Chapter 12:

Performance Evaluation and

Decentralization
Cornerstones of Managerial Accounting, 4e

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 Learning Objectives
1. Explain how and why firms choose to decentralize.
2. Compute and explain return on investment.
3. Compute and explain residual income and economic value
added.
4. Explain the role of transfer pricing in a decentralized firm.
5. (Appendix 12A) Explain the uses of the Balanced Scorecard,
and compute cycle time, velocity, and manufacturing cycle
efficiency.

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 Decentralization and
1 Responsibility Centers
► In general, a company is organized along lines of
responsibility. Today, most companies use a more flattened
hierarchy that emphasizes teams.
► Firms with multiple responsibility centers usually choose
one of two decision-making approaches to manage their
diverse and complex activities: centralized or decentralized.
► In centralized decision making, decisions are made at the very top
level, and lower level managers are charged with implementing
these decisions.
► Decentralized decision making allows managers at lower levels to
make and implement key decisions pertaining to their areas of
responsibility. The practice of delegating decision-making authority
to the lower levels of management in a company is called
decentralization.
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1 Centralization and Decentralization

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 1 Reasons for Decentralization
►Firms decide to decentralize for several reasons,
including the following:
►ease of gathering and using local information
►focusing of central management
►training and motivating of segment managers
►enhanced competition, exposing segments to market
forces

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 1 Divisions in the Decentralized Firm
►Decentralization involves a cost-benefit trade-off.
►As a firm becomes more decentralized, it passes more
decision authority down the managerial hierarchy.
►Decentralization usually is achieved by creating units
called divisions.
►Divisions can be differentiated a number of different
ways, including the following:
►types of goods or services
►geographic lines
►responsibility centers
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 1 Types of Goods or Services
► Here is an example of how PEPSICO creates its decentralized
divisions organized according to the product lines it makes.
► In a decentralized setting, some interdependencies usually exist,
like Pepsi being sold at its restaurants, which include Pizza Hut,
Taco Bell and KFC.

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 1 Geographic Lines
►Divisions may also be created along geographic
lines.
►The presence of divisions spanning one or more
regions creates the need for performance
evaluation that can take into account differences
in divisional environments.

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 1 Responsibility Centers
► A third way divisions differ is by the type of responsibility given to
the divisional manager.
► A responsibility center is a segment of the business whose
manager is accountable for specified sets of activities.
► The four major types of responsibility centers are as follows:
►Cost center: Manager is responsible only for costs.
►Revenue center: Manager is responsible only for sales, or
revenue.
►Profit center: Manager is responsible for both revenues and
costs.
►Investment center: Manager is responsible for revenues, costs,
and investments.
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 Responsibility Centers and Accounting
1 Information Used to Measure Performance
Investment centers represent the greatest degree of
decentralization (followed by profit centers and finally
by cost and revenue centers) because their managers
have the freedom to make the greatest variety of
decisions.

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 Responsibility Center
1
Interdependencies
►It is important to realize that while the responsibility
center manager has responsibility only for the activities
of that center, decisions made by that manager can
affect other responsibility centers.
►Organizing divisions as responsibility centers creates the
opportunity to control the divisions through the use of
responsibility accounting.

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 2 Return on Investment
►One way to relate operating profits to assets employed
is to compute the return on investment (ROI), which is
the profit earned per dollar of investment.
►ROI is the most common measure of performance for
an investment center and is computed as follows:
Operating income ÷ Average Operating Assets
►Operating income refers to earnings before interest and
taxes.
►Operating assets are all assets acquired to generate operating
income, including cash, receivables, inventories, land,
buildings, and equipment.
►Average operating assets is computed as:
(Beginning assets + Ending assets) ÷ 2
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 2 Margin and Turnover
►A second way to calculate ROI is to separate the formula
(Operating income ÷ Average operating assets) into
margin and turnover.
►Margin is the ratio of operating income to sales.
►It tells how many cents of operating income result from each
dollar of sales; it expresses the portion of sales that is
available for interest, taxes, and profit.
►Turnover is sales ÷ average operating assets.
►Turnover tells how many dollars of sales result from every
dollar invested in operating assets.

