1. Performance Evaluation, Variable Costing, and Decentralization
Management Accounting: The Cornerstone for Business Decisions
Chapter 11
Performance Evaluation, Variable Costing, and Decentralization
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. Learning Objectives Explain how and why firms choose to decentralize.
Explain the difference between absorption and variable costing. Prepare segmented income statements.
Compute and explain return on investment (ROI).
Compute and explain residual income and economic value added (EVA).

3. Learning Objectives
Explain the role of transfer pricing in a decentralized firm.
(Appendix) Explain the uses of the Balanced Scorecard and compute cycle time, velocity, and manufacturing cycle efficiency (MCE).

4. Comment on Decentralization and Responsibility Centers
Companies organize around responsibility centers
This is what organization charts represent
Can become cumbersome for decision making
Organizations can choose to centralize or decentralize
Most organizations are a mix of both

5. What are some reasons to decentralize?
It is easier to gather and use local information
It allows for focusing of central management
It provides training and motivation for segment managers
It enhances competition by exposing business segments to market forces

6. Illustrate Centralization Vs. Decentralization

7. Illustration of PepsiCo's Decentralized Divisions

8. Match Definitions Cost Center Revenue Center Profit Center
A responsibility center in which the manager is only accountable for sales
A responsibility center in which the manager is accountable for both revenues and costs
Revenue Center
Profit Center
A responsibility center in which the manager is accountable for revenues, costs and investments
Investment Center
A responsibility center in which the manager is only accountable for costs

9. Complete the Chart
What type of accounting information is use for measuring performance?
Capital
Center
Cost
Sales
Investment
Other
Revenue
Profit X X X X

10. Differentiate Between Product and Period Costs
Product costs can be inventoried;
they include direct material, direct labor
and overhead.
Period costs, such as selling
and administrative expenses, are
expensed in the period incurred.

11. Complete Chart
How are product and period cost classified under absorption and variable costing? Insert the word “Product” or “Period” were appropriate
Costing Method
Absorption
Variable
Direct materials
Product
Direct labor
Variable overhead
Fixed overhead
PERIOD
Selling expenses
Period
Administrative expenses

12. How to compute inventory cost under absorption & variable costing.
11-1
During the most recent year, Fairchild company had the following data associated with the product it makes.
Units in beginning inventory 0
Units produced 12,000
Units sold ($325 each) 10,000
Variable costs per unit:
Direct materials $60
Direct labor 90
Variable overhead 60
Fixed costs:
Fixed overhead per unit produced $25
Fixed selling and administrative 100,000

13. How to compute inventory cost under absorption & variable costing.
11-1
REQUIRED:
How many units are in ending inventory?
Using absorption costing, calculate the per-unit product cost. What is the value of ending inventory?
Using variable costing, calculate the per-unit product cost. What is the value of ending inventory?
Calculations:
Units in ending inventory = Units in beginning inventory + Units produced – Units sold
= ,000 – 10,000 = 2,000

14. How to compute inventory cost under absorption & variable costing.
11-1 2.
Absorption costing 3.
Variable costing
Direct materials
$ 60
Direct labor 90
Variable overhead 60
Fixed overhead 25
Unit product cost
$ 210
$ 235
Value of ending inventory = 2,000 x $235 = $470,000
Value of ending inventory = 2,000 x $210 = $420,000

15. How to prepare income statements under absorption & variable costing.
11-2
During the most recent year, Fairchild company had the following data associated with the product it makes.
Units in beginning inventory 0
Units produced 12,000
Units sold ($325) 10,000
Variable costs per unit:
Direct materials $60
Direct labor 90
Variable overhead 60
Fixed costs:
Fixed overhead per unit produced $25
Fixed selling and administrative 100,000

