CH 12

CHAPTER
CHAPTER 12
12
Decentralization
and
Performance Evaluation
Slide 12-2
Decentralized
Decentralized Organizations
Organizations
A decentralized organization is one that
grants substantial decision making
authority to the managers of subunits
Most firms are neither totally centralized
nor totally decentralized
Typically, decentralization is a matter of
degree
Slide 12-3
Learning objective 1: List and explain the advantages and

disadvantages of decentralization
Decentralized
Decentralized Organizations
Organizations
Slide 12-4

Advantages
Advantages of
of Decentralization
Decentralization
Better information leading to superior
decisions
Managers can respond quicker to changing
circumstances
Increased motivation of managers
Provides excellent training for future toplevel executives
Slide 12-5

Disadvantages
Disadvantages of
of Decentralization
Decentralization
Costly duplication of activities
Lack of goal congruence
- Management may pursue personal goals
that are incompatible with the companys
goals
- To control goal congruence, companies
evaluate the performance of subunit
managers
Slide 12-6

All of the following are advantages of

decentralization except:
a. Faster response to changing
circumstances
b. Costly duplication of activities
c. Increased motivation of managers
d. Better information, leading to superior
decisions
Answer: b
Costly duplication of activities
Slide 12-7

Evaluating
Evaluating Subunits
Subunits
Evaluation of subunits is undertaken to
identify successful operations and areas
needing improvement
Top management perform incremental
analysis to determine:
- Whether a successful operation should
be expanded
- Whether an unsuccessful operation
should be eliminated or improved
Slide 12-8
Learning objective 2: Explain why companies evaluate the

performance of subunits and subunit managers
Evaluating
Evaluating Subunit
Subunit Managers
Managers
A company evaluates subunit
managers in order to motivate them to
take actions that maximize the value of
the firm
Reasons for evaluating subunit
managers:
- Identifies successful operations and
areas needing improvement
- Influences the behavior of managers
Slide 12-9

Responsibility
Responsibility Accounting
Accounting and
and
Performance
Performance Evaluation
Evaluation
Responsibility accounting is a technique
that holds managers responsible only for
costs and revenues that they can control
This idea should play a prominent role in
the design of accounting systems
- Costs and revenues are traced to the
organizational level where they can be
controlled
Slide 12-10

Tracing
Tracing Costs
Costs to
to Organizational
Organizational
Levels
Levels
Slide 12-11

Responsibility
Responsibility Centers
Centers
Responsibility centers are units
responsible for the generation of revenue
and/or the incurrence of costs
Three types of responsibility centers:
- Cost centers
- Profit centers
- Investment centers
Slide 12-12
Learning objective 3: Identify cost centers, profit

centers, and investment centers
Cost
Cost Centers
Centers
Subunit responsible for controlling costs
but not responsible for generating
revenue,e.g. janitorial, maintenance,
computer services, production
Must provide service to company at a
reasonable cost
Evaluation based on comparison of
budgeted or standard costs with actual
costs
Slide 12-13

Profit
Profit Centers
Centers
Subunits responsible for generating
revenues as well as controlling costs
Goal is to maximize profit for the division
- Performance can be evaluated in terms
of profitability
- Motivates managers to focus their
attention on ways of maximizing profit
Slide 12-14

Profit
Profit Centers
Centers
Methods used to evaluate profitability
Current compared to budgeted income
Current compared to past income
Comparison with other profit centers
i.e., relative performance evaluation
Slide 12-15

Investment
Investment Centers
Centers
Subunit responsible for generating
revenue, controlling costs, and investing
in assets
Goal is to maximize return on
investment
Evaluation based on comparison with a
benchmark, previous years, or other
investment centers
Slide 12-16

Nordstrom
Nordstrom
Slide 12-17

An investment center is responsible for:

a.
b.
c.
d.
Investing in long term assets

Controlling costs
Generating revenues
All of the above
Answer:
d. All of the above
Slide 12-18

