Performance Evaluation in the Decentralized Firm

1. CHAPTER Performance Evaluation in the Decentralized Firm

2. Objectives 1.Define responsibility accounting, and describe four types of responsibility centers. 2. Tell why firms choose to decentralize. 3. Compute and explain return on investment (ROI) and economic value added (EVA). 4. Discuss methods of evaluating and rewarding managerial performance. 5. Explain the role of transfer pricing in a decentralized firm. After studying this chapter, you should be able to:

3. Responsibility accounting is a system that measures the results of each responsibility center according to the information managers need to operate their centers.

4. Types of Responsibility Centers Cost center:A responsibility center in which a manager is responsible only for costs. Revenue center:Aresponsibility center in which a manager is responsible only for sales. Continued

5. Types of Responsibility Centers Profit center:A responsibility center in which a manager is responsible for both revenues and costs. Investment center:Aresponsibility center in which a manager is responsible for revenues, costs, and investments.

6. ACCOUNTING INFORMATION USED TO MEASURE PERFORMANCE Capital Cost Sales Investment Other Cost center x Revenue center Direct cost x only Profit center x x Investment center x x x x

7. Reasons for Decentralization • 1. Ease of gathering and using local information • 2. Focusing of central management • 3. Training and motivating segment managers • 4. Enhanced competition, exposing segments to market forces

8. Operating income Average operating assets Beginning net book value + Ending net book value 2 Return on Investment ROI =

9. $1,800,000 $10,000,000 Comparison of ROI Electronics Medical Supplies Divisions Divisions 2003: Sales $30,000,000 $117,00,000 Operating income 1,800,000 3,510,000 Average operating assets 10,000,000 19,500,000 ROI 18 18 % %

10. $2,000,000 $10,000,000 Comparison of ROI Electronics Medical Supplies Divisions Divisions 2004: Sales $40,000,000 $117,00,000 Operating income 2,000,000 2,925,000 Average operating assets 10,000,000 19,500,000 ROI 20 15 % %

11. Operating Income Sales Sales Average operating assets Margin and Turnover Margin x Turnover ROI =

12. MARGIN AND TURNOVER COMPARISONS Electronics Medical Supplies Division Division 2003 2004 2003 2004 Margin 6.0% 5.0% 3.0% 2.5% Turnover x 3.0x 4.0x 6.0x 6.0 ROI 18.0% 20.0% 18.0% 15.0%

13. 1.It encourages managers to focus on the relationship among sales, expenses, and investments. 2. It encourages managers to focus on cost efficiency. 3. It encourages managers to focus on operating asset efficiency. Advantages of ROI

14. It can produce a narrow focus on divisional profitability at the expense of profitability for the overall firm. It encourages managers to focus on the short run at the expense of the long run. Disadvantages of ROI

15. Economic Value Added • Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital. EVA = After-tax operating income – (Weighted average cost of capital x Total capital employed)

16. Cost of Capital • There are two steps involved in computing cost of capital: • 1. Determine the weighted average cost of capital (a percentage figure) • 2. Determine the total dollar amount of capital employed

17. Weighted Average Cost of Capital Suppose that a company has two sources of financing: $2 million of long-term bonds paying 9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average cost of capital is computed as follows:

18. Weighted Average Cost of Capital Thus, the company’s weighted average is 10.35 percent. Amount Percent x After-Tax Cost = Weighted Cost Bonds $2,000,000 0.25 0.009(1 –0.4) = .054 0.0135 Equity 6,000,000 0.75 0.06 + 0.06 = .120 0.0900 Total $8,000,000 0.1035

19. EVA Example • Suppose that Mahalo, Inc., had after-tax operating income last year of $900,000. Three sources of financing were used by the company: $2 million of mortgage bonds paying 8 percent interest, $3 million of unsecured bonds paying 10 percent interest, and $10 million in common stock, which was considered to be no more or less risky than other stocks. Mahalo, Inc. pays a marginal tax rate of 40 percent.

