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Decentralization and Performance Evaluation
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  1. Decentralization and Performance Evaluation

  2. Decentralization and Performance Evaluation • Responsibility Centers • Costs and benefits of decentralization • Return on Investment • Residual Income

  3. Decentralization and Performance Evaluation • Responsibility Centers • Costs and benefits of decentralization • Return on Investment • Residual Income

  4. Responsibility Centers Responsibility Centers include: • Cost Centers • Revenue Centers • Profit Centers • Investment Centers

  5. Responsibility Centers • Cost Centers • A cost center is a segment whose manager is responsible for costs but not for revenues. • Revenue Centers • Profit Centers • Investment Centers

  6. Responsibility Centers • Cost Centers • Revenue Centers • Revenue center managers are mostly responsible for generating sales, not for the cost of goods sold. • Profit Centers • Investment Centers

  7. Responsibility Centers • Cost Centers • Revenue Centers • Profit Centers • Profit center managers are responsible for revenues as well as costs. These costs may include indirect costs. • Investment Centers

  8. Responsibility Centers • Cost Centers • Revenue Centers • Profit Centers • Investment Centers • Investment center managers are responsible not only for revenues and costs, but also for the investment required to generate profits.

  9. Responsibility Centers Levi Strauss San Francisco Levi Strauss Canada Levi Strauss U.S.A. Levi Strauss Europe Investment Centers Profit Centers Cost Centers Revenue Centers Dockers Jeans Factories Warehouses Sales offices

  10. Responsibility Centers What reports are used to evaluate these responsibility center managers? • Cost Centers • report of costs • Revenue Centers • report of sales • Profit Centers • Divisional income statement • Investment Centers • Return on Investment

  11. Decentralization and Performance Evaluation • Responsibility Centers • Costs and benefits of decentralization • Return on Investment • Residual Income

  12. Responsibility Centers Benefits of Decentralization: • Takes advantage of knowledge and expertise within the organization. • Autonomy can be an intrinsic reward. • Places fewer demands on top management.

  13. Responsibility Centers Costs of Decentralization: • Loss of Control. • Goal Congruence.

  14. Decentralization and Performance Evaluation • Responsibility Centers • Costs and benefits of decentralization • Return on Investment • Residual Income

  15. ROI and Residual Income Where IRR = Internal Rate of Return ROI = Return on Investment NPV = Net Present Value R.I. = Residual Income

  16. Return on Investment (ROI) Some Measure of Income ROI = Some Measure of Investment Examples of ROI that you may have seen: ROE = Return on Equity ROA = Return on Assets These are usually employed at a firm-wide level for financial statement analysis. In cost accounting, we are usually more interested in ROI calculations for a part of the firm (e.g., a division).

  17. Return On Investment (ROI) Operating Profit ROI = Divisional Investment Operating Profit Divisional Revenues = x Division Revenues Divisional Investmt = Return on Sales x Turnover Ratio

  18. Return On Investment (ROI) Operating Profit ROI = Division Investment ADVANTAGES: ROI is a measure of profitability that is independent of the size of the division. DISADVANTAGES: Can encourage divisional managers to reject good investments.

  19. Decentralization and Performance Evaluation • Responsibility Centers • Costs and benefits of decentralization • Return on Investment • Residual Income

  20. Residual Income (RI) RI = Profits - (Hurdle Rate x Investment) This hurdle rate usually should be equal to or greater than the cost of capital. ADVANTAGES: Some argue that Residual Income comes very close to what investors care about. E.V.A. (Economic Value Added) is a type of Residual Income calculation.

  21. Measurement Issues Income: Residual Income should exclude interest on debt. Both RI and ROI might include some allocated corporate costs. Investment: Always includes identifiableassets. Can also include some allocated corporate assets. Fixed assets might be stated at Original Cost Original cost less accumulated depreciation (book value) Current replacement cost

  22. Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows: TurkeyFish Net Operating Income $50,000$60,000 Average Operating Assets $250,000$400,000 The required rate of return, which is the cost of capital, for the Cat Food Company is 18%. What is the residual income for the FishDivision?

  23. Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows: TurkeyFish Net Operating Income $50,000 $60,000 Average Operating Assets $250,000 $400,000 The required rate of return, which is the cost of capital, for the Cat Food Company is 18%. What is the residual income for the FishDivision? operating income - (average investment x cost of capital) = $60,000 - ($400,000 x 18%) = $60,000 - $72,000 = ($12,000)

  24. Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows: TurkeyFish Net Operating Income $50,000 $60,000 Average Operating Assets $250,000 $400,000 The required rate of return, which is the cost of capital, for the Cat Food Company is 18%. What is the return on investment (ROI) for the Turkey Division?

  25. Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows: TurkeyFish Net Operating Income $50,000 $60,000 Average Operating Assets $250,000 $400,000 The required rate of return, which is the cost of capital, for the Cat Food Company is 18%. What is the return on investment (ROI) for the Turkey Division? operating income ÷ average operating assets = $50,000 ÷ $250,000 = 20%

  26. Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows: TurkeyFish Net Operating Income $50,000 $60,000 Average Operating Assets $250,000 $400,000 The required rate of return, which is the cost of capital, for the Cat Food Company is 18%. A project with a return of $36K on an investment of $200K exists. If divisions are evaluated based on residual income, which divisions would accept the project?

  27. Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows: TurkeyFish Net Operating Income $ 50,000 $ 60,000 Average Operating Assets $250,000 $400,000 The required rate of return, which is the cost of capital, for the Cat Food Company is 18%. A project with a return of $36,000 on an investment of $200,000 exists. If divisions are evaluated based on residual income, which divisions would accept the project? $36,000 - ($200,000 x 18%) = $0. Both Turkey division and Fish division are indifferent.