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.

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).

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).

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

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

Illustrate Centralization Vs. Decentralization

Illustration of PepsiCo's Decentralized Divisions

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

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

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.

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

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

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 = 0 + 12,000 – 10,000 = 2,000

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

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

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

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

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

Review the Relationships Between Production, Sales & Income   IF 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

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 200,000 150,000 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.

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 $ 450,000 $ 320,000 $ 770,000 Variable cost of goods sold (225,000) (160,000) (385,000) Variable selling expense (22,500) (16,000) (38,500) Contribution margin $ 202,500 $ 144,000 346,500 Less: direct fixed expenses: Direct fixed overhead (30,000) (20,000) (50,000) Direct sell & admin (10,000) (15,000) (25,000) Segment margin $ 162,500 $ 109,000 $ 271,500 Less: common fixed expenses Common fixed overhead (100,000) Common sell & admin Net income $ 151,500

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

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

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

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%

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.

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

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 taxes @30% 18,000 Net income $ 42,000 Total capital employed equaled $330,000. Celimar’s actual cost of capital is 10%.

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

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.

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

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?

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?

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).

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.