Chapter 11
Other Cost Tools for Cost
Control and Performance
Evaluations
Topics to be Discussed
Introduction
Management of Decentralized
Organizations
Accounting Information Systems and
Decentralized Organizations
Responsibility Accounting and Segment
Reporting
Cost, Profit and Investment Centers
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
Management of Decentralized
Organizations
Centralized: a few individuals at the
top of an organization retain decisionmaking authority.
Decentralized: managers at various
levels throughout the organization
make key decisions about operations
relating to their specific area of
responsibility.
Management of Decentralized
Organizations
Segment: any activity
or part of the business
for which a manager
needs cost, revenue or
profit data.
Management of Decentralized
Organizations
Advantages of Decentralization
Those closest to the problem are more
familiar with the problem
Key in improving customer service
Higher job satisfaction of managers
Managers receive on-the-job training,
making them better managers
Management of Decentralized
Organizations
Disadvantages of Decentralization
Decision making spread among too many
managers, causing a lack of company focus
Managers concerned with their own area and lose
sight of big picture
Managers make decision benefiting their own
segment, not always in the best interest of the
company
Managers not adequately trained in decision
making at early states of their careers
Accounting Information Systems and
Decentralized Organizations
Key Concept
Decentralized organizations require
very well-integrated information
systems. The flow of information
and open communication between
divisions and upper and lower
management is critical.
Responsibility Accounting and
Segment Reporting
Responsibility Accounting:
Holding managers responsible
for ONLY those things under their
control.
Responsibility Accounting and
Segment Reporting
Key Concept
The key to effective decision making in a
decentralized organization is responsibility
accounting - holding managers responsible for
only those things under their control.
Should a manager on an engine assembly line
be held responsible for a production problem
dealing the the vehicle body?
Cost, Profit and Investment Centers
Cost Center
The manager has
control over costs but
not over revenue or
capital investment
decisions.
Example: Human
Resources Manager
Cost, Profit and Investment Centers
Revenue Center
Manager has control
over the generation of
revenue but not costs.
Example: Reservation
Department of an
airline
Cost, Profit and Investment Centers
Profit Center
Manager has control
over both cost and
revenue but not
capital investment
decisions.
Example: Manager of
a specific hotel chain
Cost, Profit and Investment Centers
Investment Center
Manager is responsible for
the amount of capital
invested in generating its
income. They are in
essence separate
businesses with their own
value chains.
Example: Owner of own
independent store
Topics to Measure Performance
Profit Center Performance and
Segmented Income Statements
Investment Centers and Measure of
Performance
Return on Investment
Residual Income
Profit Center Performance and Segmented
Income Statements
Segmented Income Statements
calculate income for each major
segment of an organization in
additon to the company as a whole.
Profit Center Performance and Segmented
Income Statements
J. C. Penney Co. allocates the corporate costs
of auditing, legal, and personnel services to its
subsidiaries based on the time spent providing
the services to each subsidiary. In the past, the
allocation was made based on the revenue
earned by each subsidiary. (“Teamwork Pays
Off at Penney’s,” Business Week, no. 2734, pp.
107-108)
Profit Center Performance and Segmented
Income Statements
Pause and Reflect
Do you think the new allocation bases
are appropriate or should Penney’s
treat the auditing, legal, and personnel
costs as common costs?
The Segmented Income Statement
Consulting
Audit Dept.
Dept.
Total Firm
Tax Dept.
$1,000,000
$500,000
$400,000
$100,000
400,000
200,000
160,000
40,000
Contribution margin
$600,000
$300,000
$240,000
$60,000
Less:Traceable fixed
200,000
100,000
75,000
25,000
$400,000
$200,000
$165,000
$35,000
Client billings
Less: Variable expense
Segment margin
Less: Common fixed
Net income
200,000
$200,000
The Segmented Income Statement
Individual Tax Business Tax
Tax Dept.
Division
Division
Client billings
Less: Variable expense
Contribution margin
Less:Traceable fixed
Divisional Segment margin
$500,000
$100,000
$400,000
200,000
80,000
120,000
$300,000
$20,000
$280,000
80,000
30,000
50,000
$220,000
$(10,000)
$230,000
Departmental Segment margin $200,000
The Segmented Income Statement
Contribution Margin: primarily a
measure of short-run profitability.
Segment Margin: a measure of longterm profitability and is more appropriate
in addressing long-term decisions such as
whether to drop product lines.
The Segmented Income Statement
Pause and Reflect
Garcia and Buffet have considered
allocating the advertising costs to each
division based on the revenue generated
in each division. Comment on whether
this is an appropriate allocation base.
The Segmented Income Statement
The segment margin of the individual tax
division is negative. In the long run, the
individual tax division is not profitable.
Before the firm decides to eliminate the
individual tax division, what other
quantitative and qualitative factors
should they consider?