16. How to prepare income statements under absorption & variable costing.
11-2
REQUIRED:
Calculate the cost of goods sold under absorption costing
Calculate the cost of goods sold under variable costing
Prepare an income statement under absorption costing
Prepare an income statement under variable costing
Calculation:
Cost of goods sold = Absorption product cost x Units sold
= $235 x 10,000 = $2,350,000
Cost of goods sold = Variable product cost x Units sold
= $210 x 10,000 = $2,100,000

17. How to prepare income statements under absorption & variable costing.
11-2 3.
Fairchild Company
Absorption-Costing Income Statement
Sales ($325 x 10,000)
$3,250,000
Cost of goods sold
2,350,000
Gross Margin
$ 900,000
Less: Selling & Administrative Expenses
100,000
Net income
$ 800,000

18. How to prepare income statements under absorption & variable costing.
11-2 4.
Fairchild Company
Variable-Costing Income Statement
Sales ($325 x 10,000)
$3,250,000
Less: Variable expenses:
Variable cost of goods sold
2,100,000
Contribution Margin
$1,150,000
Less: Fixed expenses:
Fixed overhead
$300,000
Fixed selling & administrative
100,000
400,000
Net income
$ 750,000

19. Review the Relationships Between Production, Sales & IncomeIF
THEN 1.
Production > Sales
Absorption net income > Variable net income 2.
Production < Sales
Absorption net income < Variable net income 3.
Production = Sales
Absorption net income = Variable net income

20. How to prepare a segmented income statement.
11-3
Audiomatronics, Inc., produces MP3 players and DVD players in a single factory. The following information was provided for the following year.
MP3 Players DVD Players
Sales $400,000 $290,000
Variable cost of good sold 200, ,000
Direct fixed cost 30,000 20,000
A 5% sales commission is paid for each of the two product lines. Direct fixed selling and administrative expense was estimated to be $10,000 for the MP3 line and $15,000 for the DVD line.
Common fixed overhead for the factory was estimated at $100,000; common selling and administrative expense was estimated to be $20,000.

21. How to prepare a segmented income statement.
11-3
REQUIRED: Prepare a variable costing segmented income statement for Audiomatronics, Inc., for the coming year.
Calculation:
MP3 Players
DVD Players
Total
Sales
$ ,000
$ ,000
$ 770,000
Variable cost of goods sold
(225,000)
(160,000)
(385,000)
Variable selling expense
(22,500)
(16,000)
(38,500)
Contribution margin
$ ,500
$ ,000
346,500
Less: direct fixed expenses:
Direct fixed overhead
(30,000)
(20,000)
(50,000)
Direct sell & admin
(10,000)
(15,000)
(25,000)
Segment margin
$ ,500
$ ,000
$ 271,500
Less: common fixed expenses
Common fixed overhead
(100,000)
Common sell & admin
Net income
$ 151,500

22. List Three Ways Investment Centers are Evaluated
Economic Value
Added
ROI
Residual Income

23. Match Definitions ROI Sales / Average operating assets
Ave. Operating Assets
Operating income / Sales
Operating income / Average operating assets
Margin
(Beginning net book value + Ending net book value) / 2
Turnover

24. How to calculate average operating assets, margin, turnover & ROI.
11-4
Celimar Company’s Eastern Division earned operating income of $60,000 on Sales of $600,000. At the beginning of the year the net book value of the assets were $305,700, while at the end of the year they were $354,300.
REQUIRED: For the Eastern Division calculate:
Average operating assets
Margin
Turnover
ROI

25. How to calculate average operating assets, margin, turnover & ROI.
11-4
Calculation:
Average operating assets = (Beginning assets + ending assets) / 2 = ($305,700 + $354,300) / 2 = $330,000
Margin = Operating income / Sales = $60,000 / $600,000 = 10% or 0.10
Turnover = Sales / Average operating assets = $600,000 / $330,000 = 1.82 times
ROI = Margin x Turnover = .10 x 1.82 = 18.2% or 0.182
OR ROI = Operating income / Average operating assets = $60,000 / $330,000 = 18.2%

26. What are three advantages of ROI?
It encourages managers to focus on the relationship among sales, expenses and investment, as should be the case for a manager of an investment center.
It encourages a manager to focus on cost efficiency.
It encourages a manager to focus on operating asset efficiency.