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 2 Margin and Turnover (continued)

►The equation that yields ROI from the Margin

and Turnover is as follows:
Margin Turnover
ROI = Operating Income X Sales
Sales Average Operating
Assets
Notice that ‘‘Sales’’ in the above formula can be cancelled
out to yield the original ROI formula of Operating
income/Average operating assets.

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 Cornerstone 12-1
2 Calculating Average Operating Assets,
Margin, Turnover, and Return on Investment

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 Cornerstone 12-1
2 Calculating Average Operating Assets,
Margin, Turnover, and Return on Investment
(continued)

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 Advantages of Return on
2
Investment
►At least three positive results stem from the use
of ROI:
►It encourages managers to focus on the relationship
among sales, expenses, and investment, as should be
the case for a manager of an investment center.
►It encourages managers to focus on cost efficiency.
►It encourages managers to focus on operating asset
efficiency.

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 Disadvantages of the
2
Return on Investment Measure
►Overemphasis on ROI can produce myopic
behavior.
►Two negative aspects associated with ROI
frequently are:
►It can produce a narrow focus on divisional
profitability at the expense of profitability for the
overall firm.
►It encourages managers to focus on the short run at
the expense of the long run.

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 3 Residual Income
►To compensate for the tendency of ROI to discourage
investments that are profitable for a company but that
lower a division’s ROI, some companies have adopted
alternative performance measures such as 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)
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 Cornerstone 12-2
3 Calculating Residual Income

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 Cornerstone 12-2
3 Calculating Residual Income (continued)

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 3 Advantage of Residual Income
►The advantage of using residual income is that
its use encourages managers to accept any
project that earns a return that is above the
minimum rate.
►This prevents the fallacy of using ROI that may
reject a profitable project that reduces divisional
ROI.

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 3 Disadvantages of Residual Income
► Unfortunately, residual income, like ROI, can encourage a
short-run orientation.
► Another problem with residual income is that, unlike ROI, it
is an absolute measure of profitability. Thus, direct
comparison of the performance of two different investment
centers becomes difficult, as the level of investment may
differ.
► One possible way to correct this disadvantage is to compute both
ROI and residual income and to use both measures for performance
evaluation. ROI could then be used for interdivisional comparisons.

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 3 Economic Value Added (EVA)
►Another financial performance measure that is similar
to residual income is economic value added.
►Economic value added (EVA) is after tax operating
income minus the dollar cost of capital employed.
►The dollar cost of capital employed is the actual percentage
cost of capital multiplied by the total capital employed.
►EVA is expressed as follows:

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 Cornerstone 12-3
3 Calculating Economic Value-Added

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 Cornerstone 12-3
3 Calculating Economic Value-Added
(continued)

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 Behavioral Aspects of
3
Economic Value Added
► The key feature of EVA is its emphasis on after-tax operating profit and the
actual cost of capital.
► Investors like EVA because it relates profit to the amount of resources needed
to achieve it.
► 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.
► In some companies, the responsibility for investment decisions rests with
corporate management. As a result, the cost of capital is considered a
corporate expense rather than an expense attributable to particular divisions.
► Without an EVA analysis, the result of investments do not show up as reducing
divisional operating income and may seem free to divisions who want more.

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 4 Transfer Pricing
►In many decentralized organizations, the output of one
division is used as the input of another.
►As a result, the value of the transferred good is revenue
to the selling division and cost to the buying division.
►This value, or internal price, is called the transfer price.
►Transfer price is the price charged for a component by the
selling division to the buying division of the same company.

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 Impact of Transfer Pricing on
4
Divisions and the Firm as a Whole
►When one division of a company sells to another
division, both divisions as well as the company as a
whole are affected.
►The price charged for the transferred good affects both
►the costs of the buying division
►the revenues of the selling division
►Thus, the profits of both divisions, as well as the
evaluation and compensation of their managers, are
affected by the transfer price.

