18

Organizational
Design,
Responsibility
Accounting, and
Evaluation of
Divisional
Performance
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
18-2

Learning Objective 1
18-3

Decentralized Organizations
• Decentralization - assigning of specific
responsibilities to subunits of organizations.
• Goal congruence - when subunit managers in
the organization hold a common set of objectives.
• Individual goal congruence - when a
member’s personal goals are consistent with those
of the organization as a whole.
18-4

Goal Congruence and Performance

Measurement
Behavioral congruence - when individuals
behave in the best interest of the organization
regardless of their own goals.
It is best for all concerned if the
evaluation system used to
measure a manager’s
achievements result in at least
behavioral congruence (if not
goal congruence).
Example: Overall company
profitability.
18-5

Decentralized Organizations and

Responsibility Accounting
Responsibility accounting - a system
of internal reporting tailored to specific
organizational structures. It allows the
aggregation of cost, profit and/or returns
at the subunit levels, so that managers
responsible for achieving results at each
level can have their performance
evaluated more appropriately.
18-6

Centralization versus Decentralization

 Centralized  Decentralized
Decisions are handed Decisions are made at
down from the top divisional and
echelon of departmental levels.
management and
subordinates carry
them out.
18-7

Learning Objective 2
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Benefits of Decentralization
 Managers have specialized skills that permit
them to manage their departments most
effectively.
 Their resulting autonomy provides a training
opportunity for increased responsibility.
 Managers with such authority exhibit positive
motivation.
 Delegation of tasks lightens the time burden on
upper-level managers.
 It also encourages timely
responses to problem solving.
18-9

Costs of Decentralization
 Local managers may narrow their focus to their
own subunit’s performance.
 Local managers may make decisions that are not
congruent with the preferences of top
management.
 Some tasks or services may be duplicated among
the decentralized subunits.
18-10

Learning Objective 3
18-11

Responsibility Accounting
1. Cost centers - responsible for the cost of a well
defined activity.
2. Discretionary cost centers – responsible for the
cost of an activity that is not well defined.
3. Revenue center – responsible for revenue
attributed to the subunit.
4. Profit center – responsible for profit of a subunit.
5. Investment center – responsible for profit and the
invested capital of a subunit.
18-12

Learning Objective 4
18-13

Performance Reports
Shows the budgeted and actual amounts of key financial results
tailored to the objectives of specific responsibility centers.
Cost Total
formula fixed
per hour costs Budget Actual Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed expenses
Depreciation $ 12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,000 0
Total fixed costs $ 14,000 $ 14,000 0
Total overhead costs $ 74,000 $ 77,300 $ 3,300 U
18-14

Performance Reports
Shows the budgeted and actual amounts of key financial results
tailored to the objectives of specific responsibility centers.
Management by exception means that
managers follow up on only the most significant
variances betweenCostbudgeted
Totaland actual results.
formula fixed
per hour costs Budget Actual Variances
Machine hours 8,000 8,000 0
Variable costs
Indirect labor $ 4.00 $ 32,000 $ 34,000 $ 2,000 U
Indirect material 3.00 24,000 25,500 1,500 U
Power 0.50 4,000 3,800 200 F
Total variable costs $ 7.50 $ 60,000 $ 63,300 $ 3,300 U
Fixed expenses
Depreciation $12,000 $ 12,000 $ 12,000 0
Insurance 2,000 2,000 2,000 0
Total fixed costs $ 14,000 $ 14,000 0
Total overhead costs $ 74,000 $ 77,300 $ 3,300 U
18-15

Budgets, Variance Analysis and

Responsibility Accounting

The flexible budget provides the

benchmark against which actual
revenues, expenses and profits are
compared.
18-16

Activity-Based Responsibility
Accounting
Activity-based costing systems associate costs
with the activities that drive those costs.
The database created by an ABC system,
coupled with nonfinancial measures of
operational performance for each activity,
enables management to employ activity-based
responsibility accounting.
18-17

How Responsibility Accounting

Affects Behavior
Exchange information or assign blame?
The system should identify the individual in the
organization who is in the best position to explain
each particular event or financial result.
Can you help me
Sure, I’ll be glad to understand the
give you my input unfavorable
about the variance. cost variance?
18-18

Learning Objective 5
18-19

Performance Measurement in
Investment Centers
Return on Investment (ROI) is the ratio of
profits to investment in the assets that
generate those profits.

