2 LEARNING OBJECTIVES Explain how & why firms choose to decentralize. Explain the difference between absorption & variable costing, & prepare segmented income statements.Compute & explain return on investment (ROI).Continued
3 LEARNING OBJECTIVESCompute & explain residual income & economic value added (EVA).Explain the role of transfer pricing in a decentralized firm.
4 What is a responsibility accounting system? LO 1What is a responsibility accounting system?A responsibility accounting system measures the results of responsibility centers according to information managers need to operate their centers.
5 REASONS FOR DECENTRALIZATION LO 1REASONS FOR DECENTRALIZATIONFirms decide to decentralize:For ease of gathering, using local informationTo focus central managementTo train & motivate segment managers,To enhance competition & expose segments to market forces
6 RESPONSIBILITY CENTER: Definition LO 1RESPONSIBILITY CENTER: DefinitionIs a segment of the business whose manager is accountable for specified sets of activities.
7 RESPONSIBILITY CENTERS LO 1RESPONSIBILITY CENTERSMajor types of responsibility centers are:Cost centersManager responsible for cost onlyRevenue centerManager responsible for sales onlyProfit centerManager responsible for sales & costsInvestment centerManager responsible for sales, costs, & capital investment
8 What are 2 ways to calculate income & how do they differ? LO 2What are 2 ways to calculate income & how do they differ?2 ways to calculate income are by absorption costing & variable costing.They differ in the treatment of fixed factory overhead.
9 COMPARISON COSTING METHODS LO 2COMPARISON COSTING METHODSEXHIBIT 10-4
10 INVENTORY VALUATION: Background LO 2INVENTORY VALUATION: BackgroundUnits in beginning inventoryUnits produced10,000Units sold ($300 per unit)8,000Variable costs per unitDirect materials$ 50Direct labor100Variable overhead50Fixed costsFixed overhead per unit produced25Fixed selling & administrative100,000
11 ABSORPTION COSTING Direct materials $ 50 Direct labor 100 LO 2ABSORPTION COSTINGDirect materials$ 50Direct labor100Variable overhead50Fixed overhead per unit produced25Unit product cost$ 225Value of ending inventory =2,000 x $ 225 = $ 450,000
12 VARIABLE COSTING Direct materials $ 50 Direct labor 100 LO 2VARIABLE COSTINGDirect materials$ 50Direct labor100Variable overhead50Unit product cost$ 200Value of ending inventory =2,000 x $ 200 = $ 400,000
13 ABSORPTION INCOME STATEMENT LO 2ABSORPTION INCOME STATEMENTSales ($300 x 8,000)$ 2,400000Less Cost of goods sold1,800,000Gross margin$ 600,000Less S&A expenses100,000Operating income$ 500,000CGS =8,000 x $ 225 = $ 1,800,000
14 VARIABLE INCOME STATEMENT LO 2VARIABLE INCOME STATEMENTSales$ 2,400,000Less variable expenses1,600,000Contribution margin800,000Less fixed costs350,000Operating income$ ,000Variable costs: 8,000 x $200Fixes costs: $250, ,000
15 ABSORPTION VS. VARIABLE LO 2ABSORPTION VS. VARIABLEIf more is sold than produced, variable costing income > absorption-costing income, opposite of Fairchild situation. Equal production & sales means equal income.
16 LO 2EXPLANATIONThe difference between variable costing & absorption costing year to year is equal to the change in fixed overhead. Under absorption costing, fixed overhead is assigned to inventory produced. Under variable costing, fixed overhead is a period expense .inventoryproducedperiod expense
17 How do variable & absorption costing affect performance evaluation? LO 2How do variable & absorption costing affect performance evaluation?Variable costing ensures that direct relationship between sales & income holds whereas absorption costing does not.
18 LO 2SEGMENT: DefinitionIs a subunit of a company of sufficient importance to warrant performance reports.
19 DIRECT FIXED EXPENSES: Definition LO 2DIRECT FIXED EXPENSES: DefinitionAre fixed expenses directly traceable to a segment & therefore, avoidable. If segment eliminated, so are expenses.avoidable
20 COMPARATIVE INCOME STATEMENTS LO 2COMPARATIVE INCOME STATEMENTSSegment margin is contribution to firm’s common fixed costs.EXHIBIT 10-11
21 Average Operating Assets LO 3FORMULA: ROIROI relates operating profits to assets employed.Return on Investment (ROI)= Operating IncomeAverage Operating Assets
22 Margin is the ratio of operating to sales. LO 3What is margin?What is turnover?Margin is the ratio of operating to sales.Turnover tells how many dollars of sales results from every dollar of invested assets.MarginTurnover
23 ADVANTAGES OF ROI Encourages managers to focus on LO 3ADVANTAGES OF ROIEncourages managers to focus onRelationship among sales, expenses (& possibility investment if this is investment center)Cost efficiencyOperating asset efficiency
24 LO 4DISADVANTAGES OF ROICan product a narrow focus on divisional profitability at expense of profitability for overall firmEncourages managers to focus on short run at expense of long run
25 RESIDUAL INCOME Residual Income = Operating income LO 4RESIDUAL INCOMEResidual income is the difference between operating income and minimum dollar return on sales.Residual Income= Operating income– (Min. rate of return x Ave. Operating Assets)= $48,000 – (0.12 x $300,000)= $12,000
26 ADVANTAGES & DISADVANTAGES: Residual Income LO 4ADVANTAGES & DISADVANTAGES: Residual IncomeAdvantage: Gives another view of project profitabilityDisadvantagesCan encourage short run orientationDirect comparisons are difficult
27 ECONOMIC VALUE ADDED (EVA) LO 4ECONOMIC VALUE ADDED (EVA)EVA is net income minus total annual cost of capital. Projects with positive EVA are acceptable.Economic value added (EVA)= Net income– (% cost of capital x Capital employed)
28 TRANSFER PRICING: Definition LO 5TRANSFER PRICING: DefinitionIs the price charged for a component by the selling division to the buying division of the same company.