Managerial Accounting
by James Jiambalvo
Chapter 12:
Decentralization and
Performance
Evaluation
Slides Prepared by:
Scott Peterson
Northern State
University
Objectives
1. List and explain the advantages and
disadvantages of decentralization.
2. Explain why companies evaluate the
performance of subunit managers.
3. Identify cost centers, profit centers,
and investment centers.
4. Calculate and interpret return on
investment (ROI).
Objectives
(Continued)
5. Explain why using a measure of profit to
evaluate performance can lead to
overinvestment and why using a measure
of return on investment (ROI) can lead to
underinvestment
6. Calculate and interpret residual income
(RI) and economic value added (EVA).
7. Explain the potential benefits of using a
Balanced Scorecard to assess
performance.
Advantages of Decentralization
1. Better information leading to superior
decisions.
2. Faster response to changing
circumstances.
3. Increased motivation of managers.
4. Excellent training for future top level
executives.
Advantages of Decentralization
Disadvantages of
Decentralization
1. Costly duplication of activities.
2. Lack of goal congruence.
Why Companies Evaluate The
Performance of Subunits and
Subunit Managers
1. Decentralization naturally leads to evaluate
subunits and managers.
2. Companies evaluate performance of
subunits and managers for two reasons:
a. Evaluation identifies successful operations
and areas needing improvement.
b. Evaluating performance influences manager
behavior.
Responsibility Accounting and
Performance Evaluation
1. Responsibility accounting holds
managers responsible for only costs and
revenues which they can control.
2. To implement responsibility accounting
in a decentralized organization, costs
and revenues are traced to the
organizational level where they can be
controlled.
Responsibility Accounting and
Performance Evaluation
Cost Centers, Profit Centers,
and Investment Centers
1. Subunits are organizational units with
identifiable collections of related resources
and activities.
2. A subunit may be a:
a. Department
b. Subsidiary
c. Division.
3. Subunits are sometimes referred to as
responsibility centers and include cost
centers, profit centers, and investment
centers.
Cost Centers, Profit Centers,
and Investment Centers
(Continued)
4. Subunits are also called responsibility
centers.
5. Include:
a. Cost centers
b. Profit centers
c. Investment centers.
Cost Centers
1. Subunit that has responsibility for
controlling costs but does not have
responsibility for generating revenue.
2. Examples: janitorial, computer service, and
production departments.
3. Managerial goal: to provide services at a
reasonable cost to the company.
4. Evaluation: compare budgeted/standard
costs with actual costs.
Profit Centers
1. Subunit that has responsibility for generating
revenues as well as for controlling costs.
2. Examples: copier and camera divisions of
an electronics firm.
3. Managerial goal: to maximize profit
(revenues – expenses) for the division.
4. Evaluation: profit from the current year may
be compared with budget or previous years
or compared with with other profit centers on
a relative basis.
Investment Centers
1. Subunit that has responsibility for:
a. Generating revenues
b. Controlling costs
c. Investing in assets
2. Managers of investment centers have
control over inventory, receivables,
equipment purchases, etc...
3. Held responsible for generating some kind
of return on them.
Investment Centers
(Continued)
4. Examples: Nordstrom, Inc. subunit
Faconnable.
5. Managerial goal: to maximize return on
investment.
6. Evaluation: rate of return (%) relative to a
benchmark/budget rate of return or relative
to other investment center rates of return.
Evaluating Investment Centers
with ROI
1. ROI is one of the primary tools for evaluating
performance of investment centers.
2. Calculated as follows: ROI = Income
Invested Capital
3. ROI focuses on income AND investment
4. Natural advantage over income (alone) as a
measure of performance.
5. Removes the bias of larger investment over
smaller investment.
