1. Managerial Accounting by Whitecotton, Libby, and Phillips, second edition.

2. Decentralized Performance Evaluation
Chapter 10
Decentralized Performance Evaluation
Chapter 10: Decentralized Performance Evaluation
As a company gets large, no one manager, or even a small group of managers, can be directly involved in every aspect of the company’s operations. Instead, top management must delegate responsibility to employees and managers at lower levels in the organization to make decisions on its behalf. The delegation of responsibility and decision-making authority throughout an organization is called decentralization. A key component of successful decentralization is performance evaluation of decentralized business segments.

3. Decentralization of Responsibility
Decentralization pushes decision making down to lower-level managers.
In a decentralized organization, decision-making authority is spread throughout the organization, and managers are given a great deal of autonomy to decide how to manage their individual units. In a centralized organization, decision-making authority is kept at the very top of the organization. High-level executives make all strategic and operational decisions and charge lower-level managers with implementing those decisions.
Decentralization often occurs as organizations continue to grow.

4. List and explain the advantages and disadvantages of decentralization.
Learning Objective 10-1
List and explain the advantages and disadvantages of decentralization.
Learning objective 10-1 is to list and explain the advantages and disadvantages of decentralization.

5. Decentralization of Responsibility
The advantages of decentralization are: 
Recognizes that managers have specialized knowledge and can react quickly to local information.
Allows the development of managerial expertise.
Allows top management to focus on strategic issues.
The disadvantages of decentralization are:
Has the potential to duplicate resources.
Allows managers the opportunity to make decisions that are good for themselves or their division, but which are not in the best interests of the organization overall.
When decision-making authority has been decentralized, the organization must find a way to monitor and evaluate managerial performance. Ideally, the company’s performance measurement system should be designed so that the manager’s goals and incentives are aligned with the organization’s goals and objectives. Unfortunately, that is much easier said than done and is not always achieved in practice.

6. Learning Objective 10-2
Describe the different types of responsibility centers and explain how managers in each type are evaluated.
Learning objective 10-2 is to describe the different types of responsibility centers and explain how managers in each type are evaluated.

7. Responsibility Centers
Responsibility accounting gives managers authority and responsibility for a particular part of the organization and then evaluates them based on the results of that area of responsibility.
Managers of responsibility centers should be held responsible only for that which they can control.
Responsibility accounting gives managers authority and responsibility for a particular part of the organization and then evaluates them based on the results of that area of responsibility. Responsibility centers can be established based on business function, product or service offerings, or geographic areas. Managers of responsibility centers should be held responsible only for that which they can control.

8. Organizational Chart for Apple
Here is a partial organization chart for Apple, Inc. Apple manages its business primarily on a geographic basis, with divisions in North/South America, Europe/Middle East/Africa, and Japan/Asia-Pacific. Apple retail stores are operated as a separate business unit from these geographic segments. In addition to these geographic divisions, Apple is also organized by major product lines and service offerings. To manage this large, geographically dispersed company, Apple must delegate decision making responsibility throughout the organization.

9. Responsibility Centers
Cost
Center
Revenue
Center
Profit
Center
Investment
Center
One of the most important concepts in responsibility accounting is the controllability principle, which states that managers should be held responsible only for what they can control. The four different types of responsibility centers vary according to what the business managers can control and, thus, what they should be held responsible for:
• The manager of a cost center is responsible for controlling cost.
• The manager of a revenue center is responsible for generating revenue.
• The manager of a profit center is responsible for profit (revenue - cost).
• The manager of an investment center is responsible for profit (revenue -cost) and the investments of assets.
Responsibility
Centers

10. Cost Centers
Cost center managers have the authority to incur costs to support their areas of responsibility.
Cost center managers have the authority to incur costs to support their areas of responsibility. All of Apple’s corporate support functions would be treated as cost centers: advertising, human resources, purchasing, distribution and logistics, information technology, legal services, and accounting. Note that these centers do not generate revenue directly from customers, although they can have an indirect impact on revenue. For example, dollars spent on advertising should have an impact on the generation of revenue.
One of the primary tools that cost center managers use to manage costs is the budgetary control system described in the last two chapters. However, cost center managers are responsible for more than just controlling costs. Usually they are also responsible for providing a high level of service to the rest of the organization whether in distribution, human resources, accounting, legal services, or some other internal function. Later in this chapter we discuss the use of the balanced scorecard to assess how well managers perform on dimensions other than cost, including internal processes, customer service, and employee satisfaction and turnover.

