Chapter Twelve

1
Chapter Twelve

• Responsibility Accounting

2
Pros and Cons of Decentralization

• Pros
• Better information, leading to better decisions
• Faster response to changing circumstances
• Increased motivation for managers
• Excellent training for future leaders

3
Pros and Cons of Decentralization

• Cons
• Costly duplication of activities
• Lack of goal congruence

4
Goal Congruence

• Goal congruence means that as people work to
  achieve their own goals, they also work to
  achieve the goals of the company.

5
Responsibility Accounting
A responsibility accounting system generates
reports to employees, including managers, about
the performance of their assigned responsibility.

• Types of responsibility centers
• Cost center
• Revenue center
• Profit center
• Investment center

6
Cost Centers

• A cost center is a segment whose manager is
  responsible for costs but not for revenues.
• Examples
• Manufacturing cells
• Office of the CEO
• Legal department
• Accounting department

7
Profit and Investment Centers

• A profit center is a segment whose manager is
  responsible for revenues as well as costs.
• An investment center is a segment whose manager
  is responsible not only for revenues and costs,
  but also for the investment required to generate
  profits.

8
Performance Evaluation Criteria

• Selecting criteria to measure and evaluate
  performance is important because the criteria
  influence managers actions. YOU GET WHAT YOU
  MEASURE! The most common deficiencies in
  performance measures are
• using a single measure that emphasizes only one
  objective of the organization and
• using measures that either misrepresent or fail
  to reflect the organizations objectives or the
  employees responsibilities.

9
Managerial Accounting IssuesRelated to
Decentralization

• The need to develop methods of evaluating
  performance that work to the benefit of the
  company as a whole.
• The need to develop transfer prices that produce
  decisions in the best interest of the company.

10
Measures of Performance

• Companies use four principal measures to evaluate
  divisions
• Income
• Return on Investment (ROI)
• Residual Income (RI)
• Economic Value Added (EVA)

11
ROI Formula

• ROI Divisional income/Divisional investment
• Companies define and measure divisional income
  and divisional investment in various ways.

12
Alternative ROI Formula

• ROI Profit margin x Turnover
• Profit Margin Divisional income/Divisional
  sales
• Turnover Divisional sales/Divisional investment

13
An ROI Example

• 2002
  Alpha Division Beta Div
• Divisional sales 10,000 60,000
• Divisional income (NOPAT) 1,000 2,500
• Average divisional as sets 6,000 17,500
• 2003
• Divisional sales 17,500 60,000
• Divisional income (NOPAT) 1,250 2,750
• Average divisional assets 6,000 17,500
• Cost of capital is 10 percent

14
NOPAT

• NOPAT is net operating profit after tax
• Equals net income plus interest net of tax
• Relates income to assets utilized to generate
  that income
• Does not consider the effect of using financial
  leverage (debt) on the rate of return
• Is consistent with return on assets from Acct 284

15
Return on Sales and Turnover Comparisons

• 
  Alpha Alpha Beta Beta 2002 2003 2002 2003
• Profit margin 10.0 7.1 4.2 4.6
• Turnover 1.667 2.917 3.429 3.429
• ROI 16.7 20.7 14.4 15.8

16
A Residual Income Example

• Residual income NOPAT (Assets x RRR)
• RRR required rate of return
• Alpha Alpha Beta Beta 2002 2003 2002 2003
• Divisional operating assets 6,000 6,000 17,500
  17,500
• Divisional operating income 1,000 1,250 2,500
  2,750
• Minimum return 600 600 1,750 1,750
• Residual income 400 650 750 1,000

17
Comparison of ROI versus RI

Alpha Alpha Beta Beta
2002 2003 2002 2003 Return on investment 16.7 20.
7 14.4 15.8 Residual income 400 650 750 1,0
00 Which method would you prefer?
18
ROI Versus RI

• Using ROI to evaluate divisions can encourage
  them to reject good investments and accept poor
  investments.

19
ROI, RI and Goal Congruence

• ROI evaluation will encourage managers to accept
  any opportunity above the current ROI
• RI will encourage managers to accept any
  opportunity above the cost of capital.
• Which gives better goal congruence?
• Which would encourage growth?

20
Economic Value Added

• Same calculation as residual income but adjusts
  for capitalization of Research and development
  costs and other accounting distortions
• R D is then amortized against income
• Gives managers the incentive to spend R D
• Other adjustments to income that are designed to
  encourage certain behaviors are often
  incorporated into performance evaluation
  techniques.

21
Whole Foods Market

• Whole foods markets uses EVA analysis
• http//www.wholefoodsmarket.com/investor/eva.html
• Date5/2/2006

22

• We use Economic Value Added ("EVA") to evaluate
  our business decisions and as a basis for
  determining incentive compensation. In its
  simplest definition, EVA is equivalent to net
  operating profits after taxes minus a charge for
  the cost of capital necessary to generate those
  profits. We believe that one of our core
  strengths is our decentralized culture, where
  decisions are made at the store level, close to
  the customer. We believe this is one of our
  strongest competitive advantages, and that EVA is
  the best financial framework that team members
  can use to help make decisions that create
  sustainable shareholder value.
• We use EVA extensively for capital investment
  decisions, including evaluating new store real
  estate decisions and store remodeling proposals.
  We are turning down projects that do not add
  long-term value to the Company. The EVA
  decision-making model is also enhancing operating
  decisions in stores. Our emphasis is on EVA
  improvement, as we want to challenge our teams to
  continue to innovate and grow EVA in new ways. We
  believe that opportunities always exist to
  increase sales and margins, to lower operating
  expenses and to make investments that add value
  in ways that benefit all of our stakeholders. We
  believe that focusing on EVA improvement
  encourages continuous improvement of our business.