Evaluating Investment Centers
with ROI
(Continued)
1. ROI breaks down into two components:
a. Profit margin:
Income
Sales
b. Investment turnover:
Sales
Invested Capital
Measuring Income and
Invested Capital When
Calculating ROI
1. For ROI calculations, companies measure
“income” in a variety of ways:
a. Net income
b. Income before interest and taxes
c. Controllable profit…
2. The text uses uses Net Operating Profit
After Taxes, NOPAT. This formula does not
hold managers responsible for interest.
What is NOPAT?
Net Income
Add Back:
Interest Expense
less tax savings
NOPAT
$3,900,000
1,000,000
(350,000)
$4,550,000
Measuring Income and
Invested Capital When
Calculating ROI
(Continued)
1. Invested capital is measured in a variety of
ways.
2. In the text, invested capital is measured as:
Total Assets - Noninterest-bearing current
liabilities
3. Examples of noninterest-bearing current
liabilities:
a. Accounts payable
b. Income taxes payable
c. Accrued liabilities
Problems With Using ROI
1. Major problem with ROI: the denominator,
invested capital, is based on historical costs,
net of depreciation.
2. As those assets become fully depreciated,
the invested capital denominator becomes
extremely low and the ROI number quite
high.
3. Managers may therefore be compelled to
put off purchases of new equipment
necessary for long-term success. They
“underinvest.”
Problems of Overinvestment
and Underinvestment: You Get
What You Measure
1. Managers of investment centers with high
ROI’s may be unwilling to invest in assets
that will dilute their current ROI.
2. This will lead to “underinvestment.”
3. Conversely, evaluation in terms of profit can
lead to “overinvestment.”
Residual Income (RI)
1. Residual Income (RI): net operating profit
after taxes of an investment center in
excess of the profit required for the level of
investment.
2. RI = NOPAT - Cost of Capital x Investment
3. RI has the potential to solve both the
overinvestment and underinvestment
problem because it compels investment in
the range between cost of capital and
current ROI.
Residual Income (RI): Example
1. Facts: NOPAT=$4,550,000, Invested
Capital=$65,000,000, cost of capital=10%.
2. Calculate residual income (loss):
3. RI = $4,550,000 – (.10 x $65,000,000)
4. RI = ($1,950,000)
5. Negative residual value; not good!
Solving The Overinvestment
and Underinvestment Problems
1. What happens under RI when a project
comes along that will earn 11%?
a. The manager will make the investment:
underinvestment problem solved!
2. What happens under RI when a project
comes along that will earn 9%?
a. The manager will NOT make the
investment: overinvestment problem
solved!
Economic Value Added (EVA)
1. Economic Value Added, EVA, is a
performance measure developed by the
consulting firm Stern Stuart.
2. What is it? RI adjusted for “accounting
distortions.”
3. Primary distortion is related to research and
development (R&D).
Economic Value Added (EVA)
(Continued)
1. Under GAAP, R&D is expensed
immediately.
2. Under EVA, R&D is capitalized and
amortized over a number of future
accounting periods.
3. EVA has gained considerable attention in
the financial press.
adjusted
4. EVA = NOPAT
– (Cost of Capital x
adjusted
Investment
)
Using A Balanced Scorecard To
Evaluate Performance
1. Problem with ROI and RI/EVA is that these
financial measures are ALL “backward
looking.”
2. Balanced Scorecard is a set of performance
measures :
a. Financial perspective
b. Customer perspective
c. Internal process perspective
d. Learning and growth
Using A Balanced Scorecard To
Evaluate Performance
(Continued)
3. Balanced Scorecard uses performance
measures that are tied to the company’s
strategy for success.
4. Balance is a key factor using this technique.
How Balance is Achieved in A
Balanced Scorecard
Balance between qualitative and
quantitative, forward and backward
measures, and balanced company
dimensions!
 Performance is assessed across a
balanced set of dimensions.
 Quantitative measures are balanced with
qualitative measures.
 There is a balance of backward-looking and
forward-looking measures.
How Balance is Achieved in A
Balanced Scorecard
Appendix: Transfer Pricing
1.
2.
3.
4.
5.
6.
7.
