0 CHAPTER 13 Decentralization and Performance Evaluation © 2009 Cengage Learning.

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CHAPTER 13

Decentralization and Performance Evaluation

© 2009 Cengage Learning

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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

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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.

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•Segment

•Any activity or part of the business for which a manager needs cost, revenue, or profit data

•Can be a branch, division, department, or individual product

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•Advantages of Decentralization

•Those closest to the problem are more familiar with the problem

•Higher job satisfaction of managers

•Managers receive on-the-job training, making them better managers

•Decisions are often made in a more timely fashion

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•Disadvantages of Decentralization

•Decision making spread among too many managers, causing a lack of company focus•Managers make decisions benefiting their own segment, not always in the best interests of the company•Managers not adequately trained in decision making at early stages of their careers•Lack of coordination and communication between segments•May result in duplicative costs/efforts

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Responsibility Accounting and

Segment Reporting

The key to effective decision making in a decentralized organization is responsibility accounting—holding managers responsible for only those things under their control.

Key Concept

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Cost, Revenue, Profit, and Investment Centers

•Cost Center

•The manager has control over costs but not over revenue or capital investment decisions.

•Example: Human Resources Manager

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•Revenue Center

•The manager has control over the generation of revenue but not costs.

•Example: Sales Manager of a retail store

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•Profit Center

•The manager has control over both cost and revenue but not capital investment decisions.

•Example: Manager of a particular location of a hotel chain

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•Investment Center

•The manager is responsible for the amount of capital invested in generating income.

It is, in essence, a separate business with its own value chain.

•Investment centers are often called strategic business units (SBUs)

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Profit Center Performance and Segmented Income

Statements

Segmented Income Statements calculate income for each major segment of an organization in addition to the company as a whole.

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The Segmented Income Statement

Client billings

Less: Variable expense

Contribution margin

Less: Traceable fixed

Segment margin

Less: Common fixed

Net income

Total Firm

$1,000,000

400,000

$600,000

200,000

$400,000

200,000

$200,000

Tax Dept.

$500,000

200,000

$300,000

100,000

$200,000

Audit Dept.

$400,000

160,000

$240,000

75,000

$165,000

Consulting Dept.

$100,000

40,000

$60,000

25,000

$35,000

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Client billings

Less: Variable expense

Contribution margin

Less: Traceable fixed

Divisional segment margin

Less: Common fixed

Departmental segment margin

Tax Dept.

$500,000

200,000

$300,000

80,000

$220,000

20,000

$200,000

Individual Tax

Division

$100,000

80,000

$20,000

30,000

$(10,000)

Business Tax

Division

$400,000

120,000

$280,000

50,000

$230,000

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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.

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The segment margin of the individual tax division is negative. In the long run, the individual tax

division is not profitable.Before the firm decides to

eliminate the individual tax division, what other quantitative and qualitative factors should it

consider?

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Segment Performance and ABC

ABC can affect the classification of costs as traceable or common.When ABC is used, batch-level and product-level activities and costs are driven by factors such as the number of setups, parts, customer orders, supervision hours, etc.

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Investment Centers and Measures of

Performance

Evaluating investment centers requires focusing on the level of investment required in generating a segment’s profit.

Key Concept

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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.

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Investment Centers and Measures of Performance

•Does the manager of a local branch of a national bank likely manage a profit center or an investment center?•What about the manager of the local Pizza Hut?•What about the manager of an independent pizza restaurant or clothing store who is also the owner of that store?

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Return on Investment (ROI)

ROI measures the rate of return generated by an investment center’s assets.ROI = Margin X TurnoverMargin = Net Operating Income /SalesTurnover = Sales/Average Operating AssetsROI =ROI =

Net Operating Income SalesNet Operating Income Sales

Sales Sales Average Operating Average Operating AssetsAssets

XX

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Net Operating Income: Income before interest and taxesOperating Assets: Cash, accounts receivable, inventory, and property, plant, and equipment

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•Increase sales revenue

•Reduce operating costs

•Reduce investment in operating assets

What do I need to do to increase my ROI?

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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?

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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?

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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?

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Residual Income

Residual Income The amount of income earned in excess of a predetermined minimum rate of return on assets. All things equal, the higher the residual income of an investment center, the better.

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Residual Income

RI = Net Operating Income - ( Average Operating Assets X Minimum Required Rate of Return)

If net income is $60,500, average operating assets are $100,000, and the required ROI is 20%, what is the RI?

RI = $60,500 - ($100,000 X .20)RI = $40,500

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Economic Value Added (EVA)

•EVA tells management whether shareholder wealth is being created by focusing on whether after-tax profits are greater than the cost of capital.

•Economic value added = After-tax operating profit – [(Total assets - Current liabilities) x Weighted average cost of capital)]

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Economic Value Added (EVA)

How is EVA different from residual income?

1. EVA is based on after-tax operating profit.2. Assets are often shown net of current liabilities.3. Companies may modify income and asset measurements based on GAAP.4. EVA considers the actual cost of capital, both debt and equity, instead of a minimum rate of return.

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Performance and Management

Compensation Decisions• Measuring the performance of a

segment is not always the same as measuring the performance of the manager of that segment

• Measuring the performance of the manager should be based on variables the manager controls (responsibility accounting)

Incentive structure can include Cash and bonuses Stock-based compensation

including stock options Noncash benefits and

perquisites (perks)

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Performance and Management Compensation

Decisions

In order to motivate managers and ensure goal congruence, the compensation of managers should be linked to performance and based on a combination of short-term and long-term goals.

Key Concept

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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:

1. Use the market price if it is available.

2. Base the transfer price on the cost of the product transferred.

3. Let the buyer and seller negotiate the price.

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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.

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Transfer Price at Cost

•If no outside market exists, or when the selling division has excess capacity, transfer prices are often based on the cost of the product being transferred.

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Negotiated Transfer Price

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

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A General Model for Computing Transfer Prices

Minimum Transfer Price =Variable Costs of Producing and Selling +Contribution Margin Lost on Outside Sales

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A General Model for Computing Transfer

Prices

The transfer price that provides the most benefit to the company as a whole is the one that should be chosen.

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International Aspects of Transfer Pricing

•When international divisions are involved, the focus of transfer pricing centers on minimizing taxes, duties, and foreign exchange risks.•Managers must also be aware and sensitive to geographic, political, and economic circumstances in the

environment in which they operate.

0 CHAPTER 13 Decentralization and Performance Evaluation © 2009 Cengage Learning.

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