Performance Evaluation for Decentralized Operations

1. 0 23 Performance Evaluation for Decentralized Operations

2. 0 23-1 Decentralized Operations Separating a business into divisionsor operating units and delegating responsibility to unit managers is called decentralization.

3. It allows managers to focus on acquiringexpertisein their areas of responsibility. 0 23-1 Advantages of Decentralization • Decentralizing decision making provides excellent training for managers. • Decentralization helps managers create goodcustomer relations by responding quickly to customers’ needs. • Managers often become more creative in suggesting operating and product improvement.

4. Decisions made by one manager may negatively affect the profitability of the entire company. 0 23-1 Disadvantages of Decentralization • 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 ).

5. 0 23-1 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.

6. 0 23-1 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

7. Revenue – Cost Profit Revenue – Cost Profit Investment in assets 0 23-1 The three centers differ in their scope of responsibility, as shown below: Cost Center Profit Center Investment Center Cost 10

8. 0 23-2 Responsibility Accounting for Cost Centers In a cost center, the unit manager has responsibility and authority for controlling the costs incurred.

9. 0 23-2 Responsibility Accounting Reports for Cost Centers (continued) 13

10. 0 23-2 Responsibility Accounting Reports for Cost Centers from Manager, Plant A Budget Performance Report 14 (Continued)

11. 0 23-2 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)

12. 0 23-2 Responsibility Accounting Reports for Cost Centers To Manager, Plant A’s Budget Performance Report 16 (Concluded)

13. 0 23-3 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).

14. 0 23-3 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.

15. 0 23-3 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.

16. 0 23-3 22

17. 0 23-3 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

18. 0 23-3 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)

19. $400,000 40,000 purchase requisitions = $10 per purchase requisition 0 23-3 NEG Example Service Usage Purchasing Theme Park Division 25,000 purchase requisitions Movie Production Division 15,000 Total 40,000 purchase requisitions (Continued) 25

20. $255,000 15,000 payroll checks = $17 per payroll check 0 23-3 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

21. $250,000 1,000 hours = $250 per hour 0 23-3 NEG Example Service Usage Legal Theme Park Division 100 billed hours Movie Production Division 900 Total 1,000 billed hours (Concluded) 27

22. 0 23-3 Service Department Charges to NEG Divisions 28

23. Example Exercise 23-2 0 23-3 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

24. Follow My Example 23-2 0 23-3 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: PE23-2A, PE23-2B

25. 0 23-3 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.

26. 0 23-4 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.

27. 0 23-4 Divisional Income Statements—DataLink Inc. 37

28. 0 23-4 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.

29. Rate of return on investment (ROI) Income from operations Invested assets = 0 23-4 Rate of return on investment is one of the most widely used measures for investment centers and is computed as follows: The higher the rate of return on investment, the better the division utilizes its assets to generate income. 39

30. 0 23-4 DuPont Formula Income from operation Sales Sales Invested assets x ROI = Investment Turnover Profit Margin 44

31. $ 70,000 $560,000 $560,000 $350,000 ROI = x 12.5% x 1.6 20% ROI = ROI = 0 23-4 DuPont’s Northern Division (ROI) Income from operation Sales Sales Invested assets x ROI = 45

32. $ 84,000 $672,000 $672,000 $700,000 ROI = x 12.5% x 0.96 12% ROI = ROI = 0 23-4 DuPont’s Central Division (ROI) Income from operation Sales Sales Invested assets x ROI = 46

33. $ 75,000 $750,000 $750,000 $500,000 ROI = x 10% x 1.5 15% ROI = ROI = 0 23-4 DuPont’s Southern Division (ROI) Income from operation Sales Sales Invested assets x ROI = 47

34. Example Exercise 23-4 0 23-4 Campbell Company has income from operations of $35,000, invested in assets of $140,000, and sales of $437,500. Use the DuPont formula to compute the rate of return on investment and show (a) the profit margin, (b) the investment turnover, and (c) the rate of return on investment. 51

35. Follow My Example 23-4 $35,000 $437,500 a. Profit margin = = 8% $437,500 $140,000 = 3.125 b. Investment turnover = c. Rate of return on investment = 8% x 3.125 = 25% 0 23-4 52 For Practice: PE23-4A, PE23-4B

36. 0 23-4 Residual Income Residual income is the excess of income from operations over a minimum acceptable income from operations. 53

37. Northern Central Southern Division Division Division Income from operations $70,000 $84,000 $75,000 Residual income $35,000 $14,000 $25,000 0 23-4 Minimum acceptable income from operations as a percent of assets: $350,000 x 10% 35,000 $700,000 x 10% 70,000 $500,000 x 10% 50,000 54

38. Example Exercise 23-5 0 23-4 The Wholesale Division of PeanutCo has income from operations of $87,000 and assets of $240,000. The minimum acceptable rate of return on assets is 12%. What is the residual income for the division? 55

39. Follow My Example 23-5 0 23-4 Income from operations $87,000 Minimum acceptable income from operations as a percent of assets: $240,000 x 12% (28,800) Residual income $58,200 56 For Practice: PE23-5A, PE23-5B

40. 0 23-4 The Balanced Scorecard The balanced scorecard is a set of financial and nonfinancial measures that reflect multiple performance dimensions of a business.

41. 0 23-4 The Balanced Scorecard 58

42. 0 23-5 Transfer Pricing When divisions transfer products or render services to each other, a transfer pricing is used to charge for the products or services

43. 0 23-5 61

44. 0 23-5 Market Price Approach Using the market priceapproach, the transfer price is the price at which the product or service transferred could be sold to outside buyers.

45. 0 23-5 Negotiated Price Approach The negotiated priceapproach allows the managers of decentralized units to agree (negotiate) among themselves as to the transfer price.

46. 0 23-5 Cost Price Approach Under the cost priceapproach, cost is used to set transfer prices. Cost may refer to either total product cost per unit or variable cost per unit.