Chapter 12 Decentralization and Performance Evaluation

Presentation Outline
I. The Concept of Decentralization II. Types of Responsibility Centers III. Evaluating Investment Centers with Return on Investment (ROI) IV. The Balanced Scorecard V. Transfer Prices

I. The Concept of Decentralization

A. Decentralization Defined B. Advantages/Disadvantages of Decentralization C. Two Reasons for Evaluating Subunit Performance D. Responsibility Accounting

A. Decentralization Defined

Firms that grant substantial decision making authority to the managers of subunits are referred to as decentralized organizations. Most firms are neither totally centralized nor totally decentralized.

B. Advantages/Disadvantages of Decentralization
Advantages  Better information, leading to superior decisions.  Faster response to changing circumstances.  Increased motivation of managers  Excellent training for future top level executives. Disadvantages  Costly duplication of activities.  Lack of goal congruence.

C. Two Reasons for Evaluating Subunit Performance

Identification of successful areas of operation and areas in need of improvement. Influence over the behavior of managers. Note that it is quite possible to have a good manager and a bad subunit.

D. Responsibility Accounting
Managers should only be held responsible for costs and revenues that they control. In a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled. (See Illustration 12-3 on p. 421)

II. Types of Responsibility Centers

A. Cost Centers B. Profit Centers C. Investment Centers

A. Cost Centers
 A cost center is a subunit that has responsibility for controlling costs but not for generating revenues.  Most service departments (i.e., maintenance, computer) are classified as cost centers.  Production departments may be cost centers when they simply provide components for another department.  Cost centers are often controlled by comparing actual with budgeted or standard costs.

B. Profit Centers
 A profit center is a subunit that has responsibility of generating revenue and controlling costs.  Profit center evaluation techniques include:
 Comparison of current year income with a target or budget.  Relative performance evaluation compares the center with other similar profit centers.

C. Investment Centers
 An investment center is a subunit that is responsible for generating revenue, controlling costs, and investing in assets.  An investment center is charged with earning income consistent with the amount of assets invested in the segment.  Most divisions of a company can be treated as either profit centers or investment centers.

III. Evaluating Investment Centers with Return on Investment (ROI)

A. The Components of ROI B. Measuring ROI Income and Invested Capital C. Problems with Using ROI D. Residual Income (RI) as an Alternative to ROI

A. The Components of ROI

ROI has a distinct advantage over income as a measure of performance since it considers both income (the numerator) and investment (the denominator). ROI = Income Invested capital
Investment Turnover

Profit Margin

ROI =

Income Sales

Sales Invested capital

The breakdown of the formula shows that managers can increase return by more profit and/or generating more sales for each investment dollar.

B. Measuring ROI Income and Invested Capital

ROI Income  Investment center income will be measured using net operating profit after taxes (NOPAT).  NOPAT should exclude nonoperating items such as interest expense and nonoperating gains and losses, net of the tax effect. ROI Invested Capital  Invested capital is measured as total assets less noninterest bearing current liabilities.  Noninterest bearing current liabilities are deducted from total assets because they are a free source of funds and reduce the cost of the investment in assets.

See Illustration 12-4 on page 426

C. Problems with Using ROI

Investment in assets is typically measured using historical cost. ROI becomes larger as assets become depreciated. This may result in managers taking unnecessary delays in updating equipment. Managers may turn down projects with positive net present values, simply because accepting the project results in a reduced ROI. In other words, projects may be turned down if they provide a return above the cost of capital but below the current ROI.

D. Residual Income (RI) as an Alternative to ROI

Residual Income = NOPAT Required Profit = NOPAT Cost of Capital x Investment = NOPAT Cost of Capital x (Total Assets Noninterest Bearing Current Liabilities)
Residual Income (RI) overcomes the underinvestment problem of ROI since any investment earning more than the cost of capital will increase residual income.

IV. The Balanced Scorecard

A. The Balanced Scorecard Approach B. The Balanced Scorecard Dimensions C. How Balance is Achieved

A. The Balance Scorecard Approach

 A problem with just assessing performance with financial measures is that such measures are backward looking.  The balanced scorecard approach also focuses on what managers are currently doing to create future shareholder value.

B. The Balanced Scorecard Dimensions

Financial Perspective Is company achieving financial goals?

Customer Perspective Is company meeting customer expectations?

Strategy

Internal Process Is company improving critical internal processes?

Learning and Growth Is company improving its ability to innovate?

C. How Balance is Achieved

Performance is assessed across a balanced set of dimensions (see Illustration 12-10 on p. 437). Quantitative measures (e.g., number of defects) are balanced with qualitative measures (e.g., rate of customer satisfaction). There is a balance of backward-looking and forward-looking measures.

V. Transfer Prices
A. Transfer Price Defined B. Market Prices as the Maximum C. Variable Cost as the Minimum Excess Capacity Exists D. Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum Excess Capacity Does Not Exist E. Transfer Pricing and Income Taxes in an International Context

A. Transfer Price Defined

The price that is used to value internal transfers of goods and services within the same company is known as the transfer price.

B. Market Prices as the Maximum

The transfer price should not exceed what the acquiring division would have to pay for a similar good and given set of conditions on the outside market. If the outside market is cheaper, the good should be acquired outside the organization.

C. Variable Cost as the Minimum Excess Capacity Exists

The supplying division should not set a transfer price that is lower than the variable cost of supplying the good and/or service to the requesting division. This may be less than the variable cost of serving an outside customer.

D. Variable Cost Plus Lost Contribution Margin on Outside Sales as the Minimum Excess Capacity Does Not Exist
The minimum transfer price will add a lost contribution margin on outside sales if the supplying division must turn away outside customers to provide the good and/or service to the requesting division.

E. Transfer Pricing and Income Taxes in an International Context

When income tax rates between countries differ significantly, a supplier in a lower rate country will want to charge the purchasing division a higher transfer price to lower taxable income for the purchaser in the higher rate nation, and vice versa.

Summary
Decentralization and Responsibility Accounting Cost, Profit, and Investment Centers ROI Residual Income Balanced Scorecard Transfer Pricing