1. © 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. Chapter 12: Performance Evaluation and Decentralization Cornerstones of Managerial Accounting, 4e

2. © 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. Decentralization and Responsibility Centers ► In general, a company is organized along lines of responsibility. Today, most companies use a more flattened hierarchy that emphasizes teams. ► 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. The practice of delegating decision-making authority to the lower levels of management in a company is called decentralization. 1

3. © 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. Centralization and Decentralization 1

4. © 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. Divisions in the Decentralized Firm ► Decentralization involves a cost-benefit trade-off. ► As a firm becomes more decentralized, it passes more decision authority down the managerial hierarchy. ► Decentralization usually is achieved by creating units called divisions. ► Divisions can be differentiated a number of different ways, including the following: ► types of goods or services ► geographic lines ► responsibility centers 1

5. © 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. Responsibility Centers ► Another 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. 1

6. © 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. Return on Investment ► One way to relate operating profits to assets employed is to compute the return on investment (ROI), which is the profit earned per dollar of investment. ► ROI is the most common measure of performance for an investment center and is computed as follows: Operating income ÷ Average Operating Assets ► 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 2

7. © 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. Margin and Turnover ► 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 sales ÷ average operating assets. ► Turnover tells how many dollars of sales result from every dollar invested in operating assets. 2

8. ► The equation that yields ROI from the Margin and Turnover is as follows: Margin Turnover ROI = Operating Income X Sales Sales Average Operating Assets © 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. Margin and Turnover (continued) 2 Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets.

9. © 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. Return on Investment ► One way to relate operating profits to assets employed is to compute the return on investment (ROI), which is the profit earned per dollar of investment. ► ROI is the most common measure of performance for an investment center and is computed as follows: Operating income ÷ Average Operating Assets ► 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 2

10. © 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. Margin and Turnover ► 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 sales ÷ average operating assets. ► Turnover tells how many dollars of sales result from every dollar invested in operating assets. 2

11. ► The equation that yields ROI from the Margin and Turnover is as follows: Margin Turnover ROI = Operating Income X Sales Sales Average Operating Assets © 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. Margin and Turnover (continued) 2 Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets.

12. © 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. Residual Income ► To compensate for the tendency of ROI to discourage investments that are profitable for a company but that lower a division’s ROI, some companies have adopted alternative performance measures such as residual income. ► 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) 3

13. © 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. Economic Value Added (EVA) ► 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. ► EVA is expressed as follows: 3

14. © 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. Transfer Pricing ► In many decentralized organizations, the output of one division is used as the input of another. ► As a result, the value of the transferred good is revenue to the selling division and cost to the buying division. ► This value, or internal price, is called the transfer price. ► Transfer price is the price charged for a component by the selling division to the buying division of the same company. 4

15. © 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. Transfer Pricing Policies ► Several transfer pricing policies are used in practice, including: ► market price ► cost-based transfer prices ► negotiated transfer prices 4

16. © 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. Appendix 12A: The Balanced Scorecard – Basic Concepts ► 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. 5

17. © 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. The Balanced Scorecard – An Example 5

18. © 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. The Role of Performance Measures ► The Balanced Scorecard is not simply a collection of critical performance measures. ► The performance measures are derived from a company’s vision, strategy, and objectives. ► These measures must be balanced between the following measures: ► performance driver measures (i.e., lead indicators of future financial performance) and outcome measures (i.e., lagged indicators of financial performance) ► objective and subjective measures ► external and internal measures ► financial and nonfinancial measures 5

19. © 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. Linking Performance Measures to Strategy ► Balancing outcome measures with performance drivers is essential to linking with the organization’s strategy. ► Performance drivers make things happen and are indicators of how the outcomes are going to be realized. ► Outcome measures are also important because they reveal whether the strategy is being implemented successfully with the desired economic consequences. ► A testable strategy can be defined as a set of linked objectives aimed at an overall goal. 5

20. © 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. A Testable Strategy Example 5

21. © 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. The Four Perspectives and Performance Measures ► The four perspectives define the strategy of an organization and provide the structure or framework for developing an integrated, cohesive set of performance measures. ► These measures, once developed, become the means for articulating and communicating the strategy of the organization to its employees and managers. ► The measures also serve the purpose of aligning individual objectives and actions with organizational objectives and initiatives. 5