20. Weighted Average Cost of Capital Weighted Amount Percent x After-Tax Cost = Cost Mortgage bonds $ 2,000,000 0.133 0.048 0.006 Unsecured bonds 3,000,000 0.200 0.060 0.012 Common stock 10,000,000 0.667 0.120 0.080 Total $15,000,000 Weighted average cost of capital 0.098

21. EVA Example • Mahalo’s EVA is calculated as follows: • After tax operating income $900,000 • Less: Cost of capital 784,000 • EVA $116,000

22. Behavioral Aspects of EVA A number of companies have discovered that EVA helps to encourage the right kind of behavior from their divisions in a way that emphasis on operating income alone cannot. The underlying reason is EVA’s reliance on the true cost of capital.

23. Behavioral Aspects of EVA • In many companies, the responsibility for investment decisions rests with corporate management. As a result, the cost of capital is considered a corporate expense. If a division builds inventories and investment, the cost of financing that investment is passed along to the overall income statement and does not show up as a reduction from the division’s operating income.

24. Incentive Pay for Managers • Why would managers not provide good service? There are three reasons: • 1. They may have low ability • 2. They may prefer not to work as hard as needed • 3. They may prefer to spend company resources on perquisites

25. Incentive Pay for Managers Perquisites are a type of fringe benefit given to managers over and above a salary. • A nice office • Use of a company car or jet • Expense accounts • Paid country club memberships

26. Transfer Pricing • The value of a transferred good is revenue to the selling division and cost to the buying division. This value is called transfer pricing.

27. Transfer Pricing • (1) divisional performance measures • (2) firmwide profits • (3) divisional autonomy Transfer pricing affects both transferring divisions and the firm as a whole through its impact on--

28. Opportunity Cost Approach This approach identifies the minimum and maximum price that a selling division would be willing to accept and the maximum price that a buying division would be willing to pay. The minimum transfer price is the transfer price that would leave the selling division no worse off if the goods were sold to an internal division than if the good were sold to an external party (floor). The maximum transfer price is the transfer price that would leave the buying division no worse off if an input were purchased from an internal division than if the good were purchased externally (ceiling).

29. The Transfer Pricing Illustration Tyson Manufacturers produces small appliances. The Small Parts Division produces parts used by the Small Motors Division. The parts also are sold to other manufacturers and wholesalers.

30. The Transfer Pricing Illustration The Small Motors Division is operating at 70 percent capacity. A request is received for 100,000 units of a certain model at $30 per unit. A component for this motor can be supplied by the Small Parts Division. The transfer price is $8 despite the Small Parts Division only experiencing a cost of $5 per unit.

31. The Transfer Pricing Illustration Direct materials $10 Transferred-in component 8 Direct labor 2 Variable overhead 1 Fixed overhead 10 Total cost $31 Using the $8 transfer price, the total cost is $31 per unit, calculated as follows:

32. The Transfer Pricing Illustration The Small Motors Division is operating at 70 percent capacity, so the $10 fixed cost is not relevant. Recalculating the cost-- Direct materials $10 Transferred-in component 8 Direct labor 2 Variable overhead 1 Total cost $21 The Small Motors Division can pay the Small Parts Division $8 per unit and still make a substantial contribution to the overall profitability of the Division.

33. When imperfections exist in competitive markets for the intermediate product, market price may no longer be suitable. Negotiated Transfer Prices

34. Negotiated Transfer Prices In this case, negotiated transfer prices may be a practical alternative. Opportunity costs can be used to define the boundaries of the negotiation set.

35. Disadvantages of Negotiated Transfer Prices • A division manager who has private information may take advantage of another divisional manager. • Performance measures may be distorted by the negotiated skills of managers. • Negotiation can consume considerable time and resources.

36. Despite the disadvantages, negotiated price transfer prices offer some hope of complying with the three criteria of goal congruence, autonomy, and accurate performance evaluation.

37. Chapter Thirteen The End