Cornerstonesof Managerial Accounting 3e

Cornerstonesof Managerial Accounting 3e

MOWEN / HANSEN / HEITGERMOWEN / HANSEN / HEITGERCOPYRIGHT © 2009 South-Western/Cengage Learning

Chapter TwelvePerformance Evaluation and

Decentralization

Chapter TwelvePerformance Evaluation and

Decentralization

Learning ObjectivesLearning Objectives

1. Explain how and why firms choose to decentralize.

2. Compute and explain return on investment.

3. Compute and explain residual income and economic value added.

4. Explain the role of transfer pricing in a decentralized firm.

5. (Appendix) Explain the uses of the Balanced Scorecard, and compute cycle time, velocity, and manufacturing cycle efficiency.

3

OBJECTIVE OBJECTIVE 11

Explain how and why firms choose to decentralize.

DecentralizationDecentralization

• Delegating decision-making authority• Why firms decentralize:

– Ease of gathering and using local information– Focusing on central management from detailed

operations to strategic planning– Training and motivating of segment managers

to prepare new high-level managers– Enhanced competition, exposing segments to

market forces, which allow each unit to act as an autonomous business unit

• Achieved by creating Divisions

5

DivisionsDivisions

• Differentiated by:– Type of product or service provided– Geographic lines

• Type of responsibility given to divisional manager– Responsibility Center is a segment of

business whose manager is accountable for specified sets of activities

6

Types of Responsibility CentersTypes of Responsibility Centers

• Cost center– Manager is responsible only for costs

• Revenue center– Manager is responsible only for sales

• Profit center– Manager is responsible for both revenues and

costs

• Investment center– Manager is responsible for revenues, costs,

and investments

7

Measuring the Performance of Profit CentersMeasuring the Performance of Profit Centers

• Preparation of segmented income statements– Two method of computing income:

• Variable costing • Full or Absorption costing

– Methods often lead to different operating income figures

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OBJECTIVE OBJECTIVE 22

Compute and explain return on investment.

Return on Investment (ROI)Return on Investment (ROI)

10

Operating Income ÷ Average Operating Assets

Earnings before income and taxes (EBIT)

Formula:

Return on Investment (ROI)Return on Investment (ROI)

11

Operating Income ÷ Average Operating Assets

(Beginning assets + Ending assets) ÷ 2

Formula:

Return on Investment (ROI)Return on Investment (ROI)

12

Margin x Turnover

Operating Income ÷ Sales

Alternative Formula:

Return on Investment (ROI)Return on Investment (ROI)

13

Margin x Turnover

Sales ÷ Average Operating Assets

Alternative Formula:

Margin and TurnoverMargin and Turnover

• Margin– Ratio of operating income to sales– Tells how many cents of operating income

result from each dollar of sales– Expresses the portion of sales that is available

for interest, taxes, and profit

• Turnover– Divides sales by average operating assets– Tells how many dollars of sales result from

every dollar invested in operating assets

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Advantages of ROIAdvantages of ROI

• Encourages managers to focus on– Relationship among:

• Sales• Expenses• Investment

– Cost efficiency– Operating asset efficiency

15

Disadvantages of ROIDisadvantages of ROI

• Can produce a narrow focus on divisional profitability at the expense of profitability for the overall firm

• Encourages managers to focus on the short run at the expense of the long run

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Cornerstone 12-1Cornerstone 12-1

HOW TO Calculate Average Operating Assets, Margin, Turnover, and Return on

Investment

17

ExampleExample

Information:

Sales

Cost of goods sold

Gross marginSelling and administrative expense

$480,000

222,000

Operating income $ 48,000

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$258,000210,000

Operating Assets were $277,000 at the beginning of the year and $323,000 at the end of the year

ExampleExample

1. Average operating assets

2. Margin

3. Turnover

4. Return on investment

Required:

19

Calculate:

ExampleExample

20

Average operating

assets(Beginning assets + Ending assets)/2=

= ($277,000 + $323,000) / 2

= $300,000

ExampleExample

21

Margin Operating Income / Sales=

= $48,000 / $480,000

= 0.10 or 10%

ExampleExample

22

Turnover Sales / Average operating assets=

= $480,000 / $300,000

= 1.6

ExampleExample

23

Return on Investment

(ROI)Margin × Turnover=

= 0.10 × 1.6

= .16 or 16%

Alternatively:

Operating income / Average operating assets

= $48,000 / $300,000

= .16 or 16%

OBJECTIVE OBJECTIVE 33

Compute and explain residual income and economic value added.

