Responsibility Accounting Chapter Twelve Responsibility Accounting 1 1 1 1

Pros and Cons of Decentralization Better information, leading to better decisions Faster response to changing circumstances Increased motivation for managers Excellent training for future leaders

Pros and Cons of Decentralization Costly duplication of activities Lack of goal congruence

Goal Congruence Goal congruence means that as people work to achieve their own goals, they also work to achieve the goals of the company. 9 5

Responsibility Accounting A responsibility accounting system generates reports to employees, including managers, about the performance of their assigned responsibility. Types of responsibility centers Cost center Revenue center Profit center Investment center 6 11 6

Cost Centers A cost center is a segment whose manager is responsible for costs but not for revenues. Examples: Manufacturing cells Office of the CEO Legal department Accounting department 13 7

Profit and Investment Centers A profit center is a segment whose manager is responsible for revenues as well as costs. An investment center is a segment whose manager is responsible not only for revenues and costs, but also for the investment required to generate profits. 17 9

Performance Evaluation Criteria Selecting criteria to measure and evaluate performance is important because the criteria influence managers’ actions. YOU GET WHAT YOU MEASURE! The most common deficiencies in performance measures are: using a single measure that emphasizes only one objective of the organization; and using measures that either misrepresent or fail to reflect the organization’s objectives or the employee’s responsibilities. 21 11

Managerial Accounting Issues Related to Decentralization The need to develop methods of evaluating performance that work to the benefit of the company as a whole. The need to develop transfer prices that produce decisions in the best interest of the company. 17 8

Measures of Performance Companies use four principal measures to evaluate divisions: Income Return on Investment (ROI) Residual Income (RI) Economic Value Added (EVA) 7 8 9 18

ROI Formula ROI = Divisional income/Divisional investment Companies define and measure divisional income and divisional investment in various ways. 19 10

Alternative ROI Formula ROI = Profit margin x Turnover Profit Margin = Divisional income/Divisional sales Turnover = Divisional sales/Divisional investment 20 11

An ROI Example 2002 Alpha Division Beta Div Divisional sales $10,000 $60,000 Divisional income (NOPAT) 1,000 2,500 Average divisional as sets 6,000 17,500 2003 Divisional sales $17,500 $60,000 Divisional income (NOPAT) 1,250 2,750 Average divisional assets 6,000 17,500 Cost of capital is 10 percent

NOPAT NOPAT is net operating profit after tax Equals net income plus interest net of tax Relates income to assets utilized to generate that income Does not consider the effect of using financial leverage (debt) on the rate of return Is consistent with return on assets from Acct 284

Return on Sales and Turnover Comparisons Alpha Alpha Beta Beta 2002 2003 2002 2003 Profit margin 10.0% 7.1% 4.2% 4.6% Turnover 1.667 2.917 3.429 3.429 ROI 16.7% 20.7% 14.4% 15.8%

A Residual Income Example Residual income = NOPAT – (Assets x RRR) RRR = required rate of return Alpha Alpha Beta Beta 2002 2003 2002 2003 Divisional operating assets $6,000 $6,000 $17,500 $17,500 Divisional operating income $1,000 $1,250 $2,500 $2,750 Minimum return 600 600 1,750 1,750 Residual income $400 $650 $750 $1,000 23 14

Comparison of ROI versus RI Alpha Alpha Beta Beta 2002 2003 2002 2003 Return on investment 16.7% 20.7% 14.4% 15.8% Residual income $400 $650 $750 $1,000 Which method would you prefer?

ROI Versus RI Using ROI to evaluate divisions can encourage them to reject good investments and accept poor investments. 25 16

ROI, RI and Goal Congruence ROI evaluation will encourage managers to accept any opportunity above the current ROI RI will encourage managers to accept any opportunity above the cost of capital. Which gives better goal congruence? Which would encourage growth?

Economic Value Added Same calculation as residual income but adjusts for capitalization of Research and development costs and other “accounting distortions” R & D is then amortized against income Gives managers the incentive to spend R & D Other adjustments to income that are designed to encourage certain behaviors are often incorporated into performance evaluation techniques.

