Organizational Design, Responsibility Accounting, and ... · Organizational Design, Responsibility...
Transcript of Organizational Design, Responsibility Accounting, and ... · Organizational Design, Responsibility...
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-1
Organizational Design,Responsibility Accounting,
and Evaluation of DivisionalPerformance
Student Tutorial
19
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-2
Decentralized Organizations AndResponsibility Accounting
Most organizations are divided into smaller units, divisions, segments, business units, work centers, or departments
which have particular responsibilities
Most organizations are divided into smaller units, divisions, segments, business units, work centers, or departments
which have particular responsibilities
When the managers of subunits throughoutthe organization have incentives to performin the common interest of the organization
When the managers of subunits throughoutthe organization have incentives to performin the common interest of the organization
When do you have GOAL CONGRUENCE?When do you have GOAL CONGRUENCE?
BEHAVIOURAL CONGRUENCEPerformance evaluation and incentive systems are
designed to encourage employees to behave as if theirgoals are congruent with organizational goals.
BEHAVIOURAL CONGRUENCEPerformance evaluation and incentive systems are
designed to encourage employees to behave as if theirgoals are congruent with organizational goals.
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Decentralized Organizations AndResponsibility Accounting
GOAL CONGRUENCE
GOAL CONGRUENCE
BEHAVIOURAL CONGRUENCE
BEHAVIOURAL CONGRUENCE
Various concepts and tools used to measure the performance
of people and the departments in order to foster goal
or behavioural congruence
Various concepts and tools used to measure the performance
of people and the departments in order to foster goal
or behavioural congruence
RESPONSIBILITYACCOUNTING
RESPONSIBILITYACCOUNTING
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19-4
CentralizedOrganizations
CentralizedOrganizations
DecentralizedOrganizations
DecentralizedOrganizations
Centralization Vs. Decentralization
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19-5
CentralizedOrganizations
CentralizedOrganizations
DecentralizedOrganizations
DecentralizedOrganizations
Decisions arehanded down fromthe top echelon of
managementand subordinates
carry them out
Decisions arehanded down fromthe top echelon of
managementand subordinates
carry them out
Decisions aremade at
divisional anddepartmental levels
Decisions aremade at
divisional anddepartmental levels
Centralization Vs. Decentralization
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19-6Benefits And Costs Of ADecentralized Organization
! Subunit managers are specialists
! Autonomy in decision makingprovides managerial training
! Managers with decision makingauthority usually exhibit greatermotivation
! Delegating provides time relief toupper-level managers
! Empowering employees draws onthe knowledge and expertise ofthose closest to operations
! Delegating to the lowest levelenables a timely response toopportunities and problems
! Managers sometimes have anarrow focus of their own units’performance rather than theorganization’s overall goals
! The narrow focus may causemanagers to tend to ignore theconsequences of their actionson the organization’s othersubunits
! Some tasks or services may beduplicated unnecessarily
BENEFITS COSTS
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19-7Decentralized Organizations AndResponsibility Accounting -
Question #1Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-8Decentralized Organizations AndResponsibility Accounting -
Question #1
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-9Decentralized Organizations AndResponsibility Accounting -
Question #1
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
If the environment was stable, one person could runthe world. It is instability that gives rise to the need
for local decision-making. Try again.
If the environment was stable, one person could runthe world. It is instability that gives rise to the need
for local decision-making. Try again.
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-10Decentralized Organizations AndResponsibility Accounting -
Question #1
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
If the firm is small, then why would we want todelegate authority to middle management? Try
again.
If the firm is small, then why would we want todelegate authority to middle management? Try
again.
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-11Decentralized Organizations AndResponsibility Accounting -
Question #1Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
Which of the following is more characteristic of adecentralized than a centralized organization?
A. Quick response time to changes in localconditions
B. The firm faces a relatively stable environmentC. The firm is relatively smallD. There is little incentive for lower level
management to make decisions
Why would you want to put decision-makingauthority in the hands of unmotivated management?
