0. Decentralization and Performance Evaluation
CHAPTER 13
Decentralization and Performance Evaluation
© 2009 Cengage Learning

1. Introduction
The dilemma for companies is to find tools that allow the evaluation of managers at all levels in the organization. How would the evaluation be different for each of these?
A plant manager in a factory
The manager of a retail store
The regional sales manager
The CEO

2. Management of Decentralized Organizations
Centralized: a few individuals at the top of an organization retain decision-making authority.
Decentralized: managers at various levels throughout the organization make key decisions about operations relating to their specific area of responsibility.

3. Management of Decentralized Organizations
Segment
Any activity or part of the business for which a manager needs cost, revenue, or profit data
Can be a branch, division, department, or individual product

4. Management of Decentralized Organizations
Advantages of Decentralization
Those closest to the problem are more familiar with the problem
Higher job satisfaction of managers
Managers receive on-the-job training, making them better managers
Decisions are often made in a more timely fashion

5. Management of Decentralized Organizations
Disadvantages of Decentralization
Decision making spread among too many managers, causing a lack of company focus
Managers make decisions benefiting their own segment, not always in the best interests of the company
Managers not adequately trained in decision making at early stages of their careers
Lack of coordination and communication between segments
May result in duplicative costs/efforts

6. Responsibility Accounting and Segment Reporting
Key Concept
The key to effective decision making in a decentralized organization is responsibility accounting—holding managers responsible for only those things under their control.

7. Cost, Revenue, Profit, and Investment Centers
Cost Center
The manager has control over costs but not over revenue or capital investment decisions.
Example: Human Resources Manager

8. Cost, Revenue, Profit, and Investment Centers
Revenue Center
The manager has control over the generation of revenue but not costs.
Example: Sales Manager of a retail store

9. Cost, Revenue, Profit, and Investment Centers
Profit Center
The manager has control over both cost and revenue but not capital investment decisions.
Example: Manager of a particular location of a hotel chain

10. Cost, Revenue, Profit, and Investment Centers
The manager is responsible for the amount of capital invested in generating income. It is, in essence, a separate business with its own value chain.
Investment centers are often called strategic business units (SBUs)

11. Profit Center Performance and Segmented Income Statements
Segmented Income Statements calculate income for each major segment of an organization in addition to the company as a whole.

12. The Segmented Income Statement
Consulting Dept.
$100,000
40,000
$60,000
25,000
$35,000
Total Firm
$1,000,000
400,000
$600,000
200,000
$400,000
$200,000
Tax Dept.
$500,000
200,000
$300,000
100,000
$200,000
Audit Dept.
$400,000
160,000
$240,000
75,000
$165,000
Client billings
Less: Variable expense
Contribution margin
Less: Traceable fixed
Segment margin
Less: Common fixed
Net income

13. The Segmented Income Statement
Individual Tax Division
$100,000
80,000
$20,000
30,000
$(10,000)
Business Tax Division
$400,000
120,000
$280,000
50,000
$230,000
Tax Dept.
$500,000
200,000
$300,000
80,000
$220,000
20,000
$200,000
Client billings
Less: Variable expense
Contribution margin
Less: Traceable fixed
Divisional segment margin
Less: Common fixed
Departmental segment margin

14. The Segmented Income Statement
Contribution Margin: primarily a measure of short-run profitability.
Segment Margin: a measure of long-term profitability and is more appropriate in addressing long-term decisions, such as whether to drop product lines.

15. The Segmented Income Statement
The segment margin of the individual tax division is negative. In the long run, the individual tax division is not profitable.
Before the firm decides to eliminate the individual tax division, what other quantitative and qualitative factors should it consider?

16. Segment Performance and ABC
ABC can affect the classification of costs as traceable or common.
When ABC is used, batch-level and product-level activities and costs are driven by factors such as the number of setups, parts, customer orders, supervision hours, etc.

17. Investment Centers and Measures of Performance
Key Concept
Evaluating investment centers requires focusing on the level of investment required in generating a segment’s profit.

18. Investment Centers and Measures of Performance
Performance reports focus on measures specifically developed to focus on the level of investment required, such as return on investment, residual income, and economic value added.

