1. Performance Evaluation for Decentralized Operations
Chapter 14
Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, segmented income statements, and return on investment (R O I) and residual income measures are used to help control decentralized organizations.

2. Centralized and Decentralized Businesses
Centralized business – all major planning and operating decisions are made by top management.
Decentralized business – separating a business into segments/divisions and delegating responsibility to segment managers.
Segments can be structured around common functions, products, or regions.
In a centralized company, decisions are made at the very top level of the organization and lower-level manager are charged with implementing these decisions. On the other hand, decentralized organizations allow managers at lower levels to make and implement key decisions pertaining to their areas of responsibility. The proper amount of decentralization for a company depends on the company’s unique circumstances.

3. Decentralization Advantages of Decentralization
Delegating authority to unit managers:
can result in better decisions because these managers anticipate and react to operating data more quickly.
allows managers to focus on their area of expertise.
provides excellent manager training.
Disadvantages of Decentralization
Decisions made by one manager may negatively affect the profitability of the entire organization.
Possible duplication of assets and costs in operating divisions.
Decentralized decision making has many benefits for an organization. In large organizations it is often difficult for top management to maintain daily contact with all operations and maintain operational expertise in all product lines and services. Delegating authority to managers closer to the operations usually results in better decisions because these managers can often anticipate and react to operating data more quickly than top management. In a decentralized organization, the managers become experts in their area of operation.
One other advantage of decentralization operations is that it provides excellent training for managers, which help them in developing skills early in their careers.
There are also disadvantages of decentralization. One is that decisions made by one manager may negatively affect the profits of the company. Managers of different divisions may compete against each other to the detriment of the organizations.
Another disadvantage of decentralized operations is that they might duplicate assets and expenses.

4. Responsibility Accounting in Decentralized Operations
In a decentralized business, an important function of accounting is to assist unit managers in evaluating and controlling their areas of responsibility.
A responsibility center is the area/function for which a unit manager is responsible.
Responsibility accounting is the process of measuring and reporting operating data by responsibility center.

5. Types of Responsibility Centers
Cost Center
Profit Center
Investment Center
In a decentralized business, accounting assists manager making the decisions in the evaluation and control of their areas of responsibilities. Each area is called a responsibility center and responsibility accounting for each area is the process of measuring and reporting operating data.
Three types of responsibility centers are:
• Cost centers, which have responsibility over costs.
• Profit centers, which have responsibility over revenues and costs.
• Investment centers, which have responsibility over revenue, costs, and investment in assets.

6. Responsibility Accounting for Cost Centers
Cost Centers in a University
Unit manager only has responsibility and authority for controlling costs.
A cost center manager has responsibility for controlling costs. A cost center manager does not make decisions concerning sales or the amount of fixed assets invested in the center. Cost centers vary in size and function and cost centers may actually exist within other cost centers. For example, the department of accounting at a university may be classified as a cost center. The department is part of College of Business, and each college within the university could be considered a cost center.

8. Responsibility Accounting for Profit Centers
Unit manager has responsibility and authority for controlling costs and generating revenues.
Focus is on controllable revenues and expenses.
We will illustrate profit center income reporting for the Nova Entertainment Group (NEG).

9. Responsibility Accounting for Profit Centers
Nova Entertainment Group has two profit centers.

10. Service Departments
In addition to direct expenses, divisions may also have expenses for services provided by centralized service departments.
Examples include:
Research and development
Purchasing
Payroll accounting
Information systems
A profit center’s income needs to reflect the costs for any such services used.

11. Allocating Service Charges
An activity base for each service department is used to charge service department expenses to profit centers.
The activity bases for the centralized services NEG uses are as follows:

12. Allocating Service Charges
NEG service usages:
Service department charge rates determine how much to allocate to each division.
Rate calculation: Total service department expense
Total service usage

14. The divisional income statements include the service department charges.

15. Responsibility Accounting for Investment Centers
Unit manager has responsibility and authority for controlling costs, generating revenues, and efficiently managing the assets invested in the center.
Income from operations is important, but so is the rate of return on investment.

16. Rate of Return on Investment (ROI)
ROI = Income from Operations
Invested Assets
We’ll use Datalink Inc., a cellular phone company, to illustrate the accounting for investment centers.

17. Responsibility Accounting for Investment Centers
Datalink has three investment centers.
The Central Division seems to be the most profitable.

18. Rate of Return on Investment (ROI)
ROI = Income from Operations
Invested Assets
The Central Division is the least profitable when using ROI as the measure of profitability.

19. The DuPont Formula An expanded ROI formula using two factors:
Ratio of income from operations to sales (often called the profit margin).
Ratio of sales to invested assets (often called the investment turnover).
ROI = Profit Margin X Investment Turnover
ROI can be improved by increasing the profit margin or investment turnover.

20. ROI = Income from Operations × Sales
The DuPont Formula
ROI = Income from Operations × Sales
Sales Invested Assets
The ending result will be the same as the more basic ROI formula, but this method allows for greater analysis by separating profitability and investment turnover.

21. Analyzing Datalink’s Investment Centers
DuPont ROI
(Profit Margin × Investment Turnover)
RATE
Northern
70K /560K × 560K /350K
12.5% × 1.6
20%
Central
84K/672K × 672K/700K
12.5% × 0.96
12%
Southern
75K/750K × 750K/500K
10% × 1.5
15%

22. Analyzing Datalink’s Investment Centers
Although the Northern and Central Divisions have the same profit margin (12.5%), the Northern Division uses its assets more efficiently (1.6 compared with 0.96)
The Southern Division is not as profitable and uses its assets less efficiently than the Northern Division.

23. As division manager would you invest in this project?
ROI - A Major Drawback
As division manager at Northern, your compensation package includes a salary plus bonus based on your division’s ROI -- i.e., the higher your ROI, the bigger your bonus.
The company requires an ROI of 10% on all new investments -- your division has been producing an ROI of 20%.
You have an opportunity to invest in a new project that will produce an ROI of 18%.
As division manager would you invest in this project?

24. Residual Income
Excess of income from operations over a minimum acceptable rate of return on assets.

25. Datalink’s Residual Income (Assuming a 10% minimum return rate)
The Northern Division has the highest residual income.

26. The Balanced Scorecard
Customer Service
Customer Satisfaction
Delivery Performance
Build to Schedule
Customer Complaints
Financial Measures
Cash Flow
Income
Residual Income
ROI
Internal Processes
Lead Time
Manufacturing Cycle Time
Productivity
Quality and Safety
Innovation and Learning
R&D Investment
Training Per Employee
Employee Training
Employee Turnover

27. Key Concepts/Definitions
A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.
The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company.
A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. While domestic 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.
The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. Suboptimization occurs when managers do not act in the best interests of the overall company or even their own divisions.

28. Transfer Pricing