Try again.
Why would you want to put decision-makingauthority in the hands of unmotivated management?
Try again.
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-12Responsibility AccountingThe purpose of a RESPONSIBILITY ACCOUNTING system is to
ensure that each manager and worker in the organization is striving toward the overall goals set by top management
The purpose of a RESPONSIBILITY ACCOUNTING system is to ensure that each manager and worker in the organization is
striving toward the overall goals set by top management
A RESPONSIBILITY CENTER is a subunit in an organization whose manager is held accountable for specified financial
and nonfinancial results of the subunit’s activities
A RESPONSIBILITY CENTER is a subunit in an organization whose manager is held accountable for specified financial
and nonfinancial results of the subunit’s activities
Cost CenterCost
Center
Discretionary Cost
Center
Discretionary Cost
CenterRevenue
CenterRevenue
Center
ProfitCenterProfit
Center
Investment Center
Investment Center
RESPONSIBILITYCENTERS
RESPONSIBILITYCENTERS
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19-13Responsibility AccountingRESPONSIBILITY CENTERSRESPONSIBILITY CENTERS
InvestmentCenter
InvestmentCenter
• the manager is responsible for the profit and theinvested capital used to generate the profit
• the manager is responsible for the profit and theinvested capital used to generate the profit
ProfitCenterProfit
Center• the manager is responsible for the subunit’s profit • the manager is responsible for the subunit’s profit
RevenueCenter
RevenueCenter
• the manager is responsible for the revenue of the subunit
• the manager is responsible for the revenue of the subunit
DiscretionaryCost Center
DiscretionaryCost Center
• input-output relationships are not well specified• the manager is responsible for the cost of activities• input-output relationships are not well specified
• the manager is responsible for the cost of activities
Cost Center Cost Center• well-defined input-output relationships
• the manager is responsible for the cost of activities• well-defined input-output relationships
• the manager is responsible for the cost of activities
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19-14Organization Chart: OutbackOutfitters, Ltd.
Salesdepartment
Investmentcenter
Investmentcenter
Profitcenter
Revenuecenter
Cost center
Cost center
President
Vice-president
General plantmanager
Sales dept.manager
Productiondept. manager
Supervisorof work center
OutbackOutfitters, Ltd.
Koala campgear division
Sydneyplant
Productiondepartment
Packagingwork center
Managers Responsibility center
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19-15Performance ReportA performance report shows the budgeted and actual amounts
of key financial results appropriate for the type or responsibility involved
A performance report shows the budgeted and actual amounts of key financial results appropriate
for the type or responsibility involved
BUDGETEDamounts
of keyfinancialresults
BUDGETEDamounts
of keyfinancialresults
ACTUALamounts
of keyfinancialresults
ACTUALamounts
of keyfinancialresults
VARIANCEVARIANCE
Management by exception means management only follows upon the most significant variances
Management by exception means management only follows upon the most significant variances
Management by exception is used to control an organization’s operations effectively
Management by exception is used to control an organization’s operations effectively
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19-16
Activity-Based ResponsibilityAccounting
Focus on the financial performance
measures of cost,revenues, and profit for thesubunits of the organization
Focus on the financial performance
measures of cost,revenues, and profit for thesubunits of the organization
Activity-basedresponsibility systems focus
not only on the cost ofperforming activities but on
the activities themselves
Activity-basedresponsibility systems focus
not only on the cost ofperforming activities but on
the activities themselves
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19-17How Does ResponsibilityAccounting Affect Behaviour
The proper focus of a responsibility system
is informational
The proper focus of a responsibility system
is informational
Some organizations useperformance reports that
distinguish between controllable or uncontrollable costs or revenues
Some organizations useperformance reports that
distinguish between controllable or uncontrollable costs or revenues
Causing managers to react constructively and strive for
improved performance
Causing managers to react constructively and strive for
improved performance
Identifying costs as controllableor uncontrollable is not always
easy.
