Chapter 11

1. Chapter 11 Decentralization and Performance Evaluation

2. Introduction • The dilemma for companies is to find tools that allow the evaluation of managers at all levels in the organization. How would the evaluation be different for each of these? • A plant manager in a factory • The manager of a retail store • The regional sales manager • The CEO

3. Management of Decentralized Organizations Centralized: a few individuals at the top of an organization retain decision-making authority. Decentralized: managers at various levels throughout the organization make key decisions about operations relating to their specific area of responsibility.

4. Management of Decentralized Organizations Segment:any activity or part of the business for which a manager needs cost, revenue, or profit data.

5. Responsibility Accounting and Segment Reporting Responsibility Accounting:Holding managers responsible for ONLY those things under their control.

6. Cost, Profit, and Investment Centers Cost Center The manager has control over costs but not over revenue or capital investment decisions. Example: Human Resources Manager

7. Cost, Profit, and Investment Centers Revenue Center Manager has control over the generation of revenue but not costs. Example: Reservation Department of an airline

8. Cost, Profit, and Investment Centers Profit Center Manager has control over both cost and revenue but not capital investment decisions. Example: Manager of a specific hotel chain

9. Cost, Profit, and Investment Centers Investment Center Manager is responsible for the amount of capital invested in generating income. It is in essence a separate business with its own value chains. Example: Manager of store or branch

10. The Segmented Income Statement Contribution Margin: primarily a measure of short-run profitability. Segment Margin: a measure of long-term profitability and is more appropriate in addressing long-term decisions such as whether to drop product lines.

11. Investment Centers and Measures of Performance Performance reports focus on measures specifically developed to focus on the level of investment required, such as return on investment, residual income, and economic value added. And what do you plan to use to justify your decision to remodel these facilities?

12. Return on Investment (ROI) ROI measures the rate of return generated by an investment center’s assets. ROI = Margin X Turnover Margin = Net Operating Income /Sales Turnover = Sales/Average Operating Assets Net Operating Income Sales ROI = X Sales Average Operating Assets

13. Return on Investment (ROI) Net Operating Income: Income before interest and taxes Operating Assets: Cash, accounts receivable, inventory, and property, plant, and equipment

14. Return on Investment (ROI) • Increase sales revenue • Reduce operating costs • Reduce investment in operating assets What do I need to do to increase my ROI?

15. Return on Investment (ROI) Either by increasing sales volume without changing the sales price or by increasing the sales price without affecting volume. How do you increase sales revenue?

16. Return on Investment (ROI) The decrease can be in the variable or fixed costs. The key is that any decrease in operating costs will increase operating income and have a positive impact on ROI. How do you reduce operating costs?

17. Return on Investment (ROI) Although this may be difficult to do in the short run with property, plant, and equipment, average operating assets can be reduced by better management of accounts receivable, a reduction in inventory levels, and so on. How do you decrease the amount of operating assets?

18. Residual Income Residual Income: the amount of income earned in excess of some predetermined minimum level of return on assets. The higher the residual income of an investment center, the better.

19. Segment Performance and Transfer Pricing • Transfer pricing is needed when segments within the same company sell products or services to one another. • The three approaches to establishing transfer prices are: • Use the market price if it is available. • Base the transfer price on the cost of the product transferred. • Let the buyer and seller negotiate the price.

20. Segment Performance and Transfer Pricing I knew accepting that transfer price would lower my ROI too far! If managers of the separate divisions are evaluated based on profit or other performance measures like ROI or EVA, the transfer price becomes very important.

21. Transfer Price at Market If there is an outside market for the product being transferred between divisions, the transfer price should be based on the market price of the product. However, the buyer and seller must be allowed to go outside if doing so would create a better profit.

22. Transfer Price at Cost If no outside market exists, or when the selling division has excess capacity, transfer prices are often established based on the cost of the product being transferred.

23. Negotiated Transfer Price Transfer prices are negotiated between buyer and seller and end up somewhere between cost and the market price.

24. A General Model for Computing Transfer Prices Minimum Transfer Price = Variable Costs of Producing and Selling + Contribution Margin Lost on Outside Sales

25. Which costs are you responsible for in your budget? End of Chapter 11