27. How to calculate residual income.
11-5
Celimar Company’s Eastern Division earned operating income of $60,000 on Sales of $600,000. At the beginning of the year the net book value of the assets were $305,700, while at the end of the year they were $354,300. Celimar requires a minimum rate of return of 12%.
REQUIRED: For the Eastern Division calculate:
Average operating assets
Residual income
Calculation:
Average operating assets = (Beginning assets + ending assets) / 2 = ($305,700 + $354,300) / 2 = $330,000
Residual income = Operating income = - (Minimum rate of return x Average operating assets) = $60,000 – (0.12 x $330,000) = $60,000 - $39,600 = $20,400

28. How to calculate EVA.
11-6
Celimar Company’s Eastern Division earned net income last year as shown in the following income statement:
Sales
$600,000
Cost of goods sold
330,000
Gross Margin
$270,000
Less: Sell & Admin Exp.
210,000
Operating income
$ 60,000
Less: Income
18,000
Net income
$ 42,000
Total capital employed equaled $330,000. Celimar’s actual cost of capital is 10%.

29. How to calculate EVA.
11-6
REQUIRED: Calculate EVA for Eastern Division
Calculation:
EVA = After-tax operating income – (Actual percentage cost of capital x Total capital employed)
= $42,000 – (10% x $330,000)
= $42,000 - $33,000
= $9,000

30. Discuss Transfer Pricing
This represents the charge Bravo Division pays Romeo Division for the use of Romeo Division’s output.
It represents a complex issue.
It becomes an emotionally charged issue since performance measurement is affected by the value established for the transfer price.
A company can not make a profit from itself. Real profits come from selling to third parties.

31. Define the three ways to set transfer prices.
Market Price
Cost-Based
Negociated

32. How to calculate transfer prices.
11-7
Omni, Inc., has a number of divisions, including Indigo Division, a producer of microcircuit boards and Lima Division a producer of controllers for heating and controlling manufacturers.
Indigo produces the bk-912 model that can be used by Lima Division in the production of its control systems for regulating heating and air conditioning systems. The market price of the bk-912 is $15 and the full cost is $8
REQUIRED:
1. If Omni, Inc. has a transfer pricing policy that requires transfer at full cost, what would the transfer price be? Do you suppose that Indigo and Lima would choose to transfer at that price?

33. How to calculate transfer prices.
11-7
2. If Omni, Inc. has a transfer pricing policy that requires transfer at market price, what would the transfer price be? Do you suppose that Indigo and Lima would choose to transfer at that price?
3. Now suppose that Omni, Inc., allows negotiated transfer pricing and that Indigo Division can avoid a $3 selling expense by selling to Lima Division. Which division sets the minimum transfer price, and what is it? Which division sets the maximum transfer price and what is it? Do you suppose that Indigo and Lima Divisions would choose to transfer somewhere in the bargaining range?

34. How to calculate transfer prices.
11-7
Calculations:
The full cost transfer price is $8. Lima Division would be delighted with that price, but Indigo Division would refuse to transfer since $15 could be earned in the outside market.
The market price is $15. Both Indigo and Lima divisions would be willing to transfer at that price (since neither division would be worse off than if it bought/sold in the outside market).

35. How to calculate transfer prices.
11-7
3. Minimum transfer price = $15 - $3 = $12
The price is set by Indigo Division, the selling division.
Maximum transfer price = $15
This price is the market price and is set by Lima Division, the buying division.
Yes, both divisions would be willing to a accept a transfer price within the bargaining range. Precisely what the transfer price would be depends on the negotiating skills of the Indigo and Lima Division managers.