Performance Evaluation for

Decentralized Operations
Centralized and Decentralized Operations

 In a centralized company, all major planning and operating

decisions are made by top management.
 In a decentralized company, managers of separate divisions or
units are delegated operating responsibility.
 The division (unit) managers are responsible for planning and
controlling the operations of their divisions.
 Advantages:
 Allows managers closest to the operations to make decisions
 Provides excellent training for managers
 Allows managers to become experts in their area of operation
 Helps retain managers
 Improves creativity and customer relations
 Disadvantages of Decentralization
 Decisions made by managers may negatively affect the profits of the company
 Duplicates assets and expenses
Responsibility Accounting

 Involves preparation of a report for each level of responsibility

in the company's organization chart.
 Begins with the lowest level of responsibility and moves
upward to higher levels.
 Permits management by exception at each level of
responsibility.
 Each higher level can obtain the detailed report for each lower
level.
 Responsibility Accounting

Partial
organization chart
Responsibility
reporting system Report A
President sees
summary
data of vice
presidents.
 Permits comparative
evaluations. Report B
Vice president sees
summary of
 Plant manager can rank controllable costs in
his/her functional
each department area.

manager’s effectiveness
in controlling Report C
Plant manager sees
manufacturing costs. summary of
controllable costs for
each department in
 Comparative rankings the plant.

provide incentive for a

manager to control costs. Report D
Department
manager sees
controllable costs of
his/her department.
 Types of Responsibility Centers

Three basic types:

 Cost centers
► Incurs costs but does not directly generate revenues.
► Managers have authority to incur costs.
► Managers evaluated on ability to control costs.
► Usually a production department or a service department.
 Profit centers
 Investment centers
 Types of Responsibility Centers

Three basic types:

 Cost centers
 Profit centers
► Incurs costs and generates revenues.
► Managers judged on profitability of center.
► Examples include individual departments of a retail store
or branch bank offices.
 Investment centers
Types of Responsibility Centers

Three basic types:

 Cost centers
 Profit centers
 Investment centers
► Incurs costs, generates revenues, and has investment funds
available for use.
► Manager evaluated on profitability of the center and rate of return
earned on funds.
► Often a subsidiary company or a product line.
► Manager able to control or significantly influence investment
decisions such as plant expansion.
Review Question

Under responsibility accounting, the evaluation of a manager’s

performance is based on matters that the manager:

a. Directly controls.

b. Directly and indirectly controls.

c. Indirectly controls.

d. Has shared responsibility for with another manager.

Types of Responsibility Centers

Responsibility Accounting for Cost Centers

 A cost center manager has responsibility for controlling costs
 Based on a manager’s ability to meet budgeted goals for
controllable costs.
 Results in responsibility reports which compare actual
controllable costs with flexible budget data.
► Include only controllable costs in reports.
► No distinction between variable and fixed costs.
Responsibility Accounting for Profit Centers

 A profit center manager has the responsibility and authority for

making decisions that affect both costs and revenues and, thus,
profits.
 Controllable revenues are revenues earned by the profit center.
 Controllable expenses are costs that can be influenced
(controlled) by the decisions of profit center managers.

 Profit centers may be divisions, departments, or products.

 Responsibility Accounting for Profit Centers based on detailed
information about both controllable revenues and controllable
costs.
Direct and Indirect Fixed Costs

 Direct fixed costs

► Relate specifically to one responsibility center.
► Incurred for the sole benefit of the center.
► Called traceable costs since they can be traced directly to
one center.

► Most direct fixed costs are controllable by the profit center

manager.
Direct and Indirect Fixed Costs

 Indirect fixed costs

► Pertain to a company's overall operating activities.

► Incurred for the benefit of more than one profit center.

► Called common costs since they apply to more than one

center.

► Most are not controllable by the profit center manager.

Service Department Charges
 Service department charges are indirect expenses to a profit center.
 Services provided by internal centralized service departments are
often more efficient than services contracted with outside
providers.
 Service department charges are allocated to profit centers based on
the usage of the service by each profit center.
Service Department Charges
Nova Entertainment Group (NEG) has two operating divisions: Theme
Park Division and Movie Production Division. The revenues and
direct operating expenses for the two divisions are shown below.

 NEG’s service departments and the expenses they incurred for the
year ended December 31, 2012, are as follows:
Purchasing $400,000
Payroll Accounting 255,000
Legal 250,000
Total $905,000
 An activity base for each service department is used to charge service
department expenses to the Theme Park and Movie Production
divisions. The activity base for each service department is as follows:
Service Department Charges

Service
Service Usage—Purchasing
Usage—Purchasing
Theme Park Division 25,000 purchase requisitions
Movie Production Division 15,000
Total 40,000 purchase requisitions
$400,000
= $10 per purchase requisition
40,000 purchase
requisitions
Service Department Charges

Service
Service Usage—Payroll
Usage—Payroll Accounting
Accounting

Theme Park Division 12,000 payroll checks

Movie Production Division 3,000
Total 15,000 payroll checks
$255,000
= $17 per payroll check
15,000 payroll checks
Service Department Charges

Service
ServiceUsage—Legal
Usage—Legal

Theme Park Division 100 billed hours

Movie Production Division 900
Total 1,000 billed hours
$250,000
= $250 per hour
1,000 hours
Service Department Charges

Service Department Charge = Service Usage x Service Department Charge Rate

Illustration
 The centralized legal department of Johnson Company has
expenses of $60,000. The department has provided a total of
2,000 hours of service for the period.
The East Division has used 500 hours of legal service during the
period, and the West Division has used 1,500 hours.
How much should each division be charged for legal services?

