision authority down the managerial hierarchy. • Decentralization usually is achieved by creating units called divisions. • Divisions can be differentiated a number of different ways, including the following: • types of goods or services • geographic lines • responsibility centers LO-1

7. Responsibility Centers • Another way divisions differ is by the type of responsibility given to the divisional manager. • A responsibility center is a segment of the business whose manager is accountable for specified sets of activities. LO-1

8. Responsibility Centers (cont.) • The four major types of responsibility centers are as follows: • Cost center: Manager is responsible only for costs. • Revenue center: Manager is responsible only for sales, or revenue. • Profit center: Manager is responsible for both revenues and costs. • Investment center: Manager is responsible for revenues, costs, and investments. LO-1

9. Return on Investment • One way to relate operating profits to assets employed is to compute the return on investment (ROI), which is the profit earned per dollar of investment. • ROI is the most common measure of performance for an investment center and is computed as follows: Operating income ÷ Average Operating Assets LO-2

10. Return on Investment (cont.) • Operating income refers to earnings before interest and taxes. • Operating assets are all assets acquired to generate operating income, including cash, receivables, inventories, land, buildings, and equipment. • Average operating assets is computed as: (Beginning assets + Ending assets) ÷ 2 LO-2

11. Margin and Turnover • A second way to calculate ROI is to separate the formula (Operating income ÷ Average operating assets) into margin and turnover. • Marginis the ratio of operating income to sales. • It tells how many cents of operating income result from each dollar of sales; it expresses the portion of sales that is available for interest, taxes, and profit. • Turnoveris sales ÷ average operating assets. • Turnover tells how many dollars of sales result from every dollar invested in operating assets. LO-2

12. Margin and Turnover (cont.) • The equation that yields ROI from the Margin and Turnover is as follows: Margin: Turnover: ROI = Operating Income X Sales Sales Average Operating Assets Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets. LO-2

13. Residual Income • Companies have adopted alternative performance measures such as residual income. • ROI can discourage investments that are profitable for a company but lowers a division’s ROI LO-3

14. Residual Income (cont.) • Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets: Residual income = Operating income – (Minimum rate of return x Average operating assets) LO-3

15. Economic Value Added (EVA) • Another financial performance measure that is similar to residual income is economic value added. • Economic value added (EVA) is after tax operating income minus the dollar cost of capital employed. • The dollar cost of capital employed is the actual percentage cost of capital multiplied by the total capital employed. LO-3

16. Economic Value Added (EVA) (cont.) • EVA is expressed as follows: LO-3

17. Transfer Pricing • In decentralized organizations, the output of one division is used as the input of another. • The value of the transferred good is revenue to the selling division and cost to the buying division. • This value, or internal price, is called the transfer price. • Transfer price is the price charged for a component by the selling division to the buying division of the same company. LO-4

18. Transfer Pricing Policies • Several transfer pricing policies are used in practice, including: • market price • cost-based transfer prices • negotiated transfer prices LO-4

19. Appendix 12A: The Balanced Scorecard – Basic Concepts • Segment income, ROI, residual income, and EVA are important measures of managerial performance, but they lead managers to focus only on dollars. LO-5

20. Appendix 12A: The Balanced Scorecard – Basic Concepts • Balanced Scorecard translates an organization’s mission and strategy into operational objectives and performance measures for the following four perspectives: • The financial perspective describes the economic consequences of actions taken in the other three perspectives. LO-5

21. Appendix 12A: The Balanced Scorecard – Basic Concepts • The customer perspective defines the customer and market segments in which the business unit will compete. • The internal business processperspectivedescribes the internal processes needed to provide value for customers and owners. • The learning and growth perspective defines the capabilities that an organization needs to create long-term growth and improvement. LO-5

22. The Balanced Scorecard – An Example LO-5

23. The Role of Performance Measures • The Balanced Scorecard is not simply a collection of critical performance measures. • The performance measures are derived from a company’s vision, strategy, and objectives. LO-5

24. The Role of Performance Measures (cont.) • These measures must be balanced between the following measures: • performance driver measures (i.e., lead indicators of future financial performance) and outcome measures (i.e., lagged indicators of financial performance) • objective and subjective measures • external and internal measures • financial and nonfinancial measures LO-5

25. Linking Performance Measures to Strategy • Balancing outcome measures with performance drivers is essential to linking with the organization’s strategy. • Performance drivers make things happen and are indicators of how the outcomes are going to be realized. LO-5

26. Linking Performance Measures to Strategy (cont.) • Outcome measures are also important because they reveal whether the strategy is being implemented successfully with the desired economic consequences. • A testable strategy can be defined as a set of linked objectives aimed at an overall goal. LO-5

27. A Testable Strategy Example LO-5

28. The Four Perspectives and Performance Measures • The four perspectives define the strategy of an organization and provide the structure or framework for developing an integrated, set of performance measures. • These measures become the means for articulating and communicating the strategy of the organization to its employees and managers. LO-5

29. The Four Perspectives and Performance Measures (cont.) • The measures also serve the purpose of aligning individual objectives and actions with organizational objectives and initiatives. LO-5