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Investment Center Performance Evaluation

CHAPTER 11

Managerial Accounting 11E

Maher/Stickney/Weil

PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

© 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.

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DIVISION: Definition

Is a segment that conducts both production and marketing

activities.

LO 1

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DIVISIONS

A division may be a profit center, responsible for revenues and operating costs.

A division may also be an investment center, responsible for assets in addition to revenues and operating costs.

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ADVANTAGES OF DECENTRALIZATION

Major advantages of decentralization (authority and responsibility are delegated from top management) include:¯Enabling local personnel to respond quickly to a changing

environment.¯Freeing top management from detailed operating decisions.¯Dividing large, complex problems into manageable pieces.¯Training managers and providing a basis for evaluating

their decision-making performance.¯Motivating ambitious managers.

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DISADVANTAGES OF DECENTRALIZATION

Major disadvantages of decentralization include:¯Local managers do not act to achieve the overall

goals of the organization.¯Possible conflicts between goals of a division and

those of the organization.

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PERFORMANCE EVALUATIONS

Top management should distinguish between an organizational division and the division manager. Many measures used to evaluate divisions can/should be adjusted to account for revenues, costs, and investments that are controllable by its manager.

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RETURN ON INVESTMENT (ROI): Definition

Is a method of evaluating performance based on assets

invested.

ROI = Division operating profit ÷ Division Investment

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QUESTIONS FOR ROI

Before applying ROI, managers must find answers to several questions:¯How does the firm measure revenues?¯Which costs does the firm deduct in measuring

divisional operating costs?¯How does the firm measure investment?

LO 2

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TRANSFER PRICE: Definition

Is the value assigned to goods or services transferred from one

unit to another within the organization.

LO 3

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SETTING TRANSFER PRICES

Management must consider congruence with organizational goals when setting transfer prices. Methods of setting transfer prices include:

1. Top management intervenes to set prices2. Top management establishes policies for

setting transfer prices3. Division managers negotiate their own

transfer prices

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TRANSFER PRICING POLICIES 1

Management has several choices for transfer pricing policies¯Market-price based

¯Best in competitive market ¯Only if market prices are readily available

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TRANSFER PRICING POLICIES 2

Management has several choices for transfer pricing policies

¯Transfer prices based on cost¯Full-absorption costs

¯Only if differential or variable costs are available

¯Activity-based costing¯Cost-plus pricing¯Standard costs or actual costs

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TRANSFER PRICING POLICIES 3

Management has several choices for transfer pricing policies

¯Other motivational aspects¯Dual pricing

¯Provides selling division with profit but charges buying division with costs only

¯Other incentives¯Balanced scorecard¯Basing part of supplying manager’s bonus on purchasing

center’s profits

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NEGOTIATED PRICESThere are advantages and disadvantages to

having managers negotiate transfer prices.¯ Advantage: preserves autonomy of

division managers¯ Disadvantages

¯ Consumes management time¯ May depend on manager’s negotiating ability

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The economic transfer pricing rule tomaximize Company profits is to

Transfer at the differential outlay cost to theselling division (VC), + opportunity cost

of making internal transfers ($0 withidle capacity; selling price – VC

with no idle capacity)

LO 4

DECISION RULE

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DIRECT and INDIRECT COSTS: Definition

Refers to whether cost associates directly with the

division.

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CONTROLLABLE and NON-CONTROLLABLE: Definition

Refers to whether the division manager can affect the cost.

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DIRECT and INDIRECT COSTS

Managers should be held responsible for direct costs (any cost necessary to operate). They are always deducted for performance evaluation of a division whereas manager evaluation should only include direct costs that are controllable. Similarly, divisions can partially control indirect controllable costs.

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ROI COMPONENTS

Management must decide (a) which assets to include in the investment base and (b) what valuation to use for those assets. Problems occur when assets are shared among divisions or when considering centralized services. Valuation may be net or gross book value.

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PROFIT MARGINLO 8

ROI = Profit Margin Divisional Revenues X

Divisional RevenuesDivisional Investment

PROFIT MARGIN PERCENTAGE

INVESTMENT TURNOVER

RATIO

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PROFIT MARGIN PERCENTAGE: Definition

Indicates the portion of each dollar of revenue that is profit.

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INVESTMENT TURNOVER RATIO: Definition

Is the ratio of divisional sales to investment in divisional assets; a measure of the effective use

of invested funds.

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MINIMUM ROI

Management must set a standard or desired ROI rate for each period and a minimum ROI for each division.

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ECONOMIC VALUE ADDED (EVA): Definition

Is the amount of earnings generated above the cost of

funds invested to generate those earnings.

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EVALO 9

EVA = Net operating profit after tax -(Weighted-average cost of capital X Investment)

Where Investment is (Total Assets – Noninterest-bearing current liabilities)

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Adjusting GAAP data for incentive plans

The main adjustments made to GAAP data for incentive plans include:¯Capitalize/amortize R & D expenditures and customer

development, advertising, promotion expenditures¯Capitalize/amortize employee training expenditures¯Make price-level adjustments¯Use market values of assets to assess value declines¯Restate inventories at replacement cost.¯Do not amortize goodwill.

