McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Decentralization

10-2 Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. Decision-making authority leads to job satisfaction. Lower-level decision often based on better information. Lower-level decision often based on better information. Lower-level managers can respond quickly to customers.

10-3 Decentralization in Organizations Disadvantages of Decentralization Lower-level managers may make decisions without seeing the “big picture.” Lower-level managers may make decisions without seeing the “big picture.” May be a lack of coordination among autonomousmanagers. May be a lack of coordination among autonomousmanagers. Lower-level manager’s objectives may not be those of the organization. Lower-level manager’s objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization. May be difficult to spread innovative ideas in the organization.

10-4 Cost, Profit, and Investments Centers ResponsibilityCenterResponsibilityCenter Cost Center Cost Center Profit Center Profit Center Investment Center Investment Center Cost, profit, and investment centers are all known as responsibility centers.

10-5 Cost, Profit, and Investments Centers Cost Center A segment whose manager has control over costs, but not over revenues or investment funds.

10-6 Cost, Profit, and Investments Centers Profit Center A segment whose manager has control over both costs and revenues, but no control over investment funds. Revenues: Sales Interest Other Costs: Mfg. costs Commissions Salaries Other

10-7 Cost, Profit, and Investments Centers Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. Investment center managers are usually evaluated using return on investment (ROI) or residual income. Corporate Headquarters

10-8 Responsibility Centers Cost Centers Investment Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

10-9 Responsibility Centers Profit Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

10-10 Responsibility Centers Cost Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

10-11 Decentralization and Segment Reporting segment A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be... A Sales Territory A Service Center An Individual Store Quick Mart

10-12 Traceable and Common Fixed Costs In segment reports, traceable fixed costs should be distinguished from common fixed costs. Traceable Common

10-13 Identifying Traceable Fixed Costs Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer division means... No computer division manager.

10-14 Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but... We still have a company president. Identifying Common Fixed Costs

10-15 Learning Objective 1 Compute the return on investment (ROI) and show how changes in sales, expenses, and assets affect an organization’s ROI.

10-16 ROI = Net operating income Average operating assets Cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Income before interest and taxes (EBIT) Income before interest and taxes (EBIT) Return on Investment (ROI) Formula

10-17 Net Book Value vs. Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets. With this approach, ROI mechanically increases over time as the accumulated depreciation increases. An alternative to net book value is the gross cost of the asset, which ignores accumulated depreciation.

10-18 ROI = Net operating income Average operating assets ROI = Margin  Turnover Return on Investment (ROI) Formula Turnover = Sales Average operating assets Margin = Net operating income Sales

10-19 Increasing ROI There are three ways to increase ROI...  Increase Sales  Reduce Expenses  Reduce OperatingAssets

10-20 Increasing ROI – An Example Regal Company reports the following: Net operating income $ 30,000 Net operating income $ 30,000 Average operating assets $ 200,000 Average operating assets $ 200,000 Sales $ 500,000 Sales $ 500,000 Operating expenses $ 470,000 Operating expenses $ 470,000 ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI = What is Regal Company’s ROI?

10-21 $30,000 $500,000 × $200,000 ROI = 6%  2.5 = 15% ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI = Increasing ROI – An Example

10-22 Increasing Sales Without an Increase in Operating Assets Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000. Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000. Regal’s net operating income increased to $42,000. Regal’s net operating income increased to $42,000. There was no change in the average operating assets of the segment. There was no change in the average operating assets of the segment. Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000. Regal’s manager was able to increase sales to $600,000 while operating expenses increased to $558,000. Regal’s net operating income increased to $42,000. Regal’s net operating income increased to $42,000. There was no change in the average operating assets of the segment. There was no change in the average operating assets of the segment. Let’s calculate the new ROI.

