Managerial accounting 6e jams jambalvo chapter 12

CHAPTER 12
Decentralization
and
Performance Evaluation
Slide 12-2


Decentralized Organizations
 As firms increase in size and complexity,
business segments or subunits are
organized

 The managers of the segments are granted
decision making authority so that the firm
will function efficiently and effectively
 Firms that grant substantial decision
making authority to the managers of
subunits are referred to as decentralized
organizations

Slide 12-3

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Decentralized Organizations
 Most firms are neither totally centralized

nor totally decentralized

 Typically, decentralization is a matter of
degree
 A firm is more decentralized if more
decision making authority is delegated to
sub-unit managers

 Performance evaluation can be used to
ensure that managers make decisions that
are in the best interest of the entire firm

Slide 12-4

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Decentralized Organizations

Slide 12-5

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.

Advantages of Decentralization
 A primary reason is that subunit managers
have better information than top
management and can respond quicker to
changing circumstances
 Other reasons include
 Some firms decentralize because they believe
that managers are more motivated and work
harder
 Decentralized organizations provide excellent
training for future top-level executives

Slide 12-6

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Disadvantages of Decentralization
 Decentralization can cause problems
 It may result in a costly duplication of
activities
 Managers may pursue personal goals that
are incompatible with the goals of the
company as a whole
 This problem is called goal congruence
 To control goal congruence, companies
evaluate the performance of subunit

managers

Slide 12-7

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Test Your Knowledge 1
All of the following are advantages of
decentralization except:
a.
b.
c.
d.

Faster response to changing circumstances
Costly duplication of activities
Increased motivation of managers
Better information, leading to superior
decisions

Answer: b
Costly duplication of activities

Slide 12-8

Learning objective 1: Explain the advantages and disadvantages

of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Evaluating Subunits
Evaluation of subunits is undertaken to identify
successful operations and areas needing
improvement
Top management may perform incremental
analysis to determine:
Whether a successful operation should be
expanded
Whether an unsuccessful operation should
be eliminated or improved
Slide 12-9

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Evaluating Subunit Managers
 A company evaluates subunit managers
in order to motivate them to take actions
that maximize the value of the firm
 Reasons for evaluating subunit managers:
 Identifies successful operations and areas
needing improvement

 Influences the behavior of managers

Slide 12-10

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Responsibility Accounting and
Performance Evaluation
 Responsibility accounting is a technique that
holds managers responsible only for costs
and revenues that they can control
 This idea should play a prominent role in the
design of accounting systems used to
evaluate managers
 Costs and revenues are traced to the
organizational level where they can be
controlled

Slide 12-11

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.

Tracing Costs to Organizational
Levels

Slide 12-12

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Responsibility Centers
 Responsibility centers are organizational
units responsible for the generation of
revenue and/or the incurrence of costs
 Responsibility centers typically are
classified as being
 Cost centers
 Profit centers, or
 Investment centers

Slide 12-13

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Cost Centers

 A cost center is a subunit that has
responsibility for controlling costs but
does not have responsibility for
generating revenue
 Most service departments are classified as
cost centers
 The managers of these departments are
responsible for making sure their services
are provided at a reasonable cost to the
company
Slide 12-14

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Cost Centers
 A common approach to controlling cost
centers is to compare their actual costs
with standard or budgeted costs
 If variances from standard are significant,
an investigation into the activities of the
cost center should be undertaken to
determine whether costs are out of control
 Other performance measures can be used
as well

Slide 12-15

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Profit Centers
 A profit center is a subunit that has
responsibility for generating revenues as
well as for controlling costs
 Because both revenues and costs are
under the control of the profit center
manager, the performance of the profit
center can be evaluated in terms of
profitability
 This motivates managers to focus their
attention on ways of maximizing profit
center profitability
Slide 12-16

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Companies use a variety of methods to profit
centers
Income earned in the current year may be

compared with an income target
Income earned may be compared with income
earned in the prior year
Some firms use relative performance evaluation,
which involves evaluating the profitability of each
profit center relative to the profitability of similar
profit centers
Slide 12-17

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Investment Centers
 An investment center is a subunit that is
responsible for generating revenue,
controlling costs, and investing in assets
 An investment center is changed with
earning income consistent with the
amount of assets invested in the segment

Slide 12-18

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.

Investment Centers
 If the manager can influence decisions
affecting investment in divisional assets,
the division should be considered an
investment center
 Managers play a major role in the
determining the level of inventory,
accounts receivable and equipment
 It seems reasonable to hold them
responsible for earning a return on these
assets
Slide 12-19

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Test Your Knowledge 2
An investment center is responsible for:
a.
b.
c.
d.

Investing in long term assets
Controlling costs
Generating revenues

All of the above

Answer:
d. All of the above

Slide 12-20

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Test Your Knowledge 3
Profit centers are often evaluated using:
a.
b.
c.
d.

Investment turnover
Income targets or profit budgets
Return on investment
Residual income

Answer:
b. Income targets or profit budgets

Slide 12-21

Learning objective 1: Explain the advantages and disadvantages
of decentralization, explain why companies evaluate the
performance of subunits and subunit managers, and identify cost
centers, profit centers, and investment centers.


Evaluating Investment Centers With
ROI
 One of the primary tools for evaluating the
performance of investment centers is
return on investment, or ROI
 ROI is calculated as the ratio of investment
center income to invested capital

 Focuses management’s attention on both
income (numerator) and the level of
investment (denominator)

Slide 12-22

Learning objective 2: Calculate and interpret return on
investment (ROI), residual income (RI), and economic
value added (EVA)


ROI Components
 Some companies break ROI into two
components
 Profit margin and
 Investment turnover

Slide 12-23

Learning objective 2: Calculate and interpret return on
investment (ROI), residual income (RI), and economic
value added (EVA)


Measuring Income and Invested Capital
for ROI
In calculating ROI, companies measure “income” in a
variety of ways
Net income, earnings before interest and taxes,
controllable profit, etc.
Most common method is NOPAT
Net operating profit after taxes
NOPAT excludes interest expense, which is a
nonoperating expense
Therefore, add interest expense back to net
income and adjust tax expense accordingly
Slide 12-24

Learning objective 2: Calculate and interpret return on
investment (ROI), residual income (RI), and economic
value added (EVA)


Measuring Income and Invested
Capital for ROI
 In calculating ROI, companies measure

“invested capital” in a variety of ways
 Common approaches include
 Total assets
 Total assets after adding back accumulated
depreciation
 Total assets less current liabilities
 Total assets less non-interest-bearing
current liabilities (method used in this
textbook)
Slide 12-25

Learning objective 2: Calculate and interpret return on
investment (ROI), residual income (RI), and economic
value added (EVA)