Chapter Twelve

1
Chapter Twelve

• Decentralization and Performance Evaluation

2
Introduction

• Decentralization means that decision making power
  concerning costs, revenues and/or investments is
  delegated to managers of subunits down the
  organizational chart.

3
Objectives

• Discuss the advantages and disadvantages of
  decentralization.
• Explain why companies evaluate the performance of
  subunit managers.
• Three types of responsibility centers are cost
  centers, profit centers, and investment centers
• Calculate and interpret return on investment
  (ROI).

4
Objectives (Continued)

• 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
• Calculate and interpret residual income (RI) and
  economic value added (EVA).
• Explain the potential benefits of using a
  Balanced Scorecard to assess performance.

5
Advantages of Decentralization

• Better information leading to superior decisions.
• Faster response to changing circumstances.
• Increased motivation of managers.
• Excellent training for future top level
  executives.

6
Advantages of Decentralization
7
Disadvantages of Decentralization

• Costly duplication of activities.
• Lack of goal congruence.

8
Why Companies Evaluate The Performance of
Subunits and Subunit Managers

• Decentralization naturally implies evaluation of
  subunits and managers.
• Companies evaluate performance of subunits and
  managers for two reasons
• To identify successful operations and areas
  needing improvement.
• To influences and motivate manager behavior.

9
Responsibility Accounting and Performance
Evaluation

• Responsibility accounting holds managers
  responsible only for decisions about things they
  can control.
• To implement responsibility accounting in a
  decentralized organization, costs revenues, and
  capital expenditures are traced to the
  organizational level where they can be controlled.

10
Responsibility Accounting and Performance
Evaluation
11
Cost Centers, Profit Centers, and Investment
Centers

• Subunits are organizational units or
  responsibility centers with identifiable
  collections of related resources and activities.
• They may be classified into
• Cost Centers
• Profit Centers
• Investment Centers

12
Cost Centers

• Subunit that has responsibility for controlling
  costs but does not have responsibility for
  generating revenue.
• Examples Service and production departments.
• Managerial goal to provide services or make
  products at a reasonable cost to the company.
• Evaluation compare budgeted/standard costs with
  actual costs.

13
Profit Centers

• Subunit that has responsibility for generating
  revenues as well as for controlling costs.
• Examples copier and camera divisions of an
  electronics firm.
• Managerial goal to generate profit (revenues
  expenses) for the division.
• Evaluation profit from the current year may be
  compared with budget or previous years or
  compared with with other profit centers on a
  relative basis.

14
Investment Centers

• Subunit that has responsibility for
• Generating revenues
• Controlling costs
• Investing in assets
• Managers of investment centers have control over
  inventory, receivables, equipment purchases,
  etc...
• They are held responsible for generating some
  kind of return on them.

15
Investment Centers (Continued)

• Managerial goal is to generate return on
  invested capital
• Evaluation rate of return () relative to a
  benchmark/budget rate of return or relative to
  other investment center rates of return.
• Are the camera and copy divisions really profit
  centers or investment centers?

16
Evaluating Investment Centers with Return On
Investment (ROI)

• ROI is one of the primary tools for evaluating
  performance of investment centers.
• Calculated as follows ROI Income
• Invested Capital
• ROI focuses on income AND investment
• Natural advantage over income (alone) as a
  measure of performance.
• Removes the bias of larger investment over
  smaller investment.

17
Evaluating Investment Centers with ROI (Continued)

• ROI can be analyzed into two components
• Profit margin Income
• Sales
• Investment turnover Sales
• Invested Capital

18
Measuring Income and Invested Capital When
Calculating ROI

• For ROI calculations, companies measure income
  in a variety of ways
• Net income
• Income before interest and taxes
• Controllable profit
• Our text uses uses Net Operating Profit After
  Taxes, NOPAT. This formula does not hold managers
  responsible for interest.

19
What is NOPAT?

• Net Income 3,900,000
• Add Back
• Interest Expense 1,000,000
• less tax deduction of interest (350,000)
• NOPAT 4,550,000

20
Measuring Income and Invested Capital When
Calculating ROI (Continued)

• Invested capital is measured in a variety of
  ways.
• In the text, invested capital is measured as
• Total Assets Non-interest-bearing current
  liabilities
• Examples of non-interest-bearing current
  liabilities
• Accounts payable
• Income taxes payable
• Accrued liabilities (wages, utilities etc)

21
Problems With Using ROI

• Major problem with ROI the denominator, invested
  capital, is based on historical costs, net of
  depreciation.
• As those assets become fully depreciated, the
  invested capital denominator becomes extremely
  low and the ROI number quite high.
• Managers may therefore be compelled to put off
  purchases of new equipment necessary for
  long-term success. They under-invest.

