Managerial accounting 5th jiambalvo ch12

Learning objective 3: Identify cost centers, profit Slide 12-14 Cost Centers  A cost center is a subunit that has responsibility for controlling costs but does not have responsibility f

Prepared by

Slide 12-2

CHAPTER 12

Decentralization

and Performance Evaluation

Decentralization

and Performance Evaluation

Decentralized Organizations

Decentralized Organizations

 As firms increase in size and

complexity, business segments or

subunits are organized

 The managers of the segments are

granted decision making authority

so that the firm will function efficiently and effectively

 Firms that grant substantial decision making authority to the managers of subunits are referred to

as decentralized organizations

Learning objective 1: List and explain the advantages and

Slide 12-4

Decentralized Organizations

Decentralized Organizations

 Most firms are neither totally

centralized nor totally

delegated to sub-unit managers

 Performance evaluation can be used

to ensure that managers make decisions that are in the best interest of the entire firm

Decentralized Organizations

Decentralized Organizations

Learning objective 1: List and explain the advantages and

Slide 12-6

Advantages of Decentralization

 A primary reason is that subunit

managers have better information

than top management and can

respond quicker to changing

circumstances

 Other reasons include

 Some firms decentralize because they

believe that managers are more motivated and work harder

 Decentralized organizations provide

excellent training for future top-level executives

Disadvantages of Decentralization

Disadvantages of Decentralization

 Decentralization can cause

of the company as a whole

 This problem is called goal congruence

 To control goal congruence, companies evaluate the performance

All of the following are advantages of

decentralization except:

a Faster response to changing

circumstances

b Costly duplication of activities

c Increased motivation of managers

d Better information, leading to

superior decisions

Answer: b

Costly duplication of activities

Test Your Knowledge 1

Slide 12-8 Learning objective 1: List and explain the advantages and

 Top management may perform

incremental analysis to determine:

 Whether a successful operation

should be expanded

 Whether an unsuccessful operation should be eliminated or improved

Learning objective 2: Explain why companies evaluate the

 A company evaluates subunit

managers in order to motivate

them to take actions that maximize the value of the firm

 Reasons for evaluating subunit

Responsibility Accounting and

Performance Evaluation

Responsibility Accounting and

Performance Evaluation

 Responsibility accounting is a

technique that holds managers

responsible only for costs and

revenues that they can control

 This idea should play a prominent role

in the design of accounting systems used to evaluate managers

 Costs and revenues are traced to the organizational level where they can

be controlled

Slide 12-12

Tracing Costs to Organizational Levels

Tracing Costs to Organizational Levels

Learning objective 2: Explain why companies evaluate the

Responsibility Centers

 Responsibility centers are

organizational units responsible for the generation of revenue and/or

the incurrence of costs

 Responsibility centers typically are classified as being

 Cost centers

 Profit centers, or

 Investment centers

Learning objective 3: Identify cost centers, profit

Slide 12-14

Cost Centers

 A cost center is a subunit that has responsibility for controlling costs but does not have responsibility for generating revenue

 Most service departments are

classified as cost centers

 The managers of these departments are responsible for making sure

their services are provided at a reasonable cost to the company

 If variances from standard are

significant, an investigation into the activities of the cost center should

be undertaken to determine whether costs are out of control

 Other performance measures can be used as well

 Because both revenues and costs

are under the control of the profit center manager, the performance of the profit center can be evaluated in terms of profitability

 This motivates managers to focus their attention on ways of

maximizing profit center profitability Learning objective 3: Identify cost centers, profit

Profit Centers

 Companies use a variety of methods to profit centers

 Income earned in the current year may

be compared with an income target

 Income earned may be compared with income earned in the prior year

 Some firms use relative performance

evaluation, which involves evaluating the profitability of each profit center relative to the profitability of similar profit centers

