13 -1

CHAPTER Performance
Evaluation in
the
Decentralized
Firm
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Objectives
1. Define responsibility accounting,
After studying this and
describe four types of responsibility
chapter, you should centers.
2. Tell why firms choose
be abletoto:
decentralize.
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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Responsibility accounting is a system that

measures the results of each responsibility
center according to the information managers
need to operate their centers.
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Types of Responsibility Centers

Cost center: A responsibility center in
which a manager is responsible only
for costs.
Revenue center: A responsibility
center in which a manager is
responsible only for sales.

Continued
 13 -5

Types of Responsibility Centers

Profit center: A responsibility center
in which a manager is responsible for
both revenues and costs.
Investment center: A responsibility
center in which a manager is
responsible for revenues, costs, and
investments.
 13 -6

ACCOUNTING INFORMATION USED TO MEASURE

PERFORMANCE
Capital
Cost Sales Investment Other
Cost center x
Revenue center Direct cost x
only
Profit center x x
Investment center x x x x
 13 -7

Reasons for Decentralization

1. Ease of gathering and using local

information
2. Focusing of central management
3. Training and motivating segment
managers
4. Enhanced competition, exposing segments
to market forces
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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 Medical Supplies
Divisions Divisions
2003:
Sales $30,000,000 $117,00,000
Operating income 1,800,000 3,510,000
Average operating assets 10,000,000 19,500,000
ROI 18 % 18 %

$1,800,000
$10,000,000
 13 -10

Comparison of ROI
Electronics Medical Supplies
Divisions Divisions
2004:
Sales $40,000,000 $117,00,000
Operating income 2,000,000 2,925,000
Average operating assets 10,000,000 19,500,000
ROI 20 % 15 %

$2,000,000
$10,000,000
 13 -11

Margin and Turnover

ROI = Margin x Turnover

Operating Income Sales

Sales
Average operating assets
 13 -12

MARGIN AND TURNOVER COMPARISONS

Electronics Medical Supplies
Division Division
2003 2004 2003 2004

Margin 6.0% 5.0% 3.0% 2.5%

Turnover x 3.0 x 4.0 x 6.0 x 6.0
ROI 18.0% 20.0% 18.0% 15.0%
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Advantages of ROI
1. It encourages managers to
focus on the relationship
among sales, expenses,
and investments.
2. It encourages managers to
focus on cost efficiency.
3. It encourages managers to
focus on operating asset
efficiency.
 13 -14

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
focus on the short run at the
expense of the long run.
 13 -15

Economic value added (EVA) is after-

tax operating profit minus the total
annual cost of capital.

EVA = After-tax operating income – (Weighted

average cost of capital x Total capital
employed)
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There are two steps involved in

computing cost of capital:

1. Determine the
weighted average cost
of capital (a
percentage figure)
2. Determine the total
dollar amount of
capital employed
 13 -17
Weighted Average Cost of Capital
Suppose that a company has two sources of
financing: $2 million of long-term bonds paying
9 percent interest and $6 million of common
stock, which is considered to be of average risk.
If the company’s tax rate is 40 percent and the
rate of interest on long-term government bonds
is 6 percent, the company’s weighted average
cost of capital is computed as follows:
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Weighted Average Cost of Capital
Amount Percent x After-Tax Cost = Weighted Cost
Bonds $2,000,000 0.25 0.009(1 –0.4) = .054 0.0135
Equity 6,000,000 0.75 0.06 + 0.06 = .120 0.0900
Total $8,000,000 0.1035
Thus, the company’s
weighted average is
10.35 percent.
 13 -19

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.
 13 -20
Weighted Average Cost of Capital
Weighted
Amount Percent x After-Tax Cost = Cost
Mortgage
bonds $ 2,000,000 0.133 0.048 0.006
Unsecured
bonds 3,000,000 0.200 0.060 0.012
Common
stock 10,000,000 0.667 0.120 0.080
Total $15,000,000
Weighted average cost of capital 0.098
 13 -21

EVA Example

Mahalo’s EVA is calculated as follows:

After tax operating income $900,000
Less: Cost of capital 784,000
EVA $116,000
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Behavioral Aspects of EVA
A number of companies have discovered that
EVA helps to encourage the right kind of
behavior from their divisions in a way that
emphasis on operating income alone cannot.
The underlying reason is EVA’s reliance on the
true cost of capital.
 13 -23
Behavioral Aspects of EVA
In many companies, the responsibility for
investment decisions rests with corporate
management. As a result, the cost of capital is
considered a corporate expense. If a division
builds inventories and investment, the cost of
financing that investment is passed along to the
overall income statement and does not show up
as a reduction from the division’s operating
income.
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Incentive Pay for Managers

Why would managers not provide good service?
There are three reasons:
1. They may have low ability
2. They may prefer not to work as hard as
needed
3. They may prefer to spend company resources
on perquisites
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Incentive Pay for Managers

Perquisites are a type of fringe benefit given
to managers over and above a salary.
 A nice office
 Use of a company car or jet
 Expense accounts
 Paid country club memberships
 13 -26

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
(3) divisional autonomy
 13 -28

Opportunity Cost Approach

This approach identifies the minimum and
maximum price that a selling division would be
willing to accept and the maximum price that a
buying division would be willing to pay.

The maximum
minimum transfer price is the transfer price that
would leave the selling
buying division
division no
no worse
worse off
off ifif the
an
goods
input were
were sold to an
purchased internal
from division
an internal than ifthan
division the if
good
the were
good sold
were to an external
purchased party(ceiling).
externally (floor).
 13 -29
The Transfer Pricing Illustration

Tyson Manufacturers
produces small appliances.
The Small Parts Division
produces parts used by the
Small Motors Division.
The parts also are sold to
other manufacturers and
wholesalers.
 13 -30
The Transfer Pricing Illustration
The Small Motors Division is
operating at 70 percent
capacity. A request is received
for 100,000 units of a certain
model at $30 per unit. A
component for this motor can
be supplied by the Small Parts
Division. The transfer price is
$8 despite the Small Parts
Division only experiencing a
cost of $5 per unit.
 13 -31
The Transfer Pricing Illustration
Using the $8 transfer price, the
total cost is $31 per unit,
calculated as follows:

Direct materials $10

Transferred-in component 8
Direct labor 2
Variable overhead 1
Fixed overhead 10
Total cost $31
 13 -32
The Transfer Pricing Illustration
The Small Motors Division is
operating at 70 percent capacity,
so the $10 fixed cost is not
relevant. Recalculating the cost--
Direct materials $10
Transferred-in component 8
Direct labor 2
Variable overhead 1
Total cost $21
The Small Motors Division can pay the Small Parts
Division $8 per unit and still make a substantial
contribution to the overall profitability of the Division.
 13 -33

Negotiated Transfer Prices

When imperfections exist in
competitive markets for the
intermediate product, market price
may no longer be suitable.
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Negotiated Transfer Prices

In this case, negotiated transfer
prices may be a practical
alternative. Opportunity costs can
be used to define the boundaries
of the negotiation set.
 13 -35

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.
 13 -36

Despite the disadvantages,

negotiated price transfer prices
offer some hope of complying with
the three criteria of goal
congruence, autonomy, and
accurate performance evaluation.
 13 -37

Chapter Thirteen

The End
13 -38