FUNCTIONAL-BASED RESPONSIBILITY

ACCOUNTING 
 Objectives
Objectives
1. Define responsibility
After accounting,
studying this and
After studying this
describe four types
chapter, of responsibility centers.
chapter, you
you should
should
2. Tell why firms choose
be able toto:
decentralize.
be able to:
3. Compute and explain return on investment
(ROI) and economic value added (EVA).
4. Discuss methods of evaluating and rewarding
managerial performance.
 Responsibility
Responsibilityaccounting
accountingisisaasystem
systemthat
that
measures
measuresthe
theresults
resultsof
ofeach
eachresponsibility
responsibility
center
centeraccording
accordingto tothe
theinformation
informationmanagers
managers
need
needtotooperate
operatetheir
theircenters.
centers.
Types
Types of
of Responsibility
Responsibility Centers
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
Continued
Types
Types of
of Responsibility
Responsibility Centers
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.
 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
Reasons
Reasons for
for
Decentralization
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
 Return
Return on
on Investment
Investment

Operating income
ROI =
Average operating assets

Beginning net book value +

Ending net book value
2
 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
 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
 Margin
Margin and
and Turnover
Turnover

ROI = Margin x Turnover

Operating Income Sales

Sales
Average operating assets
 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%
 Advantages
Advantages of
of ROI
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.
 Disadvantages
Disadvantages of
of ROI
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.
Residual income
Residual income is the difference
between operating income and the
minimum dollar return required on a
company’s operating assets:

Residual income = Operating income -

(Minimum rate of return X
Average operating assets)
•Sales $480,000
•Cost of goods sold 222,000
•Gross margin $258,000
•Selling and administrative expense 210,000
•Operating income $ 48,000
•Beginning opeating assets $277,000
•Ending Operating assets $323,000
•Minimum rate of return 12%
•RI?
 Economic value added (EVA) is after-tax operating
profit minus the total annual cost of capital.

EVA
EVA==After-tax
After-tax operating
operating income
income –– (Weighted
(Weighted
average
average cost
cost of
of capital
capital xx Total
Total capital
capital
employed)
employed)
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
Weighted Average Cost of Capital
Suppose
Suppose thatthat aa company
company has has two
two sources
sources of
of
financing:
financing: $2 $2 million
million ofof long-term
long-term bonds
bonds paying
paying
99 percent
percent interest
interest andand $6 $6 million
million of
of common
common
stock,
stock, whichwhich isis considered
considered to to be
be of
of average
average risk.
risk.
IfIf the
the company’s
company’s tax tax rate
rate isis 40
40 percent
percent andand the
the
rate
rate of of interest
interest onon long-term
long-term government
government bondsbonds
isis 66 percent,
percent, thethe company’s
company’s weighted
weighted average
average
cost
cost of
of capital
capital isis computed
computed as as follows:
follows:
 Weighted Average Cost of Capital
Amount Percent x After-Tax Cost = Weighted Cost
Bonds $2,000,000 0.25 0.09(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,
Thus, the
the company’s
company’s
weighted
weighted average
average isis
10.35
10.35 percent.
percent.
 EVA
EVA Example
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.
 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
 EVA
EVA Example
Example

Mahalo’s EVA is calculated as follows:

After tax operating income $900,000
Less: Cost of capital 784,000
EVA $116,000
 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.
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.
 Incentive
Incentive Pay
Pay for
for Managers
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
 Incentive
Incentive Pay
Pay for
for Managers
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