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Incentive Issues

CHAPTER 12

PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

© 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.

Managerial Accounting 11E

Maher/Stickney/Weil

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CHAPTER GOALChapter 12 discusses issues in design and use of

management performance evaluation and incentive plans to motivate managers to act in the organization’s best interests. Good performance evaluation and incentive plans induce “win-win” results if they avoid incentives for fraudulent financial reporting.

☼ ☼

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PAY INCENTIVES

Managers receive bonuses for performance that may be based on divisional or corporate results. Bonuses may be based on annual performance or on performance over several years and may be paid immediately or deferred and spread over several years.

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What forms do divisional incentives

take?

Divisional incentives can be cash or profit sharing for short-term performance; stock or stock options as

deferred compensation; and special awards.

LO 1MANAGERS WANT TO KNOW!

How will performance be evaluated?

Performance can be evaluated based on

accounting numbers, returns to stockholders or

both.

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DESIGNING INCENTIVE COMPENSATION

Management must ascertain two things in designing incentive systems:¯What behavior does the system motivate?¯What behavior does management desire?

LO 1

WARNING! Rewarding managers for performance reflected in annual accounting

numbers gives managers incentives totake actions that make the numbers look

good but not actions that benefitthe organization.

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INCENTIVES and PRODUCT LIFE CYCLE

A major problem with short-run incentive plans is that managers are penalized for developing products that might produce long-run benefits. Under U.S.GAAP, firms write off research and development costs when incurred. IFRSs do not require as much write-off as U.S. GAAP

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PRODUCT LIFE CYCLE: Stages

Four stages of the product life cycle are:¯Design and development: low sales but high

research, design and development costs¯Growth¯Maturity¯Decline

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EXPECTANCY THEORY: Definition

Maintains that people act in ways to obtain rewards they desire and prevent penalties

they wish to avoid.

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AGENCY THEORY: Definition

Deals with relations between supervisors and workers and assumes employees will not necessarily behave as their

employers desire.

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EXHIBIT 12.2

LO 2

The objective of a good incentive

compensation is to minimize agency

costs.

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What are extrinsicrewards ? Extrinsic rewards come

from outside the individual, i.e., the

supervisor, etc.

LO 2MANAGERS WANT TO KNOW!

What are intrinsicrewards ?

Intrinsic rewards come from inside the individual such as satisfaction for a

job well done.

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BALANCED SCORECARD: Definition

Is a model of lead and lag indicators of performance

including both financial and nonfinancial performance

measures.

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BALANCED SCORECARD PERSPECTIVES

Four perspectives of the balanced scorecard approach are:¯Learning and growth¯Internal business and production process

perspective¯Customer ¯Financial

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INCENTIVE QUESTION 1

Should rewards be based on current or futureperformance?

An advantage to basing on future performance is the “golden handcuffs” that tie managers to the company. Most companies use a combination of current and deferred rewards.

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INCENTIVE QUESTION 2

Should rewards be based on division or company-wide performance?

When based on the manager’s responsibility center alone, it focuses the attention without considering the impact of their actions on the whole company. Most companies use both.

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INCENTIVE QUESTION 3

Should rewards use a fixed formula or subjective judgment in providing rewards?

The advantage of a formula-based plan is that managers know what is expected and what reward they will get if they meet expectations.

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INCENTIVE QUESTION 4

Should rewards be based on accounting results or stock performance?

Tying managers’ compensation to stock performance loads uncontrollable risk on them. Using EVA both focuses managers on creating value for shareholders and relies on nonstock performance measures.

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INCENTIVE QUESTION 5

Should rewards be based on absolute or relative performance evaluation?

Relative performance compares divisional performance with other divisions in the same industry with less than optimum comparisons.

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INCENTIVE QUESTION 6

Should rewards be cash, stock or prizes? Many companies use a combination because

of the different (current vs. deferred) methods of reward. Expectancy theory finds prizes more attractive and more motivating.

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FRAUDULENT FINANCIAL REPORTING: Definition

Is intentional conduct resulting in materially misleading

financial statements.

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TYPES OF FRAUD

Fraudulent financial reporting usually falls into two categories:¯Improper revenue recognition

¯Firm reports profit in wrong accounting period

¯Overstating inventory¯Increases reported earnings in period of

overstatement ¯In absence of continuing overstatement, must

result in reduced earnings in next period

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INTERNAL CONTROL: Definition

Is a process designed to provide reasonable assurance that an organization will achieve its objectives in (a) operating

effectiveness and efficiency; (b) reliability of financial reporting; and (c) compliance with applicable laws

and regulations.

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INDEPENDENT AUDITORS

Independent audits ¯Are required by the SEC for firms selling

securities across state lines¯Help prevent fraud through reviews of

internal controls

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CORRUPTION

According to economists, three elements that must be present for corruption to occur are: ¯Individual must have discretionary power to award

contract or rights¯Economic benefits are associated with

discretionary power¯Legal system must be unlikely to detect

wrongdoing

LO 5