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CHAPTER

Performance
Evaluation in
the
Decentralized
Firm

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Objectives
1. Define responsibility
accounting,
After studying
this and
describe fourchapter,
types ofyou
responsibility
centers.
should
2. Tell why firms choose
decentralize.
be abletoto:
3. Compute and explain return on investment
(ROI) and economic value added (EVA).
4. Discuss methods of evaluating and rewarding
managerial performance.
5. Explain the role of transfer pricing in a
decentralized firm.

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Responsibility accounting is a system that


measures the results of each responsibility
center according to the information managers
need to operate their centers.

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Types of Responsibility Centers


Cost center: A responsibility center in
which a manager is responsible only
for costs.
Revenue center: A responsibility center
in which a manager is responsible only
for sales.
Continued

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Types of Responsibility Centers


Profit center: A responsibility center in
which a manager is responsible for
both revenues and costs.
Investment center: A responsibility
center in which a manager is
responsible for revenues, costs, and
investments.

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ACCOUNTING INFORMATION USED TO MEASURE


PERFORMANCE

Cost

Cost center

Sales

Capital
Investment

Other

Revenue center Direct cost


only

Profit center

Investment center

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Reasons for Decentralization


1. Ease of gathering and using local
information
2. Focusing of central management

3. Training and motivating segment


managers
4. Enhanced competition, exposing segments
to market forces

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Return on Investment
Operating income
ROI =
Average operating assets
Beginning net book value +
Ending net book value
2

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Comparison of ROI
Electronics
Divisions

Medical Supplies
Divisions

2003:
Sales
$30,000,000
Operating income
1,800,000
Average operating assets 10,000,000
ROI
18 %

$1,800,000
$10,000,000

$117,00,000
3,510,000
19,500,000
18%

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Comparison of ROI
Electronics
Divisions

Medical Supplies
Divisions

2004:
Sales
$40,000,000
Operating income
2,000,000
Average operating assets 10,000,000
ROI
20 %

$2,000,000
$10,000,000

$117,00,000
2,925,000
19,500,000
15%

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Margin and Turnover


ROI = Margin x Turnover

Operating Income Sales


Sales
Average operating assets

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MARGIN AND TURNOVER COMPARISONS


Electronics
Division
2003

Margin
Turnover
ROI

6.0%
x 3.0
18.0%

Medical Supplies
Division

2004

2003

2004

5.0%
x 4.0
20.0%

3.0%
x 6.0
18.0%

2.5%
x 6.0
15.0%

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Advantages of ROI
1. It encourages managers to

focus on the relationship


among sales, expenses, and
investments.
2. It encourages managers to
focus on cost efficiency.
3. It encourages managers to
focus on operating asset
efficiency.

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Disadvantages of ROI
1) It can produce a narrow

focus on divisional
profitability at the expense
of profitability for the
overall firm.
2) It encourages managers to

focus on the short run at the


expense of the long run.

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Economic value added (EVA) is aftertax operating profit minus the total
annual cost of capital.

EVA = After-tax operating income (Weighted


average cost of capital x Total capital
employed)

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There are two steps involved in


computing cost of capital:

1. Determine the
weighted average cost
of capital (a
percentage figure)
2. Determine the total
dollar amount of
capital employed

Weighted Average Cost of Capital

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Suppose that a company has two sources of


financing: $2 million of long-term bonds paying
9 percent interest and $6 million of common
stock, which is considered to be of average risk.
If the companys tax rate is 40 percent and the
rate of interest on long-term government bonds
is 6 percent, the companys weighted average
cost of capital is computed as follows:

Weighted Average Cost of Capital


Amount

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Percent x After-Tax Cost = Weighted Cost

Bonds $2,000,000

0.25

0.009(1 0.4) = .054

0.0135

Equity 6,000,000

0.75

0.06 + 0.06 = .120

0.0900

Total $8,000,000

0.1035

Thus, the companys


weighted average is
10.35 percent.

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EVA Example
Suppose that Mahalo, Inc., had after-tax
operating income last year of $900,000. Three
sources of financing were used by the company:
$2 million of mortgage bonds paying 8 percent
interest, $3 million of unsecured bonds paying
10 percent interest, and $10 million in common
stock, which was considered to be no more or
less risky than other stocks. Mahalo, Inc. pays
a marginal tax rate of 40 percent.

