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MAS – LECTURE NOTES ARMIN GLENN ARANETA, CPA

DECENTRALIZATION AND PERFORMANCE EVALUATION

RESPONSIBILITY ACCOUNTING
RESPONSIBILITY ACCOUNTING – a system of accounting wherein costs and revenues are
accumulated and reported by levels of responsibility or by responsibility centers within the
organization.
RESPONSIBILITY CENTER
 Also called “accountability center”, a clearly identified part or segment of an
organization that is accountable for a specified function or set of activities.
 Any part of the organization that a particular manager is responsible for
TYPES OF RESPONSIBILITY CENTERS:
a) Cost Center (or expense center) – a segment of an organization in which managers are
held responsible for the costs or expenses incurred in the segment. (e.g. Maintenance
Department)
b) Revenue Center – where management is responsible primarily for revenues. (e.g. Sales
Department)
c) Profit Center – a segment of the organization in which the manager is held responsible
for both revenue and costs. (e.g. Branches)
d) Investment Center – a segment of the organization where the manager controls
revenues, costs, and investments. The center’s performance is measured in terms of the
use of the assets as well as the revenues earned and the costs incurred.
e) Service Center – usually operated as a cost center.
ORGANIZATIONAL STRUCTURES:
1) Centralized Organization – top management makes most decisions and controls most
activities of the organizational segments from the firm’s central office.
2) Decentralized Organization – there is employee empowerment; top management grants
subordinate managers a significant degree of autonomy and independence in operating
and making decisions relating to their sphere of responsibility.
 A responsibility accounting system works best in a decentralized organization.
CLASSIFICATIONS OF COSTS IN RESPONSIBILITY ACCOUNTING:
1) By responsibility center
2) By cost type, as to controllability
3) By specified cost items or cost elements within each classification in (1) and (2).
RESPONSIBILITY VS ACCOUNTABILITY
Responsibility has two facets, (1) the obligation to secure results, and (2) the obligation to report
back the results achieved to higher authority.
Accountability denotes the obligation to report results achieved to higher authority.

THE CONCEPT OF DECENTRALIZATION

Decentralization – refers to the separation or division of the organization into more manageable
units wherein each unit is managed by an individual who is given decision authority and held
accountable for his decisions.
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 Goal congruence – all members of an organization have incentives to perform for a

common interest.
 Sub-optimization – occurs when one segment of a company takes action that is in its own
best interests, but is detrimental to the firm as a whole.

BENEFITS OF DECENTRALIZATION:
1. Better access to local information
2. Cognitive limitations
3. More timely response
4. Focusing of central management
5. Training and evaluation
6. Motivation
7. Enhanced competition
COSTS OF DECENTRALIZATION:
1. Some decisions made in one sub-unit may bring about negative effect to the other sub-
units or the organization as a whole.
2. Decentralization necessitates a more elaborate reporting system hence, the costs off
gathering and reporting of data is increase.
3. Job duplication or overlapping of functions is usually encountered in a decentralized set-
up.

PERFORMANCE EVALUATION
Performance measures for investment centers usually attempt to assess how well managers are
utilizing invested assets of the division to produce profits by relating operating profits to assets.

Return on Investment (ROI) is the most common measure of performance for investment
centers. ROI can be defined as follows:

ROI = Operating Income

Average Operating Assets

Operating income refers to earnings before interest and taxes. Operating assets include all assets
acquired to generate operating income, including cash, receivables, inventories, land, buildings,
and equipment.

The ROI formula can also be broken down into the product of margin and turnover. Margin is
the ratio of operating income to sales. Turnover is defined as sales divided by average operating
assets.

