San Sebastian College Recoletos

Canlubang Campus

Management Advisory Services

DECENTRALIZATION AND PERFORMANCE EVALUATION

RESPONSIBILITY ACCOUNTING

RESPONSIBILITY ACCOUNTING a system of accounting wherein costs and revenues are accumulated
and reported by levels of responsibility or by responsibility centers within the organization

Responsibility center (also called accountability center)

a clearly identified part or segment of an organization that is accountable for a specified function or set of
activities.
any part of the organization that a particular manager is responsible for

TYPES OF RESPONSIBILITY CENTERS:

a. Cost Center (or expense center) a segment of an organization in which managers are held responsible
for the costs or expenses incurred n the segment.
b. Revenue Center where management is responsible primarily for revenues.
c. Profit Center a segment of the organization in which the manager is held responsible for both revenues
and costs.
d. Investment Center a segment of the organization where the manager controls revenues,
costs, and investments. The centers performance is measured in terms of the use of the assets as well as
the revenues earned and the costs incurred.

CLASSIFICATIONS OF COSTS IN RESPONSIBILITY ACCOUNTING

1. By responsibiity center
2. By cost type, as to controllability
3. By specific cost items or cost elements within each classification in (1) and (2).

RESPONSIBILITY VS. ACCOUNTABILITY

Responsibility has two facets, (1) the obligation to secure results, and (2) the obligation to report back the
results achieved to higher authority.
Accountability denotes the obligation to report results achieved to higher authority.

THE CONCEPT OF DECENTRALIZATION

Decentralization refers to the separation or division of the organization into more manageable units wherein
each unit is managed by an individual who is given decision authority and held accountable for his decisions.
Goal congruence all members of an organization have incentives to perform for a common interest.
Sub-optimization occurs when one segment of a company takes action that s in its own best interests,
but is detrimental to the firm as a whole.

BENEFITS OF DECENTRALIZATION

1. Better access to local information

2. Cognitive limitations
3. More timely response

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4. Focusing of central management
5. Training and evaluation
6. Motivation
7. Enhanced competition.

COSTS OF DECENTRALIZATION

1. Some decisions made in one sub-unit may bring about negative effect to the other sub-units or the
organization as a whole.
2. Decentralization necessitates a more elaborate reporting system hence, the costs of gathering and reporting
of data increase.
3. Job duplication or overlapping of functions s usually encountered in a decentralized set-up.

MEASURING THE PERFORMANCE OF INVESTMENT CENTERS

Performance measures for investment centers usually attempt to assess how well managers are utilizing
invested assets of the division to produce profits by relating operating profits to assets.

Return on investment (ROI) is the most common measure of performance for investment centers. ROI can
be defined as follows:

Operating income refers to earnings before interest and taxes. Operating assets include all assets acquired to
generate operating income, including cash, receivables, inventories, land, buildings, and equipment.

The ROI formula can also be broken down into the product of margin and turnover. Margin is the ratio of
operating income to sales. Turnover is defined as sales divided by average operating assets.

or

Three advantages of using ROI to evaluate the performance of investment centers:

1. It encourages managers to pay careful attention to the relationships among sales, expenses, and
investment, as should be the case for a manager of an investment center.
2. It encourages cost efficiency.
3. It discourages excessive investment in operating assets.

Two disadvantages of using ROI are:

1. It discourages managers from investing n projects that would decrease the divisional ROI but would
increase the profitability of the company as a whole. (Generally, projects with an ROI less than a
divisions current ROI would be rejected.)
2. It can encourage myopic behavior, in that managers may focus on the short run at the expense of the
long run.

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Residual income (RI) the difference between operating income and the minimum peso return required on a
companys operating assets. The equation for RI can be expressed as follows:

RI = Operating Income (Minimum Rate of Return x Operating Assets)

ECONOMIC VALUE ADDED (EVA) a more specific version of residual income. It represents the
segments true economic profit because t measures the benefit obtained by using resources in a particular way.

After-tax operating income

(EBIT x[1 - Tax Rate]) xx
Less desired income
(After-tax WACC* x [Total assets Non-interest-bearing Current liabilities]) xx
Economic Value Added (EVA) xx

* WACC = Weighted average cost of capital

TRANSFER PRICING

TRANSFER PRICE the monetary value or the price charged by one segment of a firm for the goods and
services it supplies to another segment of the same firm.