19. Investment Centers and Measures of Performance
Does the manager of a local branch of a national bank likely manage a profit center or an investment center?
What about the manager of the local Pizza Hut?
What about the manager of an independent pizza restaurant or clothing store who is also the owner of that store?

20. Return on Investment (ROI)
ROI measures the rate of return generated by an investment center’s assets.
ROI = Margin X Turnover
Margin = Net Operating Income /Sales
Turnover = Sales/Average Operating Assets
Net Operating Income Sales
ROI = X
Sales Average Operating
Assets

21. Return on Investment (ROI)
Net Operating Income: Income before interest and taxes
Operating Assets: Cash, accounts receivable, inventory, and property, plant, and equipment

22. Return on Investment (ROI)
Increase sales revenue
Reduce operating costs
Reduce investment in operating assets
What do I need to do to increase my ROI?

23. Return on Investment (ROI)
Either by increasing sales volume without changing the sales price or by increasing the sales price without affecting volume.
How do you increase sales revenue?

24. Return on Investment (ROI)
The decrease can be in the variable or fixed costs. The key is that any decrease in operating costs will increase operating income and have a positive impact on ROI.
How do you reduce operating costs?

25. Return on Investment (ROI)
Although this may be difficult to do in the short run with property, plant, and equipment, average operating assets can be reduced by better management of accounts receivable, a reduction in inventory levels, and so on.
How do you decrease the amount of operating assets?

26. Residual Income Residual Income
The amount of income earned in excess of a predetermined minimum rate of return on assets.
All things equal, the higher the residual income of an investment center, the better.

27. Residual Income
RI = Net Operating Income - ( Average Operating Assets X Minimum Required Rate of Return)
If net income is $60,500, average operating assets are $100,000, and the required ROI is 20%, what is the RI?
RI = $60,500 - ($100,000 X .20)
RI = $40,500

28. Economic Value Added (EVA)
EVA tells management whether shareholder wealth is being created by focusing on whether after-tax profits are greater than the cost of capital.
Economic value added = After-tax operating profit – [(Total assets - Current liabilities) x Weighted average cost of capital)]

29. Economic Value Added (EVA)
How is EVA different from residual income?
1. EVA is based on after-tax operating profit.
2. Assets are often shown net of current liabilities.
3. Companies may modify income and asset measurements based on GAAP.
4. EVA considers the actual cost of capital, both debt and equity, instead of a minimum rate of return.

30. Performance and Management Compensation Decisions
Measuring the performance of a segment is not always the same as measuring the performance of the manager of that segment
Measuring the performance of the manager should be based on variables the manager controls (responsibility accounting)
Incentive structure can include
Cash and bonuses
Stock-based compensation including stock options
Noncash benefits and perquisites (perks)

31. Performance and Management Compensation Decisions
Key Concept
In order to motivate managers and ensure goal congruence, the compensation of managers should be linked to performance and based on a combination of short-term and long-term goals.

32. Segment Performance and Transfer Pricing
Transfer pricing is needed when segments within the same company sell products or services to one another.
The three approaches to establishing transfer prices are:
Use the market price if it is available.
Base the transfer price on the cost of the product transferred.
Let the buyer and seller negotiate the price.

33. Transfer Price at Market
If there is an outside market for the product being transferred between divisions, the transfer price should be based on the market price of the product.
However, the buyer and seller must be allowed to go outside if doing so would create a better profit.

34. Transfer Price at Cost
If no outside market exists, or when the selling division has excess capacity, transfer prices are often based on the cost of the product being transferred.

35. Negotiated Transfer Price
Transfer prices are negotiated between buyer and seller and end up somewhere between cost and the market price.

36. A General Model for Computing Transfer Prices
Minimum Transfer Price =
Variable Costs of Producing and Selling +
Contribution Margin Lost on Outside Sales

37. A General Model for Computing Transfer Prices
The transfer price that provides the most benefit to the company as a whole is the one that should be chosen.

38. International Aspects of Transfer Pricing
When international divisions are involved, the focus of transfer pricing centers on minimizing taxes, duties, and foreign exchange risks.
Managers must also be aware and sensitive to geographic, political, and economic circumstances in the environment in which they operate.