ACC423: Mgt Acctg II

1. ACC423: Mgt Acctg II DECENTRALIZATION AND PERFORMANCE MEASUREMENT By: E. P. Enyi, Ph.D, MBA, ACA, FAAFM, RFS, MFP, FIIA Head, Dept of Accounting, Covenant University, Ota, Nigeria

2. DECENTRALIZATION • Decentralization is the breaking down of the decision making process of an organization into smaller semi-autonomous decision units such as cost centers. It is the transfer of decision making from top management to lower level management. • Total decentralization (where such exists) means minimum constraints and maximum freedom for managers at the lower levels of an organization to make decisions. Total centralization is the opposite. Most organizational structures fall somewhere between the two extremes (Horngren, Bhimani, Datar & Forster, 2005). • The essence of decentralization is the freedom for managers at lower levels of the organization to make decisions. • BENEFITS OF DECENTRALIZATION • The following benefits are attributable to decentralization: • Creates greater responsiveness to local needs in terms of better information about customers, competitors, suppliers, employees and factors that affect performances; • Leads to quicker decision making as layer after layer of management control is avoided in simple decisions requiring quick response.

3. Increases motivation as subunit managers are usually more highly motivated when they can exercise greater individual initiative. • Aids management development and learning • Sharpens the focus managers as this is more concentrated on a smaller area than a larger group. • DEMERITS OF DECENTRALIZATION • The following disadvantages are ascribed to over-decentralization of activities and decision making in an organization: • It leads to suboptimal (or incongruent) decision making which arises when a decision’s benefit to one subunit is more than offset by the costs or loss of benefits to the organization as a whole. • Results in duplication of activities. • Focuses managers attention on the subunit rather than the organization as a whole. • Increases costs of gathering information as a result maintaining independent data bases for internal transfer pricing purposes.

4. TYPES OF DECENTRALIZATION An organization may want to implement one of the following four types of decentralization: COST CENTRE A cost-centre is a division which management is given the responsibility as to the generation of costs only. REVENUE CENTRE A revenue centre is a division which management is given the responsibility for the collection of revenue only. PROFIT CENTRE A profit centre is a division which management is given the responsibility to generate both revenue and costs. INVESTMENT CENTRE This is a division which management is given the responsibility to invest in capital projects and generate costs and revenue without recourse to the head office. This is usually the case of local branches of multi-national companies.

5. DIVISIONAL PERFORMANCE EVALUATION One of the major advantages of decentralization is the possibility of measuring the individual abilities of the various divisional managers through the comparison of their divisional performance with those of others as well as with the over-all organizational performance. There are two main methods measuring divisional performances; these are: RETURN ON INVESTMENT (ROI) Where the division takes the garb of an investment centre, the ROI method can be employed in the performance evaluation. However, it must be pointed out here that the ROI is not a very good measure of divisional managers’ performance as it can lead to sub-optimal decision; instead, the residual income approach is preferred. The ROI is measured as net income divided by the capital invested (i.e. Net-Income / Capital Invested). RESIDUAL INCOME The residual income approach is used to more critically evaluate divisional performance. It is defined as the controllable profit of a division, less the cost of capital charged on controllable investment. EXAMPLE: NUASA Ltd., has two divisions, A and B. A summary of the annual reports from

6. the two divisions for the past year is given below. Given that the company’s cost of capital is 12% per annum, appraise the two divisions and identify the most profitable of the two. Division A Division B N N Capital Invested 240,000 400,000 Turnover 765,000 912,000 Operating Costs 717,000 840,000 SOLUTION Turnover 765,000 912,000 Less: Operating Costs 717,000840,000 NET INCOME 48,00072,000 Return On Investment 48/240 = 20% 72/400 = 18% Using the ROI approach, division A seems to be more profitable.

7. Using the Residual Income Approach: Division A Division B N ` N NET INCOME (Controllable Profit) 48,000 72,000 Less: Interest On Invested Capital @ 12% 28,80048,000 RESIDUAL INCOME 19,20024,000 NOTE Invested Capital is 240,000 for A and 400,000 for B. Conclusion Though the two measures of performance produced rational bases for performance evaluation, the ROI which is a relative measure tends to suggest that division A performed better than B relative to the resources employed but the Residual Income which is a more absolute measure states that division B brings in more money into the organization than A. There are other methods of measuring divisional performance and these are covered under transfer pricing.