Chapter Fifteen Performance Evaluation © 2015 McGraw-Hill Education.

LO 1 Describe the concept of decentralization. LO

An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items. 15-3

Decentralization Improves quality of decisions. Encourages upper-level management to concentrate on strategic decisions. Improves productivity. Develops lower-level managers. Improves performance evaluation. Advantages 15-4

Decision-Making is Pushed Down Decentralization often occurs as organizations continue to grow. Decentralization 15-5

Organization Chart Corporate headquarters – Panther Holding Company Lumber manufacturing division Home building division Furniture manufacturing division Wilson Carpet Company Selma Sopha Corporation Tables Incorporated Sales department Production department Planning department Accounting department Cutting department Assembly department Finishing department Responsibility Level

Responsibility Centers Investment Center Profit CenterCost Center 15-7

Cost Center Profit Center Investment Center Evaluation Measures Profitability Return on investment (ROI) Residual income (RI) Cost control Quantity and quality of services Managerial Performance Measurement 15-8

Since the exercise of control may be clouded, managers are usually held responsible for items over which they have predominant rather than absolute control. I’m in control Controllability Concept Managers should only be evaluated on revenues or costs they control. 15-9

LO 1 Distinguish between flexible and static budgets. LO

Preparing Flexible Budgets The master budget, sometimes called a static budget, is based solely on the planned volume of activity. Flexible budgets differ from static budgets in that they show expected revenues and costs at a variety of volume levels

Preparing Flexible Budgets Melrose Manufacturing, a producer of small high-quality trophies, plans to make and sell 18,000 trophies during Melrose uses a standard cost system as outlined below: 15-12

Preparing Flexible Budgets With very little effort, the accountant can provide management with a flexible budget for both budgeted and actual levels of activity. The flexible budget is a critical tool in effective performance evaluation

Preparing Flexible Budgets From the standard cost information, Melrose prepares the following static and flexible budgets. Exhibit 15.1 Static and Flexible Budgets in Excel Spreadsheet 18,000 × $80 = $1,440,000 $ 259,

LO 1 Classify variances as being favorable or unfavorable. LO

Determining Variances for Performance Evaluation The differences between standard and actual amounts are called variances. A variance may be favorable or unfavorable. When actual sales are less than expected, an unfavorable sales variance exists. When actual sales revenue is greater than expected revenue, a company has a favorable sales variance

Determining Variances for Performance Evaluation Variances are not limited to the evaluation of revenues. They can also be used to understand the differences between standard and actual amounts of costs. When actual costs are less than standard costs, cost variances are favorable because lower costs increase net income. Unfavorable cost variances exist when actual costs are more than standard costs

LO 1 Compute and interpret sales and variable cost volume variances. LO

Sales Volume Variances The difference between the static budget sales amount and the flexible budget sales amount is a measure of the sales volume variance. Exhibit 15.2 Melrose Manufacturing Company’s Volume Variances 15-19

Interpreting the Volume Variances In a standard cost system, marketing managers are usually responsible for the volume variance. Because sales volume drives production, production managers have little control over volume variance. In the case of Melrose, the marketing manager exceeded planned sales volume by 1,000 units, resulting in an $80,000 favorable revenue variance ($80 × 1,000). The unfavorable cost variances are somewhat misleading. Melrose incurred higher costs because it manufactured and sold more units than planned

Fixed Cost Considerations The fixed costs are the same in both the static and flexible budgets. Spending Variance The difference between the budgeted fixed costs and the actual fixed costs Fixed Cost Volume Variance The difference between costs at planned volume versus actual volume 15-21

LO 1 Compute and interpret flexible budget variances. LO

Flexible Budget Variances For effective performance evaluation, management must compare the actual results achieved to the flexible budget based on the actual volume of activity. Here is a comparison of the standard amount and actual amount per unit for the current period for Melrose

Flexible Budget Variances Now we are comparing actual results achieved with the results that should have been achieved at the activity level. Exhibit 15.3 Flexible Budget Variances for Melrose Manufacturing Company $78 × 19,000 = $1,482,

