Libby, Libby and Short

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CHAPTER
Performance Evaluation in the Decentralized Firm
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Objectives
1. Define responsibility accounting, and describe
four types of responsibility centers. 2. Tell why
firms choose to decentralize. 3. Compute and
explain return on investment (ROI) and economic
value added (EVA). 4. Discuss methods of
evaluating and rewarding managerial
performance. 5. Explain the role of transfer
pricing in a decentralized firm.
After studying this chapter, you should be able
to
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• Responsibility accounting is a system that
  measures the results of each responsibility
  center according to the information managers need
  to operate their centers.

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Types of Responsibility Centers
Cost center A responsibility center in which a
manager is responsible only for costs. Revenue
center A responsibility center in which a
manager is responsible only for sales.
Continued
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Types of Responsibility Centers
Profit center A responsibility center in which
a manager is responsible for both revenues and
costs. Investment center A responsibility
center in which a manager is responsible for
revenues, costs, and investments.
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ACCOUNTING INFORMATION USED TO MEASURE PERFORMANCE


Capital Cost Sales
Investment Other
Cost center x Revenue center Direct
cost x only Profit center x x Investment
center x x x x
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Reasons for Decentralization

• 1. Ease of gathering and using local information
• 2. Focusing of central management
• 3. Training and motivating segment managers
• 4. Enhanced competition, exposing segments to
  market forces

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Return on Investment
ROI
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Comparison of ROI
Electronics
Medical Supplies
Divisions
Divisions
2003 Sales 30,000,000 117,00,000 Operating
income 1,800,000 3,510,000 Average operating
assets 10,000,000 19,500,000 ROI 18 18


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Comparison of ROI
Electronics
Medical Supplies
Divisions
Divisions
2004 Sales 40,000,000 117,00,000 Operating
income 2,000,000 2,925,000 Average operating
assets 10,000,000 19,500,000 ROI 20 15


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Margin and Turnover
Margin x Turnover
ROI
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MARGIN AND TURNOVER COMPARISONS
Electronics
Medical Supplies
Division
Division

2003 2004 2003
2004
Margin 6.0 5.0 3.0 2.5 Turnover x 3.0
x 4.0 x 6.0 x 6.0 ROI
18.0 20.0 18.0 15.0
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Advantages of ROI

• 1. It encourages managers to focus on the
  relationship among sales, expenses, and
  investments.
• 2. It encourages managers to focus on cost
  efficiency.
• 3. It encourages managers to focus on operating
  asset efficiency.

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Disadvantages of ROI

• It can produce a narrow focus on divisional
  profitability at the expense of profitability for
  the overall firm.
• It encourages managers to focus on the short run
  at the expense of the long run.

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Economic Value Added

• Economic value added (EVA) is after-tax operating
  profit minus the total annual cost of capital.

EVA After-tax operating income (Weighted
average cost of capital x Total capital employed)
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Cost of Capital

• There are two steps involved in computing cost of
  capital
• 1. Determine the weighted average cost of capital
  (a percentage figure)
• 2. Determine the total dollar amount of capital
  employed

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Weighted Average Cost of Capital

• Suppose that a company has two sources of
  financing 2 million of long-term bonds paying
  9 percent interest and 6 million of common
  stock, which is considered to be of average risk.
  If the companys tax rate is 40 percent and the
  rate of interest on long-term government bonds is
  6 percent, the companys weighted average cost of
  capital is computed as follows

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Weighted Average Cost of Capital

Amount Percent x After-Tax Cost
Weighted Cost
Bonds 2,000,000 0.25 0.009(1 0.4)
.054 0.0135 Equity 6,000,000 0.75 0.06 0.06
.120 0.0900 Total 8,000,000 0.1035
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EVA Example

• Suppose that Mahalo, Inc., had after-tax
  operating income last year of 900,000. Three
  sources of financing were used by the company 2
  million of mortgage bonds paying 8 percent
  interest, 3 million of unsecured bonds paying 10
  percent interest, and 10 million in common
  stock, which was considered to be no more or less
  risky than other stocks. Mahalo, Inc. pays a
  marginal tax rate of 40 percent.