Residual IncomeResidual Income

Operating Income F

Formula:

Minimum rate of return × Average operating assets

Set by the company

25

Residual IncomeResidual Income

Operating Income F

Formula:

Minimum rate of return × Average operating assets

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If residual income is less than zero, the company is earning less than the minimum rate of return

If residual income is exactly zero, the company is earning precisely the minimum rate of return

If residual income is greater than zero, the company is earning more than the minimum rate of return

Advantages & Disadvantages of Residual Income

Advantages & Disadvantages of Residual Income

• Advantages– It encourages managers to accept any

project that earns above the minimum rate

• Disadvantages– Can encourage a short run orientation– Residual income is an absolute measure of

profitability• Direct comparison is difficult when level of

investments differ

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Cornerstone 12-2Cornerstone 12-2

HOW TO Calculate Residual Income

28

ExampleExample

Information:

Sales

Cost of goods sold

Gross marginSelling and administrative expense

$480,000

222,000

Operating income $ 48,000

29

$258,000210,000

Operating Assets were $277,000 at the beginning of the year and $323,000 at the end of the year

A minimum rate of return of 12 percent is required

ExampleExample

1. Average operating assets

2. Residual income

Required:

30

Calculate:

ExampleExample

31

Average operating

assets(Beginning assets + Ending assets)/2=

= ($277,000 + $323,000) / 2

= $300,000

ExampleExample

32

Residual Income

Operating Income

=

= $48,000 - $36,000

= $12,000

F Minimum rate of return ×

Average Operating

Assets

Residual IncomeResidual Income

F

Formula:

Actual percentage cost of capital × Total capital employed

33

If EVA is positive then the company is creating wealth

If EVA is negative then the company is destroying wealth

After-tax operating income

Cornerstone 12-3Cornerstone 12-3

HOW TO Calculate Economic Value Added

34

ExampleExample

Information:

Sales

Cost of goods sold

Gross marginSelling and administrative expense

$480,000

222,000

Operating income $ 48,000

35

$258,000210,000

Total capital employed equaled $300,000. Actual cost of capital is 10%

Less: Income Taxes (@ 30%) 14,400 Net income $ 33,600

ExampleExample

Calculate Economic Value Added (EVA) for the Western Division.

Required:

36

ExampleExample

EVA = ×

= $33,600 - (0.10 × $300,000)

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After-tax operating income

Actual % cost of capital

Total capital

employed

= $33,600 - $30,000

= $3,600

Advantages of EVAAdvantages of EVA

• Helps to encourage the right kind of behavior

• Relies on the true cost of capital

• Cost of capital is considered a corporate expense and is passed along to the overall income statement

• Makes investment seem free to the divisions so they want more

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OBJECTIVE OBJECTIVE 44

Explain the role of transfer pricing in a decentralized firm.

Transfer PricingTransfer Pricing

• Price charged for a component by the selling division to the buying division of the same company

• Sale is a revenue to the selling division• Sale is a cost to the buying division• Transfer Pricing policies:

– Market price– Cost-based transfer pricing– Negotiated transfer pricing

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Cornerstone 12-4Cornerstone 12-4

HOW TO Calculate Transfer Price

41

ExampleExample

• Alpha Division– Produces cb-117 model that is used by Delta

Division

– Market price is $14

– Full cost of the board is $9

• Delta Division is a heating and air-conditioning manufacturer

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Information:

Omni Inc. has a number of divisions

ExampleExample

1. If Omni Inc. has a transfer pricing policy that requires transfer at full cost…

a. What will the transfer price be?

b. Do you suppose that Alpha and Delta divisions choose to transfer at that price?

2. If Omni Inc. has a transfer pricing policy that requires transfer at market price…

a. What would the transfer price be?

b. Do you suppose that Alpha and Delta divisions would choose to transfer at that price?

43

Required:

Advantages of EVAAdvantages of EVA

3. Now suppose that Omni Inc. allows negotiated transfer pricing and that Alpha Division can avoid $3 of selling expense by selling to Delta Division.

a. Which division sets the minimum transfer price and what is it?

b. Which division sets the maximum transfer price, and what is it?

c. Do you suppose that Alpha and Delta divisions would choose to transfer somewhere in the bargaining range?

44

Required continued:

ExampleExample

Transfer Pricing at Full Cost:

Full cost transfer price $9

Delta Division would like the price, but…

Alpha Division would refuse to transfer since $14 could be earned in the outside

market

ExampleExample

Transfer Pricing at Market Price:

Market price is $14

Both Delta and Alpha divisions would be willing to transfer at that price (since neither

division would be worse off than if it bought/sold in the outside market)

ExampleExample

Transfer Pricing at a Negotiated Transfer Price:

Minimum transfer price = $14 – $3 = $11

This price is set by Alpha division (the selling division)

Maximum transfer price = $14

This price is the market price and is set by Delta division (the buying division)

Alpha and Delta will negotiate a price somewhere between $11 and $14

OBJECTIVE OBJECTIVE 55

(Appendix) Explain the uses of the Balanced Scorecard and compute cycle time, velocity, and manufacturing cycle efficiency.