22
Problems of Overinvestment and Underinvestment
You Get What You Measure

• Underinvestment results when Managers of
  investment centers with high ROIs are unwilling
  to invest in good projects or assets that will
  dilute their current ROI.
• Conversely, evaluation in terms of profit can
  lead to overinvestment.

23
Residual Income (RI)

• Residual Income (RI) net operating profit after
  taxes of an investment center in excess of the
  profit required for the level of investment.
• RI NOPAT - Cost of Capital x Investment
• Using RI may avoid overinvestment and
  underinvestment tendencies because it will reward
  managers who invest in projects returning above
  the firms cost of capital

24
Residual Income (RI) Examples

• The Camera Division Earned 180,000 and had
  invested capital of 1,000,000.
• Suppose the cost of capital is 10, and the
  division has the chance to earn 60,000 a year
  more on additional investment of 500,000.
• If performance is based on ROI manager may
  reject, but RI yields a better decision.

25
Economic Value Added (EVA)

• A refined version of RI, which has gained wide
  acceptance is called Economic Value Added
• Developed by the consulting firm Stern Stewart
  to adjust RI for accounting distortions.
• The principal distortion is related to research
  and development (RD).

26
Economic Value Added (EVA) (Continued)

• Under GAAP, RD is expensed immediately while
  Under EVA, RD is capitalized and amortized over
  a number of future accounting periods.
• EVA NOPATadjusted minus
• (Cost of Capital x Investmentadjusted)

27
Using A Balanced Scorecard To Evaluate Performance

• ROI RI and EVA are criticized because they do
  little more than summarized the past backward
  looking.
• Balanced Scorecard is a framework of performance
  measures which incorporate forward looking and
  qualitative information
• Financial perspective
• Customer perspective
• Internal process perspective
• Learning and growth

28
Using A Balanced Scorecard To Evaluate
Performance (Continued)

• Balanced Scorecard uses performance measures that
  are tied to the companys strategy for success.
• Progress towards current financial goals is only
  one component of success in the longer run. Other
  factors may be more important for success in the
  future
• Consider the balanced scorecard measured shown in
  illustration 12-10

29
How Balance is Achieved in A Balanced Scorecard

• Balance between qualitative and quantitative,
  forward and backward measures, and balanced
  company dimensions!
• Performance is assessed across a balanced set of
  dimensions.
• Quantitative measures are balanced with
  qualitative measures.
• There is a balance of backward-looking and
  forward-looking measures.

30
How Balance is Achieved in A Balanced Scorecard
31
Quick Review Question 1

• A profit center is responsible for all of the
  following except
• Investing in long term assets.
• Controlling costs.
• Generating revenues.
• It is responsible for all of the above, no
  exception.

32
Quick Review Question 1

• A profit center is responsible for all of the
  following except
• Investing in long term assets.
• Controlling costs.
• Generating revenues.
• It is responsible for all of the above, no
  exception

33
Quick Review Question 2

• What is the difference between RI and EVA?
• RI is a new concept.
• EVA makes adjustments for accounting
  distortions.
• RI excludes research and development as an
  expense.
• EVA includes a capital charge.

34
Quick Review Question 2

• What is the difference between RI and EVA?
• RI is a new concept.
• EVA makes adjustments for accounting
  distortions.
• RI excludes research and development as an
  expense.
• EVA includes a capital charge.

35
Quick Review Question 3

• Return on Investment (ROI) is calculated as
• Sales / Total assets.
• Gross margin / Invested capital.
• Investment center income / Invested capital.
• Income / Sales.

36
Quick Review Question 3

• Return on Investment (ROI) is calculated as
• Sales / Total assets.
• Gross margin / Invested capital.
• Investment center income / Invested capital.
• Income / Sales.

37
Quick Review Question 4

• Investment center income is 864,000. Investment
  turnover is 2. ROI is 24. Sales is?
• 8,000,000
• 7,200,000
• 6,000,000
• 3,600,000

38
Quick Review Question 4

• Investment center income is 864,000. Investment
  turnover is 2. ROI is 24. Sales is?
• 8,000,000
• 7,200,000
• 6,000,000
• 3,600,000