Cost centers are often evaluated using:

a.
b.
c.
d.
Variance analysis
Operating margin
Return on investment
Residual income
Answer:
a. Variance analysis
Slide 12-19
Learning objective 3: Identify cost centers,

profit centers, and investment centers
Profit centers are often evaluated using:

a.
b.
c.
d.
Investment turnover
Income targets or profit budgets
Residual income
Answer:
b. Income targets or profit budgets
Slide 12-20
Learning objective 3: Identify cost centers,

profit centers, and investment centers
Evaluating
Evaluating Investment
Investment Centers
Centers
With
With ROI
ROI
ROI is a primary tool for evaluating the
performance of investment centers
Ratio of investment center income to
invested capital
Focuses managements attention on both
income (numerator) and level of
investment (denominator)
Slide 12-21
Learning objective 4: Calculate and interpret

return on investment (ROI)
ROI
ROI Components
Components
ROI may be broken down into two
components:
Profit margin and
Investment turnover
Slide 12-22
Learning objective 4: Calculate and

interpret return on investment (ROI)
Measuring
Measuring Income
Income and
and Invested
Invested
Capital
Capital for
for ROI
ROI
In calculating ROI, companies measure
income in a variety of ways
Most common method is NOPAT
Net
Operating
Profit
After
Taxes
Slide 12-23

Measuring
Measuring Income
Income and
and Invested
Invested
Capital
Capital for
for ROI
ROI
To calculate NOPAT, a company must
make adjustments to net income:
Add back non-operating expense to net
income, e.g. interest expense
Adjust tax expense accordingly
Slide 12-24

Measuring
Measuring Income
Income and
and Invested
Invested
Capital
Capital for
for ROI
ROI
In calculating ROI, companies measure
invested capital in a variety of ways
Common approaches:
- Total assets
- Total assets after adding back accumulated
depreciation
- Total assets less current liabilities
- Total assets less non-interest-bearing current
liabilities (method used in this textbook)
Slide 12-25

NOPAT
NOPAT Example
Example
Slide 12-26

ROI
ROI
France,
France, Germany,
Germany, and
and
Japan
Japan
Slide 12-27

Information for Davenport Mills

Net income $16,000,000
Interest expense $1,300,000
Tax rate 40%
Total assets $225,000,000
Current liabilities $45,000,000 of which
$30,00,000 are non-interest bearing
Calculate NOPAT
= Net income + interest expense (1 - tax rate)
= $16,000,000 + $1,300,000 (1 - .40)
= $16,780,000
Slide 12-28


Tax rate 40%
Calculate invested capital
= Total assets non-interest-bearing CL
= $225,000,000 - $30,000,000
= $195,000,000
Slide 12-29


Tax rate 40%
Calculate ROI
= NOPAT Invested capital
= $16,780,000 $195,000,000
= 8.605%
Slide 12-30
objective 4: Calculate and

Learning
Calculating
Calculating ROI
ROI
Slide 12-31

Problems
Problems with
with Using
Using ROI
ROI
Invested capital is typically based on
historical costs
- Fully depreciated assets lead to a low
invested capital number resulting in
high ROI
- Makes comparison of investment
centers using ROI difficult
Slide 12-32

Problems
Problems with
with Using
Using ROI
ROI
Managers may put off purchase of new
equipment, i.e. may lead to under
investment
Projects with positive net present value
but low initial profitability might not be
undertaken
Managers with high ROI may consider the
effect on ROI, rather than NPV
Slide 12-33


Tax rate 40%
Calculate residual income if cost of capital is 10%

= NOPAT (Cost of Capital x Invested Capital)
= $16,780,000 (10% x $195,000,000)
= ($2,720,000)
Slide 12-34

Problems
Problems of
of Overinvestment
Overinvestment and
and
Underinvestment
Underinvestment
Evaluation using profit can lead to
overinvestment
- Managers motivated to make investments
that earn a return less than cost of capital
Evaluation using ROI can lead to

underinvestment
- Managers may not take on projects with a
low ROI just to increase profit if they are
evaluated in terms of the return they earn
Slide 12-35
Learning objective 5: Explain why using a measure of profit to evaluate

performance can lead to overinvestment and why using a measure of
return on investment (ROI) can lead to underinvestment
Use of profit as a performance measure:

a. May lead to overinvestment in assets
b. Is appropriate for an investment center
c. Is appropriate as long as profit is calculated
using GAAP
d. Encourages managers to finance operations
with debt rather than equity
Answer:
a. May lead to overinvestment in assets
Slide 12-36