Slide 12-18

Investment Centers

 An investment center is a subunit that is responsible for generating revenue, controlling costs, and

investing in assets

 An investment center is changed

with earning income consistent with the amount of assets invested

in the segment

Learning objective 3: Identify cost centers, profit

Investment Centers

 If the manager can influence

decisions affecting investment in divisional assets, the division

should be considered an

investment center

 Managers play a major role in the determining the level of inventory, accounts receivable and equipment

 It seems reasonable to hold them responsible for earning a return on these assets

d All of the above

Test Your Knowledge 2

Learning objective 3: Identify cost centers, profit

Profit centers are often evaluated

Learning objective 4: Calculate and interpret

 One of the primary tools for

evaluating the performance of

investment centers is return on

investment, or ROI

 ROI is calculated as the ratio of

investment center income to invested capital

 Focuses management’s attention

on both income (numerator) and

the level of investment

(denominator)

 In calculating ROI, companies

measure “income” in a variety of

ways

 Net income, earnings before

interest and taxes, controllable profit, etc.

 Most common method is NOPAT

 Net operating profit after taxes

 NOPAT excludes interest expense, which is a nonoperating expense

 Therefore, add interest expense back

to net income and adjust tax expense accordingly Learning objective 4: Calculate and interpret

Measuring Income and Invested Capital for ROI

Measuring Income and Invested Capital for ROI

 In calculating ROI, companies

measure “invested capital” in a

 Total assets less current liabilities

 Total assets less bearing current liabilities (method used in this textbook)

non-interest-Slide 12-26

NOPAT Example

Learning objective 4: Calculate and

ROI – France, Germany, and

Japan

ROI – France, Germany, and

Japan

Test Your Knowledge 4

Learning objective 4: Calculate and

Information for Davenport Mills

Calculate invested capital

= Total assets – non-interest-bearing

current liabilities = $225,000,000 -

$30,000,000

Test Your Knowledge 5

Test Your Knowledge 6

Learning objective 4: Calculate and

Calculating ROI

Slide 12-32

Problems with Using ROI

 Invested capital is typically based

on historical costs

 Fully depreciated assets lead to a low invested capital number

resulting in high ROI

 This makes comparison of

investment centers using ROI difficult

Learning objective 4: Calculate and

interpret return on investment (ROI)

Problems with Using ROI

 Managers may put off purchase of new equipment, which may lead to under investment

 Projects with positive net present

value but low initial profitability

might not be undertaken

 Managers with high ROI may

consider the effect on ROI, rather than NPV

 We would like managers to invest

in assets that earn a return in

excess of the cost of capital

 If we evaluate managers in terms of growth in profit, they may be

motivated to make investments that earn a return that is less than the

Problems of Overinvestment

and Underinvestment

Problems of Overinvestment

and Underinvestment

 An obvious solution is to evaluate

managers in terms of ROI

 Managers won’t be motivated to

take on projects with a low return just to increase profits

 ROI can lead managers to underinvest, that is they may pass

up projects that earn a return that is greater than the cost of capital

Slide 12-36

Use of profit as a performance measure:

a May lead to overinvestment in assets

b Is appropriate for an investment center

c Is appropriate as long as profit is

calculated using GAAP

d Encourages managers to finance

operations with debt rather than equity

Answer:

a May lead to overinvestment in assets

Test Your Knowledge 7

Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of

Decision Making

Learning objective 6: Calculate and interpret residual income

Slide 12-38

Evaluation Using Economic

Value Added (EVA)

Evaluation Using Economic

Value Added (EVA)

 Firms that use EVA typically tie

bonus compensation to the measure

 Thus, managers become very focused on achieving high levels of EVA

Residual Income (RI)

 Residual income (RI) is the net

operating profit after taxes of an

investment center in excess of its

required profit

 The required profit is equal to the

investment center’s required rate of return times the level of investment

in the center

 RI = NOPAT – Required Profit

Economic Value Added

(EVA)

Economic Value Added

(EVA)

