Professional Documents
Culture Documents
CHAPTER
Performance
Evaluation in
the
Decentralized
Firm
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Objectives
1. Define responsibility
accounting,
After studying
this and
describe fourchapter,
types ofyou
responsibility
centers.
should
2. Tell why firms choose
decentralize.
be abletoto:
3. Compute and explain return on investment
(ROI) and economic value added (EVA).
4. Discuss methods of evaluating and rewarding
managerial performance.
5. Explain the role of transfer pricing in a
decentralized firm.
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Cost
Cost center
Sales
Capital
Investment
Other
Profit center
Investment center
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Return on Investment
Operating income
ROI =
Average operating assets
Beginning net book value +
Ending net book value
2
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Comparison of ROI
Electronics
Divisions
Medical Supplies
Divisions
2003:
Sales
$30,000,000
Operating income
1,800,000
Average operating assets 10,000,000
ROI
18 %
$1,800,000
$10,000,000
$117,00,000
3,510,000
19,500,000
18%
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Comparison of ROI
Electronics
Divisions
Medical Supplies
Divisions
2004:
Sales
$40,000,000
Operating income
2,000,000
Average operating assets 10,000,000
ROI
20 %
$2,000,000
$10,000,000
$117,00,000
2,925,000
19,500,000
15%
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Margin
Turnover
ROI
6.0%
x 3.0
18.0%
Medical Supplies
Division
2004
2003
2004
5.0%
x 4.0
20.0%
3.0%
x 6.0
18.0%
2.5%
x 6.0
15.0%
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Advantages of ROI
1. It encourages managers to
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Disadvantages of ROI
1) It can produce a narrow
focus on divisional
profitability at the expense
of profitability for the
overall firm.
2) It encourages managers to
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Economic value added (EVA) is aftertax operating profit minus the total
annual cost of capital.
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1. Determine the
weighted average cost
of capital (a
percentage figure)
2. Determine the total
dollar amount of
capital employed
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Bonds $2,000,000
0.25
0.0135
Equity 6,000,000
0.75
0.0900
Total $8,000,000
0.1035
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EVA Example
Suppose that Mahalo, Inc., had after-tax
operating income last year of $900,000. Three
sources of financing were used by the company:
$2 million of mortgage bonds paying 8 percent
interest, $3 million of unsecured bonds paying
10 percent interest, and $10 million in common
stock, which was considered to be no more or
less risky than other stocks. Mahalo, Inc. pays
a marginal tax rate of 40 percent.
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Weighted
Percent x After-Tax Cost = Cost
Mortgage
bonds $ 2,000,000
0.133
Unsecured
bonds
3,000,000
0.200
Common
stock
10,000,000
0.667
Total
$15,000,000
Weighted average cost of capital
0.048
0.006
0.060
0.012
0.120
0.080
0.098
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EVA Example
Mahalos EVA is calculated as follows:
After tax operating income
Less: Cost of capital
EVA
$900,000
784,000
$116,000
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Transfer Pricing
The value of a
transferred good is
revenue to the selling
division and cost to the
buying division. This
value is called transfer
pricing.
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Transfer Pricing
Transfer pricing affects both transferring divisions
and the firm as a whole through its impact on-(1) divisional performance measures
(2) firmwide profits
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$10
8
2
1
10
$31
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$10
8
2
1
$21
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Disadvantages of Negotiated
Transfer Prices
1. A division manager who has private
information may take advantage of another
divisional manager.
2. Performance measures may be distorted by
the negotiated skills of managers.
3. Negotiation can consume considerable time
and resources.
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Chapter Thirteen
The End
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