decentralization and performance evaluation. responsibility centers costs and benefits of...
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Decentralization and Decentralization and Performance EvaluationPerformance Evaluation
Decentralization and Performance Evaluation
• Responsibility Centers• Costs and benefits of
decentralization• Return on Investment• Residual Income
Decentralization and Performance Evaluation
• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income
Responsibility Centers
• Cost Centers
• Revenue Centers
• Profit Centers
• Investment Centers
Responsibility Centers include:
Responsibility Centers
• Cost Centers
– A cost center is a segment whose manager is
responsible for costs but not for revenues.
• Revenue Centers
• Profit Centers
• Investment Centers
Responsibility Centers
• Cost Centers
• Revenue Centers
– Revenue center managers are mostly responsible
for generating sales, not for the cost of goods sold.
• Profit Centers
• Investment Centers
Responsibility Centers
• Cost Centers
• Revenue Centers
• Profit Centers
– Profit center managers are responsible for revenues
as well as costs. These costs may include indirect
costs.
• Investment Centers
Responsibility Centers• Cost Centers
• Revenue Centers
• Profit Centers
• Investment Centers
– Investment center managers are responsible not
only for revenues and costs, but also for the
investment required to generate profits.
Responsibility Centers
Levi Strauss
San Francisco
Levi Strauss
Canada
Levi Strauss
U.S.A.
Levi Strauss
Europe
Dockers Jeans
Factories Warehouses
Sales offices
Investment Centers
Profit Centers
Cost Centers
Revenue Centers
Responsibility Centers
• Cost Centers– report of costs
• Revenue Centers– report of sales
• Profit Centers– Divisional income statement
• Investment Centers– Return on Investment
What reports are used to evaluate these responsibility center managers?
Decentralization and Performance Evaluation
• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income
Responsibility Centers
• Takes advantage of knowledge and expertise within the organization.
• Autonomy can be an intrinsic reward.
• Places fewer demands on top management.
Benefits of Decentralization:
Responsibility Centers
• Loss of Control.
• Goal Congruence.
Costs of Decentralization:
Decentralization and Performance Evaluation
• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income
ROI and Residual IncomeProjectLevel
Measure
DivisionLevel
Measure
Ratio: I RR ROI
DollarReturns: NPV R.I .
Where
IRR = Internal Rate of Return
ROI = Return on Investment
NPV = Net Present Value
R.I. = Residual Income
Return on Investment (ROI)
Examples of ROI that you may have seen:
ROE = Return on Equity
ROA = Return on Assets
These are usually employed at a firm-wide level for financial statement analysis. In cost accounting, we are usually more interested in ROI calculations for a part of the firm (e.g., a division).
ROI = Some Measure of InvestmentSome Measure of Income
Return On Investment (ROI)
ROI = Divisional Investment
= Operating Profit
Division Revenuesx Divisional Revenues
Divisional Investmt
Operating Profit
= Return on Sales x Turnover Ratio
Return On Investment (ROI)
ADVANTAGES:ROI is a measure of profitability that is independent of the size of the division.
DISADVANTAGES:Can encourage divisional managers to reject good investments.
ROI = Division Investment
Operating Profit
Decentralization and Performance Evaluation
• Responsibility Centers• Costs and benefits of decentralization• Return on Investment• Residual Income
Residual Income (RI)
ADVANTAGES:
Some argue that Residual Income comes very close to what investors care about.
RI = Profits - (Hurdle Rate x Investment)
This hurdle rate usually should be equal to or greater than the cost of capital.
E.V.A. (Economic Value Added) is a type of Residual Income calculation.
Measurement IssuesIncome:
Residual Income should exclude interest on debt.
Both RI and ROI might include some allocated corporate costs.
Investment:
Always includes identifiable assets.
Can also include some allocated corporate assets.Fixed assets might be stated at Original Cost Original cost less accumulated depreciation (book value) Current replacement cost
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the residual income for the Fish Division?
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the residual income for the Fish Division?
operating income - (average investment x cost of capital)= $60,000 - ($400,000 x 18%)= $60,000 - $72,000= ($12,000)
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the return on investment (ROI) for the Turkey Division?
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
What is the return on investment (ROI) for the Turkey Division?
operating income ÷ average operating assets= $50,000 ÷ $250,000 = 20%
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey FishNet Operating Income $50,000 $60,000Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
A project with a return of $36K on an investment of $200K exists. If divisions are evaluated based on residual income, which divisions would accept the project?
Cat Food Company has two divisions, Turkey and Fish. Operating results for the two divisions are as follows:
Turkey FishNet Operating Income $ 50,000 $ 60,000Average Operating Assets $250,000 $400,000
The required rate of return, which is the cost of capital, for the Cat Food Company is 18%.
A project with a return of $36,000 on an investment of $200,000 exists. If divisions are evaluated based on residual income, which divisions would accept the project?
$36,000 - ($200,000 x 18%) = $0.Both Turkey division and Fish division are indifferent.