Identifying costs as controllableor uncontrollable is not always
easy.
A responsibility accountingsystem does not emphasize
blame
A responsibility accountingsystem does not emphasize
blameSome costs that are not
controllable in the short runbecome controllable in the
long run
Some costs that are not controllable in the short runbecome controllable in the
long run
Many costs are influenced by more than one person
Many costs are influenced by more than one person
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19-18
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Decentralized Organizations AndResponsibility Accounting - Question #2
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19-19
That’s true, but it doesn’t help us to answerthe question. Try again.
That’s true, but it doesn’t help us to answerthe question. Try again.
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Decentralized Organizations AndResponsibility Accounting - Question #2
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19-20
Of course it isn’t easy, but it isn’t right either.Try again.
Of course it isn’t easy, but it isn’t right either.Try again.
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Decentralized Organizations AndResponsibility Accounting - Question #2
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-21
If they aren’t controllable in the short run, wecan’t hold someone responsible. Try again.
If they aren’t controllable in the short run, wecan’t hold someone responsible. Try again.
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Decentralized Organizations AndResponsibility Accounting - Question #2
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-22
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Decentralized Organizations AndResponsibility Accounting - Question #2
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-23
That’s just silly. Of course it emphasizesblame. That’s the point, isn’t it? Try again.That’s just silly. Of course it emphasizes
blame. That’s the point, isn’t it? Try again.
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Which of the following is not true about responsibilityaccounting?
A. Costs are classified on the basis of controllabilityB. Identifying costs as controllable or uncontrollable
is not always easyC. Some costs that are not controllable in the short
run become controllable in the long runD. Many costs are influenced by one personE. A responsibility accounting system does not
emphasize blame
Decentralized Organizations AndResponsibility Accounting - Question #2
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-24
Production manager looks only at costsProduction manager looks only at costs
Sales manager looks only at benefits
Sales manager looks only at benefits
Motivating Desired BehaviourOrganizations often use the responsibility accounting system
to motivate actions considered desirable by upper-level management
Organizations often use the responsibility accounting system to motivate actions considered desirable
by upper-level management
Disrupted productionMore setupsHigher costsNeed for outsourcing
Disrupted productionMore setupsHigher costsNeed for outsourcing
Potential Costs of Accepting Rush Order
Potential Costs of Accepting Rush Order
Sometimes the responsibility accounting system can solve behavioural problems and promote teamwork
Sometimes the responsibility accounting system can solve behavioural problems and promote teamwork
Satisfied customersGreater future salesSatisfied customersGreater future sales
The modifiedresponsibility system
made the sales manager look at both the costs and benefits
Potential Benefits of Accepting Rush Order
Potential Benefits of Accepting Rush Order
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19-25
Measuring Performance InInvestment Centers
Large subunits are usually designated as INVESTMENT CENTERSLarge subunits are usually designated as INVESTMENT CENTERS
The manager is held accountable for the INVESTMENT CENTER’Sprofits and the capital invested to earn that profit
The manager is held accountable for the INVESTMENT CENTER’Sprofits and the capital invested to earn that profit
The retail sales managerThe retail sales manager