23

• Over 500 leaders throughout the Company are on
  EVA-based incentive compensation plans, of which
  the primary measure is EVA improvement. EVA-based
  plans cover our senior executive leadership,
  regional leadership and the store leadership team
  in all stores. Incentive compensation for each of
  these groups is determined based on relevant EVA
  measures at different levels, including the total
  company level, the regional level, the store or
  facility level, and the team level. We believe
  using EVA in a multi-dimensional approach best
  measures the results of decisions made at
  different levels of the Company. We expect to
  continue to expand the use of EVA as a
  significant component of our compensation
  structure throughout the Company in the coming
  years.
• The following table sets forth selected EVA
  information based on a 9 weighted average cost
  of capital and a 40 tax rate for the fiscal
  years ended September 25, 2005 and September 26,
  2004.(in thousands)

24
2005 2004
Net operating profit after tax (NOPAT)     165,579 136,684
Capital charge     139,793 139,793 119,101 119,101
EVA     25,786 25,786 17,583 17,583
Increase in EVA     8,203 -
EVA calculations not updated in 2003, due to lease restatements. EVA calculations not updated in 2003, due to lease restatements. EVA calculations not updated in 2003, due to lease restatements. EVA calculations not updated in 2003, due to lease restatements. EVA calculations not updated in 2003, due to lease restatements. EVA calculations not updated in 2003, due to lease restatements. EVA calculations not updated in 2003, due to lease restatements.
The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands) The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands) The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands) The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands) The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands) The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands) The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands)
25
        2005   2005
GAAP net income     136,351 129,511
Provision for income taxes     100,782 100,782 86,341 86,341
Interest expense and other     38,832 38,832 11,955 11,955
Net operating profit before taxes (NOPBT)     275,965 275,965 227,807 227,807
Taxes (40)     110,386 110,386 91,121 91,121
NOPAT     165,579 136,686
Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands) Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands) Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands) Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands) Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands) Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands) Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands)
      2005 2005 2004 2004
Total assets     1,696,953 1,370,882
Total liabilities     537,648 537,648 523,589 523,589
Net assets     1,159,305 1,159,305 847,293 847,293
Long-term debt and capital lease obligations     87,919 87,919 171,305 171,305
Implied goodwill (from pooling-of-interest transactions)     162,803 162,803 162,803 162,803
Other     143,740 143,740 141,977 141,977
EVA capital     1,553,767 1,323,378
Accumulated components of net income not included in NOPAT Accumulated components of net income not included in NOPAT Accumulated components of net income not included in NOPAT Accumulated components of net income not included in NOPAT Accumulated components of net income not included in NOPAT Accumulated components of net income not included in NOPAT Accumulated components of net income not included in NOPAT
             
EVA is a registered trademark of Stern Stewart Co. EVA is a registered trademark of Stern Stewart Co. EVA is a registered trademark of Stern Stewart Co. EVA is a registered trademark of Stern Stewart Co. EVA is a registered trademark of Stern Stewart Co. EVA is a registered trademark of Stern Stewart Co. EVA is a registered trademark of Stern Stewart Co.
26
The Balanced Scorecard

• An approach known as the balanced scorecard has
  become popular recently. This approach extends
  performance evaluation from merely looking at
  financial results to formally incorporating
  measures that look at customer satisfaction,
  internal business processes, and the learning and
  growth potential of the organization.

27
The Balanced Scorecard (Continued)

• The balanced scorecard asks four basic questions
• 1. How do customers see us? (the customer
  perspective)
• 2. What must we excel at? (the internal business
  process perspective)
• 3. Can we continue to improve and create value?
  (the learning growth perspective)
• 4. How do we look to stockholders? (the financial
  perspective)

28
Transfer Price

• Sometimes a center with no external customers is
  made into an artificial profit center. Then
  transfer prices, which are prices that one center
  charges another center within the company, are
  needed.

29
TRANSFER PRICING POLICIESTransfer Pricing Methods

• Actual costs with or without a markup
• Budgeted costs with or without a markup
• Market-based prices
• Incremental cost
• Negotiated prices

30
Actual Cost

• These transfer prices are not wise because the
  selling manager has no incentive to keep costs
  down.
• Worse, a price that is actual costs plus a
  percentage markup gives the selling manager more
  profit the higher costs go.

31
Budgeted Cost

• This method does not reward the selling manager
  if costs go up, and actually encourages the
  selling manager to keep costs down.

32
Market-Based Prices

• This method is generally consider, the best. The
  biggest problem is that an outside market price
  may not exist.
• The transfer price may be less than the market
  price due to cost savings from selling internally.

33
Incremental Cost

• Such prices are theoretically best from the
  companys viewpoint when the selling division is
  operating below capacity.
• Incremental cost can be as low as the variable
  cost of the goods or services.

34
Negotiated Prices

• This method allows managers to bargain with each
  other and alleviates some problems that arise
  with other methods.
• Normally will lead to the right outcome if
  managers negotiate in good faith.