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Performance Performance Evaluation in Evaluation in

the the Decentralized Decentralized

FirmFirm

CHAPTERCHAPTER

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1. Define responsibility accounting, and describe four types of responsibility centers.

2. Tell why firms choose to decentralize.3. Compute and explain return 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.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

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Responsibility accounting is a system that measures the results of each responsibility

center according to the information managers need to operate their centers.

Responsibility accounting is a system that measures the results of each responsibility

center according to the information managers need to operate their centers.

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Types of Responsibility CentersTypes of Responsibility 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.

ContinuedContinued

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Types of Responsibility CentersTypes of Responsibility 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.

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ACCOUNTING INFORMATION USED TO MEASURE ACCOUNTING INFORMATION USED TO MEASURE PERFORMANCEPERFORMANCE

CapitalCapital Cost Sales Investment Other Cost Sales Investment Other

Cost center x

Revenue center Direct cost xonly

Profit center x x

Investment center x x x x

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Reasons for DecentralizationReasons for 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

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Return on InvestmentReturn on InvestmentReturn on InvestmentReturn on Investment

ROI = Operating income

Average operating assets

Beginning net book value + Ending net book value

2

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Comparison of ROIComparison of ROI

Electronics Medical SuppliesElectronics Medical Supplies Divisions DivisionsDivisions Divisions2003:

Sales $30,000,000 $117,00,000Operating income 1,800,000 3,510,000Average operating assets 10,000,000 19,500,000ROI 18 18% %

$1,800,000$10,000,000

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Comparison of ROIComparison of ROI

Electronics Medical SuppliesElectronics Medical Supplies Divisions DivisionsDivisions Divisions2004:

Sales $40,000,000 $117,00,000Operating income 2,000,000 2,925,000Average operating assets 10,000,000 19,500,000ROI 20 15% %

$2,000,000$10,000,000

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Margin and TurnoverMargin and TurnoverMargin and TurnoverMargin and Turnover

ROI = Margin x Turnover

Operating IncomeSales

SalesAverage operating assets

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MARGIN AND TURNOVER COMPARISONSMARGIN AND TURNOVER COMPARISONS Electronics Medical SuppliesElectronics Medical Supplies

Division Division Division Division

Margin 6.0% 5.0% 3.0% 2.5%Turnover x 3.0 x 4.0 x 6.0 x 6.0ROI 18.0% 20.0% 18.0% 15.0%

2003 2004 2003 20042003 2004 2003 2004

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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.

Advantages of ROIAdvantages of ROI

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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.

Disadvantages of ROIDisadvantages of ROI

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Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.

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

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

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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

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Weighted Average Cost of Capital

Suppose that a company has two sources of financing: $2 million of long-term bonds paying

9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average

cost of capital is computed as follows:

Suppose that a company has two sources of financing: $2 million of long-term bonds paying

9 percent interest and $6 million of common stock, which is considered to be of average risk. If the company’s tax rate is 40 percent and the rate of interest on long-term government bonds is 6 percent, the company’s weighted average

cost of capital is computed as follows:

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Weighted Average Cost of Capital

Amount Percent x After-Tax Cost = Weighted Cost

Bonds $2,000,000 0.25 0.09(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, the company’s weighted cost of capital average is 10.35 percent.

Thus, the company’s weighted cost of capital average is 10.35 percent.

6m/8m

1 = 100% laba0,4 = 40% pajak

0,06 = risk free for common stock

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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.

EVA ExampleEVA ExampleEVA ExampleEVA Example

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Weighted Average Cost of Capital

Weighted Amount Percent x After-Tax Cost = Cost

Mortgage bonds $ 2,000,000 0.133 0.048 0.006Unsecured bonds 3,000,000 0.200 0.060 0.012Common stock 10,000,000 0.667 0.120 0.080 Total $15,000,000Weighted average cost of capital 0.098

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Mahalo’s EVA is calculated as follows:

After tax operating income $900,000

Less: Cost of capital 784,000

EVA $116,000

EVA ExampleEVA ExampleEVA ExampleEVA Example

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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 EVA’s reliance on the true cost of capital.

Behavioral Aspects of EVA

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Behavioral Aspects of EVAIn 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 division’s operating income.

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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

Incentive Pay for ManagersIncentive Pay for ManagersIncentive Pay for ManagersIncentive Pay for Managers

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Incentive Pay for ManagersIncentive Pay for ManagersIncentive Pay for ManagersIncentive Pay for 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

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The value of a transferred good is

revenue to the selling division and cost to the buying division. This value is called

transfer pricing.

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing

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(1) divisional performance measures

(2) firmwide profits

(3) divisional autonomy

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing

Transfer pricing affects both transferring divisions and the firm as a whole through its impact on--

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Opportunity Cost ApproachOpportunity Cost 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 transfer price is the transfer price that would leave the selling division no worse off if the goods were sold to an internal division than if the

good were sold to an external party (floor).

The minimum transfer price is the transfer price that would leave the selling division no worse off if the goods were sold to an internal division than if the

good were sold to an external party (floor).

The maximum transfer price is the transfer price that would leave the buying division no worse off if an

input were purchased from an internal division than if the good were purchased externally (ceiling).

The maximum transfer price is the transfer price that would leave the buying division no worse off if an

input were purchased from an internal division than if the good were purchased externally (ceiling).

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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.

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The Transfer Pricing Illustration

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.

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The Transfer Pricing Illustration

Using the $8 transfer price, the total cost is $31 per unit,

calculated as follows:

Direct materials $10Transferred-in component 8Direct labor 2Variable overhead 1Fixed overhead 10 Total cost $31

Direct materials $10Transferred-in component 8Direct labor 2Variable overhead 1Fixed overhead 10 Total cost $31

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The Transfer Pricing Illustration

The Small Motors Division is operating at 70 percent capacity,

so the $10 fixed cost is not relevant. Recalculating the cost--

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.

Direct materials $10Transferred-in component 8Direct labor 2Variable overhead 1Total cost $21

Direct materials $10Transferred-in component 8Direct labor 2Variable overhead 1Total cost $21

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Negotiated Transfer PricesNegotiated Transfer Prices

When imperfections exist in competitive markets for the

intermediate product, market price may no longer be suitable.

When imperfections exist in competitive markets for the

intermediate product, market price may no longer be suitable.

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Negotiated Transfer PricesNegotiated Transfer Prices

In this case, negotiated transfer prices may be a practical

alternative. Opportunity costs can be used to define the boundaries

of the negotiation set.

In this case, negotiated transfer prices may be a practical

alternative. Opportunity costs can be used to define the boundaries

of the negotiation set.

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Disadvantages of Negotiated Transfer Prices

Disadvantages of Negotiated Transfer Prices

1. A division manager who has private information may take advantage of another divisional manager.

2. Performance measures may be distorted by the negotiated skills of managers.

3. Negotiation can consume considerable time and resources.

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Despite the disadvantages, negotiated price transfer prices

offer some hope of complying with the three criteria of goal

congruence, autonomy, and accurate performance evaluation.

Despite the disadvantages, negotiated price transfer prices

offer some hope of complying with the three criteria of goal

congruence, autonomy, and accurate performance evaluation.

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The EndThe EndThe EndThe End

Chapter ThirteenChapter Thirteen