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- 1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Performance Measurement in Decentralized Organizations Chapter 11
- 2. 11-2 Cost, Profit, and Investments Centers Responsibility Center Cost Center Profit Center Investment Center Cost, profit, and investment centers are all known as responsibility centers.
- 3. 11-3 Cost Center A segment whose manager has control over costs, but not over revenues or investment funds.
- 4. 11-4 Profit Center A segment whose manager has control over both costs and revenues, but no control over investment funds. Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other
- 5. 11-5 Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. Corporate Headquarters
- 6. 11-6 Responsibility Centers Salty Snacks Product Manger Bottling Plant Manager Warehouse Manager Distribution Manager Beverages Product Manager Confections Product Manager Operations Vice President Finance Chief FInancial Officer Legal General Counsel Personnel Vice President Superior Foods Corporation Corporate Headquarters President and CEO Cost Centers Investment Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.
- 7. 11-7 Responsibility Centers Salty Snacks Product Manger Bottling Plant Manager Warehouse Manager Distribution Manager Beverages Product Manager Confections Product Manager Operations Vice President Finance Chief FInancial Officer Legal General Counsel Personnel Vice President Superior Foods Corporation Corporate Headquarters President and CEO Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization. Profit Centers
- 8. 11-8 Responsibility Centers Salty Snacks Product Manger Bottling Plant Manager Warehouse Manager Distribution Manager Beverages Product Manager Confections Product Manager Operations Vice President Finance Chief FInancial Officer Legal General Counsel Personnel Vice President Superior Foods Corporation Corporate Headquarters President and CEO Cost Centers Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.
- 9. 11-9 Decentralization and Segment Reporting A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be . . . Quick Mart An Individual Store A Sales Territory A Service Center
- 10. 11-10 Superior Foods: Geographic Regions East $75,000,000 Oregon $45,000,000 Washington $50,000,000 California $120,000,000 Mountain States $85,000,000 West $300,000,000 Midwest $55,000,000 South $70,000,000 Superior Foods Corporation $500,000,000 Superior Foods Corporation could segment its business by geographic regions.
- 11. 11-11 Superior Foods: Customer Channel Convenience Stores $80,000,000 Supermarket Chain A $85,000,000 Supermarket Chain B $65,000,000 Supermarket Chain C $90,000,000 Supermarket Chain D $40,000,000 Supermarket Chains $280,000,000 Wholesale Distributors $100,000,000 Drugstores $40,000,000 Superior Foods Corporation $500,000,000 Superior Foods Corporation could segment its business by customer channel.
- 12. 11-12 Keys to Segmented Income Statements There are two keys to building segmented income statements: A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.
- 13. 11-13 Identifying Traceable Fixed Costs Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer division means . . . No computer division manager.
- 14. 11-14 Identifying Common Fixed Costs Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but . . . We still have a company president.
- 15. 11-15 Traceable Costs Can Become Common Costs It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.
- 16. 11-16 Segment Margin The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. Time Profits
- 17. 11-17 Traceable and Common Costs Fixed Costs Traceable Common Don’t allocate common costs to segments.
- 18. 11-18 Levels of Segmented Statements Let’s look more closely at the Television Division’s income statement. Webber, Inc. has two divisions. Computer Division Television Division Webber, Inc.
- 19. 11-19 Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Income Statement Contribution Margin Format Television Division Sales 300,000 $ Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin 60,000 $ Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate sections.
- 20. 11-20 Levels of Segmented Statements Segment margin is Television’s contribution to profits. Our approach to segment reporting uses the contribution format. Income Statement Contribution Margin Format Television Division Sales 300,000 $ Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin 60,000 $ Contribution margin is computed by taking sales minus variable costs.
