THE SUM OF THE PARTS…
Three years of losses for Centex Yarns’ Nylon
Fibers Division
How long will management let this go on?
What information would help Monica make her
case?
DECENTRALIZATION
Pushes decision making and responsibility down
the organization chart to lower level managers
Requires a way to evaluate the decentralized
managers and the segments of the business they
manage
Runs along a continuum
No “right” degree of decentralization
THE DECENTRALIZATION CONTINUUM
CENTRALIZED
DECENTRALIZED
Where do you want to be?
Decision making
authority is at
the top
Decision making
authority is
delegated to lower
level managers
EFFECTS OF DECENTRALIZATION
ADVANTAGES
Better information for
operational decisions
More timely information for
operational decisions
Develops decision making
skills for future
Gives top managers time to
focus on strategic planning
DISADVANTAGES
Conflict between operational
decisions and corporate
strategy
Duplicated work effort across
units
Reduced communication
between units
Increased potential for errors
as managers learn to make
decisions
RESPONSIBILITY ACCOUNTING
An organization is divided into operating units,
where managers have decision making authority
Unit managers are evaluated only on those items
under their control
• Costs
• Profits
• Investments (assets)
COST CENTER
Manager has control over only the
costs incurred by the center
No control over revenue or
investment in assets
Goal is to minimize costs while
providing an acceptable service
level or product quality
Compare actual results to flexible
budget
PROFIT CENTER
Manager has control over both
revenues and costs for the center
No control over investment in
assets
Goal is to maximize unit’s profit
Actual profit compared to flexible
budget
INVESTMENT CENTER
Manager is responsible for
revenues, costs and investment in
assets
Goal is to maximize returns through
ROI or residual income
CENTEX YARNS’ DECENTRALIZED STRUCTURE
WHAT IS A SEGMENT?
© Baris Simsek/iStockphoto
A part of the organization that
management wishes to evaluate
No “correct” way to divide an
organization
ONE WAY TO SEGMENT CENTEX YARNS
Polyester
Fibers Division
Revenue
Rope
Division
Nylon Fibers
Division
Total
$10,600,000
$6,725,000
$8,650,000
$25,975,000
Cost of goods sold
7,638,550
4,011,800
6,959,750
18,610,100
Gross profit
2,961,450
2,713,200
1,690,250
7,364,900
S&A expenses
2,332,450
1,309,200
1,790,250
5,431,900
629,000
$1,404,000
$ (100,000)
Operating income
$
Does this format help Centex Yarns’ managers decide
what to do with the Nylon Fibers Division?
$ 1,933,000
SEGMENT MARGIN INCOME STATEMENT
Polyester
Fibers Division
Revenue
Rope
Division
Nylon Fibers
Division
Total
$10,600,000
$6,725,000
$8,650,000
$25,975,000
Variable COGS
5,543,000
2,368,000
4,414,000
12,325,000
Variable S&A
1,334,000
649,000
890,000
2,873,000
Contribution margin
3,723,000
3,708,000
3,346,000
10,777,00
Traceable fixed COGS
1,685,000
1,382,000
2,208,000
5,275,000
236,000
174,000
273,000
683,000
$ 1,802,000
$2,152,000
$ 865,000
4,819,000
Traceable S&A
Segment margin
Common fixed expenses
Net operating income
Now how does the Nylon Fibers Division look?
2,886,000
$ 1,933,000
WATCH OUT…
Textile Yarns
Group
Industrial
Yarns Group
Nylon Fibers
Division
$6,055,000
$2,595,000
$8,650,000
3,168,400
1,245,600
4,414,000
683,000
207,000
890,000
2,203,600
1,142,400
3,346,000
Traceable fixed COGS
744,400
415,200
1,159,600
Traceable S&A
191,100
81,900
273,000
$1,268,100
$ 645,300
1,913,400
Revenue
Variable COGS
Variable S&A
Contribution margin
Segment margin
Common fixed expenses
Net operating income
1,048,400
$ 865,000
$2,208,000 in Traceable Fixed Costs to Nylon Fibers
Division are now part traceable and part common
RETURN ON INVESTMENT
What return did a manager earn on the assets that
he had control over?
