Cornerstones of Managerial Accounting 3e MOWEN / HANSEN / HEITGER COPYRIGHT © 2009 South-Western/Cengage Learning
Cornerstonesof Managerial Accounting 3e
Cornerstonesof Managerial Accounting 3e
MOWEN / HANSEN / HEITGERMOWEN / HANSEN / HEITGERCOPYRIGHT © 2009 South-Western/Cengage Learning
Chapter TwelvePerformance Evaluation and
Decentralization
Chapter TwelvePerformance Evaluation and
Decentralization
Learning ObjectivesLearning Objectives
1. Explain how and why firms choose to decentralize.
2. Compute and explain return on investment.
3. Compute and explain residual income and economic value added.
4. Explain the role of transfer pricing in a decentralized firm.
5. (Appendix) Explain the uses of the Balanced Scorecard, and compute cycle time, velocity, and manufacturing cycle efficiency.
3
OBJECTIVE OBJECTIVE 11
Explain how and why firms choose to decentralize.
DecentralizationDecentralization
• Delegating decision-making authority• Why firms decentralize:
– Ease of gathering and using local information– Focusing on central management from detailed
operations to strategic planning– Training and motivating of segment managers
to prepare new high-level managers– Enhanced competition, exposing segments to
market forces, which allow each unit to act as an autonomous business unit
• Achieved by creating Divisions
5
DivisionsDivisions
• Differentiated by:– Type of product or service provided– Geographic lines
• Type of responsibility given to divisional manager– Responsibility Center is a segment of
business whose manager is accountable for specified sets of activities
6
Types of Responsibility CentersTypes of Responsibility Centers
• Cost center– Manager is responsible only for costs
• Revenue center– Manager is responsible only for sales
• Profit center– Manager is responsible for both revenues and
costs
• Investment center– Manager is responsible for revenues, costs,
and investments
7
Measuring the Performance of Profit CentersMeasuring the Performance of Profit Centers
• Preparation of segmented income statements– Two method of computing income:
• Variable costing • Full or Absorption costing
– Methods often lead to different operating income figures
8
OBJECTIVE OBJECTIVE 22
Compute and explain return on investment.
Return on Investment (ROI)Return on Investment (ROI)
10
Operating Income ÷ Average Operating Assets
Earnings before income and taxes (EBIT)
Formula:
Return on Investment (ROI)Return on Investment (ROI)
11
Operating Income ÷ Average Operating Assets
(Beginning assets + Ending assets) ÷ 2
Formula:
Return on Investment (ROI)Return on Investment (ROI)
12
Margin x Turnover
Operating Income ÷ Sales
Alternative Formula:
Return on Investment (ROI)Return on Investment (ROI)
13
Margin x Turnover
Sales ÷ Average Operating Assets
Alternative Formula:
Margin and TurnoverMargin and Turnover
• Margin– Ratio of operating income to sales– Tells how many cents of operating income
result from each dollar of sales– Expresses the portion of sales that is available
for interest, taxes, and profit
• Turnover– Divides sales by average operating assets– Tells how many dollars of sales result from
every dollar invested in operating assets
14
Advantages of ROIAdvantages of ROI
• Encourages managers to focus on– Relationship among:
• Sales• Expenses• Investment
– Cost efficiency– Operating asset efficiency
15
Disadvantages of ROIDisadvantages of ROI
• Can produce a narrow focus on divisional profitability at the expense of profitability for the overall firm
• Encourages managers to focus on the short run at the expense of the long run
16
Cornerstone 12-1Cornerstone 12-1
HOW TO Calculate Average Operating Assets, Margin, Turnover, and Return on
Investment
17
ExampleExample
Information:
Sales
Cost of goods sold
Gross marginSelling and administrative expense
$480,000
222,000
Operating income $ 48,000
18
$258,000210,000
Operating Assets were $277,000 at the beginning of the year and $323,000 at the end of the year
ExampleExample
1. Average operating assets
2. Margin
3. Turnover
4. Return on investment
Required:
19
Calculate:
ExampleExample
20
Average operating
assets(Beginning assets + Ending assets)/2=
= ($277,000 + $323,000) / 2
= $300,000
ExampleExample
21
Margin Operating Income / Sales=
= $48,000 / $480,000
= 0.10 or 10%
ExampleExample
22
Turnover Sales / Average operating assets=
= $480,000 / $300,000
= 1.6
ExampleExample
23
Return on Investment
(ROI)Margin × Turnover=
= 0.10 × 1.6
= .16 or 16%
Alternatively:
Operating income / Average operating assets
= $48,000 / $300,000
= .16 or 16%
OBJECTIVE OBJECTIVE 33
Compute and explain residual income and economic value added.