Weighted Average Cost of Capital


Amount

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Weighted
Percent x After-Tax Cost = Cost

Mortgage
bonds $ 2,000,000
0.133
Unsecured
bonds
3,000,000
0.200
Common
stock
10,000,000
0.667
Total
$15,000,000
Weighted average cost of capital

0.048

0.006

0.060

0.012

0.120

0.080
0.098

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EVA Example
Mahalos EVA is calculated as follows:
After tax operating income
Less: Cost of capital

EVA

$900,000
784,000

$116,000

Behavioral Aspects of EVA


A number of companies have discovered that
EVA helps to encourage the right kind of
behavior from their divisions in a way that
emphasis on operating income alone cannot.
The underlying reason is EVAs reliance on the
true cost of capital.

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Behavioral Aspects of EVA


In many companies, the responsibility for
investment decisions rests with corporate
management. As a result, the cost of capital is
considered a corporate expense. If a division
builds inventories and investment, the cost of
financing that investment is passed along to the
overall income statement and does not show up
as a reduction from the divisions operating
income.

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Incentive Pay for Managers


Why would managers not provide good service?
There are three reasons:
1. They may have low ability
2. They may prefer not to work as hard as
needed
3. They may prefer to spend company resources
on perquisites

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Incentive Pay for Managers


Perquisites are a type of fringe benefit given
to managers over and above a salary.
A nice office
Use of a company car or jet
Expense accounts
Paid country club memberships

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Transfer Pricing
The value of a
transferred good is
revenue to the selling
division and cost to the
buying division. This
value is called transfer
pricing.

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Transfer Pricing
Transfer pricing affects both transferring divisions
and the firm as a whole through its impact on-(1) divisional performance measures
(2) firmwide profits

(3) divisional autonomy

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Opportunity Cost Approach


This approach identifies the minimum and
maximum price that a selling division would be
willing to accept and the maximum price that a
buying division would be willing to pay.
minimum transfer price is the transfer price that
The maximum
would leave the selling
buying division
division no
no worse
worse off
off ifif the
an
goods
were
sold to an
internal
division
than ifthan
the if
input
were
purchased
from
an internal
division
good
were
sold
to an external
party(ceiling).
(floor).
the
good
were
purchased
externally

The Transfer Pricing Illustration


Tyson Manufacturers
produces small appliances.
The Small Parts Division
produces parts used by the
Small Motors Division.
The parts also are sold to
other manufacturers and
wholesalers.

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The Transfer Pricing Illustration

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The Small Motors Division is


operating at 70 percent
capacity. A request is received
for 100,000 units of a certain
model at $30 per unit. A
component for this motor can
be supplied by the Small Parts
Division. The transfer price is
$8 despite the Small Parts
Division only experiencing a
cost of $5 per unit.

The Transfer Pricing Illustration


Using the $8 transfer price, the
total cost is $31 per unit,
calculated as follows:
Direct materials
Transferred-in component
Direct labor
Variable overhead
Fixed overhead
Total cost

$10
8
2
1
10
$31

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The Transfer Pricing Illustration

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The Small Motors Division is


operating at 70 percent capacity,
so the $10 fixed cost is not
relevant. Recalculating the cost-Direct materials
Transferred-in component
Direct labor
Variable overhead
Total cost

$10
8
2
1
$21

The Small Motors Division can pay the Small Parts


Division $8 per unit and still make a substantial
contribution to the overall profitability of the Division.

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Negotiated Transfer Prices


When imperfections exist in
competitive markets for the
intermediate product, market price
may no longer be suitable.

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Negotiated Transfer Prices


In this case, negotiated transfer
prices may be a practical
alternative. Opportunity costs can
be used to define the boundaries of
the negotiation set.

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Disadvantages of Negotiated
Transfer Prices
1. A division manager who has private
information may take advantage of another
divisional manager.
2. Performance measures may be distorted by
the negotiated skills of managers.
3. Negotiation can consume considerable time
and resources.

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Despite the disadvantages,


negotiated price transfer prices offer
some hope of complying with the
three criteria of goal congruence,
autonomy, and accurate
performance evaluation.

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Chapter Thirteen

The End

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