Approves theoverall pricing
policies inthe retail
division’s stores
Approves theoverall pricing
policies inthe retail
division’s stores
Has the autonomy to sign contracts
to buy merchandise
for resale
Has the autonomy to sign contracts
to buy merchandise
for resale
Has the authority toto build new stores
rent space in shopping centers, or close existing
stores
Has the authority toto build new stores
rent space in shopping centers, or close existing
stores
These decisions influence theorganization’s profit
These decisions influence the amount
of capital invested in the division
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19-26
Return On Investment As APerformance Measure
Mail Order Division
Koala Camp Gear Division Retail Division
Sales revenue $350,000,000 $405,000,000 $960,000,000Income 14,000,000 45,000,000 48,000,000Invested capital 70,000,000 300,000,000 480,000,000
Return on investment (ROI) = Return on investment (ROI) = IncomeInvested capital
IncomeInvested capital
Income Invested capital
= Return on Investment (ROI)
Mail-order division
$14,000,000 $70,000,000 = 20%
Koala Camp Gear division
$45,000,000 $300,000,000 = 15%
Retail division$48,000,000 $480,000,000 = 10%
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-27
Factors Underlying ROI
Return on investment Income
Invested CapitalIncome
Sales revenueSales revenue
Invested capital= = X
SalesMarginSales
Margin
CapitalTurnoverCapital
Turnover
Focuses on thenumber of sales
dollars generatedby each dollar of invested capital
Focuses on thenumber of sales
dollars generatedby each dollar of invested capital
Measures the percentage of each sales dollar that
remains as profit after allexpenses are covered
Measures the percentage of each sales dollar that
remains as profit after allexpenses are covered
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-28
Focuses on the number of salesdollars generated by each dollar of
invested capital
Focuses on the number of salesdollars generated by each dollar of
invested capital
Measures the percentage of each sales dollar that remains as
profit after all expenses are covered
Measures the percentage of each sales dollar that remains as
profit after all expenses are covered
Mail-order division
$14,000,000 $350,000,000
$350,000,000 $70,000,000 = 20%
Koala Camp Gear division
$45,000,000 $405,000,000
$405,000,000 $300,000,000 = 15%
Retail division$48,000,000
$960,000,000$960,000,000 $480,000,000 = 10%
SalesMargin
CapitalTurnoverX
Factors Underlying ROI
Return on investment Income
Invested CapitalIncome
Sales revenueSales revenue
Invested capital= = X
X
X
X
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19-29
Improving A Division’s ROI
Retail division’sROI
Sales margin
Capital turnover
14% 7% 2
15% 5% 3
10% 5% 2Current retaildivision ROI
Improved retail
division ROI
Improved retail
division ROI
Increase sales marginIncrease sales price while selling less quantity
or decrease expenses
Increase capital turnoverIncrease sales revenues or reduce
the division’s invested capital
X
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-30
Compute CookevilleCorporation’s Asset
Turnover Ratio
Compute CookevilleCorporation’s Asset
Turnover Ratio??
Compute CookevilleCorporation’s Profit
Margin
Compute CookevilleCorporation’s Profit
Margin??
Return on InvestmentCookeville Corporation has provided the following information:
Sales: $1,000,000Income: $250,000
Assets: $5,000,000
Cookeville Corporation has provided the following information:Sales: $1,000,000Income: $250,000
Assets: $5,000,000
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-31
Compute CookevilleCorporation’s Asset
Turnover Ratio
Compute CookevilleCorporation’s Asset
Turnover Ratio
$1,000,000 ÷ $5,000,000 = 20%$1,000,000 ÷ $5,000,000 = 20%
Compute CookevilleCorporation’s Profit
Margin
Compute CookevilleCorporation’s Profit
Margin
$250,000 ÷ $1,000,000 = 25%$250,000 ÷ $1,000,000 = 25%
Return on InvestmentCookeville Corporation has provided the following information:
Sales: $1,000,000Income: $250,000
Assets: $5,000,000
Cookeville Corporation has provided the following information:Sales: $1,000,000Income: $250,000
Assets: $5,000,000
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-32
??