 East Division Service Charge for Legal Department:

$15,000 = 500 billed hours X ($60,000/2,000 hours)
 West Division Service Charge for Legal Department:

$45,000 = 1,500 billed hours X ($60,000/2,000 hours)

Responsibility Report

 Budgeted and actual controllable revenues and costs are

compared over time
 Uses cost-volume-profit income statement format:
► Deduct controllable fixed costs from the contribution margin.
► Controllable margin - excess of contribution margin over
controllable fixed costs.
► Do not report noncontrollable fixed costs.
Rate of Return on Investment
 One measure that considers the amount of assets invested
in an investment center is the rate of return on investment
(ROI) or rate of return on assets. It is computed as
follows:

Income from Operations

ROI =
Invested Assets
 LO 4

Rate of Return on Investment

Dupont
Dupont Formula
Formula

Income from Operations Sales

ROI = x
Sales Invested Assets

Profit
ProfitMargin Investment
Margin InvestmentTurnover
Turnover
 LO 4

Rate of Return on Investment

 The profit margin and the investment turnover reflect the
following underlying operating relationships of each
division:
 Profit margin indicates operating profitability by computing
the rate of profit earned on each sales dollar.
 Investment turnover indicates operating efficiency by
computing the number of sales dollars generated by each dollar
of invested assets.
 LO 4
Residual Income
 Residual income is the excess of income from operations
over a minimum acceptable income from operations, as
shown below:
 LO 4

Residual Income
 The major advantage of residual income as a performance
measure is that it considers both the minimum acceptable
rate of return, invested assets, and the income from
operations for each division.
 Northern Central Southern
Profit Margin Division Division Division
Income from operations $ 70,000$ 84,000 $ 75,000
Revenues (Sales) $560,000$672,000$750,000
Profit margin 12.5%12.5%10.0%
Investment Turnover
Revenues (Sales) $560,000 $672,000 $750,000
Invested assets $350,000 $700,000 $500,000
Investment turnover 1.6 .96 1.5
Return on Investment (ROI)
Income from operations $ 70,000 $ 84,000 $ 75,000
Invested assets $350,000 $700,000 $500,000
Rate of return on investment 20% 12% 15%
 Minimum
Income Acceptable
from – Residual
Rate of =
Income
Operations Return on
Assets
 Baldwin Company
Divisional Income Statements
For the Year Ended December 31, 2006

Northern Central Southern

Division Division Division
Income from operations $70,000 $84,000 $75,000
Minimum acceptable income
from operations as a percent
of invested assets:
$350,000 x 10% 35,000
$700,000 x 10% 70,000
$500,000 x 10% 50,000
Residual income $35,000 $14,000 $25,000
 The
The balance
balance scorecard
scorecard isis aa set
set of
of
financial
financial and
and nonfinancial
nonfinancial measures
measures
that
that reflect
reflect multiple
multiple performance
performance
dimensions
dimensions of of aa business.
business.
Balance Score Innovation
Innovation and
and
Card Learning
Learning
•• R&D
R&Dinvestment
investment
•• R&D
R&Dpipeline
pipeline
•• Skills
Skillsand
andtraining
training
•• Time
Timeto tomarket
market

Customer
Customer Internal
•• Satisfaction
Satisfaction Process
•• Loyalty •• Efficiency
Efficiency
Loyalty
•• Perception •• Quality
Quality
Perception
•• Time
Time
Financial
Financial
•• ROI
ROI
•• Residual
Residualincome
income
•• Profit
Profit
•• Cost
Cost
•• Sales
Sales
 Transfer Pricing for Internal Sales

Vertically integrated companies

 Grow in either direction of its suppliers or its customers.
 Frequently transfer goods to other divisions as well as outside
customers.

How do
you price
goods
“sold”
within the
company?

LO 4
Transfer Pricing for Internal Sales

Transfer price - price used to record the transfer between two

divisions of a company.
 Ways to determine a transfer price:
1. Market-based transfer prices.

2. Negotiated transfer prices.

3. Cost-based transfer prices.

The objective of setting a transfer price is to motivate managers to
behave in a manner that will increase the overall company income.
Market-Based Transfer Prices

 The transfer price is the price at which the product or

service transferred could be sold to outside buyers.

 It is indifferent between selling internally and externally

if can charge/pay market price.

 Can lead to bad decisions if have excess capacity.

 Why?  No opportunity cost.