Balanced ScorecardBalanced Scorecard

• Strategic management system

• Translates an organization’s mission and strategy into:– Operational objectives – Performance measures– Four different perspectives

Operational Objectives and Performance MeasuresOperational Objectives and Performance Measures

• Financial perspective– Describes the economic consequences of actions taken

• Customer perspective– Defines the customer and market segments in which the

business unit will compete

• Internal business process perspective– Describes the internal processes needed to provide

value for customers and owners

• Learning and growth (infrastructure) perspective– Defines the capabilities that an organization needs to

create long-term growth and improvement

Strategy TranslationStrategy Translation

Specifying objectives, measures, targets, and initiatives for each

perspective

Performance MeasuresPerformance Measures

• Derived from a company’s vision, strategy, and objectives

• Measures must be balanced between– performance driver measures and outcome

measures– objective and subjective measures– external and internal measures– financial and nonfinancial measures

• Must also be carefully linked to the organization’s strategy

Financial PerspectivesFinancial Perspectives

• Established the long- and short-term financial performance objectives

• Concerned with global financial consequences of the three perspectives

• Three strategic themes– Revenue growth– Cost reduction– Asset utiltization

Revenue GrowthRevenue Growth

• Objectives:– Increase the number of new products– Create new applications for existing

products– Develop new customers and markets– Adopt a new pricing strategy

• From objectives performance measures can be designed

Cost ReductionCost Reduction

• Objectives– Reducing the cost

• Per unit of product• Per customer• Per distribution channel

• Trends tell whether costs are being reduced

• Activity-based costing can play an essential measurement role

Asset UtilizationAsset Utilization

• Principle objective– Improving asset utilization

• Measures– Return on investment– Economic value added

Customer PerspectiveCustomer Perspective

• Defines and selects the customer and market segments in which the company competes

• Objectives:– Increase market share– Increase customer retention– Increase customer acquisition– Increase customer satisfaction– Increase customer profitability

Customer PerspectiveCustomer Perspective

• Measures– Market Share– Percentage growth of business from existing

customers – Percentage of repeating customers– Number of new customers– Ratings from customer satisfaction surveys– Individual and segment profitability

• Activity-based costing is a key tool

Cycle Time and VelocityCycle Time and Velocity

• Responsiveness– Time to respond to a customer order

• Operational measures– Cycle Time

• Length of time it takes to produce a unit of output from the time raw materials are received until the good is delivered to finished goods inventory

– Velocity• Number of units of output that can be produced in a

given period of time

Cornerstone 12-5Cornerstone 12-5

HOW TO Compute Cycle Time and Velocity

60

ExampleExample

• Maximum units produced in a quarter, 200,000 units

• Actual units produced in a quarter, 160,000 units

• Productive hours in one quarter, 40,000 hours

61

Information:

ExampleExample

1. Compute the theoretical cycle time (in minutes)

2. Compute the actual cycle time (in minutes)

3. Compute the theoretical velocity in units per hour

4. Compute the actual velocity in units per hour

62

Required:

Theoretical Cycle TimeTheoretical Cycle Time

Productive hours in one quarter ×

60 minutes per hour

Maximum units produced in a

quarter

40,000 hours × 60 minutes per hour 200,000 units

12 minutes per unit

Actual Cycle Time Actual Cycle Time

Productive hours in one quarter ×

60 minutes per hour

Actual units produced in a

quarter

40,000 hours × 60 minutes per hour 160,000 units

15 minutes per unit

Theoretical VelocityTheoretical Velocity

60 minutes per hour

Theoretical cycle time

60 minutes per hour

12 minutes per unit

= 5 units per hour

=

Actual VelocityActual Velocity

60 minutes per hour

Actual cycle time

60 minutes per hour

15 minutes per unit

= 4 units per hour

=

Manufacturing Cycle EfficiencyManufacturing Cycle Efficiency

• Time-based operational measure

• Measured as:– Valued-added time divided by– Total time

• Included both value-added time and non-value added time

• As MCE improved cycle time decreases

Cornerstone 12-6Cornerstone 12-6

HOW TO Calculate Manufacturing Cycle Efficiency

68

ExampleExample

• Maximum units produced in a quarter, 200,000 units

• Actual units produced in a quarter, 160,000 units

• Productive hours in one quarter, 40,000 hours

• Actual cycle time, 15 minutes

• Theoretical cycle time, 12 minutes69

Information:

ExampleExample

1. Calculate the amount of processing time and the amount of nonprocessing time.

2. Calculate Manufacturing Cycle Efficiency (MCE)

70

Required:

Processing and Nonprocessing Time

Processing and Nonprocessing Time

Processing time = Theoretical time

Processing time = 12 minutes

Nonprocessing time =

Actual Cycle Time - Theoretical

Cycle Time

Nonprocessing time = 15 – 12 = 3 minutes

Manufacturing Cycle Time (MCE)Manufacturing Cycle Time (MCE)

Processing time

Processing time

12 (12 + 3)

+Nonprocessing

time

0.8 or 80 percent