Decision
Decision Making
Making
Slide 12-37

Residual
Residual Income
Income (RI)
(RI)
Net operating profit after taxes of an investment
center in excess of its required profit
Required profit is equal to the investment
centers required rate of return times the level of
investment in the center
- RI = NOPAT Required Profit
- Required rate of return is generally the cost of
capital for the investment center
Use total assets minus non-interest-bearing
current liabilities as a measure of investment
Slide 12-38
Learning objective 6: Calculate and interpret residual income

(RI) and economic value added (EVA)
Residual
Residual Income
Income
NIBCL = non-interest bearing current liabilities
Slide 12-39
Learning objective 6: Calculate and interpret residual

income (RI) and economic value added (EVA)
Economic
Economic Value
Value Added
Added (EVA)
(EVA)
EVA is residual income adjusted for accounting
distortions that arise from GAAP:
A performance measure approach to solving
overinvestment and underinvestment problems
Advantage is that managers are less tempted to
cut those costs that distort income under GAAP
e.g., under GAAP research and development costs
are expensed, but the costs benefit future periods
Thus, under EVA research and development is

capitalized and amortized over future periods
Slide 12-40

Economic
Economic Value
Value Added
Added (EVA)
(EVA)
Slide 12-41

Investment centers are often evaluated

using:
a.
b.
c.
d.
Standard cost variances

Residual income/EVA
Both b and c
Answer: d
Both b and c
Slide 12-42

Economic
Economic Value
Value Added
Added (EVA)
(EVA)
Slide 12-43

Using
Using aa Balanced
Balanced Scorecard
Scorecard to
to
Evaluate
Evaluate Performance
Performance
A problem in using financial measures like ROI
and EVA is that they are backward looking
Slide 12-44

Balanced
Balanced Scorecard
Scorecard
Set of performance measures constructed
for four dimensions of performance:
1.
2.
3.
4.
Slide 12-45
Financial
Customer
Internal processes
Learning and growth
Learning objective 7: Explain the potential benefits of using a

balanced scorecard to assess performance
Balanced
Balanced Scorecard
Scorecard
1. Financial
Is company meeting its financial goal?
2. Customer
Examine company success in meeting customer
expectations?
3. Internal Processes
Examines the companys success in improving
critical business processes
4. Learning and growth

Examines the companys success in improving its
ability to adapt, innovate, and grow
Slide 12-46
Learning objective 7: Explain the potential benefits of

using a balanced scorecard to assess performance
Balanced
Balanced Scorecard
Scorecard
Tying the balanced scorecard measures to
the strategy for success
- Company develops three to five
performance measures for each dimension
- Measures should be tied to company
strategy
- Balance among the dimensions is critical
You get what you measure!
Slide 12-47

Balanced
Balanced Scorecard
Scorecard
Slide 12-48

How
How Balance
Balance is
is Achieved
Achieved in
in aa
Balanced
Balanced Scorecard
Scorecard
Performance is assessed across a
balanced set of dimensions
Quantitative measures are balanced with
qualitative measures
There is a balance of backward-looking
measures and forward-looking measures
Slide 12-49

Balanced
Balanced Scorecard
Scorecard
Slide 12-50

You
You Get
Get What
What You
You Measure
Measure
Slide 12-51
objective 7: Explain the potential benefits of

Learning
Developing
Developing aa Strategy
Strategy Map
Map for
for aa
Balanced
Balanced Scorecard
Scorecard
A strategy map is a diagram of the
relationships of the strategic objectives
across the four dimensions
Useful to test the soundness of the strategy
Identifies how strategy is linked to
measures on the scorecard
Useful to communicates strategic
objectives to employees
Slide 12-52
Learning objective 8: Discuss how a strategy map can be used to

communicate the measures in a balanced scorecard
Strategy
Strategy Map
Map Example
Example
Slide 12-53
Learning objective 8: Discuss how a strategy map can be

used to communicate the measures in a balanced scorecard
Keys
Keys to
to aa Successful
Successful Balanced
Balanced
Scorecard
Scorecard
Targets
- For each measure, there should be a
target so managers know what they are
expected to achieve
Initiatives
- For each measure, the company must
identify actions that will be taken to
achieve the target
Slide 12-54
Learning objective 9: Discuss the key items related to a

successful balanced scorecard
Keys
Keys to
to aa Successful
Successful Balanced
Balanced
Scorecard
Scorecard
Responsibility
- A specific employee must be given
responsibility/accountability for the
implementation of each initiative
Funding
- Initiatives must be funded appropriately
Top Management Support
- Crucial to have the full support of top
management
Slide 12-55
Learning objective 9: Discuss the key items

