No Slide Title · Chapter 23 Performance ... approaches to transfer pricing may be used by...

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting

Pepperdine University

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

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Chapter 23

Performance Evaluation for

Decentralized Operations



Learning Objectives

1. Describe the advantages and

disadvantages of decentralized operations.

2. Prepare a responsibility accounting report

for a cost center.

3. Prepare responsibility accounting reports for

a profit center.

4. Compute and interpret the rate of return on

investment, the residual income, and the

balanced scorecard for an investment

center.



Learning Objectives

5. Describe and illustrate how the market

price, negotiated price, and cost price

approaches to transfer pricing may be used

by decentralized segments of a business.



Learning Objective 1

Describe the

advantages and

disadvantages of

decentralized

operations.



Centralized and Decentralized Operations

In a centralized company, all major

planning and operating decisions are

made by top management.

LO 1



Centralized and Decentralized Operations

LO 1

In a decentralized company, managers of

separate divisions or units are delegated

operating responsibility. The division (unit)

managers are responsible for planning and

controlling the operations of their divisions.



Advantages of Decentralization

For large companies, it is difficult for top

management to do the following:

Maintain daily contact with all operations

Maintain operating expertise in all product

lines and services

LO 1




Decentralized operations provide excellent

training for managers.

Delegating responsibility allows managers

to develop managerial experience early in

their careers.

LO 1

(continued)




It helps a company retain managers.

As a result of working closely with

customers, managers become more

creative in suggesting operating and

product improvements.

LO 1



Disadvantages of Decentralization

A primary disadvantage is that decisions

made by one manager may negatively

affect the profits of the company.

Decentralization may result in duplicate

assets and expenses.

LO 1



LO 1

Advantages and Disadvantages of Decentralization



Responsibility Accounting

In a decentralized business, accounting

assists managers in evaluating and

controlling their areas of responsibility,

called responsibility centers.

LO 1



Responsibility Accounting

Responsibility accounting is the process of

measuring and reporting operating data by

responsibility centers. Three common types

of responsibility centers are:

Cost centers

Profit centers

Investment centers

LO 1




Prepare a

responsibility

accounting report

for a cost center.



Responsibility Accounting for Cost Centers

A cost center manager has responsibility for

controlling costs.

Cost centers may vary in size from a small

department to an entire manufacturing

plant.

Cost centers may exist within other cost

centers.

LO 2




LO 2




LO 2

(continued)




LO 2

from Manager, Plant A Budget Performance Report

(continued)




LO 2

from Supervisor, Department 1—Plant A’s

Budget Performance Report

to Vice President’s Budget

Performance Report

(continued)




LO 2

to Manager, Plant A’s Budget Performance Report

(concluded)



EE 23-1




Prepare

responsibility

accounting reports

for a profit center.



Responsibility Accounting for Profit Centers

LO 3

A profit center manager has the responsibility

and authority for making decisions that affect

both costs and revenues and, thus, profits.

Profit centers may be divisions, departments,

or products.



Controllable revenues are revenues earned

by the profit center.

Controllable expenses are costs that can

be influenced (controlled) by the decisions

of profit center managers.

Responsibility Accounting for Profit Centers

LO 3



Service Department Charges

Examples of service departments include:

Research and Development

Legal

Telecommunications

Information and Computer Systems

Facilities Management

Purchasing

Publications and Graphics

Payroll Accounting

Personnel

LO 3




Service department charges are indirect

expenses to a profit center.

Services provided by internal centralized

service departments are often more

efficient than services contracted with

outside providers.

Service department charges are allocated

to profit centers based on the usage of the

service by each profit center.

LO 3




LO 3

Nova Entertainment Group (NEG) has two

operating divisions: Theme Park Division and

Movie Production Division. The revenues and

direct operating expenses for the two divisions are

shown below.

NEG




LO 3

NEG’s service departments and the expenses they

incurred for the year ended December 31, 2012, are

as follows:

Purchasing $400,000

Payroll Accounting 255,000

Legal 250,000

Total $905,000

NEG




LO 3

An activity base for each service department is

used to charge service department expenses to

the Theme Park and Movie Production divisions.

The activity base for each service department is as

follows:

(continued)

NEG




LO 3

Service Usage—Purchasing

Theme Park Division 25,000 purchase requisitions

Movie Production Division 15,000

Total 40,000 purchase requisitions

$400,000

40,000 purchase

requisitions

= $10 per purchase requisition

(continued)

NEG




LO 3

Service Usage—Payroll Accounting

Theme Park Division 12,000 payroll checks

Movie Production Division 3,000

Total 15,000 payroll checks

$255,000

15,000 payroll checks = $17 per payroll check

(continued)

NEG




LO 3

Service Usage—Legal

Theme Park Division 100 billed hours

Movie Production Division 900

Total 1,000 billed hours

$250,000

1,000 hours = $250 per hour

(concluded)

NEG




LO 3

NEG



EE 23-2



Profit Center Reporting

LO 3

NEG



Profit Center Reporting

The income from operations is a measure of

a manager’s performance.

In evaluating the profit center manager, the

income from operations should be

compared over time to a budget. However,

it should not be compared across profit

centers.

LO 3



EE 23-3




Compute and interpret the

rate of return on

investment, the residual

income, and the balanced

scorecard for an

investment center.