11. Revenue Centers
Revenue center managers are responsible for generating revenues within their areas
of the organization.
Revenue center managers are responsible for generating revenues within their areas of the organization. Revenue center managers generally receive sales targets or quotas for a particular period and are evaluated based on whether they meet those targets. Later in this chapter, we use the balanced scorecard to incorporate other measures for evaluating revenue center managers including customer satisfaction, customer retention, and customer turnover.

12. Profit Centers
Revenues
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Profit Center
Profit center managers are responsible for generating a profit (revenue minus cost) within their area of the business.
Profit center managers are responsible for generating a profit (revenue - cost) within their area of the business, whether it is a store, district, region, division, or other business segment. Because they are responsible for both costs and revenues, profit center managers often supervise revenue and cost center managers.
The most common method of evaluating a profit center manager is based on the segmented income statement, or an income statement that is broken down by product line, region, or other business segment.

13. Return on investment (ROI) and residual income
Investment Centers
Investment Center managers are responsible for generating a profit and investing assets.
Investment center managers are responsible for generating a profit (revenue - cost) and investing assets.
Because investment center managers are responsible for generating profit and investing assets, they will be evaluated based on their ability to generate enough profit to compensate for the investment in assets. There are two common measures for evaluating investment center performance: return on investment and residual income.
Investment
Center Evaluation
Return on investment (ROI) and residual income

14. Learning Objective 10-3
Describe the four dimensions of the balanced scorecard and
explain how they are used to evaluate managerial performance.
Learning objective 10-3 is to describe the four dimensions of the balanced scorecard and explain how they are used to evaluate managerial performance.

15. The Balanced Scorecard
Management translates its strategy into performance measures that employees understand and accept.
Customers
Financial
Performance measures
The balanced scorecard is a comprehensive performance measurement system that translates an organization’s vision and strategy into a set of operational performance metrics. The balanced scorecard measures organizational performance on four key dimensions:
• Customer perspective. How do we want our customers to see us?
• Learning and growth perspective. How will we sustain our ability to change and improve?
• Internal business processes. What internal processes will we require to meet the needs of our customers, employees, and shareholders?
• Financial perspective. How do we satisfy our shareholders, regulators, and other stakeholders?
For each of these dimensions, managers must devise specific objectives, measures, and targets that can be used to measure performance and identify what needs to be done to improve in the future. Those objectives, measures, and targets should be communicated to managers throughout the organization so that everyone knows what needs to be done to achieve long-term success, not just short-term financial results.
Learning and growth
Internal business processes

16. The Balanced Scorecard
Each perspective of the balanced scorecard should include objectives that support the overall strategy, along with specific metrics that will be used to measure performance on the objectives. In addition, the objectives and metrics included in the balanced scorecard should have a cause and effect relationship, where performance in one area of the scorecard ultimately affects performance in the others.
The key sequence of events in the balanced scorecard approach is that learning improves business processes. Improved business processes translate to improved customer satisfaction. When we have a high degree of customer satisfaction, we have improved financial results.

17. The Balanced Scorecard
The causal linkages between the various elements of the Balanced Scorecard are summarized in the graphic on this slide.
Although the balanced scorecard is a useful tool for linking a company's strategic vision to operational metrics, it can be very time consuming to implement, and requires involvement of employees at all levels of the organization. In addition, while the metrics in the balanced scorecard are intended to focus manager's attention on the company's long-term strategy, managers are often motivated by short-term financial results. For example, managers often receive bonuses based on achieving short-term financial results. Unless the company's incentive and reward system is re-designed to focus on long-term results, the balanced scorecard may not serve its intended purpose. Incentive systems that emphasize team-based performance rather than individual performance are more consistent with a balanced scorecard approach to performance measurement.

18. Learning Objective 10-4
Compute and interpret return on investment, investment turnover, and profit margin.
Learning objective 10-4 is to compute and interpret return on investment, investment turnover, and profit margin.

