Chapter 10 Decentralization Chapter 10: Decentralization.

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© The McGraw-Hill Companies, Inc., 2 McGraw-Hill /Irwin Decentralization Chapter 10

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Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. A decentralized organization does not confine decision-making authority to a few top executives; rather, decision-making authority is spread throughout the organization. The advantages of decentralization are as follows:   It enables top management to concentrate on strategy, higher-level decision-making, and coordinating activities. It acknowledges that lower-level managers have more detailed information about local conditions that enable them to make better operational decisions. It enables lower-level managers to quickly respond to customers. It provides lower-level managers with the decision-making experience they will need when promoted to higher level positions. It often increases motivation, resulting in increased job satisfaction and retention, as well as improved performance. Lower-level decision often based on better information. Lower-level managers can respond quickly to customers.

Transcript of Chapter 10 Decentralization Chapter 10: Decentralization.

Page 1: Chapter 10 Decentralization Chapter 10: Decentralization.

© The McGraw-Hill Companies, Inc., 2007McGraw-Hill /Irwin

Decentralization

Chapter 10

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Decentralization in Organizations

Benefits ofDecentralization Top management

freed to concentrateon strategy.

Lower-level managersgain experience indecision-making. Decision-making

authority leads tojob satisfaction.Lower-level decision

often based onbetter information.

Lower-level managers can respond quickly to

customers.

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Decentralization in Organizations

Disadvantages ofDecentralization

Lower-level managersmay make decisionswithout seeing the

“big picture.”

May be a lack ofcoordination among

autonomousmanagers.

Lower-level manager’sobjectives may not

be those of theorganization. May be difficult to

spread innovative ideasin the organization.

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Cost, Profit, and Investments Centers

ResponsibilityCenter

CostCenter

ProfitCenter

InvestmentCenter

Cost, profit,and investmentcenters are allknown asresponsibilitycenters.

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Cost Center A segment whose manager has control over costs, but not

over revenuesor investment funds.

Cost, Profit, and Investments Centers

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Profit Center A segment whose manager has control over both costs and

revenues, but no control over

investment funds.

RevenuesSalesInterestOther

CostsMfg. costsCommissionsSalariesOther

Cost, Profit, and Investments Centers

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Investment Center A segment whose manager has control over costs, revenues,

and investments in operating assets.

Corporate Headquarters

Cost, Profit, and Investments Centers

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Responsibility Centers

Salty SnacksProduct M anager

Bottling P lantM anager

W arehouseM anager

DistributionM anager

BeveragesProduct M anager

ConfectionsProduct M anager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Cost Centers

Investment Centers

Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an

organization.

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Responsibility Centers

Salty SnacksProduct M anager

Bottling P lantM anager

W arehouseM anager

DistributionM anager

BeveragesProduct M anager

ConfectionsProduct M anager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Profit Centers

Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an

organization.

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Responsibility Centers

Salty SnacksProduct M anager

Bottling P lantM anager

W arehouseM anager

DistributionM anager

BeveragesProduct M anager

ConfectionsProduct M anager

OperationsVice President

FinanceChief FInancial Officer

LegalGeneral Counsel

PersonnelVice President

Superior Foods CorporationCorporate Headquarters

President and CEO

Cost Centers

Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an

organization.

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A segmentsegment is any part or activity of an organization about which a manager

seeks cost, revenue, or profit data. A segment

can be . . .

A Sales Territory

A Service Center

An Individual StoreQuick Mart

Decentralization and Segment Reporting

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Traceable and Common Fixed Costs

In segment reports, traceablefixed costs should be distinguished

from common fixed costs.Tr

acea

ble

Common

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Traceable costs arise because of the existence of a particular segment and would disappear over

time if the segment itself disappeared.

No computer No computer division means . . .division means . . .

No computerNo computerdivision manager.division manager.

Identifying Traceable Fixed Costs

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Common costs arise because of the overall operation of the company and would not disappear

if any particular segment were eliminated.