ROI = Margin x Turnover

or
ROI = Operating Income x Sales
Sales Average Operating Assets

Three advantages of using ROI to evaluate the performance of investment centers:

1. It encourages managers to pay careful attention to the relationships among sales,
expenses, and investment, as should be the case for a manager of an investment center.
2. It encourages cost efficiency.
3. It discourages excessive investment in operating assets.
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Two disadvantages of using ROI are:

1. It discourages managers from investing in projects that would decrease the divisional
ROI but would increase the profitability of the company as a whole. (Generally, projects
with an ROI less than a division’s current ROI would be rejected.)
2. It can encourage myopic behavior, in that managers may focus on the short run at the
expense of the long run.

Residual Income (RI) – the difference between the operating income and the minimum peso
return required on a company’s operating assets. The equation for RI can be expressed as
follows:
RI = Operating Income - (Minimum Rate of Return x Operating Assets)
or
= Expected Income - (Investment x Desired Rate of Return)
! Desired Rate of Return is usually the cost of capital.
ECONOMIC VALUE ADDED (EVA) – a more specific version of residual income. It
represents the segment’s true economic profit because it measures the benefit obtained by using
resources in a particular way.
After-tax operating income
(EBIT x[1 – Tax Rate]) xx
Less: Desired Income
(After-tax WACC x [Total assets – Non-interest-bearing Current liabilities]) xx
Economic value added (EVA) xx

TRANSFER PRICING
TRANSFER PRICE – the monetary value or the price charged by one segment of a firm for the
goods and services it supplies to another segment of the same firm.
OBJECTIVES OF TRANSFER PRICING:
1. To facilitate optimal decision-making.
2. To provide a basis in measuring divisional performance.
3. To motivate the different department heads in improving their performance and that of
their departments.
APPROACHES FOR DETERMINING TRANSFER PRICE:
1. Negotiated transfer price
2. Cost-based transfer price
3. Market-based transfer price
General Rules in Choosing a Transfer Price:
 The maximum price should be no greater than the lowest market price at which the
buying segment can acquire the goods or services externally.
 The minimum price should be no less than the sum of the selling segment’s incremental
costs associated with the goods or services plus the opportunity cost of the facilities used.
 A good should be transferred internally whenever the minimum transfer price (set by the
selling division) is less than the maximum transfer price (set by the buying division). By
using this rule, total profits of the firm are not decreased by an internal transfer.

BALANCED SCORECARD
BALANCED SCORECARD – is a strategic management system that defines a strategic-based
responsibility accounting system.
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Strategy is defined as choosing the market and customer segments the business unit intends to
serve, identifying the critical internal and business processes that the unit must excel at to deliver
the value propositions to customers in the targeted market segments, and selecting the individual
and organizational capabilities required for the internal, customer, and financial objectives.
The Balanced Scorecard translates an organization’s mission and strategy into operational
objectives and performance measures for four different perspectives:

1) Financial Perspective – establishes the long and short-term financial performance

objectives. It is concerned with the global financial consequences of the other three
perspectives.
2) Customer Perspective – is the source of the revenue component for the financial
objectives. The perspective defines and selects the customer and market segments in
which the company chooses to compete.
3) Internal Business Process Perspective – describes the internal process that will provide
value for the firm’s customers and owners.
Cycle time is the time required to produce one unit of product.
Velocity is the number of units that can be produced in a given period of time.
4) Learning and Growth Perspective – is the source of the capabilities that enable the
accomplishment of the other three perspectives’ objectives.

Common Characteristics of Balanced Scorecards:

a) It should be possible, by examining a company’s balanced scorecard, to infer its strategy
and the assumptions underlying that strategy.
b) The balanced scorecard should emphasize continuous improvement rather than just
meeting present standards or targets.
c) Some of the performance measures on the balanced scorecard should be non-financial.
d) The scorecards for individuals should contain only those performance measures they can
actually influence.
e) The ultimate objectives of the organization are usually financial, but better financial
results cannot be attained without improving customers’ perceptions of the company’s
products and services. In order to improve customers’ perceptions of products and
services, it is usually necessary to improve internal business processes so that the
products and services are actually better. And in order to improve the business processes,
it is necessary that employees learn.
SOME INTERNAL BUSINESS PROCESS PERFORMANCE MEASURES
1. Delivery Cycle Time. This is the total elapsed time between when an order is placed by a
customer and when it is shipped to the customer. Part of this time is wait time that occurs before
the order is placed into production.
2. Throughput (Manufacturing Cycle) Time. This is the total elapsed time between when an
order is initiated into production and when it is shipped to the customer. It consists of process
time, inspection time, move time, and queue time.
 Process time – amount of time in which work is actually done on the product.
 Inspection time – amount of time spent to check if the product is not defective.
 Move time – time required to move materials and work in process from one workstation
to another.
 Queue time – amount of time a product spends waiting to be processed, moved,
inspected, and shipped.
3. Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time to the total
throughput time. It represents the percentage of time an order is in production in which useful
work is being done.
MCE = Process time
Throughput time
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QUALITY COST MEASUREMENT

Quality-linked activities are those activities performed because poor quality may or does exist.
Cost of quality are costs that exist because poor quality may or does exist.
Control activities are performed by an organization to prevent or detect poor quality. Control
costs are the costs of performing control activities. There are two broad categories of control
costs: prevention costs and appraisal costs. Prevention costs are incurred to prevent poor quality
in the products or services being produced. Appraisal costs are incurred to determine whether
products and services are conforming to their requirements or customer needs.
Failure activities are performed by an organization or its customers in response to poor quality.
Failure costs are the costs incurred by an organization because failure activities are performed.
There are two broad categories of failure costs: internal failure costs and external failure costs.
Internal failure costs are incurred because products and services do not conform to specifications
or customer needs and the nonconformance is detected prior to being delivered to outside parties.
External failure costs are incurred because products and services fail to conform to requirements
or satisfy customer needs and the nonconformance is detected after being delivered to outside
parties.
PRODUCTIVITY MEASUREMENT
Productivity – measures the relationship between actual inputs used (both quantities and costs)
and actual outputs produced.
Productivity Ratio = Quantity of output produced
Quantity of input used
Partial Productivity – compares the quantity of output produced with the quantity of an
individual input used.
Total factor Productivity – the ratio of quantity of output produced to the costs of all inputs
used based on current period prices.

Total factor productivity = Quantity of output produced

Costs of all inputs used
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Practice Problems:
1. Selected sales and operating data for three divisions of different accounting firms are given as
follows:

Division 1 Division 2
Division 3
Sales P12, 000, 000 P14, 000, 000 P25, 000, 000
Average operating assets 3, 000, 000 7, 000, 000 5, 000, 000
Net operating income 600, 000 560, 000 800, 000
Minimum required rate of return 14% 10% 16%
Required:
1) Compute the return on investment (ROI) for each division.
2) Compute the residual income for each division.
3) Assume that each division is presented with an investment opportunity that would yield a
15% rate of return.
a) If performance is being measured by ROI, which division or divisions will
probably accept the opportunity? Reject? Why?
b) If performance is being measured by residual income, which division or divisions
will probably accept the opportunity? Reject? Why?

2. Silver Auto Company operates a new car division (that sells high performance sports car) and
a performance parts division (that sells performance improvement parts for family cars).
Some division financial measures for 2013 are as follows:
New Car Division Performance Parts Division
Total assets P33, 000, 000 P28, 500, 000
Current liabilities 6, 600, 000 8, 400, 000
Operating income 2, 475, 000 2, 565, 000
Required rate of return 12% 12%
Silver Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a
market value of P18, 000, 000 at an interest rate of 10%, and equity capital with a market value
of P12, 000, 000 and a cost of equity of 15%.
Required: Applying the same weighted-average cost of capital (WACC) to each division,
calculate EVA for each division.