19. Return on Investment (ROI)
Investment center managers are responsible for generating profit and for the investment of assets. They will be evaluated based on their ability to generate enough operating income to justify the investment in assets used to generate the operating income. An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as net operating income divided by average invested assets.
Often it’s helpful to take a more detailed look at ROI by considering two additional financial ratios that are components of ROI, investment turnover and profit margin.
A company’s investment turnover is sales revenue divided by average invested assets. Profit margin is found by dividing net operating income by sales revenue. You can see that sales revenue is common to both profit margin and investment turnover. It’s in the denominator of profit margin and in the numerator of investment turnover. When we multiply profit margin times investment turnover, we get ROI.

20. Return on Investment (ROI)
To demonstrate how ROI can be used to evaluate investment center managers in a decentralized organization, consider the following hypothetical data for two Apple divisions: Apple retail store and Apple online store.
Notice that both divisions have the same level of investment ($2,000,000 in average invested assets). Yet the Apple retail division had an ROI of 6 percent, compared to 30 percent for the online Apple store. To gain a better understanding of the factors contributing to ROI (net operating income and average invested assets), it is useful to break each factor down further into two separate components: investment turnover and profit margin.

21. Return on Investment (ROI)
Because the Online Store has a higher investment turnover and a higher profit margin, it generates much higher operating income, and thus a higher return on investment (30%) than the Retail Store (6%).
The separate components of ROI, profit margin and investment turnover, allow us to gain more insight into why the Online Store has a much higher ROI. The investment turnover ratio shows how efficiently assets are used to generate sales revenue. Investment turnover is 1.5 for the Retail store and 3.0 for the Online Store. The Online Store generates twice sales revenue from the same $2,000,000 investment base.
The profit margin shows how much of a segment’s sales revenue remains as operating profit, after the operating costs are covered. The Online Store converts 10 percent of sales revenue to operating profit while the Retail Store converts only 4 percent of sales revenue to operating income. When we multiply the investment turnover times the profit margin, we get the return on investment. In sum, the Online Store generates more sales revenue from the same level of investment and keeps a higher percentage of the sales revenue as operating profit. The end result is that the Online Store’s return on investment (30%) is much higher than the Retail Store’s return on investment (6%).

22. Compute and interpret residual income.
Learning Objective 10-5
Compute and interpret residual income.
Learning objective 10-5 is to compute and interpret residual income.

23. Residual Income
The hurdle rate is the required return on invested assets, sometimes called the cost of capital.
Residual income is the difference between the operating income and the minimum income the organization must earn to cover the hurdle rate (the required return on invested assets), sometimes called the cost of capital. A positive residual income means that the company earned more than the minimum required income. A negative residual income means that the company did not meet the minimum required rate of return.
Residual income is the organization’s extra profit, over and above that needed to cover the required return on invested assets.

24. Residual Income
To continue the previous example, assume that Apple’s hurdle rate or minimum return on invested assets is 10 percent. Both divisions had an average investment in assets of $2,000,000. The minimum acceptable profit would be $200,000 ($2,000,000 x 10%).
Notice that the Retail Store has a negative residual income of $(80,000). That is, the region’s operating profit is not high enough to cover its 10 percent hurdle rate. Recall that the Retail Store’s ROI is only 6 percent—4 percent less than the hurdle rate. If you multiply the region’s $2,000,000 investment by the 4 percent shortfall in its ROI (compared to the hurdle rate), you get the same result: a negative residual income of $80,000.
The Online Store’s residual income is $400,000, which is more than enough to cover the 10 percent required return on investment. Recall that the Online Store is earning a 30 percent ROI. Multiplying the extra 20 percent return (over and above the 10 percent hurdle rate) by the division’s $2,000,000 investment gives the same result: a residual income of $400,000. This amount is the additional profit Online Rentals earned over and above the required ROI.

25. ROI versus Residual Income
As the store manager at Apple’s Online Store, you have the opportunity to invest $1,000,000 in a project promising a return of $150,000 (15 percent).
The company requires a minimum return of 10 percent on all projects, so the project would be acceptable from the company’s perspective.
ROI is sometimes criticized because it can lead managers to make decisions contrary to the best interests of the business, creating a lack of goal congruence. Let’s illustrate this problem with an example. Suppose you’re the manager of the Online Store, and ROI is used to evaluate your performance. The company requires an ROI of 10 percent on all invested funds. Your store has been producing an ROI of 30 percent, well above the company minimum. You are presented an opportunity to invest $1,000,000 in a new project that will produce an ROI of 15 percent. As the store manager, would you invest in this project?
Would you invest in this project?

