10-1

Division
Performance
Measurement

Chathuri
Chathuri Senarath
Senarath
 10-2

Decentralization
Decentralization
Decentralization
Decentralization
refers
refers to
to companies
companies
that
that give
give managers
managers
broad
broad authority.
authority.
 10-3

Some
Some Benefits
Benefits of
of
Decentralization
Decentralization
 Promotes better decision making
 Able to react quicker
 Increases motivation
 Prepares managers as future leaders
of the company
 10-4

Problems
Problems with
with Decentralization
Decentralization

 Managers operating in nearly autonomous

fashion might make decisions that harm the
company.
 Retailers are unhappy to buy from several
divisions, instead of one.
 10-5

Managerial
Managerial Accounting
Accounting Issues
Issues
Related
Related to
to Decentralization
Decentralization
 The need to develop methods of evaluating
performance that work to the benefit of the
company as a whole.
 The need to develop transfer prices that
produce decisions in the best interest of the
company.
 10-6

Measures
Measures of
of Performance
Performance
Three principal measures to measure
divisions:
• Income
• Return on Investment (ROI)
• Residual Income (RI)
 10-7

Measures
Measures of
of Performance
Performance
Reasons income is unsatisfactory for measuring the
performance of divisions:
 In calculating net income, companies subtract
interest and taxes, neither of which is normally
under the control of divisional managers.
 A division’s expenses usually include some
charges for services provided by central
headquarters.
Continued
Continued
 10-8

Measures
Measures of
of Performance
Performance
Reasons income is unsatisfactory for measuring the
performance of divisions:
 Factors that influence GAAP-based income do
not necessarily apply to internal reports.
 Income is not a comprehensive measure of
success.
 10-9

Return
Return on
on Investment
Investment
Divisional income
ROI =
Divisional investment
ROI
ROI isis the
the most
most frequently
frequently used
used criterion
criterion for
for
divisional
divisional performance
performance measurement.
measurement.
 10-10

Expanded
Expanded ROI
ROI Formula
Formula

Income Sales
ROI = x
Sales Investment

Return on sales Investment

(ROS) turnover
 10-11

ROI
ROI Example
Example
Rockwell (in million)
Income Sales
ROI = x
Sales Investment
$636 $7,151
ROI = x
$7,151 $6,390
ROI = 8.9% x 1.12

ROI = 10.0%
 10-12

Residual
Residual Income
Income
Residual income (RI) is the income a division produces in
excess of the minimum required rate of return.

RI = Income – (investment x target ROI)

The profit that must be

earned to satisfy the
minimum requirement
 10-13

A
A Residual
Residual Income
Income Example
Example
Division A produces $200,000 income on an investment of
$1,000,000, an ROI of 20 percent, while Division B earns
$1,500,000 on an investment of $10,000,000, an ROI of 15
percent.
Required ROI is 10%
Division A Division B
Investment $1,000,000 $10,000,000
Division income $ 200,000 $ 1,500,000
(Investment x
minimum ROI) 100,000 1,000,000
Residual income $ 100,000 $ 500,000
 10-14

A
A Residual
Residual Income
Income Example
Example
Division A produces $200,000 income on an investment of
$1,000,000, an ROI of 20 percent, while Division B earns
$1,500,000 on an investment of $10,000,000, an ROI of 15
percent.
Required ROI is 18%
Division A Division B
Investment $1,000,000 $10,000,000
Division income $ 200,000 $ 1,500,000
(Investment x
minimum ROI) 180,000 1,800,000
Residual income $ 20,000 $ (300,000 )
 10-15

ROI
ROI Versus
Versus RI
RI

Using ROI to evaluate

divisions can encourage
them to reject good
investments and accept
poor investments.
 10-16

ROI
ROI Versus
Versus RI
RI
Division Q Example
Divisional profit:
Current $300,000
From new project 75,000
Total divisional profit $375,000
Investment before new project $1,000,000
Additional investment for the
project 300,000
Total investment $1,300,000
($375,000 ÷ $1,300,000) 28.8%
 10-17

ROI
ROI Versus
Versus RI
RI
Division Q Example
Without
New Project
Divisional investment $1,000,000
Minimum required ROI 20%
Division profit $ 300,000
Less minimum required 200,000
Residual income $ 100,000
 10-18

