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Performance Evaluation for Decentralized

Operations

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Performance Evaluation for Decentralized

Operations

AC239 Seminar 8

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1

Describe the advantages and disadvantages of decentralized operations.

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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.

Decentralized Operations

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1. Allows managers closest to the operations to make decisions

2. Provides excellent training for managers

3. Allows managers to become experts in their area of operation

4. Helps retain managers

5. Improves creativity and customer relations

Advantages of Decentralization

1

Exhibit 1Advantages and Disadvantages of Decentralized Operations

(continued)

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1. Decisions made by managers may negatively affect the profits of the company

2. Duplicates assets and expenses

1

Disadvantages of Decentralization

Exhibit 1Advantages and Disadvantages of Decentralized Operations (continued)

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Responsibility Accounting

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

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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

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The area of responsibility for each center is shown below.

Cost Center Profit Center Investment Center

Cost Revenue– Cost Profit

Revenue– Cost Profit Investment in

assets

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2

Prepare a responsibility accounting report for a cost center.

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Responsibility Accounting for Cost Centers

A cost center manager has responsibility for controlling the costs.

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Cost Centers in a University Exhibit 2

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Responsibility Accounting Reports for Cost Centers

(continued)

Exhibit 3

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from Manager, Plant A Budget Performance Report

(continued)

Responsibility Accounting Reports for Cost Centers (continued)

Exhibit 3

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To Vice President’s Budget Performance Report

from Supervisor, Department 1, Plant A’s Budget Performance Report

(continued)

Responsibility Accounting Reports for Cost Centers (continued)

Exhibit 3

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To Manager, Plant A’s Budget Performance Report

Responsibility Accounting Reports for Cost Centers (concluded)

Exhibit 3

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3

Prepare responsibility accounting reports for a profit center.

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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).

Profit Center

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• Controllable revenues are revenues earned by the profit center.

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

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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.

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Payroll Accounting Department Charges to NEG’s Theme Park and Movie Production Divisions

Exhibit 4

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NEG Example

NEG’s expenses for the year ended Decem-ber 31, 2010 for each service department are as follows:

Purchasing $400,000Payroll Accounting 255,000Legal 250,000 Total $905,000

(continued)

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The activity base for each service depart-ment is a measure of the services performed. For NEG, the following applies:

Purchasing Number of purchaserequisitions

Payroll Accounting Number of payroll checks

Legal Number of billed hours

(continued)

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Purchasing

Theme Park Division 25,000 purchase requisitionsMovie Production Division 15,000Total 40,000 purchase requisitions

$400,00040,000 purchase requisitions

= $10 per purchase requisition

Service Usage

3

(continued)

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Service Usage

Payroll Accounting

Theme Park Division 12,000 payroll checksMovie Production Division 3,000 Total 15,000 payroll checks

$255,00015,000 payroll checks

= $17 per payroll check

(continued)

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Service Usage

Legal

Theme Park Division 100 billed hoursMovie Production Division 900 Total 1,000 billed hours

$250,0001,000 hours

= $250 per hour

(continued)

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Service Department Charges to NEG Divisions

Exhibit 5

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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.

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Divisional Income Statements—NEG Exhibit 6

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4

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

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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.

4

Investment Center

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Exhibit 7 Divisional Income Statements—Datalink Inc.

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Revenues

Revenues

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Investment Turnover

Profit Margin

Profit$$$

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Investment Turnover

Profit Margin

Profit margin is the ratio of income from operations to sales

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Investment turnover is the ratio of sales to invested assets

Investment Turnover

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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.

ROI =

Income from Operations

Invested Assets

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Income from Operations

SalesSales

Invested Assets×ROI =

DuPont Formula

Profit Margin

Profit Margin

Investment Turnover

Investment Turnover

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ROI =$ 70,000

$560,000×

$560,000

$350,000

ROI = 12.5% × 1.6

DataLink’s Northern Division (ROI)

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 20%

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ROI =$ 84,000

$672,000×

$672,000

$700,000

ROI = 12.5% × 0.96

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 12%

DataLink’s Central Division (ROI)

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ROI =$ 75,000

$750,000×

$750,000

$500,000

ROI = 10% × 1.5

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 15%

DataLink’s Southern Division (ROI)

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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.

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Revenues ($560,000 + $56,000) $616,000Operating expenses 385,000Income from operations before

service department charges $231,000Service department charges 154,000Income from operations $ 77,000

Projected Impact of Change

Increase of $7,000

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ROI =$ 77,000

$616,000×

$616,000

$350,000

ROI = 12.5% × 1.76

DataLink’s Northern Division (ROI) Revised

Income from Operations

SalesSales

Invested Assets×ROI =

ROI = 22%

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5

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.

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When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services.

Transfer Pricing

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Three Methods of Transfer Pricing

1. Market price approach

2. Negotiated price approach

3. Cost price approach

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Exhibit 9 Commonly Used Transfer Prices

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Income Statement—No Transfers Between Divisions

Exhibit 10

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Market Price Approach

Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers.

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The negotiated price approach allows the managers of decentralized units to agree (negotiate) among themselves as to the transfer price.

Negotiated Price Approach

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Income Statements—Negotiated Transfer Price Exhibit 11

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Comparison of Exhibits 10 and 11

Income from Operations

No Units Transferred (Exhibit 10)

20,000 Units Transferred at $15 per Unit (Exhibit 11)

Increase (Decrease)

Eastern Division $200,000 $300,000 $100,000Western Division 100,000 200,000 100,000Wilson Company $300,000 $500,000 $200,000

Variable Costs per Unit < Transfer Price < Market Price

$10 < Transfer Price < $20

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Cost Price Approach

Under the cost price approach, cost is used to set transfer prices. Cost may refer to either total product cost per unit or variable cost per unit.

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Any Questions????