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Chapter 10

Decentralized Performance
Evaluation
ACCT 2200
PROFESSOR THOMAS BOURVEAU

Learning Objective 10-1


List and explain the advantages and
disadvantages of decentralization.

Decentralization of Responsibility
Decentralization pushes
decision making down
to lower-level managers.

Decentralization often occurs as organizations continue to grow.

Decentralization of Responsibility

Learning Objective 10-2


Describe the different types of
responsibility centers and explain
how managers in each type are
evaluated.

Responsibility Centers
Responsibility accounting gives managers authority
and responsibility for a particular part of the
organization and then evaluates them based on the
results of that area of responsibility.

Managers of responsibility
centers should be held
responsible only for that
which they can control.

Learning Objective 10-3


Describe the four dimensions of the
balanced scorecard and
explain how they are used to
evaluate managerial performance.

The Balanced Scorecard


Management translates its strategy into
performance measures that employees understand
and accept.
Customers

Financial

Internal
business
processes

Performance
measures
Learning
and growth

The Balanced Scorecard

The Balanced Scorecard

Learning Objective 10-4


Compute and interpret return on
investment, investment turnover, and
profit margin.

Return on Investment (ROI)

Return on Investment (ROI)

Return on Investment (ROI)

Learning Objective 10-5

Compute and interpret residual


income.

Residual Income

The hurdle rate is the required return


on invested assets, sometimes called
the cost of capital.

Residual income is the organizations extra


profit, over and above that needed to cover
the required return on invested assets.

Residual Income

ROI versus Residual Income

As the store manager at Apples Online Store, you have the opportunity to
invest $1,000,000 in a project promising a return of $150,000 (15
percent).

The company requires a minimum return of 10 percent on all projects, so


the project would be acceptable from the companys perspective.

Would you invest in this project?

ROI versus Residual Income

Limitations of Financial
Performance Measures
Both ROI and residual income are lagging indicators of
financial performance. These measures tell how well a
company or a division has done in the past but not
necessarily how well it will do in the future.
To improve short-run financial
results, managers may make harmful
decisions to cut costs in areas such
as research and development,
employee training, or quality of
manufacturing materials.

Annual financial data for Hotels Desfleurs for 2011


Lets assume that the groups required rate of investments is 12%.

Compute the Return on investment and the residual income for each
hotel of the group.

Assume that the group has an expansion opportunity of Vaison Hotel


that will increase operating profit by 160,000 and increase total assets
by 800,000. Should they do it?

Vaison
Hotel
Hotel revenues (sales)
Hotel variable costs
Hotel fixed costs
Hotel operating profit
Interest costs on long-term debt at 10%
Profit before income taxes
Income taxes at 30%
Net profit
Average book values for 2011
Current assets
Long-term assets
Total assets
Current Liabilities
Long-term debt
Stockholders' equity
Total liabilities and shareholder equity

1,200,000
310,000
650,000
240,000
-

400,000
600,000
1,000,000
50,000
-

Perpignan
Hotel

La Rochelle
hotel

Total

1,400,000 3,185,000 5,785,000


375,000
995,000 1,680,000
725,000 1,680,000 3,055,000
300,000
510,000 1,050,000
-

450,000
600,000
180,000
420,000

500,000
600,000 1,500,000
1,500,000 2,400,000 4,500,000
2,000,000 3,000,000 6,000,000
150,000
-

300,000
-

500,000
4,500,000
1,000,000
6,000,000

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Desfleurs: ROI
Return on Investment (ROI)
Hotel
Vaison
Perpignan
La Rochelle

Operating profit

Total assets

ROI

240 000
300 000
510 000

1 000 000
2 000 000
3 000 000

=
=
=

24%
15%
17%

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Desfleurs: Residual income


Lets assume Desfleurs required rate of investments is 12%
Hotel
Vaison
Perpignan
La Rochelle

Operating Profit

240,000
300,000
510,000

Required rate of return X


investment
120,000 (= 12% x 1,000,000)
240,000 (= 12% x 2,000,000)
360,000 (= 12% x 3,000,000)

=
=
=
=

Residual
income
120,000
60,000
150,000

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Assume
Desfleurs requires a rate of return on investment of 12%
Expansion of Vaison Hotel will increase operating profit by 160,000 and
increase total assets by 800,000

For Desfleurs, expansion makes sense:


ROI of expansion is 20% (160,000 800,000)

For Vaison Hotel?

Problem of
suboptimization

Pre-expansion ROI: 240,000 1,000,000 = 24%


Post-expansion ROI:

240,000 + 160,0000 = 400,000


= 22.2%
1,000,000 + 800,000 1,800,000
Oh oh! Vaisons ROI will decrease and
maybe also the managers bonus!
Manager is not too happy.

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