- 21. 11-21 Levels of Segmented Statements Income Statement Company Television Computer Sales 500,000 $ 300,000 $ 200,000 $ Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 60,000 $ 40,000 $ Common costs Net operating income
- 22. 11-22 Levels of Segmented Statements Income Statement Company Television Computer Sales 500,000 $ 300,000 $ 200,000 $ Variable costs 230,000 150,000 80,000 CM 270,000 150,000 120,000 Traceable FC 170,000 90,000 80,000 Division margin 100,000 60,000 $ 40,000 $ Common costs 25,000 Net operating income 75,000 $ Common costs should not be allocated to the divisions. These costs would remain even if one of the divisions were eliminated.
- 23. 11-23 Traceable Costs Can Become Common Costs As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into smaller segments. Let’s see how this works using the Webber, Inc. example!
- 24. 11-24 Traceable Costs Can Become Common Costs Product Lines Webber’s Television Division Regular Big Screen Television Division
- 25. 11-25 Traceable Costs Can Become Common Costs We obtained the following information from the Regular and Big Screen segments. Income Statement Television Division Regular Big Screen Sales 200,000 $ 100,000 $ Variable costs 95,000 55,000 CM 105,000 45,000 Traceable FC 45,000 35,000 Product line margin 60,000 $ 10,000 $ Common costs Divisional margin
- 26. 11-26 Income Statement Television Division Regular Big Screen Sales 300,000 $ 200,000 $ 100,000 $ Variable costs 150,000 95,000 55,000 CM 150,000 105,000 45,000 Traceable FC 80,000 45,000 35,000 Product line margin 70,000 60,000 $ 10,000 $ Common costs 10,000 Divisional margin 60,000 $ Traceable Costs Can Become Common Costs Fixed costs directly traced to the Television Division $80,000 + $10,000 = $90,000
- 27. 11-27 External Reports The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports. 1. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. 2. Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP.
- 28. 11-28 Common Costs and Segments Segment 1 Segment 3 Segment 4 Segment 2 Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: 1. This practice may make a profitable business segment appear to be unprofitable. 2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control.
- 29. 11-29 Income Statement Haglund's Lakeshore Bar Restaurant Sales 800,000 $ 100,000 $ 700,000 $ Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 Segment margin 244,000 14,000 $ 230,000 $ Common costs 200,000 Profit 44,000 $ Quick Check Assume that Hoagland's Lakeshore prepared its segmented income statement as shown.
- 30. 11-30 Quick Check How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it.
- 31. 11-31 Quick Check How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it. A common fixed cost cannot be eliminated by dropping one of the segments.
- 32. 11-32 Quick Check Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000
- 33. 11-33 Quick Check Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000 The bar would be allocated 1/10 of the cost or $20,000.
- 34. 11-34 Quick Check If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment?
- 35. 11-35 Income Statement Haglund's Lakeshore Bar Restaurant Sales 800,000 $ 100,000 $ 700,000 $ Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 Segment margin 244,000 14,000 230,000 Common costs 200,000 20,000 180,000 Profit 44,000 $ (6,000) $ 50,000 $ Allocations of Common Costs Hurray, now everything adds up!!!
- 36. 11-36 Quick Check Should the bar be eliminated? a. Yes b. No
- 37. 11-37 Should the bar be eliminated? a. Yes b. No Quick Check Income Statement Haglund's Lakeshore Bar Restaurant Sales 700,000 $ 700,000 $ Variable costs 250,000 250,000 CM 450,000 450,000 Traceable FC 220,000 220,000 Segment margin 230,000 230,000 Common costs 200,000 200,000 Profit 30,000 $ 30,000 $ The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000!
- 38. 11-38 Return on Investment (ROI) Formula ROI = Net operating income Average operating assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. Income before interest and taxes (EBIT)
- 39. 11-39 Net Book Value versus Gross Cost Most companies use the net book value of depreciable assets to calculate average operating assets. Acquisition cost Less: Accumulated depreciation Net book value
- 40. 11-40 Understanding ROI ROI = Net operating income Average operating assets Margin = Net operating income Sales Turnover = Sales Average operating assets ROI = Margin Turnover
- 41. 11-41 Increasing ROI – An Example Regal Company reports the following: Net operating income $ 30,000 Average operating assets $ 200,000 Sales $ 500,000 Operating expenses $ 470,000 ROI = Margin Turnover Net operating income Sales Sales Average operating assets × ROI = What is Regal Company’s ROI?