26. ROI versus Residual Income
The proposed project would generate a positive residual income of $50,000, because it would earn more than the required 10% hurdle rate. However, it would reduce the division’s ROI from 30 percent to 25 percent, because the 15% return is less than the store’s current ROI of 30%.
So, as the store manager, you probably wouldn’t invest in this 15 percent project because it would reduce your overall ROI below 30 percent. The problem is that the project would be desirable to the company because it returns more than the 10 percent required by the company. So you’re doing what’s best for your personal interest, but it may not be in the company’s best interest. This example shows how a responsibility accounting system can create goal incongruence, or conflict between a manager and the organization as a whole.

27. Economic Value Added
Economic value added (EVA™) is used to measure the economic wealth created when a company’s after-tax net operating income exceeds its cost of capital. EVA:
Measures profitability based on after-tax net operating income rather than pre-tax net operating income.
Uses the cost of capital as the hurdle rate.
Uses total capital employed as the measure of investment rather than average invested assets
Economic value added (EVA™) is used to measure the economic wealth created when a company’s after-tax net operating income exceeds its cost of capital. EVA:
Measures profitability based on after-tax net operating income rather than pre-tax net operating income.
Uses the cost of capital as the hurdle rate.
Uses total capital employed as the measure of investment rather than average invested assets
EVA provides a measure of whether the company is generating sufficient after-tax income to cover the cost of capital. If EVA is positive, the company is creating economic wealth by generating profits in excess of its cost of capital. If EVA is negative, the company is not generating enough after-tax profit to cover its cost of capital, which reduces the company’s overall economic value.

28. Limitations of Financial Performance Measures
Both ROI and residual income are lagging indicators of financial performance. These measures tell how well a company or a division has done in the past but not necessarily how well it will do in the future.
To improve short-run financial results, managers may make harmful decisions to cut costs in areas such as research and development, employee training, or quality of manufacturing materials.
Both ROI and residual income are lagging indicators of financial performance. In other words, they are based on historical information taken from a company’s financial statements including past sales revenue, operating income, and assets. These measures tell how well a company or a division has done in the past but not necessarily how well it will do in the future.
Unfortunately, many of the actions that managers take to improve a company’s financial performance in the short run can prove harmful to the organization over the long run. Examples include cutting back on research and development, reducing employee training, and using less expensive materials to make a product. While all of these decisions will improve short-run financial results, they will likely hurt the company in the long term through reduced sales, quality problems, customer complaints, and increased warranty expenses. To avoid these problems, organizations should evaluate and reward managers based on more than just short-term financial results.

29. Explain how transfer prices are set in decentralized organizations.
Learning Objective 10-6
Explain how transfer prices are set in decentralized organizations.
Learning objective 10-6 is to explain how transfer prices are set in decentralized organizations.

30. Transfer Pricing
A transfer price is the amount that one division charges when it sells goods or services to another division in the same company.
Selling Division
Goods and Services
Buying Division
A transfer price is the amount that one division charges when it sells goods or services to another division in the same company. Transfers happen quite often in today’s business environment because many large corporations are composed of several relatively independent business units all owned by the same parent company. Business transactions between units or divisions in the same company are called related-party transactions.
While transfer prices have no direct effect on the entire company’s reported profit, they can have a dramatic effect on the reported profitability of a division. If managers are evaluated based on their ability to control costs and/or generate revenue, their goals may be diametrically opposed, even if they do work in the same company. The manager of the selling division is motivated to achieve the highest possible price while the manager of the buying division is motivated to pay the lowest possible price. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company.