Whole Foods Market Whole foods markets uses EVA analysis http://www.wholefoodsmarket.com/investor/eva.html Date:5/2/2006

We use Economic Value Added ("EVA") to evaluate our business decisions and as a basis for determining incentive compensation. In its simplest definition, EVA is equivalent to net operating profits after taxes minus a charge for the cost of capital necessary to generate those profits. We believe that one of our core strengths is our decentralized culture, where decisions are made at the store level, close to the customer. We believe this is one of our strongest competitive advantages, and that EVA is the best financial framework that team members can use to help make decisions that create sustainable shareholder value. We use EVA extensively for capital investment decisions, including evaluating new store real estate decisions and store remodeling proposals. We are turning down projects that do not add long-term value to the Company. The EVA decision-making model is also enhancing operating decisions in stores. Our emphasis is on EVA improvement, as we want to challenge our teams to continue to innovate and grow EVA in new ways. We believe that opportunities always exist to increase sales and margins, to lower operating expenses and to make investments that add value in ways that benefit all of our stakeholders. We believe that focusing on EVA improvement encourages continuous improvement of our business.

Over 500 leaders throughout the Company are on EVA-based incentive compensation plans, of which the primary measure is EVA improvement. EVA-based plans cover our senior executive leadership, regional leadership and the store leadership team in all stores. Incentive compensation for each of these groups is determined based on relevant EVA measures at different levels, including the total company level, the regional level, the store or facility level, and the team level. We believe using EVA in a multi-dimensional approach best measures the results of decisions made at different levels of the Company. We expect to continue to expand the use of EVA as a significant component of our compensation structure throughout the Company in the coming years. The following table sets forth selected EVA information based on a 9% weighted average cost of capital and a 40% tax rate for the fiscal years ended September 25, 2005 and September 26, 2004.(in thousands)

2005 2004 Net operating profit after tax (NOPAT)   $ 165,579 136,684 Capital charge 139,793 119,101 EVA 25,786 17,583 Increase in EVA 8,203 -* * EVA calculations not updated in 2003, due to lease restatements. The Company provides information regarding EVA as additional information about its operating results. EVA is a measure not in accordance with, or an alternative to, generally accepted accounting principles ("GAAP"). The Company's management believes that this additional EVA information is useful to shareholders, management, analysts and potential investors in evaluating the Company's results of operations and financial condition. In addition, management uses these measures for reviewing the financial results of the Company and for budget planning and incentive compensation purposes. EVA is calculated by subtracting a charge for the use of capital (capital charge) from net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income to NOPAT follows (in thousands):

Provision for income taxes 100,782 86,341 Interest expense and other   2005 GAAP net income $ 136,351 129,511 Provision for income taxes 100,782 86,341 Interest expense and other 38,832 11,955 Net operating profit before taxes (NOPBT) 275,965 227,807 Taxes (40%) 110,386 91,121 NOPAT 165,579 136,686 Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net assets to ending EVA capital follows (in thousands): 2004 Total assets 1,696,953 1,370,882 Total liabilities 537,648 523,589 Net assets 1,159,305 847,293 Long-term debt and capital lease obligations 87,919 171,305 Implied goodwill (from pooling-of-interest transactions) 162,803 Other* 143,740 141,977 EVA capital 1,553,767 1,323,378 * Accumulated components of net income not included in NOPAT — EVA® is a registered trademark of Stern Stewart & Co.

The Balanced Scorecard An approach known as the balanced scorecard has become popular recently. This approach extends performance evaluation from merely looking at financial results to formally incorporating measures that look at customer satisfaction, internal business processes, and the learning and growth potential of the organization.

The Balanced Scorecard (Continued) The balanced scorecard asks four basic questions: 1. How do customers see us? (the customer perspective) 2. What must we excel at? (the internal business process perspective) 3. Can we continue to improve and create value? (the learning & growth perspective) 4. How do we look to stockholders? (the financial perspective)

Transfer Price Sometimes a center with no external customers is made into an artificial profit center. Then transfer prices, which are prices that one center charges another center within the company, are needed. 18 10

TRANSFER PRICING POLICIES Transfer Pricing Methods Actual costs with or without a markup Budgeted costs with or without a markup Market-based prices Incremental cost Negotiated prices 34 18

Actual Cost These transfer prices are not wise because the selling manager has no incentive to keep costs down. Worse, a price that is actual costs plus a percentage markup gives the selling manager more profit the higher costs go. 35 19

Budgeted Cost This method does not reward the selling manager if costs go up, and actually encourages the selling manager to keep costs down. 36 20

Market-Based Prices This method is generally consider, the best. The biggest problem is that an outside market price may not exist. The transfer price may be less than the market price due to cost savings from selling internally. 37 21

Incremental Cost Such prices are theoretically best from the company’s viewpoint when the selling division is operating below capacity. Incremental cost can be as low as the variable cost of the goods or services. 38 22

Negotiated Prices This method allows managers to bargain with each other and alleviates some problems that arise with other methods. Normally will lead to the right outcome if managers negotiate in good faith. 39 23