© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 12:Performance Evaluation

and Decentralization

Cornerstones of Managerial Accounting, 4e

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Decentralization and Responsibility Centers

►In general, a company is organized along lines of responsibility. Today, most companies use a more flattened hierarchy that emphasizes teams.

►Firms with multiple responsibility centers usually choose one of two decision-making approaches to manage their diverse and complex activities: centralized or decentralized.►In centralized decision making, decisions are made at the very top

level, and lower level managers are charged with implementing these decisions.

►Decentralized decision making allows managers at lower levels to make and implement key decisions pertaining to their areas of responsibility. The practice of delegating decision-making authority to the lower levels of management in a company is called decentralization.

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Centralization and Decentralization1

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Divisions in the Decentralized Firm

►Decentralization involves a cost-benefit trade-off. ►As a firm becomes more decentralized, it passes more

decision authority down the managerial hierarchy.►Decentralization usually is achieved by creating units

called divisions. ►Divisions can be differentiated a number of different

ways, including the following:►types of goods or services►geographic lines►responsibility centers

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Responsibility Centers

► Another way divisions differ is by the type of responsibility given to the divisional manager.

► A responsibility center is a segment of the business whose manager is accountable for specified sets of activities.

► The four major types of responsibility centers are as follows:►Cost center: Manager is responsible only for costs.►Revenue center: Manager is responsible only for sales, or

revenue.►Profit center: Manager is responsible for both revenues and

costs.►Investment center: Manager is responsible for revenues,

costs, and investments.

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Return on Investment

►One way to relate operating profits to assets employed is to compute the return on investment (ROI), which is the profit earned per dollar of investment.

►ROI is the most common measure of performance for an investment center and is computed as follows:

Operating income ÷ Average Operating Assets►Operating income refers to earnings before interest and

taxes.►Operating assets are all assets acquired to generate operating

income, including cash, receivables, inventories, land, buildings, and equipment.

►Average operating assets is computed as:(Beginning assets + Ending assets) ÷ 2

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Margin and Turnover

►A second way to calculate ROI is to separate the formula (Operating income ÷ Average operating assets) into margin and turnover.

►Margin is the ratio of operating income to sales. ►It tells how many cents of operating income result from each

dollar of sales; it expresses the portion of sales that is available for interest, taxes, and profit.

►Turnover is sales ÷ average operating assets. ►Turnover tells how many dollars of sales result from every

dollar invested in operating assets.

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►The equation that yields ROI from the Margin and Turnover is as follows:

Margin Turnover ROI = Operating Income X Sales Sales Average Operating

Assets

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Margin and Turnover (continued)2

Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Return on Investment

►One way to relate operating profits to assets employed is to compute the return on investment (ROI), which is the profit earned per dollar of investment.

►ROI is the most common measure of performance for an investment center and is computed as follows:

Operating income ÷ Average Operating Assets►Operating income refers to earnings before interest and

taxes.►Operating assets are all assets acquired to generate operating

income, including cash, receivables, inventories, land, buildings, and equipment.

►Average operating assets is computed as:(Beginning assets + Ending assets) ÷ 2

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Margin and Turnover

►A second way to calculate ROI is to separate the formula (Operating income ÷ Average operating assets) into margin and turnover.

►Margin is the ratio of operating income to sales. ►It tells how many cents of operating income result from each

dollar of sales; it expresses the portion of sales that is available for interest, taxes, and profit.

►Turnover is sales ÷ average operating assets. ►Turnover tells how many dollars of sales result from every

dollar invested in operating assets.

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►The equation that yields ROI from the Margin and Turnover is as follows:

Margin Turnover ROI = Operating Income X Sales Sales Average Operating

Assets

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Margin and Turnover (continued)2

Notice that ‘‘Sales’’ in the above formula can be cancelled out to yield the original ROI formula of Operating income/Average operating assets.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Residual Income

►To compensate for the tendency of ROI to discourage investments that are profitable for a company but that lower a division’s ROI, some companies have adopted alternative performance measures such as residual income.

►Residual income is the difference between operating income and the minimum dollar return required on a company’s operating assets:

Residual income = Operating income – (Minimum rate of return x Average operating assets)

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Economic Value Added (EVA)

►Another financial performance measure that is similar to residual income is economic value added.

►Economic value added (EVA) is after tax operating income minus the dollar cost of capital employed. ►The dollar cost of capital employed is the actual percentage

cost of capital multiplied by the total capital employed.

►EVA is expressed as follows:

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Transfer Pricing

►In many decentralized organizations, the output of one division is used as the input of another.

►As a result, the value of the transferred good is revenue to the selling division and cost to the buying division.

►This value, or internal price, is called the transfer price. ►Transfer price is the price charged for a component by the

selling division to the buying division of the same company.

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Transfer Pricing Policies

►Several transfer pricing policies are used in practice, including:►market price►cost-based transfer prices►negotiated transfer prices

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Appendix 12A: The Balanced Scorecard – Basic

Concepts► Segment income, ROI, residual income, and EVA are important

measures of managerial performance, but they lead managers to focus only on dollar figures.

► The Balanced Scorecard translates an organization’s mission and strategy into operational objectives and performance measures for the following four perspectives:► The financial perspective describes the economic consequences of actions

taken in the other three perspectives.► The customer perspective defines the customer and market segments in

which the business unit will compete.► The internal business process perspective describes the internal processes

needed to provide value for customers and owners.► The learning and growth perspective defines the capabilities that an

organization needs to create long-term growth and improvement.

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The Balanced Scorecard – An Example5

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The Role of Performance Measures

► The Balanced Scorecard is not simply a collection of critical performance measures.

► The performance measures are derived from a company’s vision, strategy, and objectives.

► These measures must be balanced between the following measures:►performance driver measures (i.e., lead indicators of future

financial performance) and outcome measures (i.e., lagged indicators of financial performance)

►objective and subjective measures►external and internal measures►financial and nonfinancial measures

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Linking Performance Measures to Strategy

►Balancing outcome measures with performance drivers is essential to linking with the organization’s strategy.

►Performance drivers make things happen and are indicators of how the outcomes are going to be realized.

►Outcome measures are also important because they reveal whether the strategy is being implemented successfully with the desired economic consequences.

►A testable strategy can be defined as a set of linked objectives aimed at an overall goal.

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A Testable Strategy Example5

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The Four Perspectives and Performance Measures

►The four perspectives define the strategy of an organization and provide the structure or framework for developing an integrated, cohesive set of performance measures.

►These measures, once developed, become the means for articulating and communicating the strategy of the organization to its employees and managers.

►The measures also serve the purpose of aligning individual objectives and actions with organizational objectives and initiatives.

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