Income
ROI =
Invested capital
18-20

Performance Measurement in
Investment Centers
Income
ROI =
Invested capital
or
Income Sales revenue
ROI = ×
Sales revenue Invested capital
18-21

Return on Investment

The management of Matrix, Inc. is evaluating

two investment proposals.
1. Project A will generate $150,000 in operating
profits and require an investment of $600,000.
2. Project B will generate operating profits of
$500,000 and will require an investment of
$2,500,000.

Let’s calculate the ROI for these two projects.

18-22

Return on Investment
If we can invest in only one project,
we would select Project A. It has
a higher ROI.

Investments
Project A Project B
Income 150,000 500,000
Invested capital 600,000 2,500,000
ROI 25% 20%

$150,000 ÷ $600,000 = 25% ROI

18-23

Return on Investment
Matrix, Inc. provides the projected income statement
for its investment in Project A.
Matrix, Inc.
Income Statement
For the year ended 12/31/x1
Sales revenue $ 300,000
Cost of goods sold 100,000
Gross margin 200,000
Operating expenses 50,000
Net income $ 150,000

Income Sales revenue

× = ROI
Sales revenue Invested capital
$150,000 $300,000
× = ROI
$300,000 $600,000

50% × 50% = 25%

18-24

Learning Objective 6
18-25

Improving a Division’s ROI

Decrease costs
while maintaining
the same sales level.

Increase sales Decrease invested

revenue with no capital with no
change in costs. change in income.

Caveat:
None of these are
easy to achieve!
18-26

Residual Income as a Performance

Measure
Residual income is defined as . . .
Investment Investment Imputed
center’s – center’s × interest
profits invested capital rate

The imputed interest rate should be the rate of return

on investments of similar risk that are being forgone.
18-27

Residual Income as a Performance

Measure
Using our original investment proposals and a
imputed interest rate of 15%, let’s calculate the
residual income.
Investments
Project A Project B
Invested capital $ 600,000 $ 2,500,000
Imputed rate 15% 15%
Imputed interest charge 90,000 375,000
Income 150,000 750,000
Residual income $ 60,000 $ 375,000
This time Project B looks much better.
18-28

Learning Objective 7
18-29

Comparing ROI and Residual Income

ROI Residual Income
 Advantage: It uses  Advantage: It facilitates
percentages, which goal congruence with
allow easy comparison its required rate of
with required returns. return
 Disadvantage: Value of  Disadvantage: It is
invested capital is biased in favor of larger
measured in dollars of companies because it
different purchasing shows dollar results.
power.

Solution: Use both in evaluating investments.

18-30

Economic Value Added (EVA) as a

Performance Measure
All capital - debt or equity - has a cost.
 Cost of debt is equal to the interest payments
made on the debt.
 Cost of equity is the return the shareholders
could obtain in price appreciation and
dividends if they invested in a portfolio of
companies about as risky as yours.
18-31

Economic Value Added (EVA)

Investment Investment Investment Weighted-

center’s after- center’s center’s average
EVA = tax operating – – ×
total current cost of
profit assets liabilities capital

Investment center current liabilities

are subtracted from its total assets.
18-32

Weighted-Average Cost of Capital

Cost of capital is the weighted average combination
of the cost of debt and equity (WACC).

After-tax Market Cost Market

Weighted- cost of × value of + of × value of
average debt debt equity equity
cost of = Market Market
capital value of x value of
debt equity
18-33

Learning Objective 8
18-34

Measuring Investment Capital

Three issues must be considered before we can
properly measure the investment capital.