Residual IncomeResidual Income
Operating Income F
Formula:
Minimum rate of return × Average operating assets
Set by the company
25
Residual IncomeResidual Income
Operating Income F
Formula:
Minimum rate of return × Average operating assets
26
If residual income is less than zero, the company is earning less than the minimum rate of return
If residual income is exactly zero, the company is earning precisely the minimum rate of return
If residual income is greater than zero, the company is earning more than the minimum rate of return
Advantages & Disadvantages of Residual Income
Advantages & Disadvantages of Residual Income
• Advantages– It encourages managers to accept any
project that earns above the minimum rate
• Disadvantages– Can encourage a short run orientation– Residual income is an absolute measure of
profitability• Direct comparison is difficult when level of
investments differ
27
Cornerstone 12-2Cornerstone 12-2
HOW TO Calculate Residual Income
28
ExampleExample
Information:
Sales
Cost of goods sold
Gross marginSelling and administrative expense
$480,000
222,000
Operating income $ 48,000
29
$258,000210,000
Operating Assets were $277,000 at the beginning of the year and $323,000 at the end of the year
A minimum rate of return of 12 percent is required
ExampleExample
1. Average operating assets
2. Residual income
Required:
30
Calculate:
ExampleExample
31
Average operating
assets(Beginning assets + Ending assets)/2=
= ($277,000 + $323,000) / 2
= $300,000
ExampleExample
32
Residual Income
Operating Income
=
= $48,000 - $36,000
= $12,000
F Minimum rate of return ×
Average Operating
Assets
Residual IncomeResidual Income
F
Formula:
Actual percentage cost of capital × Total capital employed
33
If EVA is positive then the company is creating wealth
If EVA is negative then the company is destroying wealth
After-tax operating income
Cornerstone 12-3Cornerstone 12-3
HOW TO Calculate Economic Value Added
34
ExampleExample
Information:
Sales
Cost of goods sold
Gross marginSelling and administrative expense
$480,000
222,000
Operating income $ 48,000
35
$258,000210,000
Total capital employed equaled $300,000. Actual cost of capital is 10%
Less: Income Taxes (@ 30%) 14,400 Net income $ 33,600
ExampleExample
Calculate Economic Value Added (EVA) for the Western Division.
Required:
36
ExampleExample
EVA = ×
= $33,600 - (0.10 × $300,000)
37
After-tax operating income
Actual % cost of capital
Total capital
employed
= $33,600 - $30,000
= $3,600
Advantages of EVAAdvantages of EVA
• Helps to encourage the right kind of behavior
• Relies on the true cost of capital
• Cost of capital is considered a corporate expense and is passed along to the overall income statement
• Makes investment seem free to the divisions so they want more
38
OBJECTIVE OBJECTIVE 44
Explain the role of transfer pricing in a decentralized firm.
Transfer PricingTransfer Pricing
• Price charged for a component by the selling division to the buying division of the same company
• Sale is a revenue to the selling division• Sale is a cost to the buying division• Transfer Pricing policies:
– Market price– Cost-based transfer pricing– Negotiated transfer pricing
40
Cornerstone 12-4Cornerstone 12-4
HOW TO Calculate Transfer Price
41
ExampleExample
• Alpha Division– Produces cb-117 model that is used by Delta
Division
– Market price is $14
– Full cost of the board is $9
• Delta Division is a heating and air-conditioning manufacturer
42
Information:
Omni Inc. has a number of divisions
ExampleExample
1. If Omni Inc. has a transfer pricing policy that requires transfer at full cost…
a. What will the transfer price be?
b. Do you suppose that Alpha and Delta divisions choose to transfer at that price?
2. If Omni Inc. has a transfer pricing policy that requires transfer at market price…
a. What would the transfer price be?
b. Do you suppose that Alpha and Delta divisions would choose to transfer at that price?
43
Required:
Advantages of EVAAdvantages of EVA
3. Now suppose that Omni Inc. allows negotiated transfer pricing and that Alpha Division can avoid $3 of selling expense by selling to Delta Division.
a. Which division sets the minimum transfer price and what is it?
b. Which division sets the maximum transfer price, and what is it?
c. Do you suppose that Alpha and Delta divisions would choose to transfer somewhere in the bargaining range?
44
Required continued:
ExampleExample
Transfer Pricing at Full Cost:
Full cost transfer price $9
Delta Division would like the price, but…
Alpha Division would refuse to transfer since $14 could be earned in the outside
market
ExampleExample
Transfer Pricing at Market Price:
Market price is $14
Both Delta and Alpha divisions would be willing to transfer at that price (since neither
division would be worse off than if it bought/sold in the outside market)
ExampleExample
Transfer Pricing at a Negotiated Transfer Price:
Minimum transfer price = $14 – $3 = $11
This price is set by Alpha division (the selling division)
Maximum transfer price = $14
This price is the market price and is set by Delta division (the buying division)
Alpha and Delta will negotiate a price somewhere between $11 and $14
OBJECTIVE OBJECTIVE 55
(Appendix) Explain the uses of the Balanced Scorecard and compute cycle time, velocity, and manufacturing cycle efficiency.
