1. Chapter 22: Performance Evaluation, Variable Costing, and Decentralization
Financial and Managerial Accounting:
The Cornerstones of Business Decisions, 2e
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2. Decentralization and Responsibility Centers1
In general, a company is organized along lines of responsibility.
Traditional organizational charts illustrate the flow of responsibilities from the chief executive officer down through the vice presidents to middle- and lower-level managers.
Today, most companies use a more flattened hierarchy that emphasizes teams.
This structure is consistent with decentralization.
The practice of delegating decision-making authority to the lower levels of management in a company is called decentralization.
In general, a company is organized along lines of responsibility. Traditional organizational charts illustrate the flow of responsibilities from the chief executive officer down through the vice presidents to middle- and lower-level managers. Today, most companies use a more flattened hierarchy that emphasizes teams. This structure is consistent with decentralization. The practice of delegating decision-making authority to the lower levels of management in a company is called decentralization.
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3. Centralization and Decentralization1
Firms with multiple responsibility centers usually choose one of two decision-making approaches to manage their diverse and complex activities: centralized or decentralized. In centralized decision making, decisions are made at the very top level, and lower-level managers are charged with implementing these decisions. Decentralized decision making allows managers at lower levels to make and implement key decisions pertaining to their areas of responsibility. Organizations range from highly centralized to strongly decentralized. Most firms fall somewhere in between, with the majority tending toward decentralization.
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4. Reasons for Decentralization1
Firms decide to decentralize for several reasons, including the following:
ease of gathering and using local information
focusing of central management
training and motivating of segment managers
enhanced competition, exposing segments to market forces
Firms decide to decentralize for several reasons, including the following:
ease of gathering and using local information
focusing of central management
training and motivating of segment managers
enhanced competition, exposing segments to market forces
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5. Responsibility Centers1
A third way divisions differ is by the type of responsibility given to the divisional manager.
A responsibility center is a segment of the business whose manager is accountable for specified sets of activities.
The four major types of responsibility centers are as follows:
Cost center: Manager is responsible only for costs.
Revenue center: Manager is responsible only for sales, or revenue.
Profit center: Manager is responsible for both revenues and costs.
Investment center: Manager is responsible for revenues, costs, and investments.
A third way divisions differ is by the type of responsibility given to the divisional manager. A responsibility center is a segment of the business whose manager is accountable for specified sets of activities. The four major types of responsibility centers are as follows:
Cost center: Manager is responsible only for costs.
Revenue center: Manager is responsible only for sales, or revenue.
Profit center: Manager is responsible for both revenues and costs.
Investment center: Manager is responsible for revenues, costs, and investments.
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6. Responsibility Centers and Accounting Information for Performance1
Investment centers represent the greatest degree of decentralization (followed by profit centers and finally by cost and revenue centers) because their managers have the freedom to make the greatest variety of
decisions.
This exhibit displays responsibility centers along with the type of information that managers need to manage their operations. Investment centers represent the greatest degree of decentralization (followed by profit centers and finally by cost and revenue centers) because their managers have the freedom to make the greatest variety of decisions.
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7. 2
Absorption Costing
Absorption costing assigns all manufacturing costs to the product.
Direct materials, direct labor, variable overhead, and fixed overhead define the cost of a product.
Under this method, fixed overhead is assigned to the product through the use of a predetermined fixed overhead rate and is not expensed until the product is sold.
In other words, fixed overhead is an inventoriable cost.
Absorption costing assigns all manufacturing costs to the product. Direct materials, direct labor, variable overhead, and fixed overhead define the cost of a product. Under this method, fixed overhead is assigned to the product through the use of a predetermined fixed overhead rate and is not expensed until the product is sold. In other words, fixed overhead is an inventoriable cost.
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8. 2
Variable Costing
Variable costing stresses the difference between fixed and variable manufacturing costs.
Variable costing assigns only variable manufacturing costs to the product; these costs include direct materials, direct labor, and variable overhead.
Fixed overhead is treated as a period expense and is excluded from the product cost.
Under variable costing, fixed overhead of a period is seen as expiring that period and is charged in total against the revenues of the period.