1. Which asset value should be included in invested

capital?
2. Should the assets be shown at historical or
current cost?
3. Should we measure the investment at the
beginning or end of period amount?
18-35

Gross or Net Book Value

Matrix, Inc. is considering an investment that is projected to
produce operating profits of $25,000 before depreciation
for the next three years.
 At the beginning of the first year Matrix will invest $100,000
in an asset that has a ten-year life and no salvage value.
Straight-line depreciation is used.
 Matrix calculates ROI based on end-of-year asset values.

Let’s calculate ROI using both the gross and net book values.
18-36

Gross or Net Book Value

Profits Gross Net

Depreciation Operating
Year before book book
expense profits
depreciation value value
1 $ 25,000 $ 10,000 $ 15,000 $ 100,000 $ 90,000
2 25,000 10,000 15,000 100,000 80,000
3 25,000 10,000 15,000 100,000 70,000

($100,000 – $0) ÷ 10 = $10,000 per year

$100,000 – $10,000 = $90,000 book value

18-37

Gross or Net Book Value

Net Gross
Net book
Year operating ROI book ROI
value
profits value
1 $ 15,000 $ 90,000 16.67% $ 100,000 15.00%
2 15,000 80,000 18.75% 100,000 15.00%
3 15,000 70,000 21.43% 100,000 15.00%

The ROI increases each year under the net

$15,000 ÷ $90,000 = 16.67%
book value method even though no
operating$15,000
changes take place.
÷ $100,000 = 15%
18-38

Current Value versus Historical-Cost

Accounting
Our previous example assumed no inflation.

Let’s work with the same information and

assume that the current replacement cost of
the asset and profits before depreciation
increase by 6% per year.
18-39

Historical Cost versus Current Cost

Profits
Depreciation Operating Net book
Year before
expense profits value
depreciation
1 $ 25,000 $ 10,000 $ 15,000 $ 90,000
2 26,500 10,000 16,500 80,000
3 28,090 10,000 18,090 70,000

$25,000 × 1.06 = $26,500

18-40

Historical Cost versus Current Cost

Profits
Depreciation Operating Net book
Year before
expense profits value
depreciation
1 $ 25,000 $ 10,000 $ 15,000 $ 90,000
2 26,500 10,000 16,500 80,000
3 28,090 10,000 18,090 70,000

Using historical cost and net book value,

our ROI would be:
Net
Net book
Year operating ROI
value
profits
1 $ 15,000 $ 90,000 16.67%
2 16,500 80,000 20.63%
3 18,090 70,000 25.84%
18-41

Historical Cost versus Current Cost

Using current cost values, net operating profit would be:
Asset Net
Profit before Depreciation
Year replacement operating
depreciation expense
cost profit
1 $ 25,000 $ 106,000 $ 10,000 $ 15,000
2 26,500 112,360 10,600 15,900
3 28,090 119,102 11,236 16,854

And ROI would be:

Net
Current
Year operating ROI
cost
profit
1 $ 15,000 $ 106,000 14.15%
2 15,900 112,360 14.15%
3 16,854 119,102 14.15%
18-42

Beginning, Ending or Average Balance

If I purchase the asset
early in the year, it will boost
income for the entire year and
impact ROI.

Using the average investment

base provides acceptable
results and discourages
inappropriate investment
decisions.
18-43

Return on Investment
Allowing for the many possible
variations of its components, ROI is
the most commonly used measure of
business-unit performance.
18-44

Nonfinancial Performance Measures

The use of nonfinancial measures of
performance in incentive plans is increasing.
These measures help managers . . .
1. Focus on the drivers of profit, and
2. Recognize the time lags between nonfinancial
and financial performance.
18-45

Performance Measurement in
Nonprofit Organizations
The goals of nonprofit organizations frequently are
less clear-cut than those of for-profit enterprises.
It may be difficult to have people within nonprofit
organizations submit to the same types of
controls as are often found in the business
environment.
18-46

End of Chapter 18