Compute Cookeville Corporation’s Return onInvestment
Compute Cookeville Corporation’s Return onInvestment
Return on InvestmentCookeville Corporation has provided the following information:
Sales: $1,000,000Income: $250,000
Assets: $5,000,000
Cookeville Corporation has provided the following information:Sales: $1,000,000Income: $250,000
Assets: $5,000,000
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-33
Profit Margin × Asset Turnover = ROI25% × 20% = 5%
Profit Margin × Asset Turnover = ROI25% × 20% = 5%
Compute Cookeville Corporation’s Return onInvestment
Compute Cookeville Corporation’s Return onInvestment
Return on InvestmentCookeville Corporation has provided the following information:
Sales: $1,000,000Income: $250,000
Assets: $5,000,000
Cookeville Corporation has provided the following information:Sales: $1,000,000Income: $250,000
Assets: $5,000,000
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-34
Residual Income As A PerformanceMeasure
Return on investmentin new equipment
Increase in divisional profitIncrease in invested capital
5,500,000$50,000,000
11%= = =
Cost of investment inCIM = $50,000,000
Results in annualoperating savings of $5,500,000
The company’s cost of capital = 10%
Koala Camp Gear Division’s Return on Investment
Without Investment inNew Equipment
With Investment inNew Equipment
$45,000,000 $300,000,000 = 15%
$45,000,000 + $5,500,000 $300,000,000 + $50,000,000 < 15%
Averaging the new investment with that already inplace reduces the division’s overall ROI
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19-35
Residual Income As A PerformanceMeasure
Divisional profit $45,000,000 $50,500,000
Less imputed interest charge: Invested capital $300,000,000 $350,000,000X imputed interest rate x .10 x .10
Imputed interest charge 30,000,000 35,000,000
Residual charge $15,000,000 $15,500,000
Koala Camp Gear Division’s Residual IncomeKoala Camp Gear Division’s Residual Income
Without Investment inNew CIM Equipment
Without Investment inNew CIM Equipment
With Investment inNew CIM EquipmentWith Investment in
New CIM Equipment
Investment in new equipmentraises residual income by
$500,000
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-36
Divisional profit $45,000,000 $50,500,000
Less imputed interest charge: Invested capital $300,000,000 $350,000,000X imputed interest rate x .10 x .10
Imputed interest charge 30,000,000 35,000,000
Residual charge $15,000,000 $15,500,000
Residual Income As A PerformanceMeasure
Comparison of Residual Income: Two DivisionsComparison of Residual Income: Two Divisions
Mail-OrderDivision
Mail-OrderDivision
Koala CampGear DivisionKoala Camp
Gear Division
The Koala Camp Gear division’s residual income ismuch higher simply because it is larger than the
mail-order division
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-37
Residual Income As A PerformanceMeasure
The Byrdstown Corporation has the following two divisions:DIVISION A DIVISION B
Sales $1,500,000 $2,000,000-Total variable costs 500,000 1,000,000-Total fixed costs 250,000 500,000Average assets invested 2,000,000 3,000,000
Assume a 10% target return on investment Compute divisional residual income
The Byrdstown Corporation has the following two divisions:DIVISION A DIVISION B
Sales $1,500,000 $2,000,000-Total variable costs 500,000 1,000,000-Total fixed costs 250,000 500,000Average assets invested 2,000,000 3,000,000
Assume a 10% target return on investment Compute divisional residual income
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19-38
DIVISION A DIVISION BSales $1,500,000 $2,000,000-Total variable costs 500,000 1,000,000-Total fixed costs 250,000 500,000
$750,000 $500,000Average assets invested 2,000,000 X 10% = $200,0003,000,000 X 10% = $300,000
Residual Income $550,000 $200,000
DIVISION A DIVISION BSales $1,500,000 $2,000,000-Total variable costs 500,000 1,000,000-Total fixed costs 250,000 500,000
$750,000 $500,000Average assets invested 2,000,000 X 10% = $200,0003,000,000 X 10% = $300,000
Residual Income $550,000 $200,000
Residual Income As A PerformanceMeasure
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19-39
Residual Income As A PerformanceMeasure
DIVISION A DIVISION BSales $1,500,000 $2,000,000-Total variable costs 500,000 1,000,000-Total fixed costs 250,000 500,000
$750,000 $500,000Average assets invested 2,000,000 X 10% = $200,0003,000,000 X 10% = $300,000
Residual Income $550,000 $200,000
Assume that Division B has the opportunity to make an investment in an asset costing $500,000 which will save $55,000. Assume an income of $500,000.
