13 -1

CHAPTER

Performance
Evaluation in
the
Decentralized
Firm

13 -2

Objectives
Objectives
1. Define responsibility accounting, and describe four
After
studying
this
After
studying
types of responsibility centers.this
chapter,
you
should
chapter,
you
should
2. Tell why firms choose to decentralize.
be
able
to:
be
able
3. Compute and explain returnto:
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.

13 -3

Responsibility
Responsibility accounting
accounting isis aa system
systemthat
that
measures
measures the
the results
results of
ofeach
each responsibility
responsibility
center
center according
according to
to the
the information
information managers
managers
need
need to
to operate
operate their
their centers.
centers.

13 -4

Types
Types of
of Responsibility
Responsibility Centers
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
Continued

13 -5

Types
Types of
of Responsibility
Responsibility Centers
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.

13 -6

ACCOUNTING INFORMATION USED TO MEASURE

PERFORMANCE
Cost

Cost center

Sales

Capital
Investment

Other

Revenue center Direct cost

only

Profit center

Investment center

13 -7

Reasons
Reasons for
for Decentralization
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

13 -8

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

13 -9

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 %

13 -10

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 %

13 -11

Margin
Margin and
and Turnover
Turnover
ROI = Margin x Turnover
Operating Income Sales
Sales
Average operating assets

13 -12

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%

Advantages
Advantages of
of ROI
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.

13 -13

Disadvantages
Disadvantages of
of ROI
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.

13 -14

13 -15

Economic value added (EVA) is after-tax operating

profit minus the total annual cost of capital.

EVA
EVA== After-tax
After-tax operating
operating income
income (Weighted
(Weighted
average
average cost
cost of
of capital
capital xx Total
Total capital
capital
employed)
employed)

13 -16

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

13 -17

Suppose
Suppose that
that aa company
company has
has two
two sources
sources of
of
financing:
financing: $2
$2 million
million of
of long-term
long-term bonds
bonds paying
paying
99 percent
percent interest
interest and
and $6
$6 million
million of
of common
common
stock,
stock, which
which isis considered
considered to
to be
be of
of average
average risk.
risk.
IfIf the
the companys
companys tax
tax rate
rate isis 40
40 percent
percent and
and the
the
rate
rate of
of interest
interest on
on long-term
long-term government
government bonds
bonds
isis 66 percent,
percent, the
the companys
companys weighted
weighted average
average
cost
cost of
of capital
capital isis computed
computed as
as follows:
follows:

Weighted Average Cost of Capital

Amount

13 -18

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,
Thus, the
the companys
companys
weighted
weighted average
average isis
10.35
10.35 percent.
percent.

13 -19

EVA
EVAExample
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

13 -20

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

13 -21

EVA
EVAExample
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.

13 -22

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.

13 -23

13 -24

Incentive
Incentive Pay
Pay for
for Managers
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

13 -25

Incentive
Incentive Pay
Pay for
for Managers
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

13 -26

Transfer
Transfer Pricing
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.

13 -27

Transfer
Transfer Pricing
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

13 -28

Opportunity
Opportunity Cost
Cost Approach
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.
The
minimum
minimum transfer
transfer price
price isis the
the transfer
transfer price
price that
that
The maximum
maximum
would
buying
division
no
worse
off
an
would leave
leave the
the selling
selling
the
buyingdivision
divisionno
noworse
worseoff
offifififthe
an
goods
were
sold
internal
division
than
the
input
were
purchased
from
an
division
goods
were
sold to
to an
an
internal
division
than ififthan
the ifif
input
were
purchased
from
an internal
internal
division
than
good
were
sold
to
party
(floor).
the
good
were
purchased
externally
good
were
sold
to an
an external
external
party(ceiling).
(floor).
the
good
were
purchased
externally
(ceiling).

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.

13 -29

The Transfer Pricing Illustration

13 -30

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

13 -31

Using the $8 transfer price, the

total cost is $31 per unit,
calculated as follows:
Direct
$10
Direct materials
materials
$10
Transferred-in
88
Transferred-in component
component
Direct
22
Direct labor
labor
Variable
11
Variable overhead
overhead
Fixed
10
Fixed overhead
overhead
10
Total
$31
Total cost
cost
$31

The Transfer Pricing Illustration

13 -32

The Small Motors Division is

operating at 70 percent capacity,
so the $10 fixed cost is not
relevant. Recalculating the cost-Direct
$10
Direct materials
materials
$10
Transferred-in
88
Transferred-in component
component
Direct
22
Direct labor
labor
Variable
11
Variable overhead
overhead
Total
$21
Total cost
cost
$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.

13 -33

Negotiated
Negotiated Transfer
Transfer Prices
Prices
When
When imperfections
imperfectionsexist
exist in
in
competitive
competitive markets
markets for
for the
the
intermediate
intermediate product,
product, market
market price
price
may
may no
no longer
longer be
besuitable.
suitable.

13 -34

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

13 -35

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

13 -36

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

13 -37

Chapter Thirteen

The
The End
End

13 -38