- 42. 11-42 Increasing ROI – An Example $30,000 $500,000 × $500,000 $200,000 ROI = 6% 2.5 = 15% ROI = ROI = Margin Turnover Net operating income Sales Sales Average operating assets × ROI =
- 43. 11-43 Investing in Operating Assets to Increase Sales Assume that Regal's manager invests in a $30,000 piece of equipment that increases sales by $35,000, while increasing operating expenses by $15,000. Let’s calculate the new ROI. Regal Company reports the following: Net operating income $ 50,000 Average operating assets $ 230,000 Sales $ 535,000 Operating expenses $ 485,000
- 44. 11-44 Investing in Operating Assets to Increase Sales $50,000 $535,000 × $535,000 $230,000 ROI = 9.35% 2.33 = 21.8% ROI = ROI increased from 15% to 21.8%. ROI = Margin Turnover Net operating income Sales Sales Average operating assets × ROI =
- 45. 11-45 Major Criticism of ROI Managers evaluated on ROI may reject profitable investment opportunities.
- 46. 11-46 Residual Income - Another Measure of Performance Net operating income above some minimum return on operating assets
- 47. 11-47 Calculating Residual Income Residual income = Net operating income - Average operating assets Minimum required rate of return ( ) This computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets.
- 48. 11-48 Residual Income – An Example •The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. •In the current period, the division earns $30,000. Let’s calculate residual income.
- 49. 11-49 Residual Income – An Example Operating assets 100,000 $ Required rate of return × 20% Minimum required return 20,000 $ Actual income 30,000 $ Minimum required return (20,000) Residual income 10,000 $
- 50. 11-50 Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.
- 51. 11-51 Quick Check Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20%
- 52. 11-52 Quick Check Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20% ROI = NOI/Average operating assets = $60,000/$300,000 = 20%
- 53. 11-53 Quick Check Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No
- 54. 11-54 Quick Check Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No ROI = $78,000/$400,000 = 19.5% This lowers the division’s ROI from 20.0% down to 19.5%.
- 55. 11-55 Quick Check The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No
- 56. 11-56 Quick Check The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No ROI = $18,000/$100,000 = 18% The return on the investment exceeds the minimum required rate of return.
- 57. 11-57 Quick Check Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000
- 58. 11-58 Quick Check Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income? a. $240,000 b. $ 45,000 c. $ 15,000 d. $ 51,000 Net operating income $60,000 Required return (15% of $300,000) (45,000) Residual income $15,000
- 59. 11-59 Quick Check If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No
- 60. 11-60 Quick Check If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No Net operating income $78,000 Required return (15% of $400,000) (60,000) Residual income $18,000 Yields an increase of $3,000 in the residual income.
- 61. 11-61 Divisional Comparisons and Residual Income The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.
- 62. 11-62 Zephyr, Inc. - Continued Retail Wholesale Operating assets 100,000 $ 1,000,000 $ Required rate of return × 20% 20% Minimum required return 20,000 $ 200,000 $ Retail Wholesale Actual income 30,000 $ 220,000 $ Minimum required return (20,000) (200,000) Residual income 10,000 $ 20,000 $ Recall the following information for the Retail Division of Zephyr, Inc. Assume the following information for the Wholesale Division of Zephyr, Inc.
- 63. 11-63 Zephyr, Inc. - Continued Retail Wholesale Operating assets 100,000 $ 1,000,000 $ Required rate of return × 20% 20% Minimum required return 20,000 $ 200,000 $ Retail Wholesale Actual income 30,000 $ 220,000 $ Minimum required return (20,000) (200,000) Residual income 10,000 $ 20,000 $ The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division.
Editor's Notes
- Chapter 11: Performance Measurement in Decentralized Organizations Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, return on investment (ROI), residual income, operating performance measures, and the balanced scorecard are used to help control decentralized organizations.