DIVISION A DIVISION BSales $1,500,000 $2,000,000-Total variable costs 500,000 1,000,000-Total fixed costs 250,000 500,000
$750,000 $500,000Average assets invested 2,000,000 X 10% = $200,0003,000,000 X 10% = $300,000
Residual Income $550,000 $200,000
Assume that Division B has the opportunity to make an investment in an asset costing $500,000 which will save $55,000. Assume an income of $500,000.
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19-40
Residual Income As A PerformanceMeasure
Return on investmentin new equipment
Increase in divisional profitIncrease in invested capital
55,000$500,000
11%= = =
Cost of investment inCIM = $500,000
Results in annualoperating savings of $55,000
The company’s cost of capital = 10%
Division B’s Return on Investment
Without Investment inNew Equipment
With Investment inNew Equipment
$500,000 $3,000,000 = 16.67%
$500,000 + $50,000 $3,000,000 + $500,000 =15.7%
Averaging the new investment with that already inplace reduces the division’s overall ROI
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-41
Residual Income As A PerformanceMeasure
DIVISION BSales $2,000,000 + $55,000 = $2,055,000- Total variable costs 1,000,000 1,000,000- Total fixed costs 500,000 500,000
$500,000 $555,000Average assets invested 3,000,000 X 10% = $300,000+ $500,000 $3,500,000
X 10% $350,000Residual Income $200,000 $205,000
DIVISION BSales $2,000,000 + $55,000 = $2,055,000- Total variable costs 1,000,000 1,000,000- Total fixed costs 500,000 500,000
$500,000 $555,000Average assets invested 3,000,000 X 10% = $300,000+ $500,000 $3,500,000
X 10% $350,000Residual Income $200,000 $205,000
The investment increases residual incomeThe investment increases residual income
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19-42
Economic Value Added (EVA) As APerformance Measure
Economicvalueadded
Investmentcenter’s after-tax operating
profit
Investmentcenter’s
total assets
Investmentcenter’s current
liabilities
Weighted-averagecost ofcapital
= -- X
Two sources of long-termcapital: debt and equity
What does an EVA analysis tell us?What does an EVA analysis tell us?
How much shareholder wealth is being createdHow much shareholder wealth is being created
How does EVA differ from residual income?How does EVA differ from residual income?
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19-43
Weighted Average Cost Of CapitalAfter-taxcost of
debtcapital
Weightedaveragecost of capital
Market value
of debt
Cost ofequitycapital
Market value ofequity
Market value
of debt
Market value ofequity
+
+
=
.063
.0972
$400,000,000 .12 $600,000,000
$400,000,000 $600,000,000
+
=
+
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19-44
Economic Value Added ForOutback
Division Current LiabilitiesMail-Order $6,000,000Koala Camp Gear 5,000,000Retail 9,000,000
Outback Outfittershas $20 million incurrent liabilities
Outback Outfittershas $20 million incurrent liabilities
Economicvalueadded
Investmentcenter’s after-tax operating
profit
Investmentcenter’s
total assets
Investmentcenter’s current
liabilities
Weighted-averagecost ofcapital
=-- X
Mail-order $14 X (1 - .30) - [($ 70 - $6) X .0972] = $3,579,200Koala Camp Gear $45 X (1 - .30) - [($300 - $5) X .0972] = $2,826,000Retail $48 X (1 - .30) - [($480 - $9) X .0972] =$(12,181,200)
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19-45
Weighted Average Cost Of CapitalAfter-taxcost of
debtcapital
Market value
of debt
Cost ofequitycapital
Market value ofequity
+
