Decentralization and Responsibility Accounting

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Decentralization and Responsibility Accounting

• Performance evaluation becomes necessary when
  decision rights are delegated.

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Decentralization Why?

• Environment
• Information specialization
• Timeliness of response
• Conservation of central management time
• Computational complexity
• Training of local managers
• Motivation of local managers

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Problems associated with delegating decision
rights

• Goal congruence
• Over-consumption of perquisites
• externality
• The side effect on an individual or entity due
  to the actions of another individual or entity.
• For example, the production of energy in a
  nuclear power plant benefits the owners, but
  creates externalities in the form of radioactive
  waste for the environment and its inhabitants
• The manager of one division takes steps to
  maximize his divisions profit, but some of his
  decisions affect other divisions.
• Identifying the right person (specific knowledge)

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Key concepts in responsibility accounting

• Controllability
• The controllability principle
• Controllability problems
• Traceability

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Responsibility centers

• Standard cost centers - production variances
• Revenue centers - revenue variances
• Discretionary expense centers
• Profit centers - some measure of profit
• Investment centers - some profitability measure
  (e.g., ROI or residual income)

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Investment centers ROI and Residual Income
Investment centers The manager has been given
maximum discretion for making short-run operating
decisions on product mix, pricing and production
methods, as well as the level and type of assets
to be used.
Asset Turnover
Sales Margin
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Residual income
Residual income is as close as an accountant
comes to computing economic profit. It is
operating income after paying all providers of
capital. This is essentially EVA
Residual income Operating income - the
cost of capital
Cost of capital demanded rate of return on
invested capital size of investment
Or some other measure of income
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Simple example ROI
The Division A manager earns 50,000 on
hiscontrollable investment of 350,000. His ROI
is
What income number?
What investment number?
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Simple example Residual income
Division A
Providers of capital demand 12 on average.
This is the opportunity cost of their capital.
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Which performance measure is better?
Simple example The investors cost of capital
remains 12 throughout.
Division A
Assets 350,000
Income 50,000
ROI 14.3
Suppose the division manager is considering
investing 15,000 in an asset that will earn
2,000 in income. Will she take the investment?
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Decision 1 Will she take the investment?
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Decision 2 Simple example
Suppose the division manager is considering
disposing of an asset with a book value of
20,000 which earns 2,500 in income during any
accounting period. Will he dispose of the asset?
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Residual income Decision 1
Suppose now that the division managers
performance evaluation measure is residual
income. Will the manager choose to invest in a
new assets that makes 2,000 per year and costs
15,000?
What is the current residual income?
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Residual income Decision 2
Will the Division A manager who is evaluated
usingresidual income dispose of an asset with
annual earnings of 2,500 and a book value of
20,000?
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Compare divisons ROI and residual income
Division BAssets 250,000Contrib
37,500ROI 15
Division AAssets 350,000Contrib
50,000ROI 14.3
Which division is more profitable?
What rate of return does the larger division make
on its additional assets?
Is it more than the cost of capital?
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Group work

• Missing Information

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Margin, Turnover, ROI
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Profit centers

• Profit center Ideally, profit center is a unit
  for which the manager has the authority to make
  decisions on sources of supply and choices of
  markets.
• Profit measurement examples
• Variable contribution margin
• Controllable contribution
• Divisional contribution
• Divisional profit before taxes

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Profit Centers

• Profit center managers often are evaluated
  relative to budgeted profit.
• Budgets
• Reflect company strategy
• Reflect expected effort level
• Participatory budgeting
• Benefits (use of specific knowledge, buy-in
• Revelation principle

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Design issues for performance evaluation systems

• Representing financial (and other) goals
• Choosing measures that imply progress toward
  goals (e.g., a version of operating profit)
• Deciding how the measure should be computed
  (should it include allocated fixed costs?).
• Choosing the timing of feedback
• Setting targets (standards)
• Tying performance to rewards punishments

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The end!