ROI
ROI Versus
Versus RI
RI
Division Q Example
With New
Project
Divisional investment $1,300,000
Minimum required ROI 20%
Division profit $ 375,000
Less minimum required 260,000
Residual income $ 115,000
 10-19

ROI
ROI Versus
Versus RI
RI

The Manager of Division Z of the

same company expects income of
$200,000 on an investment of
$2,000,000 (10% ROI).
How would the manager
respond to an opportunity to
increase income $15,000 by
investing $100,000?
 10-20

ROI
ROI Versus
Versus RI
RI

$200,000 + $15,000 $215,000

New ROI = =
$2,000,000 + $100,000 $2,100,000

New ROI = 10.2%

The
The company
company should
should reject
reject the
the
investment,
investment, but
but the
the manager
manager will
will accept
accept
because
because divisional
divisional ROI
ROI increases.
increases.
 10-21

Investment
Investment
Bendan, Inc. (in millions of dollars)
Division
A B C Unallocated Total
Investment
Cash $ 20 $ 30 $ 60 $ 30 $ 140
Accounts receivable, net 60 80 90 230
Inventory 100 180 240 520
Prepaid expenses 10 10 20 20 60
Plant and equipment--
net of depreciation 200 320 440 60 1,020
Investments 10 --- --- 100 110
Total assets $400 $620 $850 $210 $2,080
Continued
Continued
 10-22

Investment
Investment
Bendan, Inc. (in millions of dollars)
Division
A B C Unallocated Total
Income
Sales $100 $400 $700 $1,200
Variable costs 30 220 400 650
Contribution margin $ 70 $180 $300 $ 550
Direct fixed costs 30 90 140 260
Divisional profit $ 40 $ 90 $160 $ 290
Common fixed costs 60
Income $ 230
 10-23

Investment
Investment
Bendan, Inc. (in millions of dollars)
Company as
A B C a Whole
Computation of ROI:
Profit of segment $ 40 $ 90 $160 $ 230
Investment in segment 400 620 850 2,080
ROI (profit/investment) 10 % 14.5 % 18.8 % 11.1 %
Computation of RI:
Profit of segment $ 40 $ 90 $160 $ 230
Required return (invest-
ment x minimum return
of 10%) 40 62 85 208
RI (profit – required return) $ 0 $ 28 $ 75 $ 22
 10-24

The
The Subject
Subject of
of Evaluation—
Evaluation—
Division
Division or
or Manager
Manager
 Internal ranking
 Historical comparisons
 Industry averages
 Budgets
 10-25

Transfer
Transfer Pricing
Pricing
Actual costs with or without a markup
Budgeted costs with or without a
markup
Market-based prices
Incremental cost
Negotiated prices
 10-26

Transfer
Transfer Pricing
Pricing
Actual Cost
These transfer prices are not wise because the
selling manager has no incentive to keep costs
down.
Worse, a price that is actual costs plus a percentage
markup gives the selling manager more profit the
higher costs go.
 10-27

Transfer
Transfer Pricing
Pricing
Budgeted Cost
This method does not reward the selling
manager if costs go up, and actually
encourages the selling manager to keep
costs down.
 10-28

Transfer
Transfer Pricing
Pricing
Market-Based Prices
This method is generally consider, the best.
The biggest problem is that an outside market
price may not exist.
The transfer price may be less than the market
price due to cost savings from selling internally.
 10-29

Transfer
Transfer Pricing
Pricing
Incremental Cost
Such prices are theoretically best from the
company’s viewpoint when the selling
division is operating below capacity.
Incremental cost can be as low as the variable
cost of the goods or services.
 10-30

Transfer
Transfer Pricing
Pricing
Negotiated Prices
This method allows managers to bargain with
each other and alleviates some problems that
arise with other methods.
The manager with the better negotiating skills
will tend to prevail.
 10-31

Multinational
Multinational Companies
Companies
Special
Special Problems
Problems
Evaluating performance
More complicated reporting needs
Currency translation problems
Little or no on-site supervision by the home-office
managers
Significant cultural and language barriers
Transfer pricing
Foreign taxes
Currency translation problems