Chapter 12 Decentralization and Performance Evaluation

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Chapter 12Decentralization and Performance
Evaluation
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Presentation Outline

1. The Concept of Decentralization
2. Types of Responsibility Centers
3. Evaluating Investment Centers with Return on
   Investment (ROI)
4. The Balanced Scorecard
5. Transfer Prices

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I. The Concept of Decentralization

1. Decentralization Defined
2. Advantages/Disadvantages of Decentralization
3. Two Reasons for Evaluating Subunit Performance
4. Responsibility Accounting

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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.

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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.

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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.

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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)

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II. Types of Responsibility Centers

1. Cost Centers
2. Profit Centers
3. Investment Centers

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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.

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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.

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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.

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

• The Components of ROI
• Measuring ROI Income and Invested Capital
• Problems with Using ROI
• Residual Income (RI) as an Alternative to ROI

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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).

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

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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.
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IV. The Balanced Scorecard

1. The Balanced Scorecard Approach
2. The Balanced Scorecard Dimensions
3. How Balance is Achieved

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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.

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B. The Balanced Scorecard Dimensions
Financial Perspective Is company
achieving financial goals?
Internal Process Is company improving critical
internal processes?
Customer Perspective Is company meeting customer
expectations?
Strategy
Learning and Growth Is company improving its
ability to innovate?
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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.

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V. Transfer Prices

1. Transfer Price Defined
2. Market Prices as the Maximum
3. Variable Cost as the Minimum Excess Capacity
   Exists
4. Variable Cost Plus Lost Contribution Margin on
   Outside Sales as the Minimum Excess Capacity
   Does Not Exist
5. Transfer Pricing and Income Taxes in an
   International Context

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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.

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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.

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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.

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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.

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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.

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Summary

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