1. Decentralization and Performance Evaluation

2. Decentralization and Performance Evaluation
Responsibility Centers
Costs and benefits of decentralization
Return on Investment
Residual Income

3. Decentralization and Performance Evaluation
Responsibility Centers
Costs and benefits of decentralization
Return on Investment
Residual Income

4. Responsibility Centers
Responsibility Centers include:
Cost Centers
Revenue Centers
Profit Centers
Investment Centers

5. Responsibility Centers
Cost Centers
A cost center is a segment whose manager is responsible for costs but not for revenues.
Revenue Centers
Profit Centers
Investment Centers

6. Responsibility Centers
Cost Centers
Revenue Centers
Revenue center managers are mostly responsible for generating sales, not for the cost of goods sold.
Profit Centers
Investment Centers

7. Responsibility Centers
Cost Centers
Revenue Centers
Profit Centers
Profit center managers are responsible for revenues as well as costs. These costs may include indirect costs.
Investment Centers

8. Responsibility Centers
Cost Centers
Revenue Centers
Profit Centers
Investment Centers
Investment center managers are responsible not only for revenues and costs, but also for the investment required to generate profits.

9. Responsibility Centers
Levi Strauss
San Francisco
Levi Strauss
Canada
Levi Strauss
U.S.A.
Levi Strauss
Europe
Investment Centers
Profit Centers
Cost Centers
Revenue Centers
Dockers
Jeans
Factories
Warehouses
Sales offices

10. Responsibility Centers
What reports are used to evaluate these responsibility center managers?
Cost Centers
report of costs
Revenue Centers
report of sales
Profit Centers
Divisional income statement
Investment Centers
Return on Investment

11. Decentralization and Performance Evaluation
Responsibility Centers
Costs and benefits of decentralization
Return on Investment
Residual Income

12. Responsibility Centers
Benefits of Decentralization:
Takes advantage of knowledge and expertise within the organization.
Autonomy can be an intrinsic reward.
Places fewer demands on top management.

13. Responsibility Centers
Costs of Decentralization:
Loss of Control.
Goal Congruence.

14. Decentralization and Performance Evaluation
Responsibility Centers
Costs and benefits of decentralization
Return on Investment
Residual Income

15. ROI and Residual Income
Where
IRR = Internal Rate of Return
ROI = Return on Investment
NPV = Net Present Value
R.I. = Residual Income

16. Return on Investment (ROI)
Some Measure of Income
ROI =
Some Measure of Investment
Examples of ROI that you may have seen:
ROE = Return on Equity
ROA = Return on Assets
These are usually employed at a firm-wide level for financial statement analysis. In cost accounting, we are usually more interested in ROI calculations for a part of the firm (e.g., a division).

17. Return On Investment (ROI)
Operating Profit
ROI =
Divisional Investment
Operating Profit
Divisional Revenues = x
Division Revenues
Divisional Investmt
= Return on Sales x Turnover Ratio

18. Return On Investment (ROI)
Operating Profit
ROI =
Division Investment
ADVANTAGES:
ROI is a measure of profitability that is independent of the size of the division.
DISADVANTAGES:
Can encourage divisional managers to reject good investments.

19. Decentralization and Performance Evaluation
Responsibility Centers
Costs and benefits of decentralization
Return on Investment
Residual Income

20. Residual Income (RI) ADVANTAGES: RI = Profits
- (Hurdle Rate x Investment)
This hurdle rate usually should be equal to or greater than the cost of capital.
ADVANTAGES:
Some argue that Residual Income comes very close to what investors care about.
E.V.A. (Economic Value Added) is a type of Residual Income calculation.

21. Measurement Issues Income:
Residual Income should exclude interest on debt.
Both RI and ROI might include some allocated corporate costs.
Investment:
Always includes identifiable assets.
Can also include some allocated corporate assets.
Fixed assets might be stated at
Original Cost
Original cost less accumulated depreciation (book value)
Current replacement cost

22. Cat Food Company has two divisions, Turkey and Fish
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey Fish
Net Operating Income $50,000 $60,000
Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the residual income for the Fish Division?

23. Cat Food Company has two divisions, Turkey and Fish
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey Fish
Net Operating Income $50,000 $60,000
Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the residual income for the Fish Division?
operating income - (average investment x cost of capital)
= $60,000 - ($400,000 x 18%)
= $60,000 - $72,000
= ($12,000)

24. Cat Food Company has two divisions, Turkey and Fish
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey Fish
Net Operating Income $50,000 $60,000
Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the return on investment (ROI) for the Turkey Division?

25. Cat Food Company has two divisions, Turkey and Fish
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey Fish
Net Operating Income $50,000 $60,000
Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the return on investment (ROI) for the Turkey Division?
operating income ÷ average operating assets
= $50,000 ÷ $250,000
= 20%

26. Cat Food Company has two divisions, Turkey and Fish
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey Fish
Net Operating Income $50,000 $60,000
Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
A project with a return of $36K on an investment of $200K exists. If divisions are evaluated based on residual income, which divisions would accept the project?

27. Cat Food Company has two divisions, Turkey and Fish
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey Fish
Net Operating Income $ 50,000 $ 60,000
Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
A project with a return of $36,000 on an investment of $200,000 exists. If divisions are evaluated based on residual income, which divisions would accept the project?
$36,000 - ($200,000 x 18%) = $0.
Both Turkey division and Fish division are indifferent.