Organizational Design,
Responsibility Accounting and
Evaluation of Divisional
Performance
Chapter 18
To “de” or not to “de”
 Centralized
 Top-down approach
 Upper management makes decisions, lower
management carries them out
 Keeps organization focused on common
goals
 Can be very bureaucratic and slow moving
To “de” or not to “de”
 Decentralized
 Responsibility for decisions pushed down to
lower levels
 Takes advantage of local knowledge,
specialization
 More timely response to issues
 Better motivation
 May lose sight of the “big picture”
 May result in duplication of effort
Responsibility centers
 Cost center
 Responsible for costs incurred
 Well-defined relationship between inputs and
outputs
 Manufacturing, etc.
 Discretionary cost center
 Relationship between inputs and outputs not
well-defined
 Marketing, etc.
Responsibility centers
 Revenue center
 Responsible for revenue generated by the
center
 Profit center
 Responsible for both revenue and costs
related to the center
 Investment center
 Responsible for capital investments and profit
Responsibility reporting
 Performance reports
 Show budgeted and actual amounts and
variances
 “Roll-up” to the next higher level
 Totals from lower levels become line items on
performance report of next higher level
Goals of responsibility reporting
 Should provide information on
performance
 Should distinguish between controllable
and uncontrollable costs and revenues
 Should motivate desired behavior
Investment center performance
 Return on investment
 Ability to use assets to generate profits
 Residual income
 Excess of profit over required return on
invested capital
 Economic value added
 Excess of after-tax operating profit over the
weighted average cost of invested capital
(less current liabilities)
Return on investment
 Economic profit after all costs including
opportunity cost of capital
 Function of asset turnover and profit
margin
 How efficiently does the center use its assets
to generate sales?
 Asset turnover
 What percentage of sales is profit?
 Profit margin
Return on investment
ROI
=
ROI
Sales
Invested capital
=
X
Profit
Invested capital
Profit
Sales
Residual income
 Amount of profit remaining after
subtracting the minimum required rate of
return on the invested capital
Residual
income
=
Investment
center
profit
Investment
center's
invested
capital
X
Imputed
interest
rate
Economic value added
 Seeks to measure the amount of
economic value (as opposed to accounting
value) added
 Adjusts accounting income for various
“distortions”
 Capitalize R&D, advertising, training, etc. that
benefit future years
 Use price level adjustments to restate to current
year values
 Etc, as many as 160 adjustments
Economic value added
 Basic formula
Investment
Economic
center's
value
= after-tax
added
operating
profit
-
Investment
center's total assets
Investment
center's
current
liabilities
Weighted
average
X
cost of
capital
Economic value added
 Calculation of weighted average cost of
capital
Weighted
average cost =
of capital
After-tax cost
of debt
X
capital
Market
value of
debt
Market
value of
debt
+
+
Cost of
equity
capital
Market
value of
equity
X
Market
value of
equity
Some considerations
 Invested capital
 Use average of beginning and end-of year
balances
 Which assets to include?
 Total assets?
 Total productive assets?
 Total assets less current liabilities?
 Gross or net book value?
Some considerations
 Different measures may motivate different
behaviors
 Example: A project that will return more than
the minimum cost of capital, but less than
current ROI
 Will increase residual income
 Will decrease ROI