 Economic value added, better

known as EVA, is simply residual

income adjusted for “accounting

distortions” that arise from

following GAAP

 GAAP required R&D to be expensed

in the period incurred, but with EVA

it is capitalized as an asset and amortized over future periods of benefit

  

Test Your Knowledge 8

Learning objective 6: Calculate and interpret residual income

Economic Value Added

(EVA)

Economic Value Added

(EVA)

Learning objective 1: List and explain the advantages and

A problem in using financial measures like

ROI and EVA is that they are “backward

looking”

Using a Balanced Scorecard

to Evaluate Performance

Using a Balanced Scorecard

to Evaluate Performance

 A problem with assessing

performance with measures like

profit, ROI and EVA is that these

measures are all backward looking

 The balanced scorecard is an

approach to performance measurement that also focuses on what managers are doing today to create future shareholder value

Slide 12-46

Balanced Scorecard

 The balanced scorecard is

constructed for four dimensions

of performance

1 Financial

Having financial measures is critical even if they are backward looking

2 Customer

Examines the company’s success

in meeting customer expectations

Learning objective 7: Explain the potential benefits of

Balanced Scorecard

 The balanced scorecard is

constructed for four dimensions

4 Learning and growth

Examines the company’s success

in improving its ability to adapt, innovate, and grow

Slide 12-48

Tying the Balanced Scorecard Measures to the Strategy for

Success

Tying the Balanced Scorecard

Measures to the Strategy for

Success

 Typically, a company will develop

three to five performance measures for each dimension

 Where possible, measures should be tied to the company’s strategy for

success

 Balance among the dimensions is

critical

 You get what you measure!

 Companies need measures that drive desirable behaviors

Learning objective 7: Explain the potential benefits of

Balanced Scorecard

1 Performance is assessed across a

balanced set of dimensions

2 Quantitative measures are balanced

with qualitative measures

3 There is a balance of

backward-looking measures and

forward-looking measures

Learning objective 7: Explain the potential benefits of

Balanced Scorecard

Slide 12-52

Balanced Scorecard

Learning objective 7: Explain the potential benefits of

You Get What You Measure

Learning objective 8: Discuss how a strategy map can be used to

objectives across the four

dimensions of the balanced

scorecard

 It is useful to test the soundness of the strategy and how the strategy is linked to measures on the scorecard

 It is useful to communicates

strategic objectives to employees

Strategy Map Example

Learning objective 9: Discuss the key items related to a

 Initiatives

 For each measure, the company

must identify actions that will be taken to achieve the target

Keys to a Successful Balanced

Scorecard

Keys to a Successful Balanced

Scorecard

 Responsibility

 A specific employee must be given

responsibility/accountability for the implementation of each initiative

 Funding

 Initiatives must be funded

appropriately

 Top Management Support

 It is crucial to have the full support

of top management

Evaluation

Learning objective A1: Discuss the use of market price, variable cost, full cost

Slide 12-60

Appendix - Transfer Pricing

 The transfer price is the price that

is used to value internal transfers

of goods or services

 For external financial reporting

purposes, a company cannot recognize revenue on the sale of goods between responsibility

centers within the firm

 The revenue has not been realized

Methods of Setting the

Transfer Price

Methods of Setting the

Transfer Price

 In practice, a number of different

approaches are taken to setting

 The most appropriate transfer price

depends on the circumstances

 Should lead subunit managers to

make decisions that maximize firm value

 Since there is no arm’s length

transaction, revenue is not recognized for financial reporting purposes

 Motivation of best decision is

measured by opportunity cost of producing an item and transferring it inside the company Learning objective A1: Discuss the use of market price, variable

Lowering Transfer Price Below

the Market Price

Lowering Transfer Price Below

the Market Price

Slide 12-64

Transfer Pricing

Learning objective A1: Discuss the use of market price, variable

© 2010 John Wiley & Sons, Inc All rights

reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is

unlawful Request for further information should

be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-

up copies for his/her own use only and not for

distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.