- Responsibility accounting systems link lower-level managers’ decision-making authority with accountability for the outcomes of those decisions. The term responsibility center is used for any part of an organization whose manager has control over, and is accountable for cost, profit, or investments. The three primary types of responsibility centers are cost centers, profit centers, and investment centers.
- The manager of a cost center has control over costs, but not over revenue or investment funds. Service departments such as accounting, general administration, legal, and personnel are usually classified as cost centers, as are manufacturing facilities. Standard cost variances and flexible budget variances, such as those discussed in Chapters 10 and 11, are often used to evaluate cost center performance.
- The manager of a profit center has control over both costs and revenue. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit. An example of a profit center is a company’s cafeteria.
- The manager of an investment center has control over cost, revenue, and investments in operating assets. Investment center managers are often evaluated using return on investment (ROI) or residual income (discussed later in this chapter). An example of an investment center would be the corporate headquarters.
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- An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as net operating income divided by average operating assets. Net operating income is income before taxes and is sometimes referred to as earnings before interest and taxes (EBIT). Operating assets include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Net operating income is used in the numerator because the denominator consists only of operating assets. The operating asset base used in the formula is typically computed as the average of the operating assets (beginning assets + ending assets/2).
- Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets. With this approach, ROI mechanically increases over time as the accumulated depreciation increases. Replacing a fully-depreciated asset with a new asset will decrease ROI. An alternative to using net book value is the use of the gross cost of the asset, which ignores accumulated depreciation. With this approach, ROI does not grow automatically over time, rather it stays constant; thus, replacing a fully-depreciated asset does not adversely affect ROI.
- DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely margin and turnover. Margin is computed as shown and is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the margin earned. Turnover is computed as shown. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets. Excessive funds tied up in operating assets depress turnover and lower ROI.
- Assume that Regal Company reports net operating income of $30,000; average operating assets of $200,000; sales of $500,000; and operating expenses of $470,000. What is Regal Company’s ROI?
- Given this information, its current ROI is 15%.
- The fourth way to increase ROI is to invest in operating assets to increase sales. Assume that Regal's manager invests $30,000 in a piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000. Let’s calculate the new ROI.
- In this case, the ROI increases from 15% to 21.8%.
- Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI in a manner that is consistent with the company’s strategy. This is why ROI is best used as part of a balanced scorecard. A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. This may make it difficult to assess this manager relative to other managers. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but that would have a negative impact on the manager’s performance evaluation.
- Residual income is the net operating income that an investment center earns above the minimum required return on its assets. Economic Value Added (EVA) is an adaptation of residual income. We will not distinguish between the two terms in this class.
- The equation for computing residual income is as shown. Notice that this computation differs from ROI. ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets.
- Assume the information for a division of Zephyr, Inc. is as follows. The Retail Division of Zephyr, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets. In the current period, the division earns $30,000. Let’s calculate residual income.
- The residual income of $10,000 is computed by subtracting the minimum required return of $20,000 from the actual income of $30,000.
- The residual income approach encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula. It motivates managers to pursue investments where the ROI associated with those investments exceeds the company’s minimum required return but is less than the ROI being earned by the managers.
- Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?
- The ROI is 20%.
- If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
- No, she would not want to invest in this project because its return is 18%, which would reduce her division’s ROI from 20% to 19.5%.
- The company’s required rate of return is fifteen percent. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
- Yes, she would want to invest in this project because the return on the investment exceeds the minimum required rate of return.
- Review this question. What is the division’s residual income?
- The residual income is $15,000.
- If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
- Yes, she would want to invest in this project because it will increase the residual income by $3,000.
- The residual income approach has one major disadvantage. It cannot be used to compare the performance of divisions of different sizes.
- Recall that the Retail Division of Zephyr had average operating assets of $100,000, a minimum required rate of return of 20%, net operating income of $30,000, and residual income of $10,000. Assume that the Wholesale Division of Zephyr had average operating assets of $1,000,000, a minimum required rate of return of 20%, net operating income of $220,000, and residual income of $20,000.
- The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division.