Segment Performance and ABC
ABC can affect the classification of
costs as traceable or common.
When ABC is used, batch level and
product level activities and costs are
driven by factors such as the number
of setups, parts, customer orders,
supervision hours, etc.
Investment Centers and Measures of
Performance
Key Concept
Evaluating investment centers
requires focusing on the level of
investment required in generating a
segment’s profit.
Investment Centers and Measures of
Performance
And what do you
plan to use to justify
your decision to remodel
these facilities?
Performance reports
focus on measures
specifically developed
to focus on the level
investment required,
such as return on
investment, residual
income, and economic
value added.
Investment Centers and Measures of
Performance
Does the manager of a local branch of a
national bank likely manage a profit or
investment center?
What about the manager of the local Pizza Hut?
What about the manager of an independent
pizza restaurant or clothing store who is also
the owner of that store?
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
Net Operating Income
ROI =
Sales
X
Sales
Average Operating
Assets
Return on Investment (ROI)
Net Operating Income: Income
before interest and taxes
Operating Assets: Cash, accounts
receivable, inventory, and property,
plant and equipment
Return on Investment (ROI)
Pause and Reflect
Why might investing in new assets
decrease ROI? Will ROI always go down
when new equipment is purchased?
Return on Investment (ROI)
What do I need to do
to increase my ROI?
Increase sales revenue
Reduce operating costs
Reduce investment in
operating assets
Return on Investment (ROI)
How do you increase
sales revenue?
Either by increasing
sales volume without
changing the sales
price or by increasing
the sales price without
affecting volume.
Return on Investment (ROI)
How do you reduce
operating costs?
The decrease can be
in the variable or fixed
costs. The key is that
any decrease in
operating costs will
increase operating
income and have a
positive impact on ROI.
Return on Investment (ROI)
How do you decrease
the amount of
operating assets?
Although this may be
difficult to do in the
short run with property,
plant and equipment,
AOA can be reduced
by better management
of accounts receivable,
a reduction in inventory
levels, and so on.
Residual Income
Residual Income: the amount of
income earned in excess of some
predetermined minimum level of
return on assets. The higher the
residual income of an investment
center, the better.
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
More Topics
Economic Value Added
Segment Performance and Transfer Pricing
Transfer Price at Market
Transfer Price at Cost
Negotiated Transfer Prices
A General Model for Computing Transfer Prices
International Aspects of Transfer Pricing
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)
Economic Value Added (EVA)
How is EVA different from residual income?
1. EVA is based on after-tax operating profit.
2. Assets are often shown net of current
liabilities.
3. Companies may modify income and asset
measurements based on GAAP.
4. EVA considers the actual cost of capital,
both debt and equity instead of a minimum rate
of return.
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:
Use the market price if it is available.
Base the transfer price on the cost of the product
transferred.
Let the buyer and seller negotiate the price.
Segment Performance and Transfer
Pricing
I knew accepting
that transfer price
would lower my
ROI too far!
If managers of the
separate divisions are
evaluated based on profit
or other performance
measures like ROI or
EVA, the transfer price
becomes very important.
Transfer Price at Market
If there is an outside market
for the product being
transferred between
divisions, the transfer price
should be based on the
market price of the product.
However, the buyer and
seller must be allowed to go
outside if doing so would
create a better profit.
Transfer Price at Cost
If no outside market exists, or when
the selling division has excess
capacity, transfer prices are often
established based on the cost of
the product being transferred.
Transfer Price at Cost
No Outside Market
Using Birdie-Maker as
an example, how
should they set a price
for a grip that cannot
be sold to other club
manufacturers?
Transfer Price at Cost
Using the Decision Model:
Step 1 - Establish a transfer
price for grips that are to be
sold to the club division.
Step 2 - Set a price that does
not adversely affect either
manager of the firm and
maximizes overall profit.
Transfer Price at Cost
Step 3 - Establish the
transfer price at:
The variable manufacturing
costs of making the grips
The full cost of making the
grips
A price so that the grip
division earns an
acceptable profit
Transfer Price at Cost
Step 4 - Which decision should
Birdie Maker make?
Negotiated Transfer Price
Transfer prices are
negotiated between
buyer and seller and
end up somewhere
between cost and the
market price.
A General Model for Computing
Transfer Prices
Minimum Transfer Price
=
Variable Costs of Producing and Selling
+
Contribution Margin Lost on Outside Sales
A General Model for Computing
Transfer Prices
Key Concept
The transfer price that provides the
most benefit to the company as a
whole is the one that should be
chosen.
International Aspects of Transfer
Pricing
The focus of transfer pricing when
international divisions are involved
centers on minimizing taxes, duties,
and foreign exchange risks.
Managers must also be aware and
sensitive to geographic , political, and
economic circumstances in the
environment in which they operate.
End of Chapter 11
Which costs are
you responsible
for in your
budget?