31. Transfer Pricing Market Price Ceiling
Range of Possible Transfer Prices
Could fall anywhere in between
The manager of the selling division is motivated to achieve the highest possible price. This is the market price at which goods and services are sold to those outside the company and is called the ceiling. The manager of the buying division is motivated to pay the lowest possible price. This is the variable cost to produce the goods and service and is called the floor. Although the transfer price does not really matter from the overall company’s perspective, it can make a big difference to individual managers.
Variable Cost
Floor

32. Transfer Pricing
Consider the estimated cost and price information for an iPad with 32GB of memory. According to iSupply, a company that breaks down popular consumer products to determine their cost, the cost of the components for an iPad (32GB) is about $326. Assembly of the component parts is outsourced for $10 per unit, bringing the total product cost to about $336 per unit. This is the cost of the device itself, excluding shipping, marketing, general and administrative, and research and development expenses. For this example, we assume that the wholesale price paid by retailers such as Best Buy and Walmart is $499. The retail price to consumers is $599. What transfer price should Apple use to record the purchase of iPads for resale at an Apple retail store?
What transfer price should Apple use to record the purchase of iPads for resale at an Apple retail store?

33. Transfer Pricing $499 Market Price Ceiling
Range of Possible Transfer Prices
Negotiated transfer price could fall anywhere in between.
Should the Apple store have to pay the same price as competitors such as Walmart or Best Buy? Keep in mind that the transfer price will be reported as Cost of Goods Sold on Manager A’s performance report. The transfer price will be reported as sales revenue on the selling manager’s performance report, while it will be reported as a cost on the buying manager’s performance report. As you can see, the motivations of the two managers are in direct conflict. The buyer will benefit from a low transfer price, while the seller will benefit from a high transfer price. Apple can take one of three approaches to determine the transfer price: market-price method, cost-based method, or negotiation.
Variable Cost
$336
Floor

34. Market-Price Method
The market price is the price that a company would charge to external customers.
Market price is appropriate when the selling division has no excess capacity.
The market price is the price that a company would charge to external customers. The only time that market price is appropriate is when the selling division is operating at capacity. In that situation, the selling division would have to give up sales to outside customers to transfer to a buying division within the company. In our example, if the selling division is operating at capacity, the transfer price should be set at $499. Anything less than $499 per case would result in lost profits from reduced sales to outside customers.
If the selling division has idle capacity, a transfer price less than $499 is appropriate. Any price above the variable cost of $336 per case will generate contribution margin for the selling division. Both parties will benefit from a transfer price less than $499. A price less than $499 will provide the selling division with contribution margin and also provide the buying division with a bargain price below the $499 market price.
With idle capacity, the selling division can generate contribution margin for itself at any price above variable cost.

35. Full manufacturing cost plus a markup is a more likely outcome.
Cost-Based Method
The cost-based method uses either the variable cost or the full manufacturing cost as the basis for setting the transfer price.
A transfer price above variable cost will provide contribution margin to the seller.
Full manufacturing cost plus a markup is a more likely outcome.
The cost-based method uses either the variable cost or the full manufacturing cost as the basis for setting the transfer price. Some companies use cost plus a markup to provide a margin above cost for the selling division while still allowing the buying division to buy at less than the market price. Any transfer price above the variable cost will provide contribution margin for the selling division. In our example, any price above $336 will provide contribution margin for the selling division. However, it is unlikely that the selling division would sell at a transfer price near $336, especially if the selling division is operating near capacity. It may be more acceptable to the selling decision to use a “cost plus” approach. For example, the selling division may set the selling price at $336 plus 25 percent, and the selling price would be $420 ($336 times 125 percent).
A more likely transfer price would be the full manufacturing cost (including general and administrative, and research and development costs) plus a markup. Such a price would provide the selling division with a profit above full manufacturing cost (and substantial contribution margin), and also provide the buying division with a bargain price below the $499 market price.

36. Excessive management time may be used in the negotiation process.
Transfer price is determined through discussions between managers of buying and selling divisions.
Excessive management time may be used in the negotiation process.
Negotiation results in transfer prices that are determined through discussions between managers of buying and selling divisions. In our example, the negotiated transfer price would range from the variable cost of $336 to the market price of $499 per unit. The final negotiated price will depend on the relative negotiating strength of the parties.
Negotiated transfer prices are not without problems. The process can be time consuming and can lead to conflict between managers. Because of the problems with negotiation, many companies have transfer pricing guidelines that tend to split the difference between the floor and ceiling prices.
Conflicts may arise between negotiating managers that damage working relationships.

37. End of Chapter 10
End of chapter 10.