Market-Based Transfer Prices

Illustration:

Alberta Company makes rubber soles for work & hiking boots.
 Two Divisions:
► Sole Division - sells soles externally.
► Boot Division - makes leather uppers for hiking
boots which are attached to purchased soles.
 Division managers compensated on division profitability.
 Management now wants Sole Division to provide at least
some soles to the Boot Division.
Illustration (cont.)

If the transfer price is set at the market price that the Boot Division
purchases soles from an outside supplier $17

The manager of the Boot Division will be indifferent toward purchasing

materials from the Sole Division or from outside suppliers  They may
purchase the materials from outside suppliers
If the Boot Division purchases the materials from the Sole Division,
the difference between the market price of $17 and the variable costs of the
Sole Division of $11 per unit can cover fixed costs and contribute to overall
company profits.
Negotiated Transfer Prices

 The negotiated price approach allows the managers to

agree (negotiate) among themselves on a transfer price

 Negotiated price provides each division manager with

an incentive to negotiate the transfer of materials.

 The overall company’s income from operations will

also increase.

 The capacity and current production of the seller should

be considered
Illustration (cont.) - No Excess Capacity

 If Sole sells to Boot,

► payment must at least cover variable cost per unit plus
► its lost contribution margin per sole (opportunity cost).
 The minimum transfer price acceptable to Sole is:
Illustration (cont.) - No Excess Capacity

Maximum Boot Division will pay is

what the sole would cost from an outside buyer: $17
Illustration (cont.) - Excess Capacity

 Can produce 80,000 soles, but can sell only 70,000.

 Available capacity of 10,000 soles.
 Contribution margin of $7 per unit is not lost.
 Minimum transfer price acceptable to Sole:
Illustration (cont.) - Excess Capacity

Transfer price = $15

$11 < Negotiate a transfer price < $17

(minimum acceptable to Sole) (maximum acceptable to Boot)
 Illustration (cont.) - Excess Capacity
 Assume Sole Division provides 10,000 units to the Boot Division. Compute
the increase in Income from Operation for the Boot Division, the Sole
Division, and the company

 Increase in Sole (Supplying) = (Transfer Price - VC per Unit) x Units Transferred

= ($15 – $11) x 10,000 = $4,000

 Increase in Boot (Purchasing) = (Market Price - Transfer Price) x Units Transferred

= ($17 - $15) x 10,000 = $2,000

 Increase in the company = $4,000 + $2,000 = $6,000

 Any transfer price within the range will increase the overall income from operations
for the Company by $6,000. However, the increases in Boot and Sole divisions’
income from operations will vary depending on the transfer price. Why?
The clock division of Control Central Corporation manufactures clocks
and then sells them to customers for $10 per unit. Its variable cost is $4
per unit, and its fixed cost per unit is $2.50. Management would like the
clock division to transfer 8,000 of these clocks to another division within
the company at a price of $5. The clock division could avoid $0.50 per
clock of variable packaging costs by selling internally.
(a)Determine the minimum transfer price, assuming the clock
division is not operating at full capacity.

Opportunity cost + Variable cost = Minimum transfer price

$0 $3.50 $3.50
The clock division of Control Central Corporation manufactures
clocks and then sells them to customers for $10 per unit. Its
variable cost is $4 per unit, and its fixed cost per unit is $2.50.
Management would like the clock division to transfer 8,000 of
these clocks to another division within the company at a price of
$5. The clock division could avoid $0.50 per clock of variable
packaging costs by selling internally.
(b) Determine the minimum transfer price, assuming the
clock division is operating at full capacity.
Opportunity cost + Variable cost = Minimum transfer price
$6 $3.50 $9.50
Cost-Based Transfer Prices
 Uses costs incurred by the division producing the goods as its
foundation.
 A variety of costs may be used in this approach, including the
following:
 Total product cost per unit
 Variable product per unit

 If total product cost per unit is used, direct materials, direct

labor, and factory overhead are included in the transfer price.
 If variable product cost per unit is used, the fixed factory
overhead cost is excluded from the transfer price.
Illustration: Alberta Company requires the division to use a
transfer price based on the variable cost of the sole. With no
excess capacity, the contribution margins per unit for the two
divisions are:

Cost-based transfer price—10,000 units

LO 4
 Cost-based pricing is bad deal for Sole Division – no
profit on transfer of 10,000 soles to Boot Division and
loses profit of $70,000 on external sales.
 Boot Division is very happy; increases contribution
margin by $6 per sole.
 If Sole Division has excess capacity, the division reports
a zero profit on these 10,000 units and the Boot Division
gains $6 per unit.
 Overall, the Company is worse off by $60,000.

 Does not reflect the division’s true profitability nor provide

adequate incentive for the division to control costs.
Review Question

The Plastics Division of Weston Company manufactures plastic molds

and then sells them for $70 per unit.
Its variable cost is $30 per unit, and its fixed cost per unit is $10.
Management would like the Plastics Division to transfer 10,000 of these
molds to another division within the company at a price of $40.
The Plastics Division is operating at full capacity.
What is the minimum transfer price that the Plastics Division should
accept?

a. $10 c. $40
b. $30 d. $70

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