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CHAPTER 12: PERFORMANCE EVALUATION AND DECENTRALIZATION Cornerstones of Managerial Accounting, 6e © 2016 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. Decentralization and Responsibility Centers A company is organized along lines of responsibility. Most companies use a more flattened hierarchy that emphasizes teams. Firms with multiple responsibility centers choose one of two decision-making approaches to manage their diverse and complex activities: centralized or decentralized. LO-1 © 2016 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. Decentralization and Responsibility Centers (cont.) In centralized decision making, decisions are made at the very top level, and lower level managers are charged with implementing these decisions. Allows managers at lower levels to make and implement key decisions pertaining to their areas of responsibility. Delegating decision-making authority to the lower levels of management in a company is called decentralization. LO-1 © 2016 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. Centralization and Decentralization LO-1 © 2016 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. 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 LO-1 © 2016 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. 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. 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 LO-1 © 2016 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. 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 computed as follows: Operating income ÷ Average Operating Assets LO-2 © 2016 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. Return on Investment (cont.) 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 © 2016 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. Margin and Turnover A second way to calculate ROI is to separate the formula into margin and turnover: Operating income ÷ Average operating assets Margin is the ratio of operating income to sales. 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. LO-2 © 2016 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. Margin and Turnover (cont.) The equation that yields ROI from the Margin and Turnover is as follows: Margin: ROI = Operating Income X Sales Turnover: 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. LO-2 © 2016 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. Average Operating Assets, Margin, Turnover, and Return on Investment LO-2 © 2016 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. Advantages of Return on 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. Managers focus on cost efficiency. It encourages managers to focus on operating asset efficiency. LO-2 © 2016 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. Disadvantages of the 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. LO-2 © 2016 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. Residual Income Companies have adopted alternative performance measures such as residual income. ROI can discourage investments that are profitable for a company but lowers a division’s ROI 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) LO-3 © 2016 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. Calculating Residual Income LO-3 © 2016 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.