3. Roronoa Company has two divisions with headquarters in Manila and Nueva Ecija. Selected
data on the two divisions follow:

Manila Nueva Ecija

Sales P 3, 600, 000 P 10, 800, 000
Net operating income 252, 000 864, 000
Average operating assets 1, 200, 000 4, 800, 000

Requirements:

1. For each division, compute the return on investment (ROI) in terms of margin and
turnover.
2. Assume that the company evaluates performance by use of residual income and that
the minimum required return for any division is 16%. Compute the residual income for
each division.
3. Is Nueva Ecija’s greater amount of residual income an indication that it is better
managed?
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4. Division One of Leo Company is currently operating at 80% of capacity. It produces a single
product and sells all its production to outside customers for P150 per unit. Variable cost is P50
per unit and fixed cost is P400, 000 at the current production level.

Division Two, which currently buys the same product from an outside supplier for P120 per unit,
would like to buy the product from Division One.

Division One will use 60% of its idle capacity if it decided to provide the requirements of
Division Two.

Required:

1. What is the minimum price that Division One should charge Division Two for this
product?
2. What is the maximum price that Division Two will be willing to pay for the product if it
will be purchased internally?

3. Assume that Division One is currently operating at 100% of capacity. What is the
minimum price that Division One should charge Division Two for this product? If left
free to negotiate without interference, would you expect the Division managers to
voluntarily agree to the transfer of the units? Why or why not?

5. Ang Puso Ko’y Nalilito Corporation has a production division which is currently
manufacturing 120, 000 units but has a capacity of 180, 000 units. The variable cost of the
product is P22 per unit, and the total fixed cost is P720, 000 of P6 per unit based on current
production.

The Purchasing Division of the Corporation offers to buy 40, 000 units form the Production
Division at P21 per unit. The Production Division manager refuses the order because the price is
below the variable cost. The Buyer Division manager argues that the order should be accepted
since by taking the order, the Production Division manager can lower the fixed cost per unit from
P6 to P4.50. (Output will increase to 160, 000 units.) this decrease of P1.50 in fixed cost per unit
will more than offset the P1 difference between the variable cost and transfer price.

Requirements:

a. If you were the Production Division manager, would you accept the Buyer Division
manager’s argument? Why or why not? (Assume that the 120, 000 units currently being
produced sell for P30 per unit in the external market.)

b. From the viewpoint of the Corporation, should the order be accepted if the manager of
the Buyer Division intends to sell each unit to the outside market for P27 after incurring
an additional processing cost of P2.25 per unit? Explain.

6. Cute Company’s manager would like to reduce the amount of time between when a customer
places an order and when the order is shipped. For the first quarter of operations during the
current year, the following data were reported:

Inspection time 0.3 day

Wait time (from order to start of production) 14 days
Process time 2.7 days
Move time 1.0 day
Queue time 5.0 days
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Requirements:

1. Compute the throughput time.

2. Compute the manufacturing cycle efficiency (MCE) for the quarter.
3. What percentage of the throughput time was spent to non-value-added activities?
4. Compute the delivery cycle time.
5. If by using Lean Production, all queue time during production is eliminated, what will
be the new MCE?

7. Classify each of the following performance measures to one or more of the four perspectives
of the balanced scorecard.

Performance Measures:

1. Throughput time
2. Economic value added
3. Employee productivity
4. Percentage of peso sales invested in employee training
5. Ratings of supplier performance
6. Increase in market share
7. Employee retention
8. On-time delivery performance to customers
9. Product quality
10. Residual income

8. Classify the following costs as prevention, appraisal, internal failure, external failure or as not
a cost of quality.

1. Product testing
2. Product recalls
3. Rework labor and overhead
4. Quality circles
5. Downtime caused by defects
6. Cost of field servicing
7. Inspection of goods.
8. Quality engineering
9. Warranty repairs
10. Statistical process control
11. Net cost of scrap
12. Depreciation of test equipment
13. Returns and allowances arising from poor quality
14. Disposal of defective products
15. Technical support to suppliers
16. Systems development
17. Warranty replacement
18. Field testing at customer site
19. Product design
20. Processing and responding to consumer complaints

“Life’s challenges are not supposed to paralyze you; they’re supposed to help you discover
who you are.”
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