Return is a measured as net operating income for
that segment
The assets are the operating assets assigned to
that segment
RETURN ON INVESTMENT CALCULATION
INCOME BEFORE INTEREST
AND TAXES
Operating Income (or segment margin)
Average Operating Assets
CASH, A/R, INVENTORY,
PPE, AND OTHER
PRODUCTIVE ASSETS
CENTEX YARNS’ DIVISIONAL ROIS
Polyester
Fibers Division
Rope
Division
Nylon Fibers
Division
Segment Margin
$1,802,000
$2,152,000
$ 865,000
Average Assets
$8,153,000
$8,406,250
$2,703,000
ROI
$1,802,000
=22.1%
$8,153,000
$2,152,000
=25.6%
$8,406,250
$865,000
=32%
$2,703,000
THE DUPONT MODEL
MARGIN
Net operating income
Sales revenue
x
Sales revenue
Average operating assets
TURNOVER
THE DUPONT MODEL- NYLON FIBERS
MARGIN
$865,000
$8,650,000
x
$8,650,000
$2,703,000
TURNOVER
ROI = 10% X 3.2 = 32%
HOW DO WE IMPROVE ROI?
Net operating income
Sales revenue
x
Sales revenue
Average operating assets
Increase Sales (to increase turnover)
Reduce Expenses (to increase margin)
Reduce Assets (to increase turnover)
AN ISSUE WITH ROI
The Nylon Fibers division has been generating a
32% ROI, well above the corporate goal of 15%.
A new project comes along with a 25% ROI.
Will the division managers choose to invest in
this project?
By the way, the managers’ bonuses are tied to
the division’s ROI.
RESIDUAL INCOME
Companies typically have a minimum return they
require on asset investments
Any income earned in excess of that minimum is
“residual income”
Any project with a positive residual income is
beneficial to the company as a whole, even though
it may lower an individual segment’s ROI
CALCULATION OF RESIDUAL INCOME
Operating Assets
x Required Rate of Return
Required Return
-
Actual Return
Required Return
Residual Income
CENTEX YARNS’ DIVISIONAL RESIDUAL INCOME
Polyester
Fibers Division
Assets
Rope
Division
Nylon Fibers
Division
$8,153,000
$8,406,250
$2,703,000
15%
15%
15%
Minimum required income
$1,222,950
$1,260,938
$ 405,450
Segment Margin
$1,802,000
$2,152,000
$ 865,000
1,222,950
1,260,938
405,450
$ 579,050
$ 891,062
$ 459,550
× Required rate of return
- Minimum required income
Residual income
ECONOMIC VALUE ADDED (EVA)
EVA = Net operating profit – (Invested capital × WACC)
A variation of residual income that measures
“economic profit”
Residual income calculates using the weighted
average cost of capital (WACC) rather than
management’s desired rate of return
FOUR STEPS TO CALCULATE EVA
Calculate net operating profit
Calculate invested capital
Calculate weighted average cost of capital
(WACC)
Calculate EVA
NYLON FIBERS DIVISION EVA
Net operating profit
• $865,000 – ($865,000×30%) = $605,500
Invested Capital
• $2,703,000 assets - $600,000 current liabilities = $2,103,000
Weighted average cost of capital
•
(6% ×40%) + (12% ×60%) = 9.6%
EVA
•
$605,500 – ($2,103,000 ×9.6%) = $403,612
INTERMEDIATE PRODUCTS
Centex
Rope Division
Product manufactured by one
division and used as a raw
material in another division
Centex Nylon
Fibers Division
Requires a transfer price
MARKET-BASED TRANSFER PRICE
Centex
Rope Division
Transfer price = $25 per reel
Market price = $25 per reel
Centex Nylon
Fibers Division
External
Customer
COST-BASED TRANSFER PRICE
Centex
Rope Division
Transfer price = $16 per reel
Centex Nylon
Fibers Division
No external market exists.
Nylon Fibers Division’s cost
to produce is $16 per reel.
COST-PLUS TRANSFER PRICE
Centex
Rope Division
Transfer price = $19.20 per reel
($16 × 1.2)
Centex Nylon
Fibers Division
No external market exists.
Nylon Fibers Division’s cost
to produce is $16 per reel.
20% profit margin required.
NEGOTIATED TRANSFER PRICE
Centex
Rope Division
Transfer price = ?
Centex Nylon
Fibers Division
No external market exists.
Nylon Fibers Division’s cost
to produce is $16 per reel.
Managers from both divisions
negotiate a transfer price.
MINIMUM TRANSFER PRICE
Minimum price = Variable cost to produce/sell + CM forgone
Transfer price should be set to generate the
greatest benefit possible to the organization as a
whole
Depends on whether excess production capacity
exists
CAPACITY EFFECTS ON TRANSFER PRICE
Excess capacity exists
• Transferred units do not require giving up existing
contribution margin
• Minimum transfer price = variable cost to produce/sell
No excess capacity exists
• Normal sales will have to be reduced to provide the
transferred units, resulting in lost contribution margin
• Minimum transfer price = variable cost to produce/sell
plus the normal contribution margin per unit