Chattanooga Manufacturing Company has the followingcapital structureBonds-market value $5,000,000After-tax cost of debt capital 6.5%Common stock-market value $10,000,000Cost of equity capital 10.0%
Chattanooga Manufacturing Company has the followingcapital structureBonds-market value $5,000,000After-tax cost of debt capital 6.5%Common stock-market value $10,000,000Cost of equity capital 10.0%
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19-46
Weighted Average Cost Of CapitalAfter-taxcost of
debtcapital
Weightedaveragecost of capital
Market value
of debt
Cost ofequitycapital
Market value ofequity
Market value
of debt
Market value ofequity
+
+
=
.065 $5,000,000 .10 $10,000,000
$5,000,000 $10,000,000
+
=
+
.08833
© McGraw-Hill Ryerson Limited, 2001Irwin/McGraw-Hill Ryerson
19-47
Economic Value Added (EVA) As APerformance Measure
Economicvalueadded
Investmentcenter’s after-tax operating
profit
Investmentcenter’s
total assets
Investmentcenter’s current
liabilities
Weighted-averagecost ofcapital
= -- X
Assume the Chattanooga Manufacturing Company has two divisionswith the following data:
After-TaxCurrent Operating TotalLiabilities Income Assets
Division A: $1,000,000 $5,000,000 $ 8,000,000Division B: $2,000,000 $1,000,000 $15,000,000
Assume the Chattanooga Manufacturing Company has two divisionswith the following data:
After-TaxCurrent Operating TotalLiabilities Income Assets
Division A: $1,000,000 $5,000,000 $ 8,000,000Division B: $2,000,000 $1,000,000 $15,000,000
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19-48
Economic Value Added (EVA) As APerformance Measure
Assume the Chattanooga Manufacturing Company has two divisionswith the following data:
After-TaxCurrent Operating TotalLiabilities Income Assets
Division A: $1,000,000 $5,000,000 $ 8,000,000Division B: $2,000,000 $1,000,000 $15,000,000
Assume the Chattanooga Manufacturing Company has two divisionswith the following data:
After-TaxCurrent Operating TotalLiabilities Income Assets
Division A: $1,000,000 $5,000,000 $ 8,000,000Division B: $2,000,000 $1,000,000 $15,000,000
After-Tax Operating Current Total Income Liabilities Assets WACC
Division A: $5,000,000 - [($1,000,000 - $ 8,000,000) X .08833]Division B: $1,000,000 - [($2,000,000 - $15,000,000) X .08833]
After-Tax Operating Current Total Income Liabilities Assets WACC
Division A: $5,000,000 - [($1,000,000 - $ 8,000,000) X .08833]Division B: $1,000,000 - [($2,000,000 - $15,000,000) X .08833]
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19-49
Economic Value Added (EVA) As APerformance Measure
After-Tax
Operating Current Total Income Liabilities Assets WACC
Division A: $5,000,000 - [($1,000,000 - $ 8,000,000) X .08833]Division B: $1,000,000 - [($2,000,000 - $15,000,000) X .08833]
After-Tax
Operating Current Total Income Liabilities Assets WACC
Division A: $5,000,000 - [($1,000,000 - $ 8,000,000) X .08833]Division B: $1,000,000 - [($2,000,000 - $15,000,000) X .08833]
Division A: $5,000,000 - [$ -7,000,000) X .08833]Division B: $1,000,000 - [$-13,000,000 X .08833]
Division A: $5,000,000 - [$ -7,000,000) X .08833]Division B: $1,000,000 - [$-13,000,000 X .08833]
EVA
Division A: $5,000,000 - 618,310 = $4,381,690Division B: $1,000,000 - 1,148,290 = $ (148,290)
EVA
Division A: $5,000,000 - 618,310 = $4,381,690Division B: $1,000,000 - 1,148,290 = $ (148,290)
Division B is not creating shareholder wealthDivision B is not creating shareholder wealth
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19-50
What Is The Division’s InvestedCapital?