related to a successful balanced scorecard
Keys
Keys to
to aa Successful
Successful Balanced
Balanced
Scorecard
Scorecard
Slide 12-56
Learning objective 9: Discuss the key items

related to a successful balanced scorecard
Evaluation
Evaluation
Slide 12-57
objective 9: Discuss the key items related

to a successful balanced scorecard
Learning
Transfer
Transfer Pricing
Pricing
Transfer pricing - price used to value
internal transfers of goods or services
Subunits of a company sell goods or
services to other subunits within the same
company
Must determine the price to use for
internal transfers
Slide 12-58
Learning objective A1: Discuss the use of market price, variable cost, full cost
plus profit, and negotiation in setting transfer prices
Methods
Methods of
of Setting
Setting the
the Transfer
Transfer
Price
Price
Pricing alternatives:
Market price
Variable costs
Full cost plus profit
Negotiated prices
Slide 12-59
Learning objective A1: Discuss the use of market price, variable

cost, full cost plus profit, and negotiation in setting transfer prices
Methods
Methods of
of Setting
Setting the
the Transfer
Transfer
Price
Price
The most appropriate transfer price depends on
the circumstances
Should lead subunit managers to make
decisions that maximize firm value
Since there is no arms length transaction, revenue
is not recognized for financial reporting purposes
Motivation of best decision is measured by
opportunity cost of producing an item and
transferring it inside the company
Slide 12-60

Lowering
Lowering Transfer
Transfer Price
Price Below
Below
the
the Market
Market Price
Price
Slide 12-61

Transfer
Transfer Pricing
Pricing
Slide 12-62

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Slide 12-63

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CH 12

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CHAPTER

Learning objective 1: List and explain the advantages and

Learning objective 1: List and explain the advantages and

Learning objective 1: List and explain the advantages and

Learning objective 1: List and explain the advantages and

All of the following are advantages of

Learning objective 1: List and explain the advantages and

Learning objective 2: Explain why companies evaluate the

Learning objective 2: Explain why companies evaluate the

Learning objective 2: Explain why companies evaluate the

Learning objective 2: Explain why companies evaluate the

Learning objective 3: Identify cost centers, profit

Learning objective 3: Identify cost centers, profit

Learning objective 3: Identify cost centers, profit

Learning objective 3: Identify cost centers, profit

Learning objective 3: Identify cost centers, profit

Learning objective 3: Identify cost centers, profit

An investment center is responsible for:

Investing in long term assets

Learning objective 3: Identify cost centers, profit

Cost centers are often evaluated using:

Learning objective 3: Identify cost centers,

Profit centers are often evaluated using:

Learning objective 3: Identify cost centers,

Learning objective 4: Calculate and interpret

Learning objective 4: Calculate and

Learning objective 4: Calculate and interpret

Learning objective 4: Calculate and

Learning objective 4: Calculate and

Learning objective 4: Calculate and

Learning objective 4: Calculate and

Information for Davenport Mills

Learning objective 4: Calculate and

Information for Davenport Mills

Learning objective 4: Calculate and interpret

Information for Davenport Mills

objective 4: Calculate and

Learning objective 4: Calculate and

Learning objective 4: Calculate and

Learning objective 4: Calculate and

Information for Davenport Mills

Net income $16,000,000

Calculate residual income if cost of capital is 10%

Learning objective 4: Calculate and

Evaluation using ROI can lead to

Learning objective 5: Explain why using a measure of profit to evaluate

Use of profit as a performance measure:

Learning objective 5: Explain why using a measure of profit to evaluate

Learning objective 5: Explain why using a measure of profit to evaluate

Learning objective 6: Calculate and interpret residual income

NIBCL = non-interest bearing current liabilities

Learning objective 6: Calculate and interpret residual

Thus, under EVA research and development is

Learning objective 6: Calculate and interpret residual

Learning objective 6: Calculate and interpret residual income

Investment centers are often evaluated

Standard cost variances

Learning objective 6: Calculate and interpret residual income

Learning objective 6: Calculate and interpret residual

Learning objective 1: List and explain the advantages and

Learning objective 7: Explain the potential benefits of using a

4. Learning and growth

Learning objective 7: Explain the potential benefits of