Responsibility Accounting

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Pros and Cons of
Decentralization
 Pros
 Betterinformation, leading to better decisions
 Faster response to changing circumstances
 Increased motivation for managers
 Excellent training for future leaders

2
Pros and Cons of
Decentralization
 Cons
 Costlyduplication of activities
 Lack of goal congruence

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Goal Congruence
Goal congruence
means that as people
work to achieve their
own goals, they also
work to achieve the
goals of the
company.

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Responsibility Accounting
A responsibility accounting system generates
reports to employees, including managers,
about the performance of their assigned
responsibility.
Types of responsibility
centers
 Cost center
 Revenue center
 Profit center
 Investment center
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Cost Centers
 A cost center is a segment whose
manager is responsible for costs but not
for revenues.
Examples:
Manufacturing cells
Office of the CEO
Legal department
Accounting department
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Profit and Investment Centers
 A profit center is a segment whose
manager is responsible for revenues as
well as costs.
 An investment center is a segment whose
manager is responsible not only for
revenues and costs, but also for the
investment required to generate profits.

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Performance Evaluation Criteria
Selecting criteria to measure and evaluate
performance is important because the
criteria influence managers’ actions. YOU
GET WHAT YOU MEASURE! The most
common deficiencies in performance
measures are:
 using a single measure that emphasizes only
one objective of the organization; and
 using measures that either misrepresent or
fail to reflect the organization’s objectives or
the employee’s responsibilities.
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Managerial Accounting Issues
Related to Decentralization

 The need to develop methods of

evaluating performance that work to the
benefit of the company as a whole.
 The need to develop transfer prices that
produce decisions in the best interest of
the company.

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Measures of Performance
Companies use four principal measures to
evaluate divisions:
Income
Return on Investment (ROI)
Residual Income (RI)
Economic Value Added (EVA)

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ROI Formula

ROI = Divisional income/Divisional

investment

Companies define and measure divisional

income and divisional investment in various
ways.

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Alternative ROI Formula

ROI = Profit margin x Turnover

Profit Margin = Divisional income/Divisional sales

Turnover = Divisional sales/Divisional investment

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An ROI Example
2002 Alpha Division Beta Div
Divisional sales $10,000 $60,000
Divisional income (NOPAT) 1,000 2,500
Average divisional assets 6,000 17,500
2003
Divisional sales $17,500 $60,000
Divisional income (NOPAT) 1,250 2,750
Average divisional assets 6,000 17,500

Cost of capital is 10 percent

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NOPAT
 NOPAT is net operating profit after tax
 Equals net income plus interest net of tax
 Relates income to assets utilized to
generate that income
 Does not consider the effect of using
financial leverage (debt) on the rate of
return
 Is consistent with return on assets from
Acct 284
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Return on Sales and Turnover
Comparisons
Alpha Alpha Beta Beta
2002 2003 2002 2003
Profit margin 10.0% 7.1% 4.2% 4.6%
Turnover 1.667 2.917 3.429 3.429
ROI 16.7% 20.7% 14.4% 15.8%

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A Residual Income Example
Residual income = NOPAT – (Assets x RRR)
RRR = required rate of return

Alpha Alpha Beta Beta

2002 2003 2002 2003
Divisional operating assets$6,000$6,000$17,500 $17,500
Divisional operating income$1,000$1,250 $2,500 $2,750
Minimum return 600 600 1,750 1,750
Residual income $400 $650 $750 $1,000

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Comparison of ROI versus RI

AlphaAlpha Beta Beta

2002 2003 2002 2003
Return on investment 16.7% 20.7% 14.4% 15.8%
Residual income $400 $650 $750 $1,000

Which method would you prefer?

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ROI Versus RI

Using ROI to
evaluate divisions
can encourage them
to reject good
investments and
accept poor
investments.
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ROI, RI and Goal Congruence
 ROI evaluation will encourage managers
to accept any opportunity above the
current ROI
 RI will encourage managers to accept any
opportunity above the cost of capital.
 Which gives better goal congruence?
 Which would encourage growth?

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Economic Value Added
 Same calculation as residual income but adjusts
for capitalization of Research and development
costs and other “accounting distortions”
 R & D is then amortized against income
 Gives managers the incentive to spend R & D
 Other adjustments to income that are designed
to encourage certain behaviors are often
incorporated into performance evaluation
techniques.