Responsibility Accounting for Investment Centers

An investment center manager has the

responsibility and the authority to make

decisions that affect not only costs and

revenues but also the assets invested in the

center.

LO 4



Responsibility Accounting for Investment Centers

DataLink Inc., a cellular phone company, has three

regional divisions. These are shown in Exhibit 6.

LO 4



Rate of Return on Investment

One measure that considers the amount of

assets invested in an investment center is

the rate of return on investment (ROI) or rate

of return on assets. It is computed as

follows:

ROI = Income from Operations

Invested Assets

LO 4




The invested assets of DataLink’s three divisions

are as follows:

LO 4




LO 4

Dupont Formula

Income from Operations

Sales

Sales

Invested Assets x ROI =

Profit Margin Investment

Turnover



The profit margin and the investment

turnover reflect the following underlying

operating relationships of each division:

Profit margin indicates operating profitability

by computing the rate of profit earned on each sales dollar.

Investment turnover indicates operating

efficiency by computing the number of sales

dollars generated by each dollar of invested

assets.


LO 4




LO 4

ROI = $ 70,000

$560,000 x

$560,000

$350,000

ROI = 12.5% x 1.6

DataLink’s Northern Division ROI


Sales

Sales


ROI = 20%

from Exhibit 6




LO 4

ROI = $ 84,000

$672,000 x

$672,000

$700,000

ROI = 12.5% x 0.96

DataLink’s Central Division ROI


Sales

Sales


ROI = 12%

from Exhibit 6




LO 4

ROI = $ 75,000

$750,000 x

$750,000

$500,000

ROI = 10.0% x 1.5

DataLink’s Southern Division ROI


Sales

Sales


ROI = 15%

from Exhibit 6




LO 4

Assume that the revenues of the Northern Division

could be increased by $56,000 through increasing

operating expenses, such as advertising, to

$385,000.

(continued)



Revenues ($560,000 + $56,000) $616,000

Operating expenses 385,000

Income from operations before

service department charges $231,000

Service department charges 154,000

Income from operations $ 77,000

Projected Impact of Change

Increase of

$7,000


LO 4

(continued)




LO 4

ROI = $ 77,000

$616,000 x

$616,000

$350,000

ROI = 12.5% x 1.76


Sales

Sales


ROI = 22% (compared to the previous ROI of 20%)

DataLink’s Northern Division

ROI Revised



EE 23-4



Residual Income

Residual income is the excess of income

from operations over a minimum

acceptable income from operations, as

shown below:

LO 4



Residual Income

A visual portrayal of this useful tool.

LO 4



LO 4

Residual Income

Datalink Inc. establishes 10% as the minimum

acceptable rate of return on divisional assets.

The residual incomes for the three divisions are

as follows:



The major advantage of residual income as

a performance measure is that it considers

both the minimum acceptable rate of

return, invested assets, and the income

from operations for each division.

LO 4

Residual Income



EE 23-5



The Balanced Scorecard

The balanced scorecard is a set of multiple

performance measures for a company.

It normally includes performance measures

for customer service, innovation and

learning, and internal processes, as shown

in Exhibit 7 (next slide).

LO 4




LO 4




LO 4

Some common performance measures

used in the balanced scorecard approach

are shown below.

(continued)




LO 4



are shown below.

(continued)




LO 4



are shown below.

(continued)




LO 4



are shown below.

(concluded)




Describe and illustrate how the

market price, negotiated price, and

cost price approaches to transfer

pricing may be used to decentralize

segments of a business.



Transfer Pricing

When divisions transfer products or render

services to each other, a transfer price is

used to charge for the products or services.

LO 5



Transfer Pricing

Three common approaches to setting

transfer prices are:

1. Market price approach

2. Negotiated price approach

3. Cost approach

LO 5



Transfer Pricing

LO 5



Transfer Pricing

LO 5



Market Price Approach

Using the market price approach, the

transfer price is the price at which the

product or service transferred could be sold

to outside buyers.

LO 5



LO 5

Negotiated Price Approach

The negotiated price approach allows the

managers of decentralized units to agree

(negotiate) among themselves on a transfer

price.

The only constraint is that the transfer price

be less than the market price, but greater

than the supplying division’s variable costs

per unit.



LO 5




LO 5


Comparison of Exhibits 9 and 10


No Units

Transferred

(Exhibit 9)

20,000 Units

Transferred at

$15 per Unit

(Exhibit 10)

Increase

(Decrease)

Eastern Division $200,000 $300,000 $100,000

Western Division 100,000 200,000 100,000

Wilson Company $300,000 $500,000 $200,000

Variable Costs per Unit < Transfer Price < Market Price

$10 < Transfer Price < $20



EE 23-6



Cost Price Approach

Under the cost price approach, cost is used

to set transfer prices. A variety of costs may

be used in this approach, including:

Total product cost per unit

Variable product cost per unit

LO 5



Cost Price Approach

If total product cost per unit is used, direct

materials, direct labor, and factory

overhead are included in the transfer price.

If variable product cost per unit is used, the

fixed factory overhead cost is excluded

from the transfer price.

LO 5

Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting

Pepperdine University



Performance Evaluation for Decentralized Operations

The End

Performance Evaluation for

Decentralized Operations

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