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 Impact of Transfer Pricing on Divisions
4 and the Firm as a Whole (continued)

► Since profit-based performance measures of the two divisions are

affected, transfer pricing often can be an emotionally charged
issue. The above exhibit illustrates the effect of the transfer price
on two divisions of a company. Division A wants the transfer price
to be as high as possible while Division C prefers it to be as low a
as possible.
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 4 Transfer Pricing Policies
►Several transfer pricing policies are used in
practice, including:
►market price
►cost-based transfer prices
►negotiated transfer prices

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 Transfer Pricing Policies:
4
Market Price
►If there is a competitive outside market for the transferred
product, then the best transfer price is the market price.
►In such a case, divisional managers’ actions will
simultaneously optimize divisional profits and firm-wide
profits.
►Furthermore, no division can benefit at the expense of
another. In this setting, top management will not be
tempted to intervene.
►The market price, if available, is the best approach to
transfer pricing.

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 Transfer Pricing Policies:
4
Cost-Based Transfer Prices
►Frequently, there is no good outside market price.
►The lack of a market price might occur because the
transferred product uses patented designs owned by
the parent company.
►Then, a company might use a cost-based transfer pricing
approach.
►Since a transfer price at cost does not allow for any
profit for the selling division, top management may
define cost as ‘‘cost plus, ’’ which allows a certain
percentage to be tacked onto the cost.
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 Transfer Pricing Policies:
4
Negotiated Transfer Prices
►Finally, top management may allow the selling and
buying division managers to negotiate a transfer price.
►This approach is particularly useful in cases with market
imperfections, such as the ability of an in-house division
to avoid selling and distribution costs that external
market participants would have to incur.
►Using a negotiated transfer price then allows the two
divisions to share any cost savings resulting from
avoided costs.

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 Negotiated Transfer Prices:
4
Bargaining Range
►When using negotiated transfer prices, a bargaining
range exists.
►Minimum Transfer Price (Floor): The transfer price that would
leave the selling division no worse off if the good were sold to
an internal division than if the good were sold to an external
party. This is sometimes referred to as the ‘‘floor’’ of the
bargaining range.
►Maximum Transfer Price (Ceiling): The transfer price that
would leave the buying division no worse off if an input were
purchased from an internal division than if the same good
were purchased externally. This is sometimes referred to as
the ‘‘ceiling’’ of the bargaining range.
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 Cornerstone 12-4
4 Calculating Transfer Price

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 Cornerstone 12-4
4 Calculating Transfer Price (continued)

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 Appendix 12A:
5 The Balanced Scorecard – Basic Concepts
► Segment income, ROI, residual income, and EVA are important
measures of managerial performance, but they lead managers to
focus only on dollar figures.
► The Balanced Scorecard translates an organization’s mission and
strategy into operational objectives and performance measures
for the following four perspectives:
► The financial perspective describes the economic consequences of actions
taken in the other three perspectives.
► The customer perspective defines the customer and market segments in
which the business unit will compete.
► The internal business process perspective describes the internal processes
needed to provide value for customers and owners.
► The learning and growth perspective defines the capabilities that an
organization needs to create long-term growth and improvement.
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5 The Balanced Scorecard – An Example

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 5 Strategy Translation
► Strategy specifies management’s desired relationships among the
four perspectives.
► Strategy translation, on the other hand, means specifying
objectives, measures, targets, and initiatives for each perspective.
Here is an example for the financial perspective.
► Objective: For the financial perspective, a company’s objective may be to
grow revenues by introducing new products.
► Measure: The performance measure may be the percentage of revenues
from the sale of new products.
► Target: The target or standard for the coming year for the measure may be
20 percent (i.e., 20 percent of the total revenues for the coming year must be
from the sale of new products).
► Initiative: The initiative describes how this is to be accomplished. The ‘‘how,’’
of course, involves the other three perspectives.