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Whole Foods Market
 Whole foods markets uses EVA analysis
 http://www.wholefoodsmarket.com/investor
/eva.html
 Date:5/2/2006

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 We use Economic Value Added ("EVA") to evaluate our business decisions
and as a basis for determining incentive compensation. In its simplest
definition, EVA is equivalent to net operating profits after taxes minus a
charge for the cost of capital necessary to generate those profits. We
believe that one of our core strengths is our decentralized culture, where
decisions are made at the store level, close to the customer. We believe this
is one of our strongest competitive advantages, and that EVA is the best
financial framework that team members can use to help make decisions that
create sustainable shareholder value.
 We use EVA extensively for capital investment decisions, including
evaluating new store real estate decisions and store remodeling proposals.
We are turning down projects that do not add long-term value to the
Company. The EVA decision-making model is also enhancing operating
decisions in stores. Our emphasis is on EVA improvement, as we want to
challenge our teams to continue to innovate and grow EVA in new ways. We
believe that opportunities always exist to increase sales and margins, to
lower operating expenses and to make investments that add value in ways
that benefit all of our stakeholders. We believe that focusing on EVA
improvement encourages continuous improvement of our business.

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 Over 500 leaders throughout the Company are on EVA-based
incentive compensation plans, of which the primary measure is EVA
improvement. EVA-based plans cover our senior executive
leadership, regional leadership and the store leadership team in all
stores. Incentive compensation for each of these groups is
determined based on relevant EVA measures at different levels,
including the total company level, the regional level, the store or
facility level, and the team level. We believe using EVA in a multi-
dimensional approach best measures the results of decisions made
at different levels of the Company. We expect to continue to expand
the use of EVA as a significant component of our compensation
structure throughout the Company in the coming years.
 The following table sets forth selected EVA information based on a
9% weighted average cost of capital and a 40% tax rate for the fiscal
years ended September 25, 2005 and September 26, 2004.(in
thousands)

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 2005 2004
Net operating profit after
tax (NOPAT) $ 165,579 $ 136,684
Capital charge 139,793 119,101
EVA 25,786 17,583
Increase in EVA $ 8,203 $ -*
* EVA calculations not updated in 2003, due to lease restatements.

The Company provides information regarding EVA as additional information

about its operating results. EVA is a measure not in accordance with, or an
alternative to, generally accepted accounting principles ("GAAP"). The
Company's management believes that this additional EVA information is useful
to shareholders, management, analysts and potential investors in evaluating
the Company's results of operations and financial condition. In addition,
management uses these measures for reviewing the financial results of the
Company and for budget planning and incentive compensation purposes. EVA
is calculated by subtracting a charge for the use of capital (capital charge) from
net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income
to NOPAT follows (in thousands):

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 2005 2005

GAAP net income $ 136,351 $ 129,511

Provision for income taxes 100,782 86,341
Interest expense and
other 38,832 11,955
Net operating profit before
taxes (NOPBT) 275,965 227,807
Taxes (40%) 110,386 91,121
NOPAT $ 165,579 $ 136,686
Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net
assets to ending EVA capital follows (in thousands):

2005 2004
Total assets $ 1,696,953 $ 1,370,882
Total liabilities 537,648 523,589
Net assets 1,159,305 847,293
Long-term debt and capital lease
obligations 87,919 171,305
Implied goodwill (from pooling-of-interest
transactions) 162,803 162,803
Other* 143,740 141,977
EVA capital $ 1,553,767 $ 1,323,378
* Accumulated components of net income not included in NOPAT

®
— EVA is a registered trademark of Stern Stewart & Co.
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The Balanced Scorecard
An approach known as the
balanced scorecard has become
popular recently. This approach
extends performance evaluation
from merely looking at financial
results to formally incorporating
measures that look at customer
satisfaction, internal business
processes, and the learning and
growth potential of the
organization.
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The Balanced Scorecard
(Continued)
The balanced scorecard asks four basic questions:
1. How do customers see us? (the customer
perspective)
2. What must we excel at? (the internal business
process perspective)
3. Can we continue to improve and create value?
(the learning & growth perspective)
4. How do we look to stockholders? (the financial
perspective)
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Transfer Price
Sometimes a center with
no external customers is
made into an artificial
profit center. Then
transfer prices, which are
prices that one center
charges another center
within the company, are
needed.
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TRANSFER PRICING POLICIES
Transfer Pricing Methods
 Actual costs with or without a markup
 Budgeted costs with or without a markup
 Market-based prices
 Incremental cost
 Negotiated prices

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Actual Cost

These transfer prices are not wise because

the selling manager has no incentive to keep
costs down.
Worse, a price that is actual costs plus a
percentage markup gives the selling manager
more profit the higher costs go.

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Budgeted Cost

This method does

not reward the
selling manager if
costs go up, and
actually encourages
the selling manager
to keep costs down.

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Market-Based Prices

This method is generally consider, the best.

The biggest problem is that an outside
market price may not exist.
The transfer price may be less than the market
price due to cost savings from selling internally.

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Incremental Cost

Such prices are theoretically best from the

company’s viewpoint when the selling
division is operating below capacity.
Incremental cost can be as low as the variable
cost of the goods or services.

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Negotiated Prices

This method allows managers to bargain

with each other and alleviates some
problems that arise with other methods.

Normally will lead to the right outcome if

managers negotiate in good faith.

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