10-23 $42,000 $600,000 × $200,000 ROI = 7%  3.0 = 21% ROI = ROI increased from 15% to 21%. ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI = Increasing Sales Without an Increase in Operating Assets

10-24 Decreasing Operating Expenses with no Change in Sales or Operating Assets Assume that Regal’s manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 40,000 Net operating income $ 40,000 Average operating assets $ 200,000 Average operating assets $ 200,000 Sales $ 500,000 Sales $ 500,000 Operating expenses $ 460,000 Operating expenses $ 460,000

10-25 Decreasing Operating Expenses with no Change in Sales or Operating Assets $40,000 $500,000 × $200,000 ROI = 8%  2.5 = 20% ROI = ROI increased from 15% to 20%. ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI =

10-26 Decreasing Operating Assets with no Change in Sales or Operating Expenses Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time techniques without affecting sales or operating expenses. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 30,000 Net operating income $ 30,000 Average operating assets $ 180,000 Average operating assets $ 180,000 Sales $ 500,000 Sales $ 500,000 Operating expenses $ 470,000 Operating expenses $ 470,000

10-27 Decreasing Operating Assets with no Change in Sales or Operating Expenses $30,000 $500,000 × $180,000 ROI = 6%  = 16.7% ROI = ROI increased from 15% to 16.7%. ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI =

10-28 Investing in Operating Assets to Increase Sales Assume that Regal’s manager invests in a $30,000 piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 50,000 Net operating income $ 50,000 Average operating assets $ 230,000 Average operating assets $ 230,000 Sales $ 535,000 Sales $ 535,000 Operating expenses $ 485,000 Operating expenses $ 485,000

10-29 $50,000 $535,000 × $230,000 ROI = 9.35%  2.33 = 21.8% ROI = ROI increased from 15% to 21.8%. ROI = Margin  Turnover Net operating income Sales Average operating assets × ROI = Investing in Operating Assets to Increase Sales

10-30 ROI and the Balanced Scorecard It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI. Which internal business process should be improved? Which customers should be targeted and how will they be attracted and retained at a profit?

10-31 In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control. Managers evaluated on ROI may reject profitable investment opportunities. Criticisms of ROI

10-32 Learning Objective 2 Compute residual income and understand its strengths and weaknesses.

10-33 The net operating income that an investment center earns above the minimum required return on its operating assets. Residual Income – Another Measure of Performance

10-34 Calculating Residual Income () This computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets.

10-35 Residual Income – An Example The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period the division earns $30,000. In the current period the division earns $30,000. The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. The Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period the division earns $30,000. In the current period the division earns $30,000. Let’s calculate residual income.

10-36 Residual Income – An Example

10-37 Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. Motivation and Residual Income

10-38 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20%

10-39 Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% Quick Check ROI = NOI/Average operating assets = $60,000/$300,000 = 20%

10-40 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

10-41 Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Quick Check ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%.

10-42 Quick Check The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

10-43 The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Quick Check ROI = $18,000/$100,000 = 18% The return on the investment exceeds the minimum required rate of return.

10-44 Quick Check Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000

10-45 Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Quick Check Net operating income$60,000 Required return (15% of $300,000) $45,000 Residual income$15,000

10-46 Quick Check If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

10-47 If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Quick Check Net operating income $78,000 Required return (15% of $400,000) 60,000 Residual income $18,000 Residual income increases $3,000.

10-48 Divisional Comparisons and Residual Income The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes. The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.

10-49 Zepher, Inc. - Continued Recall the following information for the Retail Division of Zepher, Inc. Assume the following information for the Wholesale Division of Zepher, Inc.

10-50 Zepher, Inc. - Continued It appears that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division.

10-51 Transfer Prices – Key Concepts/Definitions A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company.

10-52 There are three primary approaches to setting transfer prices: 1.Negotiated transfer prices 2.Transfers at the cost to the selling division 3.Transfers at market price There are three primary approaches to setting transfer prices: 1.Negotiated transfer prices 2.Transfers at the cost to the selling division 3.Transfers at market price Transfer Prices – Key Concepts/Definitions

10-53 End of Chapter 10