Calculating Sales Price Varianceor 15-25

The Human Element Associated with Flexible Budget Variances The flexible budget cost variances offer insight into management efficiency. As with sales variances, cost variances require careful analysis. A favorable materials variance could mean that purchasing agents are good negotiators or it might be caused by paying low prices for inferior goods

Standards are the building blocks of budgets. Performance report detail varies according to the level in an organization. Department manager receives detailed reports. Store manager receives summarized information from each department. Management by Exception 15-27

The vice president of operations receives summarized information from each unit. Management by exception Upper-level management does not receive operating detail unless problems arise. Management focuses on areas not performing as expected. Management by Exception Businesses cannot afford to have managers spend large amounts of time on operations that function normally

LO 1 Evaluate investment opportunities using return on investment. LO

Return on Investment Return on investment is the ratio of income to the investment used to generate the income. Return on investment is the ratio of income to the investment used to generate the income. ROI = Operating Income Operating Assets 15-30

Return on Investment Panther Holding Company provides the following information for the company’s second level investment centers. Let’s calculate ROI

Return on Investment Lumber Manufacturing Home Building Furniture Manufacturing = = = $60,000 $300,000 $46,080 $256,000 $81,940 $482,000 = 20% = 18% = 17% All other things being equal, higher ROIs indicate better performance

Measuring Operating Assets Using the book value of operating assets to calculate ROI will result in a higher ROI

ROI = Operating Income Operating Assets Margin Turnover Factors Affecting ROI ROI = × Sales Operating Assets Operating Income Sales 15-34

The Lumber Manufacturing Division reported the following information: Operating Income$ 60,000 Sales$ 600,000 Sales$ 600,000 Operating Assets$ 300,000 Operating Assets$ 300,000 Factors Affecting ROI Let’s calculate ROI using the expanded equation

ROI =.10 × 2 = ROI =.10 × 2 = 20% Factors Affecting ROI ROI = $60,000 $600,000 × $300,000 ROI = × Sales Operating Assets Operating Income Sales 15-36

Factors Affecting ROI Three ways to improve ROI 1 Increase Sales 2 Reduce Expenses 3 Reduce Operating Assets ( The investment base ) 15-37

The Lumber Manufacturing Division was able to increase sales to $660,000 which increased operating income to $72,600. There was no change in operating assets. The Lumber Manufacturing Division was able to increase sales to $660,000 which increased operating income to $72,600. There was no change in operating assets. Factors Affecting ROI Let’s calculate the new ROI

The division’s ROI increased from 20% to 24.2%. Factors Affecting ROI ROI =.11 × 2.2 = 24.2% ROI = $72,600 $660,000 × $300,000 ROI = × Sales Operating Assets Operating Income Sales 15-39

ROI - A Major Drawback As division manager in Lumber Manufacturing, your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager in Lumber Manufacturing, your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 20% on all new investments -- your division has been producing an ROI of 30%. You have an opportunity to invest in a new project that will produce an ROI of 25%. As division manager, would you invest in this project? 15-40

ROI - A Major Drawback As division manager, I wouldn’t invest in that project because it would lower my pay! Gee... I thought we were supposed to do what was best for the company! 15-41

LO 1 Evaluate investment opportunities using residual income. LO

Residual Income Operating Income – Investment charge = Residual income Operating Assets × Desired ROI = Investment charge Investment center’s cost of acquiring investment capital 15-43

Residual Income The Lumber Manufacturing Division currently earns $60,000 of operating income with the $300,000 of operating assets it controls. Panther has a 18% desired ROI. The Lumber Manufacturing Division currently earns $60,000 of operating income with the $300,000 of operating assets it controls. Panther has a 18% desired ROI. Let’s calculate residual income

Residual Income Panther’s desired return on investment. Operating income= $60,000 – Desired income = 54,000 = Residual income= $ 6,000 Operating assets = $300,000 × Desired ROI = 18% = Desired income = $ 54,

Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. Suboptimization occurs with ROI when managers benefit themselves at the expense of the company 15-46

Responsibility Accounting and the Balanced Scorecard The balanced scorecard is a holistic approach to evaluating managers. Balanced Scorecard Multiple financial measures Multiple non-financial measures 15-47

End of Chapter Fifteen 15-48