Chapter 12
Decentralization and
Performance Evaluation
1
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
2
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.
3
Management of Decentralized
Organizations
•Advantages of Decentralization
•Those closest to the problem are more
familiar with the problem
•Higher job satisfaction of managers
•Managers receive on-the-job training, making
them better managers
•Decisions are often made in a more timely
fashion
4
Management of Decentralized
Organizations
•Disadvantages of Decentralization
•Decision making spread among too many managers,
causing a lack of company focus
•Managers make decisions benefiting their own segment,
not always in the best interests of the company
•Managers not adequately trained in decision making at
early stages of their careers
•Lack of coordination and communication between
segments
•May result in duplicative costs/efforts
5
Responsibility Accounting and Segment
Reporting
The key to effective decision making in
a decentralized organization is
responsibility accounting—holding
managers responsible for only those
things under their control.
6
Cost, Revenue, Profit, and Investment
Centers
•Cost Center
•The manager has control over costs
but not over revenue or capital
investment decisions.
•Example: Human Resources Manager
7
Cost, Revenue, Profit, and Investment
Centers
•Revenue Center
•The manager has control over the
generation of revenue but not costs.
•Example: Sales Manager of a retail
store
8
Cost, Revenue, Profit, and Investment
Centers
•Profit Center
•The manager has control over both
cost and revenue but not capital
investment decisions.
•Example: Manager of a particular
location of a hotel chain
9
Cost, Revenue, Profit, and Investment
Centers
•Investment Center
•The manager is responsible for the
amount of capital invested in generating
income. It is, in essence, a separate
business with its own value chain.
•Investment centers are often called
strategic business units (SBUs)
10
Profit Center Performance and Segmented
Income Statements
Segmented Income Statements
calculate income for each major
segment of an organization in addition
to the company as a whole.
11
Investment Centers and Measures of
Performance
Evaluating investment centers requires
focusing on the level of investment
required in generating a segment’s
profit.
12
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
ROI =
Net Operating Income
Sales
X
Sales
Average Operating
Assets
13
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
14
Residual Income
Residual Income
The amount of income earned in
excess of a predetermined minimum
rate of return on assets.
All things equal, the higher the
residual income of an investment
center, the better.
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Residual Income
Residual Income =
Net Operating Income - ( Average Operating Assets X
Minimum Required Rate of Return)
If net income is $60,500, average operating assets are
$100,000, and the required ROI is 20%, what is the RI?
RI = $60,500 - ($100,000 X .20)
RI = $40,500
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Economic Value Added (EVA)
•EVA tells management whether shareholder
wealth is being created by focusing on whether
after-tax profits are greater than the cost of
capital.
•Economic value added = After-tax operating
profit – [(Total assets - Current liabilities) x
Weighted average cost of capital)]
17
Performance and Management
Compensation Decisions
In order to motivate managers and ensure goal
congruence, the compensation of managers
should be linked to performance and based
on a combination of short-term and long-term
goals.
18
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.
19
A General Model for Computing
Transfer Prices
Minimum Transfer Price =
Variable Costs of Producing and Selling +
Contribution Margin Lost on Outside Sales
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A General Model for Computing
Transfer Prices
The transfer price that provides the most
benefit to the company as a whole is the
one that should be chosen.
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