Variable costing stresses the difference between fixed and variable manufacturing costs. Variable costing assigns only variable manufacturing costs to the product; these costs include direct materials, direct labor, and variable overhead. Fixed overhead is treated as a period expense and is excluded from the product cost. Under variable costing, fixed overhead of a period is seen as expiring that period and is charged in total against the revenues of the period.
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9. Comparison of Variable and Absorption Costing Methods2
Comparison of Variable and Absorption Costing Methods
This slide illustrates the classification of costs as product or period costs under absorption and variable costing. Generally accepted accounting principles (GAAP) require absorption costing for external reporting. The Financial Accounting Standards Board (FASB), the Internal Revenue Service (IRS), and other regulatory bodies do not accept variable costing as a product-costing method for external reporting. Yet variable costing can supply vital cost information for decision making and control, information not supplied by absorption costing. For internal application, variable costing is an important managerial tool.
The Financial Accounting Standards Board (FASB), the Internal Revenue Service (IRS), and other regulatory bodies do not accept variable costing as a product-costing method for external reporting.
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10. Comparison of Variable and Absorption Costing Methods2
Comparison of Variable and Absorption Costing Methods
As this slide illustrates in picture form, since the only difference between the two approaches is the treatment of fixed factory overhead, the unit product cost under absorption costing is always greater than the unit product cost under variable costing.
The only difference between the two approaches is the treatment of fixed factory overhead. As a result, the unit product cost under absorption costing is always greater than the unit product cost under variable costing.
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11. Production, Sales, and Income Relationships2
Production, Sales, and Income Relationships
The relationship between variable-costing income and absorption-costing income changes as the relationship between production and sales changes.
The relationship between variable-costing income and absorption-costing income changes as the relationship between production and sales changes. If more is sold than was produced, variable-costing income is greater than absorption-costing. Selling more than was produced means that beginning inventory and units produced are being sold. Under absorption costing, units coming out of inventory have attached to them fixed overhead from a prior period. Variable-costing income is greater than absorption-costing income by the amount of fixed overhead flowing out of beginning inventory.
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12. Segmented Income Statements Using Variable Costing2
Segmented Income Statements Using Variable Costing
Variable costing is useful in preparing segmented income statements because it gives useful information on variable and fixed expenses.
A segment is a subunit of a company of sufficient importance to warrant the production of performance reports.
Segments can be divisions, departments, product lines, customer classes, and so on.
In segmented income statements, fixed expenses are broken down into two categories:
direct fixed expenses and
common fixed expenses.
Variable costing is useful in preparing segmented income statements because it gives useful information on variable and fixed expenses. A segment is a subunit of a company of sufficient importance to warrant the production of performance reports. Segments can be divisions, departments, product lines, customer classes, and so on. In segmented income statements, fixed expenses are broken down into two categories: direct fixed expenses and common fixed expenses.
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13. (Beginning assets + Ending assets) ÷ 2
Measuring the Performance of Investment Centers By Using Return on Investment 3
Typically, investment centers are evaluated on the basis of return on investment (ROI). ROI is the profit earned per dollar of investment and is calculated as:
Operating income ÷ Average Operating Assets
Other common measures include residual income and economic value added (EVA).
Operating income refers to earnings before interest and taxes.
Operating assets are all assets acquired to generate operating income, including cash, receivables, inventories, land, buildings, and equipment.
Average operating assets is computed as:
(Beginning assets + Ending assets) ÷ 2
Typically, investment centers are evaluated on the basis of return on investment (ROI). ROI is the profit earned per dollar of investment and is calculated as: Operating income ÷ Average Operating Assets
Other common measures include residual income and economic value added (EVA). Operating income refers to earnings before interest and taxes. Operating assets are all assets acquired to generate operating income, including cash, receivables, inventories, land, buildings, and equipment. Average operating assets is computed as: (Beginning assets + Ending assets) ÷ 2
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14. Margin and Turnover 3
A second way to calculate ROI is to separate the formula (Operating income/Average operating assets) into margin and turnover.
Margin is the ratio of operating income to sales.
It tells how many cents of operating income result from each dollar of sales; it expresses the portion of sales that is available for interest, taxes, and profit.
Turnover is a different measure; it is found by dividing sales by average operating assets.
Turnover tells how many dollars of sales result from every dollar invested in operating assets.
