Chapter 11
Decentralization and
Performance Evaluation
Introduction
The dilemma for companies is to find tools that
allow the evaluation of managers at all levels in
the organization. How would the evaluation be
different for each of these?
•A plant manager in a factory
•The manager of a retail store
•The regional sales manager
•The CEO
Management of Decentralized
Organizations
Centralized: a few individuals at the top of
an organization retain decision-making
authority.
Decentralized: managers at various levels
throughout the organization make key
decisions about operations relating to their
specific area of responsibility.
Management of Decentralized
Organizations
Segment: any activity or
part of the business for
which a manager needs
cost, revenue, or profit
data.
Responsibility Accounting and Segment
Reporting
Responsibility Accounting: Holding
managers responsible for ONLY
those things under their control.
Cost, Profit, and Investment Centers
Cost Center
The manager has
control over costs but
not over revenue or
capital investment
decisions.
Example: Human
Resources Manager
Cost, Profit, and Investment Centers
Revenue Center
Manager has control
over the generation of
revenue but not costs.
Example: Reservation
Department of an airline
Cost, Profit, and Investment Centers
Profit Center
Manager has control
over both cost and
revenue but not capital
investment decisions.
Example: Manager of a
specific hotel chain
Cost, Profit, and Investment Centers
Investment Center
Manager is responsible for the
amount of capital invested in
generating income. It is in
essence a separate business
with its own value chains.
Example: Manager of store or
branch
The Segmented Income Statement
Contribution Margin: primarily a measure
of short-run profitability.
Segment Margin: a measure of long-term
profitability and is more appropriate in
addressing long-term decisions such as
whether to drop product lines.
Investment Centers and Measures of
Performance
And what do you
plan to use to justify
your decision to remodel
these facilities?
Performance reports
focus on measures
specifically developed to
focus on the level of
investment required, such
as return on investment,
residual income, and
economic value added.
Return on Investment (ROI)
ROI measures the rate of return generated by an
investment center’s assets.
ROI = Margin X Turnover
Margin = Net Operating Income /Sales
Turnover = Sales/Average Operating Assets
Net Operating Income
ROI =
Sales
Sales
X
Average Operating
Assets
Return on Investment (ROI)
Net Operating Income: Income
before interest and taxes
Operating Assets: Cash, accounts
receivable, inventory, and property,
plant, and equipment
Return on Investment (ROI)
•Increase sales revenue
What do I need to do to
increase my ROI?
•Reduce operating costs
•Reduce investment in
operating assets
Return on Investment (ROI)
How do you increase
sales revenue?
Either by increasing sales
volume without changing
the sales price or by
increasing the sales price
without affecting volume.
Return on Investment (ROI)
How do you reduce
operating costs?
The decrease can be in
the variable or fixed costs.
The key is that any
decrease in operating
costs will increase
operating income and
have a positive impact on
ROI.
Return on Investment (ROI)
How do you decrease the
amount of operating
assets?
Although this may be difficult
to do in the short run with
property, plant, and
equipment, average operating
assets can be reduced by
better management of
accounts receivable, a
reduction in inventory levels,
and so on.
Residual Income
Residual Income: the amount of
income earned in excess of some
predetermined minimum level of
return on assets. The higher the
residual income of an investment
center, the better.
Segment Performance and Transfer
Pricing
Transfer pricing is needed when segments within the same
company sell products or services to one another.
The three approaches to establishing transfer prices are:
1. Use the market price if it is available.
2. Base the transfer price on the cost of the product
transferred.
3. Let the buyer and seller negotiate the price.
Segment Performance and Transfer
Pricing
I knew accepting
that transfer price
would lower my
ROI too far!
If managers of the separate
divisions are evaluated based
on profit or other
performance measures like
ROI or EVA, the transfer
price becomes very
important.
Transfer Price at Market
If there is an outside market for
the product being transferred
between divisions, the transfer
price should be based on the
market price of the product.
However, the buyer and seller
must be allowed to go outside if
doing so would create a better
profit.
Transfer Price at Cost
If no outside market exists, or when the
selling division has excess capacity,
transfer prices are often established
based on the cost of the product being
transferred.
Negotiated Transfer Price
Transfer prices are
negotiated between buyer
and seller and end up
somewhere between cost
and the market price.
A General Model for Computing
Transfer Prices
Minimum Transfer Price =
Variable Costs of Producing and Selling +
Contribution Margin Lost on Outside Sales
End of Chapter 11
Which costs are
you responsible
for in your
budget?