OBJECTIVES OF TRANSFER PRICING

1. To facilitate optimal decision-making.
2. To provide a basis in measuring divisional performance.
3. To motivate the different department heads in improving their performance and that of their departments.

APPROACHES FOR DETERMINING TRANSFER PRICE:

1. Negotiated transfer price
2. Cost-based transfer price
3. Market-based transfer price

General Rules in Choosing a Transfer Price

The maximum price should be no greater than the lowest market price at which the buying segment
can acquire the goods or services externally.
The minimum price should be no less than the sum of the selling segments incremental costs
associated with the goods or services plus the opportunity cost of the facilities used.
A good should be transferred internally whenever the minimum transfer price (set by the selling
division) is less than the maximum transfer price (set by the buying division). By using this rule, total
profits of the firm are not decreased by an internal transfer.

EXERCISES:

1. Selected sales and operating data for three divisions of different engineering firms are given as follows:

Sales P12,000,000 P14,000,000 P25,000,000

Average operating sales 3,000,000 7,000,000 5,000,000
Net operating income 600,000 560,000 800,000
Minimum required rate of return 14% 10% 16%

Required:
1) Compute the return on investment (ROI) for each division.

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 2) Compute the residual income for each division.
3) Assume that each division is presented with an investment opportunity that would yield a 15% rate of
return.
a. If performance is being measured by ROI, which division or divisions will probably accept the
opportunity? Reject? Why?
b. If performance is being measured by residual income, which division or divisions will probably
accept the opportunity? Reject? Why?

2. Performance Auto Company operates a new car division (that sells high performance sports cars) and a
performance parts division (that sells performance improvement parts for family cars).

Some division financial measures for 2013 are as follows:

New Car Division Performance Parts Division

Total assets P33,000,000 P28,500,000
Current liabilities 6,600,000 8,400,000
Operating income 2,475,000 2,565,000
Required rate of return 12% 12%

Performance Auto Company, whose tax rate is 40%, has two sources of funds: long-term debt with a
market value of P18,000,000 at an interest rate of 10%&and equity capital with a market value of
P12,000,000 and a cost of equity of 15%.

Required:

Applying the same weighted-average cost of capital (WACC) to each division, calculate EVA for
each division.

3. Rosatoroa Company has two divisions with headquarters in Manila and Cebu. Selected data on the two
divisions follow;

MANILA CEBU
Sales P3,600,000 P10,800,000
Net operating income 252,000 864,000
Average operating assets 1,200,000 4,800,000

Required:
1) For each division, compute the return on investment (ROI) in terms of margin and turnover.
2) Assume that the company evaluates performance by use of residual income and that the minimum
required return for any division is 16%. Compute the residual income for each division.
3) Is Cebus greater amount of residual income an indication that it is better managed? Explain.

4. The Electricity Division of Powerhouse Utilities reported operating income of P2,400,000 per year based
on an investment of P12,000,000. The company is considering the use of residual income as an evaluation
measure. At the present time, the division manager is faced with a decision on an incremental investment
of P4,000,000 which will increase annual operating income by P700,000 per year.

Required: Provide calculations showing the difference between the two performance measures, and
explain the possible advantage of using residual income assuming that a 16% ROI is
considered minimally acceptable.

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TRANSFER PRICING

5. Division One of Lorivi Company is currently operating at 80% of capacity. It produces a single product
and sells all its production to outside customers for P150 per unit. Variable costs is P50 per unit and fixed
cost is P400,000 at the current production level.

Division Two, which currently buys the same product from ar outside supplier for P120 per unit, would
like to buy the product from Division One.

Division One will use 60% of its idle capacity if it decides 1o provide the requirements of Division Two.

Required:
1) What is the minimum price that Division One should charge Division Two for this product?
2) What is the maximum price that Division Two will be willing to pay for the product if it will be
purchased internally?
3) Assume that Division One is currently operating at 100% of capacity. What is the minimum price that
Division One should charge Division Two for this product? If left free to negotiate without
interference, would you expect the Division managers to voluntarily agree to the transfer of the units?
Why or why not?