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Weighted Average Cost of Capital

Weighted
Amount Percent x After-Tax Cost
Cost
Mortgage bonds 2,000,000 0.133 0.048 0.006
Unsecured bonds 3,000,000 0.200 0.060 0.012 Com
mon stock 10,000,000 0.667 0.120 0.080
Total 15,000,000 Weighted average cost of
capital 0.098
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EVA Example

• Mahalos EVA is calculated as follows
• After tax operating income 900,000
• Less Cost of capital 784,000
• EVA 116,000

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Behavioral Aspects of EVA
A number of companies have discovered that EVA
helps to encourage the right kind of behavior
from their divisions in a way that emphasis on
operating income alone cannot. The underlying
reason is EVAs reliance on the true cost of
capital.
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Behavioral Aspects of EVA

• In many companies, the responsibility for
  investment decisions rests with corporate
  management. As a result, the cost of capital is
  considered a corporate expense. If a division
  builds inventories and investment, the cost of
  financing that investment is passed along to the
  overall income statement and does not show up as
  a reduction from the divisions operating income.

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Incentive Pay for Managers

• Why would managers not provide good service?
  There are three reasons
• 1. They may have low ability
• 2. They may prefer not to work as hard as needed
• 3. They may prefer to spend company resources on
  perquisites

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Incentive Pay for Managers
Perquisites are a type of fringe benefit given to
managers over and above a salary.

• A nice office
• Use of a company car or jet
• Expense accounts
• Paid country club memberships

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Transfer Pricing

• The value of a transferred good is revenue to the
  selling division and cost to the buying division.
  This value is called transfer pricing.

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Transfer Pricing
Transfer pricing affects both transferring
divisions and the firm as a whole through its
impact on--

• (1) divisional performance measures
• (2) firmwide profits
• (3) divisional autonomy

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Opportunity Cost Approach
This approach identifies the minimum and maximum
price that a selling division would be willing to
accept and the maximum price that a buying
division would be willing to pay.
The minimum transfer price is the transfer price
that would leave the selling division no worse
off if the goods were sold to an internal
division than if the good were sold to an
external party (floor).
The maximum transfer price is the transfer price
that would leave the buying division no worse off
if an input were purchased from an internal
division than if the good were purchased
externally (ceiling).
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The Transfer Pricing Illustration
Tyson Manufacturers produces small appliances.
The Small Parts Division produces parts used by
the Small Motors Division. The parts also are
sold to other manufacturers and wholesalers.
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The Transfer Pricing Illustration
The Small Motors Division is operating at 70
percent capacity. A request is received for
100,000 units of a certain model at 30 per unit.
A component for this motor can be supplied by
the Small Parts Division. The transfer price is
8 despite the Small Parts Division only
experiencing a cost of 5 per unit.
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The Transfer Pricing Illustration
Using the 8 transfer price, the total cost is
31 per unit, calculated as follows
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The Transfer Pricing Illustration
The Small Motors Division is operating at 70
percent capacity, so the 10 fixed cost is not
relevant. Recalculating the cost--
Direct materials 10 Transferred-in
component 8 Direct labor 2 Variable overhead
1 Total cost 21
The Small Motors Division can pay the Small Parts
Division 8 per unit and still make a substantial
contribution to the overall profitability of the
Division.
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Negotiated Transfer Prices
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Negotiated Transfer Prices
In this case, negotiated transfer prices may be a
practical alternative. Opportunity costs can be
used to define the boundaries of the negotiation
set.
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Disadvantages of Negotiated Transfer Prices

• A division manager who has private information
  may take advantage of another divisional manager.
• Performance measures may be distorted by the
  negotiated skills of managers.
• Negotiation can consume considerable time and
  resources.

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Despite the disadvantages, negotiated price
transfer prices offer some hope of complying with
the three criteria of goal congruence, autonomy,
and accurate performance evaluation.
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Chapter Thirteen
The End
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