Total productiveassets
Total productiveassets
Total assetsTotal assets
Total assets lesscurrent liabilities
Total assets lesscurrent liabilities
Appropriate if the division manager has considerable authority in makingdecisions about all of the division’s
assets, including nonproductive assets
Appropriate if the division manager has considerable authority in makingdecisions about all of the division’s
assets, including nonproductive assets
Appropriate if the division manager has been directed by top level management
to keep nonproductive assets in progress, making it appropriate to exclude
nonproductive assets fromthe measure of invested capital
Appropriate if the division manager has authority to secure short-term bank
loans and other short-term credit
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19-51
Gross bookvalue is
acquisitioncost
Assets - Gross Or Net Book ValueCurrent assets (cash, accounts receivable, inventories, etc.) $34,000,000Long-lived assets (land, buildings, equipment, vehicles, etc.) Gross book value (acquisition cost) $304,000,000 Less: Accumulated depreciation 64,000,000 Net book value 240,000,000Plant under construction 26,000,000Total assets $300,000,000
Net book value is
acquisitionvalue less
accumulateddepreciation
Current assets $34,000,000Long-lived assets (at gross book value) 304,000,000Plant under construction 26,000,000
Total assets (at gross book value) $364,000,000
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19-52
Net Book Value Versus Gross BookValue
! Using net book value maintainsconsistency with the balancesheet prepared for externalreporting purposes
! Using net book value tomeasure invested capital is alsomore consistent with thedefinition of income, which isthe numerator in ROIcalculations
! Using net book value maintainsconsistency with the balancesheet prepared for externalreporting purposes
! Using net book value tomeasure invested capital is alsomore consistent with thedefinition of income, which isthe numerator in ROIcalculations
! The usual methods ofcomputing depreciation arearbitrary and should not beallowed to affect ROI, residualincome, or EVA calculations
! When long lived assets aredepreciated, their net bookvalue declines over timeresulting in a misleadingincrease in ROI, residualincome, and EVA across time
! The usual methods ofcomputing depreciation arearbitrary and should not beallowed to affect ROI, residualincome, or EVA calculations
! When long lived assets aredepreciated, their net bookvalue declines over timeresulting in a misleadingincrease in ROI, residualincome, and EVA across time
Advantages of net book value; disadvantages
of gross book value
Advantages of net book value; disadvantages
of gross book value
Advantages of gross book value; disadvantages
of net book value
Advantages of gross book value; disadvantages
of net book value
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19-53Methods Of MeasuringInvestment-Center Income
The key issue is controllability; the choice involves the extent to whichuncontrollable items are allowed to influence the income measure
The key issue is controllability; the choice involves the extent to whichuncontrollable items are allowed to influence the income measure
Sales revenueLess: unit-level, batch-level, product-level and customer-level expense
= (1) Divisional contribution margin
Sales revenueLess: unit-level, batch-level, product-level and customer-level expense
= (1) Divisional contribution margin
Less: general and facility-level expenses controllable by division manager= (2) Profit margin controllable by division manager
Less: general and facility-level expenses controllable by division manager= (2) Profit margin controllable by division manager
Less: general and facility-level expenses, traceable to division, but controlled by others
= (3) Profit margin traceable to division
Less: general and facility-level expenses, traceable to division, but controlled by others
= (3) Profit margin traceable to division
Less: common general and facility-level expenses, allocated fromcompany headquarters
= (4) Divisional income before interest and taxes
Less: common general and facility-level expenses, allocated fromcompany headquarters
= (4) Divisional income before interest and taxes
Less: income taxes allocated from company headquarters= (6) Divisional net income
Less: income taxes allocated from company headquarters= (6) Divisional net income
Less: Interest expense allocated from company headquarters= (5) Divisional income before taxes
Less: Interest expense allocated from company headquarters= (5) Divisional income before taxes
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19-54
Alternatives To ROI, ResidualIncome And EVA
ROIResidual Income
EVA
Short-run performancemeasures
Multiperiod viewpoint
Takes into account
the timing of cash flows
in the investment
Actual divisionalprofit for a time
period is compared to aflexible budget
and variances areused to analyze
performance
The division’smajor investments
are evaluatedthrough a
postaudit of theinvestmentdecisions
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19-55
End of Chapter 19
At least my division did well.I wonder how the whole
company did?