Performance Evaluation for Decentralized Operations

1. 23 Performance Evaluation for Decentralized Operations

2. Describe the advantages and disadvantages of decentralized operations. 1 Prepare a responsibility accounting report for a cost center. Prepare responsibility accounting reports for a profit center. 2 3 Learning Objective 1 Learning Objective 1 Performance Evaluation for Decentralized Operations 3-1 3-1 After studying this chapter, you should be able to: Insert Chapter Objectives Describe the nature of the adjusting process. Describe the nature of the adjusting process. 23-2

3. Compute and interpret the rate of return on investment, the residual income, and the balance scorecard for an investment center. 4 Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business. 5 Performance Evaluation for Decentralized Operations (continued) 23-3

4. 1 Describe the advantages and disadvantages of decentralized operations. 23-4

5. 1 Decentralized Operations In a decentralized company, managers of separate divisions or units are delegated operating responsibility. The division (unit) managers are responsible for planning and controlling the operations of their divisions.

6. Exhibit 1 1 Advantages and Disadvantages of Decentralized Operations Advantages of Decentralization • Allows managers closest to the operations to make decisions • Provides excellent training for managers • Allows managers to become experts in their area of operation • Helps retain managers • Improves creativity and customer relations (continued)

7. Exhibit 1 1 Advantages and Disadvantages of Decentralized Operations (continued) Disadvantages of Decentralization • Decisions made by managers may negatively affect the profits of the company • Duplicates assets and expenses

8. 1 Responsibility Accounting In a decentralized business, accounting assists managers in evaluating and controlling their areas of responsibility, called responsibility centers.

9. 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

10. Revenue – Cost Profit Revenue – Cost Profit Investment in assets 1 The area of responsibility for each center is shown below. Cost Center Profit Center Investment Center Cost

11. 2 Prepare a responsibility accounting report for a cost center. 23-11

12. 2 Responsibility Accounting for Cost Centers A cost center manager has responsibility for controlling the costs.

13. Exhibit 2 2 Cost Centers in a University

14. Exhibit 3 2 Responsibility Accounting Reports for Cost Centers (continued)

15. Exhibit 3 2 Responsibility Accounting Reports for Cost Centers (continued) from Manager, Plant A Budget Performance Report (continued)

16. Exhibit 3 2 Responsibility Accounting Reports for Cost Centers (continued) To Vice President’s Budget Performance Report from Supervisor, Department 1, Plant A’s Budget Performance Report (continued)

17. Exhibit 3 2 Responsibility Accounting Reports for Cost Centers (concluded) To Manager, Plant A’s Budget Performance Report

18. Follow My Example 23-1 $26,000 over budget ($24,000 + $2,000) For Practice: PE 23-1A, PE 23-1B 2 Example Exercise 23-1 Budgetary Performance for Cost Center Nuclear Power Company’s costs were over budget by $24,000. The company is divided into the North and South regions. The North Region’s costs were under budget by $2,000. Determine the amount that the South Region’s cost was over or under budget. 23-18

19. 3 Prepare responsibility accounting reports for a profit center. 23-19

20. 3 Profit Center 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).

21. 3 • Controllable revenues are revenues earned by the profit center. • Controllable expenses are costs that can be influenced (controlled) by the decisions of profit center managers.

22. 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.

23. Exhibit 4 3 Payroll Accounting Department Charges to NEG’s Theme Park and Movie Production Divisions

24. 3 NEG Example NEG’s expenses for the year ended Decem-ber 31, 2010 for each service department are as follows: Purchasing $400,000 Payroll Accounting 255,000 Legal 250,000 Total $905,000 (continued)

25. 3 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)

26. 3 Service Usage Purchasing Theme Park Division 25,000 purchase requisitions Movie Production Division 15,000 Total 40,000 purchase requisitions $400,000 40,000 purchase requisitions = $10 per purchase requisition (continued)