Transfer Pricing
Market Price as the Transfer Price
Market Price and Opportunity Cost
Variable Cost as the Transfer Price
Full Cost Profit as the Transfer Price
Negotiated Transfer Prices
Transfer Pricing and Income Taxes in an
International Context
Transfer Pricing
Divisions often “sell” goods or services to other
units within the same company. In the
automobile manufacturing industry, batteries
manufactured in one division may be sold to
other divisions which manufacture autos.
1. Market prices
2. Variable costs
3. Full cost plus profit
4. Negotiated prices.
Market Price As The Transfer
Price
1. This method would be the same as with any
other customer at “arm’s length.”
2. The external market price is an excellent
choice because the buying and selling
divisions are treated as independent
companies.
Market Price And Opportunity
Cost
1. Opportunity cost is the foregone benefit or
increased cost of selecting one alternative
over another.
2. The selling division has a choice between
selling to the related division or into an open
market.
3. The determining factor in deciding whether
or not to sell to the related division is the
impact to the firm (overall) of the decision.
Market Price And Opportunity
Cost
Variable Cost As The Transfer
Price
1. In some cases the transferred product is
unique and is not sold in the open market.
2. Here, variable cost may be a good transfer
price.
3. Conveys accurate opportunity cost
information.
4. When no external market for the product
exists, the opportunity cost of producing and
selling the product is variable cost per unit.
Full Cost Plus Profit As The
Transfer Price
1. With variable cost transfer pricing, selling
division cannot earn a profit
2. The price may not be acceptable to
management of the selling company.
3. Many companies add a profit margin to the
full cost of production.
4. Full Cost Plus Profit may not measure the
opportunity cost of producing the product.
Negotiated Transfer Prices
1. Some companies allow managers to
negotiate transfer prices.
2. The problem is that this price may not
reflect the opportunity cost of producing and
selling the product.
3. Reflects relative bargaining prowess of
individual managers.
Transfer Pricing And Income
Taxes In An International
Context
1. Income tax rates vary significantly between
countries.
2. When goods are transferred between
countries, these tax situations may create
incentives for relatively high or low transfer
prices.
3. Creates a bias toward having high transfer
prices when selling a product from a low tax
country to a high tax country and having a
low transfer price when selling a product from
a high tax country to a low tax country.
Quick Review Question #1
1. A profit center is responsible for all of
the following except:
a. Investing in long term assets.
b. Controlling costs.
c. Generating revenues.
d. All of the above.
Quick Review Answer #1
1. A profit center is responsible for all of
the following except:
a. Investing in long term assets.
b. Controlling costs.
c. Generating revenues.
d. All of the above.
Quick Review Question #2
2. What is the difference between RI and
EVA?
a. RI is a new concept.
b. EVA makes adjustments for “accounting
distortions.”
c. RI excludes research and development
as an expense.
d. EVA includes a capital charge.
Quick Review Answer #2
2. What is the difference between RI and
EVA?
a. RI is a new concept.
b. EVA makes adjustments for “accounting
distortions.”
c. RI excludes research and development
as an expense.
d. EVA includes a capital charge.
Quick Review Question #3
3. Return on Investment (ROI) is calculated
as:
a. Sales / Total assets.
b. Gross margin / Invested capital.
c. Investment center income / Invested
capital.
d. Income / Sales.
Quick Review Answer #3
3. Return on Investment (ROI) is calculated
as:
a. Sales / Total assets.
b. Gross margin / Invested capital.
c. Investment center income / Invested
capital.
d. Income / Sales.
Quick Review Question #4
4. Investment center income is $864,000.
Investment turnover is 2. ROI is 24%.
Sales is?
a. $8,000,000
b. $7,200,000
c. $6,000,000
d. $3,600,000
Quick Review Answer #4
4. Investment center income is $864,000.
Investment turnover is 2. ROI is 24%.
Sales is?
a. $8,000,000
b. $7,200,000
c. $6,000,000
d. $3,600,000
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