A second way to calculate ROI is to separate the formula (Operating income/Average operating assets) into margin and turnover. Margin is the ratio of operating income to sales. It tells how many cents of operating income result from each dollar of sales; it expresses the portion of sales that is available for interest, taxes, and profit. Turnover is a different measure; it is found by dividing sales by average operating assets. Turnover tells how many dollars of sales result from every dollar invested in operating assets.
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15. Margin and Turnover 3
The equation that yields ROI from the Margin and Turnover is as follows:
ROI = Margin Operating Income X Turnover Sales
Sales Average Operating Assets
Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets.
The equation that yields ROI from the Margin and Turnover is as follows:
ROI = Margin Operating Income X Turnover Sales
Sales Average Operating Assets
Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets.
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16. Residual Income 4
To compensate for the tendency of ROI to discourage investments that are profitable for the company but that lower a division’s ROI, some companies have adopted alternative performance measures such as residual income.
EVA is an alternate way to calculate residual income that is being used in a number of companies.
Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:
Residual income = Operating income – (Minimum rate of return X Average operating assets)
To compensate for the tendency of ROI to discourage investments that are profitable for the company but that lower a division’s ROI, some companies have adopted alternative performance measures such as residual income. EVA is an alternate way to calculate residual income that is being used in a number of companies. Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:
Residual income = Operating income – (Minimum rate of return X Average operating assets)
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17. Economic Value Added (EVA)4
Another financial performance measure that is similar to residual income is economic value added.
Economic value added (EVA) is after tax operating income minus the dollar cost of capital employed.
The dollar cost of capital employed is the actual percentage cost of capital multiplied by the total capital employed, expressed as follows:
Another financial performance measure that is similar to residual income is economic value added. Economic value added (EVA) is after tax operating income minus the dollar cost of capital employed. The dollar cost of capital employed is the actual percentage cost of capital multiplied by the total capital employed.
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18. The Balanced Scorecard – Basic Concepts5
Segment income, ROI, residual income, and EVA are important measures of managerial performance, but they lead managers to focus only on dollar figures.
The Balanced Scorecard translates an organization’s mission and strategy into operational objectives and performance measures for the following four perspectives:
The financial perspective describes the economic consequences of actions taken in the other three perspectives.
The customer perspective defines the customer and market segments in which the business unit will compete.
The internal business process perspective describes the internal processes needed to provide value for customers and owners.
The learning and growth perspective defines the capabilities that an organization needs to create long-term growth and improvement.
Segment income, ROI, residual income, and EVA are important measures of managerial performance, but they lead managers to focus only on dollar figures. The Balanced Scorecard translates an organization’s mission and strategy into operational objectives and performance measures for the following four perspectives:
The financial perspective describes the economic consequences of actions taken in the other three perspectives.
The customer perspective defines the customer and market segments in which the business unit will compete.
The internal business process perspective describes the internal processes needed to provide value for customers and owners.
The learning and growth perspective defines the capabilities that an organization needs to create long-term growth and improvement.
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19. Impact of Transfer Pricing on Divisions and the Firm As A Whole5
When one division of a company sells to another division, both divisions as well as the company as a whole are affected.
The price charged for the transferred good affects both
the costs of the buying division
the revenues of the selling division
Thus, the profits of both divisions, as well as the evaluation and compensation of their managers, are affected by the transfer price.
When one division of a company sells to another division, both divisions as well as the company as a whole are affected. The price charged for the transferred good affects both:
the costs of the buying division
the revenues of the selling division
Thus, the profits of both divisions, as well as the evaluation and compensation of their managers, are affected by the transfer price.
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20. Transfer Pricing Policies5
The actual transfer price nets out for the company as a whole in that total pretax income for the company is the same regardless of the transfer price.
However, transfer pricing can affect the level of after-tax profits earned by the multinational company that operates in multiple countries with different corporate tax rates and other legal requirements set by the countries in which the various divisions generate income.
Several transfer pricing policies are used in practice, including the following:
market price
cost-based transfer prices
negotiated transfer prices
The actual transfer price nets out for the company as a whole in that total pretax income for the company is the same regardless of the transfer price.
However, transfer pricing can affect the level of after-tax profits earned by the multinational company that operates in multiple countries with different corporate tax rates and other legal requirements set by the countries in which the various divisions generate income. Several transfer pricing policies are used in practice, including the following:
market price
cost-based transfer prices
negotiated transfer prices
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20