27. 3 Service Usage Payroll Accounting Theme Park Division 12,000 payroll checks Movie Production Division 3,000 Total 15,000 payroll checks $255,000 15,000 payroll checks = $17 per payroll check (continued)

28. 3 Service Usage Legal Theme Park Division 100 billed hours Movie Production Division 900 Total 1,000 billed hours $250,000 1,000 hours = $250 per hour (continued)

29. Exhibit 5 3 Service Department Charges to NEG Divisions

30. 3 Example Exercise 23-2 Service Department Charges 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 each division be charged for legal services? 23-30

31. Follow My Example 23-2 For Practice: PE 23-2A, PE 23-2B 3 Example Exercise 23-2 (continued) East Division Service Charge for Legal Department: $15,000 = 500 billed hours × ($60,000/2,000 hours) West Division Service Charge for Legal Department: $45,000 = 1,500 billed hours × ($60,000/2,000 hours) 23-31

32. 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. However, it should not be compared across profit centers.

33. Exhibit 6 3 Divisional Income Statements—NEG

34. 3 Example Exercise 23-3 Income from Operations for Profit Center Using the data for the Johnson Company from Example Exercise 23-2 along with the data given below, determine the divisional income from operations for the East and West Divisions. East West DivisionDivision Sales $300,000 $800,000 Cost of goods sold 165,000 420,000 Selling expenses 85,000 185,000 Left-click this button to go to Exercise 23-2. Type “34” and press “Enter” to return. 23-34

35. Follow My Example 23-3 For Practice: PE 23-3A, PE 23-3B 3 Example Exercise 23-3 (continued) Revenue…………………………….. $300,000 $800,000 Cost of goods sold……………….. 165,000420,000 Gross profit ………………………….. $135,000 $380,000 Selling expenses………………….. 85,000 185,000 Income from operations before service department charges…... $ 50,000 $195,000 Service department charges 15,000 45,000 Income from operations………….. $ 35,000 $150,000 23-35

36. 4 Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. 23-36

37. 4 Investment Center An investment center 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.

38. Exhibit 7 4 Divisional Income Statements—Datalink Inc.

39. 4 Revenues

40. 4 Profit $$$ Profit Margin Investment Turnover

41. 4 Profit margin is the ratio of income from operations to sales Profit Margin Investment Turnover

42. 4 Investment turnover is the ratio of sales to invested assets Investment Turnover

43. 4 Rate of Return on Investment One measure that considers the amount of assets invested in an investment center is the rate of return on investment (ROI) or rate of return on assets. Income from Operations Invested Assets ROI =

44. 4 DuPont Formula Income from Operations Sales Sales Invested Assets × ROI = Profit Margin Investment Turnover

45. $ 70,000 $560,000 $560,000 $350,000 ROI = × 12.5% × 1.6 20% ROI = ROI = 4 DataLink’s Northern Division (ROI) Income from Operations Sales Sales Invested Assets × ROI =

46. $ 84,000 $672,000 $672,000 $700,000 ROI = × 12.5% × 0.96 12% ROI = ROI = 4 DataLink’s Central Division (ROI) Income from Operations Sales Sales Invested Assets × ROI =

47. $ 75,000 $750,000 $750,000 $500,000 ROI = × 10% × 1.5 15% ROI = ROI = 4 DataLink’s Southern Division (ROI) Income from Operations Sales Sales Invested Assets × ROI =

48. 4 DataLink’s Northern Division Proposal Assume that the revenues of the Northern Division could be increased by $56,000 through increasing advertising to $385,000.

49. Increase of $7,000 4 Projected Impact of Change Revenues ($560,000 + $56,000) $616,000 Operating expenses 385,000 Income from operations before service department charges $231,000 Service department charges 154,000 Income from operations $ 77,000

50. $ 77,000 $616,000 $616,000 $350,000 ROI = × 12.5% × 1.76 22% ROI = ROI = 4 DataLink’s Northern Division (ROI) Revised Income from Operations Sales Sales Invested Assets × ROI =