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 5 The Role of Performance Measures
► The Balanced Scorecard is not simply a collection of critical
performance measures.
► The performance measures are derived from a company’s vision,
strategy, and objectives.
► These measures must be balanced between the following
measures:
►performance driver measures (i.e., lead indicators of future
financial performance) and outcome measures (i.e., lagged
indicators of financial performance)
►objective and subjective measures
►external and internal measures
►financial and nonfinancial measures
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 Linking Performance Measures
5
to Strategy
►Balancing outcome measures with performance drivers
is essential to linking with the organization’s strategy.
►Performance drivers make things happen and are
indicators of how the outcomes are going to be realized.
►Outcome measures are also important because they
reveal whether the strategy is being implemented
successfully with the desired economic consequences.
►A testable strategy can be defined as a set of linked
objectives aimed at an overall goal.

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5 A Testable Strategy Example

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 5 Invalid Strategy
► If the targeted levels of performance drivers were achieved
and the expected outcomes did not materialize, then the
problem could very well lie with the strategy itself.
► Double-loop feedback occurs whenever managers receive
information about both the effectiveness of strategy
implementation as well as the validity of the assumptions
underlying the strategy.
► In a functional-based responsibility accounting system,
typically only single-loop feedback is provided.
► Single-loop feedback emphasizes only effectiveness of
implementation.
► In single-loop feedback, actual results deviating from planned
results are a signal to take corrective action so that the plan
(strategy) can be executed as intended.

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 The Four Perspectives and
5
Performance Measures
►The four perspectives define the strategy of an
organization and provide the structure or framework for
developing an integrated, cohesive set of performance
measures.
►These measures, once developed, become the means
for articulating and communicating the strategy of the
organization to its employees and managers.
►The measures also serve the purpose of aligning
individual objectives and actions with organizational
objectives and initiatives.

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5 The Financial Perspective

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5 Customer Perspective
► The customer perspective is the source of the revenue component for the
financial objectives.
► It defines and selects the customer and market segments in which the
company chooses to compete.

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5 Internal (Process) Perspective
► The internal perspective typically focuses on identifying the organization
’s core internal business processes needed for creating customer and
shareholder value to achieve the customer and financial objectives.
► The framework for this perspective is the process value chain, made up
of three processes:
► The innovation process anticipates the emerging and potential needs of
customers and creates new products and services to satisfy those needs. It
represents what is called the long-wave of value creation.
► The operations process produces and delivers existing products and
services to customers. It begins with a customer order and ends with the
delivery of the product or service. It is the short-wave of value creation.
► The postsales service process provides critical and responsive services to
customers after the product or service has been delivered.

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5 Internal (Process) Perspective (continued)

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 Responsiveness:
5
Cycle Time and Velocity
►The time to respond to a customer order is referred to
as responsiveness. Cycle time and velocity are two
operational measures of responsiveness.
►Cycle time is the length of time it takes to produce a unit of
output from the time raw materials are received (starting
point of the cycle) until the good is delivered to finished goods
inventory (finishing point of the cycle).
►Thus, cycle time is the time required to produce a product (Time ÷ Units
produced).
►Velocity is the number of units of output that can be
produced in a given period of time (Units produced ÷ Time).

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 Cornerstone 12-5
5 Computing Cycle Time and Velocity

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 Cornerstone 12-5
5 Computing Cycle Time and Velocity (continued)

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 5 Manufacturing Cycle Efficiency
►Another time based operational measure calculates
MCE (manufacturing cycle efficiency).
►MCE is measured as value-added time ÷ total time.
►Total time includes both value-added time (the time spent
efficiently producing the product) and nonvalue-added time
(such as move time, inspection time, and waiting time).
►The formula for computing MCE is:

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 Cornerstone 12-6
5 Calculating Manufacturing Cycle Efficiency

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 Cornerstone 12-6
5 Calculating Manufacturing Cycle Efficiency
(continued)

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5 Learning and Growth Perspective
► The learning and growth perspective, which represents the source
of the capabilities that enable the accomplishment of the other
three perspectives’ objectives.
► This perspective has three major objectives:
► increase employee capabilities
► increase motivation, empowerment, and alignment
► increase information systems capabilities
► Employees must not only have the necessary skills, but they must
also have the freedom, motivation, and initiative to use those skills
effectively.
► Additionally, it is important to increase information system
capabilities so employees can improve processes and effectively
execute new processes.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5 Learning and Growth Perspective
(continued)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.