Balanced ScorecardBalanced Scorecard
• Strategic management system
• Translates an organization’s mission and strategy into:– Operational objectives – Performance measures– Four different perspectives
Operational Objectives and Performance MeasuresOperational Objectives and Performance Measures
• Financial perspective– Describes the economic consequences of actions taken
• Customer perspective– Defines the customer and market segments in which the
business unit will compete
• Internal business process perspective– Describes the internal processes needed to provide
value for customers and owners
• Learning and growth (infrastructure) perspective– Defines the capabilities that an organization needs to
create long-term growth and improvement
Strategy TranslationStrategy Translation
Specifying objectives, measures, targets, and initiatives for each
perspective
Performance MeasuresPerformance Measures
• Derived from a company’s vision, strategy, and objectives
• Measures must be balanced between– performance driver measures and outcome
measures– objective and subjective measures– external and internal measures– financial and nonfinancial measures
• Must also be carefully linked to the organization’s strategy
Financial PerspectivesFinancial Perspectives
• Established the long- and short-term financial performance objectives
• Concerned with global financial consequences of the three perspectives
• Three strategic themes– Revenue growth– Cost reduction– Asset utiltization
Revenue GrowthRevenue Growth
• Objectives:– Increase the number of new products– Create new applications for existing
products– Develop new customers and markets– Adopt a new pricing strategy
• From objectives performance measures can be designed
Cost ReductionCost Reduction
• Objectives– Reducing the cost
• Per unit of product• Per customer• Per distribution channel
• Trends tell whether costs are being reduced
• Activity-based costing can play an essential measurement role
Asset UtilizationAsset Utilization
• Principle objective– Improving asset utilization
• Measures– Return on investment– Economic value added
Customer PerspectiveCustomer Perspective
• Defines and selects the customer and market segments in which the company competes
• Objectives:– Increase market share– Increase customer retention– Increase customer acquisition– Increase customer satisfaction– Increase customer profitability
Customer PerspectiveCustomer Perspective
• Measures– Market Share– Percentage growth of business from existing
customers – Percentage of repeating customers– Number of new customers– Ratings from customer satisfaction surveys– Individual and segment profitability
• Activity-based costing is a key tool
Cycle Time and VelocityCycle Time and Velocity
• Responsiveness– Time to respond to a customer order
• Operational measures– Cycle Time
• Length of time it takes to produce a unit of output from the time raw materials are received until the good is delivered to finished goods inventory
– Velocity• Number of units of output that can be produced in a
given period of time
Cornerstone 12-5Cornerstone 12-5
HOW TO Compute Cycle Time and Velocity
60
ExampleExample
• Maximum units produced in a quarter, 200,000 units
• Actual units produced in a quarter, 160,000 units
• Productive hours in one quarter, 40,000 hours
61
Information:
ExampleExample
1. Compute the theoretical cycle time (in minutes)
2. Compute the actual cycle time (in minutes)
3. Compute the theoretical velocity in units per hour
4. Compute the actual velocity in units per hour
62
Required:
Theoretical Cycle TimeTheoretical Cycle Time
Productive hours in one quarter ×
60 minutes per hour
Maximum units produced in a
quarter
40,000 hours × 60 minutes per hour 200,000 units
12 minutes per unit
Actual Cycle Time Actual Cycle Time
Productive hours in one quarter ×
60 minutes per hour
Actual units produced in a
quarter
40,000 hours × 60 minutes per hour 160,000 units
15 minutes per unit
Theoretical VelocityTheoretical Velocity
60 minutes per hour
Theoretical cycle time
60 minutes per hour
12 minutes per unit
= 5 units per hour
=
Actual VelocityActual Velocity
60 minutes per hour
Actual cycle time
60 minutes per hour
15 minutes per unit
= 4 units per hour
=
Manufacturing Cycle EfficiencyManufacturing Cycle Efficiency
• Time-based operational measure
• Measured as:– Valued-added time divided by– Total time
• Included both value-added time and non-value added time
• As MCE improved cycle time decreases
Cornerstone 12-6Cornerstone 12-6
HOW TO Calculate Manufacturing Cycle Efficiency
68
ExampleExample
• Maximum units produced in a quarter, 200,000 units
• Actual units produced in a quarter, 160,000 units
• Productive hours in one quarter, 40,000 hours
• Actual cycle time, 15 minutes
• Theoretical cycle time, 12 minutes69
Information:
ExampleExample
1. Calculate the amount of processing time and the amount of nonprocessing time.
2. Calculate Manufacturing Cycle Efficiency (MCE)
70
Required:
Processing and Nonprocessing Time
Processing and Nonprocessing Time
Processing time = Theoretical time
Processing time = 12 minutes
Nonprocessing time =
Actual Cycle Time - Theoretical
Cycle Time
Nonprocessing time = 15 – 12 = 3 minutes
Manufacturing Cycle Time (MCE)Manufacturing Cycle Time (MCE)
Processing time
Processing time
12 (12 + 3)
+Nonprocessing
time
0.8 or 80 percent