6. The Valve Division of Bench Co. produces a small valve that is used by various companies as a
component part in their products. Bench operates its divisions as autonomous units, giving its
divisional managers great discretion n pricing and other decisions. Each division is expected to generate
a rate of return of at least 14% on its operating assets. The Valve Division has average operating assets of
P700,000. The valves are sold for P5 each. Variable costs are P3 per valve, and fixed costs total P462,000
per year. The division has a capacity of 300,000 valves each year.

1) How many valves must the Valve Division sell each year to generate the desired rate of return on its
assets?
a. What is the margin earned at this level of sales?
b. What is the turnover at this level of sales?
2) Assume that the Valve Divisions current ROI is just equal to the minimum required 14%. In order to
increase the divisions ROI, the divisional manager wants to increase the selling price per valve by
4%. Market studies indicate that an increase in the selling price would cause sales to drop by 20,000
units each year. However, operating assets could be reduced by P50,000 due to decreased needs for
accounts receivable and inventory. Compute the margin, turnover, and ROI if these changes are made.

3) Refer to the original data. Assume again that the Valve Divisions current ROI is just equal to the
minimum required l4%. Rather than increase the selling price, the sales manager wants to reduce the
selling price per valve by 4h. Market studies indicate that this would fill the ant to capacity. In order
to carry the greater level of sales, however, operating assets would increase by P50,000. Compute the
margin, turnover, and ROI if these changes are made.

4) Refer to the original data. Assume that the normal volume of sales is 280,000 valves each year at a
price of P5 per valve. Another division of the company is currently purchasing 20,000 valves each
year from an overseas supplier, at a price of P4.25 per valve. The manager of the Valve Division has
adamantly refused to meet this price, pointing out that it would result in a loss for his division:
Selling price per valve P 4.25
Cost per valve:
Variable P3.00
Fixed (P462,000/300,000 valves) 1.54 4.54
Net loss per valve P(0.29)

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 The manager of the Valve Division also points out that the normal P5 selling price barely allows his
division the required 14% rate of return. If we take on some business at only P4.25 per unit, then our ROI
is obviously going to suffer, he reasons, and maintaining that ROI figure is the key to my future.
Besides, taking on these extra units would require us to increase our operating assets by at least P50,000
due to the larger inventories and receivables we would be carrying. Would you recommend that the Valve
Division sell to the other division at P4.25? Show ROI computations to support your answer.

7. The Pusong Bato Company has a production division which is currently manufacturing 120,000 units but
has a capacity of 180,000 units. The variable cost of the product is P22 per unit, and the total fixed cost is
P720,000 or P6 per unit based on current production.

The Buyer Division of the Pusong Bato Company offers to buy 40,000 units from the Production Division
at P21 per unit. The Production Division manager refuses the order because the price is below variable
cost. The Buyer Division manager argues that the order should be accepted since by taking the order, the
Production Division Manage can lower fixed cost per unit from P6 to P4.50. (Output will increase to
160,000 units.) This decrease of P1.50 in fixed cost per unit will more than offset the Pl difference
between the variable cost and the transfer price.

Required:
a. If you were the Production Division manager, would you accept the Buyer Division managers
argument? Why or why not? (Assume that the 120,000 units currently being produced sell for P30 per
unit in the external market.)
b. From the viewpoint of the Pusong Bato Company, should the order be accepted if the manager of the
Buyer Division intends to sell each unit to the outside market for P27 after incurring an additional
processing cost of P2.25 per unit? Explain.

8. Kute Chemic & Company has two divisions: Kuya Division and Ate Division. The Ate Division produces
a product at a variable cost PlO per unit and sells 50,000 units to the eternal market at P15 per unit and
40,000 units to the Kuya Division at variable cost plus 50%. However, under the dual transfer price system
in use, the Kuya Division pays only the variable cost per unit. The fixed cost of the Ate Division is
P160,000 per year.

The Kuya Division sells 40,000 units of its finished product to the external market at P30 per unit and has
a variable cost of P8 per unit in addition to the cost of the subassembly purchased from the Ate Division at
variable cost. The annual fixed cost of the Kuya Division is P180,000.

Required: Show the income statements for the two divisions and the income statement for the company
as a whole. Assume the company consists of only two divisions. Explain why, under the dual
transfer price system, the net income for the company is less than the sum of the net income
figures shown for the two divisions.

***END***

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