No computer No computer division but . . .division but . . .

We still have aWe still have acompany president.company president.

Identifying Common Fixed Costs

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Learning Objective

To compute the returnon investment (ROI)

and show how changes in sales, expenses, and

assets affect anorganization’s ROI.

LO1

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ROI = ROI = Net operating incomeNet operating incomeAverage operating assets Average operating assets

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Income before interestand taxes (EBIT)

Return on Investment (ROI) Formula

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Net Book Value vs. Gross Cost

Most companies use the net book value of depreciable assets to calculate average

operating assets.

Acquisition costLess: Accumulated depreciationNet book value

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ROI = ROI = Net operating incomeNet operating incomeAverage operating assets Average operating assets

Margin = Margin = Net operating incomeNet operating incomeSales Sales

ROI = ROI = Margin Margin Turnover Turnover

Return on Investment (ROI) Formula

Turnover = Turnover = SalesSalesAverage operating assets Average operating assets

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There are three ways to increase ROI . . .There are three ways to increase ROI . . .

IncreaseIncreaseSalesSales

ReduceReduceExpensesExpenses ReduceReduce

AssetsAssets

Increasing ROI

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Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000 Average operating assets $ 200,000Average operating assets $ 200,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 470,000Operating expenses $ 470,000

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

What is Regal Company’s ROI?

Increasing ROI – An Example

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$30,000 $500,000 × $500,000

$200,000ROI =

6% 6% 2.5 = 15% 2.5 = 15%ROI =

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

Increasing ROI – An Example

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Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000.

Regal’s net operating income increased to $42,000.

There was no change in the average operating assets of the segment.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Increasing Sales Without anIncrease in Operating Assets

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$42,000 $600,000 × $600,000

$200,000ROI =

7% 7% 3.0 = 21% 3.0 = 21%ROI =

ROI increased from 15% to 21%.

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

Increasing Sales Without anIncrease in Operating Assets

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Decreasing Operating Expenses with no Change in Sales or Operating Assets

Assume that Regal’s manager was able to reduce operating expenses by $10,000 without

affecting sales or operating assets. This would increase net operating income to $40,000.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Regal Company reports the following:Regal Company reports the following: Net operating income $ 40,000Net operating income $ 40,000 Average operating assets $ 200,000Average operating assets $ 200,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 460,000Operating expenses $ 460,000

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Decreasing Operating Expenses with no Change in Sales or Operating Assets

$40,000 $500,000 × $500,000

$200,000ROI =

8% 8% 2.5 = 20% 2.5 = 20%ROI =

ROI increased from 15% to 20%.

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

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Decreasing Operating Assets with no Change in Sales or Operating ExpensesAssume that Regal’s manager was able to reduce

inventories by $20,000 using just-in-time techniques without affecting sales or operating

expenses.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000 Average operating assets $ 180,000Average operating assets $ 180,000 Sales $ 500,000Sales $ 500,000 Operating expenses $ 470,000Operating expenses $ 470,000

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Decreasing Operating Assets with no Change in Sales or Operating Expenses

$30,000 $500,000 × $500,000

$180,000ROI =

6% 6% 2.777 = 16.66% 2.777 = 16.66%ROI =

ROI increased from 15% to 16.66%.

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

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Investing in OperatingAssets to Increase Sales

Assume that Regal’s manager invests in a $30,000 piece of equipment that increases

sales by $35,000 while increasing operating expenses by $15,000.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Regal Company reports the following:Regal Company reports the following: Net operating income $ 50,000Net operating income $ 50,000 Average operating assets $ 230,000Average operating assets $ 230,000 Sales $ 535,000Sales $ 535,000 Operating expenses $ 485,000Operating expenses $ 485,000

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$50,000 $535,000 × $535,000

$230,000ROI =

9.35% 9.35% 2.33 = 21.8% 2.33 = 21.8%ROI =

ROI increased from 15% to 21.8%.

ROI = ROI = Margin Margin Turnover Turnover Net operating income Sales

Sales Average operating assets×ROI =

Investing in OperatingAssets to Increase Sales

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ROI and the Balanced Scorecard

It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is

consistent with the company’s strategy. A well constructed balanced scorecard can provide managers with a road map that

indicates how the company intends to increase ROI.

Which internal business process should be

improved?

Which customers should be targeted and how will

they be attracted and retained at a profit?

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In the absence of the balancedscorecard, management may

not know how to increase ROI.

Managers often inherit manycommitted costs over which

they have no control.

Managers evaluated on ROImay reject profitable

investment opportunities.

Criticisms of ROI

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Learning Objective

To compute residualincome and understand

the strengths andweaknesses of this methodof measuring performance.

LO2

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Net operating incomeabove some minimum

return on operatingassets

Residual Income – AnotherMeasure of Performance

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Calculating Residual Income

Residual income =

Net operating income

-Average

operating assets

Minimum

required rate of return( )

This computation differs from ROI.

ROI measures net operating income earned relative to the investment in average operating assets.

Residual income measures net operatingincome earned less the minimum required

return on average operating assets.

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The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets.

In the current period the division earns $30,000.

Let’s calculate residual income.Let’s calculate residual income.

Residual Income – An Example

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Operating assets 100,000$ Required rate of return × 20%Minimum required return 20,000$

Actual income 30,000$ Minimum required return (20,000) Residual income 10,000$

Residual Income – An Example

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Residual income encourages managers to Residual income encourages managers to make profitable investments that wouldmake profitable investments that would

be rejected by managers using ROI.be rejected by managers using ROI.

Motivation and Residual Income

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Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?a. 25%b. 5%c. 15%d. 20%

Quick Check

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Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?a. 25%b. 5%c. 15%d. 20%

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%

Quick Check

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Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

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Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

ROI = $78,000/$400,000 = 19.5%

This lowers the division’s ROI from 20.0% down to 19.5%.

Quick Check

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The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

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The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

ROI = $18,000/$100,000 = 18%

The return on the investment exceeds the minimum required rate of return.

Quick Check

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Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?a. $240,000b. $ 45,000c. $ 15,000d. $ 51,000

Quick Check

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Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?a. $240,000b. $ 45,000c. $ 15,000d. $ 51,000

Net operating income $60,000Required return (15% of $300,000) $45,000Residual income $15,000

Quick Check

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If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Quick Check

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If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?a. Yesb. No

Net operating income $78,000Required return (15% of $400,000) 60,000Residual income $18,000 Residual income increases $3,000.

Quick Check

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Divisional Comparisonsand Residual Income

The residual income approach

has one major disadvantage.

It cannot be usedto compare

performance of divisions of

different sizes.

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Zepher, Inc. - Continued

Retail WholesaleOperating assets 100,000$ 1,000,000$ Required rate of return × 20% 20%Minimum required return 20,000$ 200,000$

Retail WholesaleActual income 30,000$ 220,000$ Minimum required return (20,000) (200,000) Residual income 10,000$ 20,000$

Recall the following information for the Retail Division of Zepher, Inc.

Assume the following information for the Wholesale

Division of Zepher, Inc.

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Zepher, Inc. - Continued

Retail WholesaleOperating assets 100,000$ 1,000,000$ Required rate of return × 20% 20%Minimum required return 20,000$ 200,000$

Retail WholesaleActual income 30,000$ 220,000$ Minimum required return (20,000) (200,000) Residual income 10,000$ 20,000$

The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the

Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the

Retail Division simply because it is a bigger division.

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Transfer Prices – Key Concepts/Definitions

A transfer price is the price charged when one segment of a company provides goods or

services to another segment of the company.

The fundamental objective in setting transfer prices is to

motivate managers to act in the best interests of the overall

company.

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There are three primary approaches to setting

transfer prices:

1. Negotiated transfer prices

2. Transfers at the cost to the selling division

3. Transfers at market price

Transfer Prices – Key Concepts/Definitions

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End of Chapter 10