Cornerstones of Managerial Accounting 2e

Chapter Eleven
Performance Evaluation, Variable Costing, and Decentralization
Mowen/Hansen
Copyright 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Objective # 1

Explain how and why firms choose to decentralize.

Decentralization
Delegating decision-making authority Why firms decentralize: Ease of gathering and using local information
Central management may not understand local conditions

Focusing on central management from detailed operations to strategic planning Training and motivating of segment managers to prepare a new high-level managers Enhanced competition, exposing segments to market forces, which allow each unit to act as an autonomous business unit Achieved by creating Divisions
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Divisions Differentiated by:

Type of product or service provided Geographic lines Type of responsibility given to divisional manager
Responsibility Center is a segment of business whose manager is accountable for specified sets of activities

Types of Responsibility Centers

Cost center

Manager is responsible only for costs

Manager is responsible only for sales Manager is responsible for both revenues and costs Manager is responsible for revenues, costs, and investments

Revenue center

Profit center
Investment center

Measuring the Performance of Profit Centers

Preparation of segmented income statements Two methods of computing income:
Variable costing Full or Absorption costing

Methods often lead to different operating income figures

Objective # 2

Explain the difference between absorption and variable costing, and prepare segmented income statements.

Variable Costing Income Statement

Assigns only variable manufacturing costs to the product

Direct Materials Direct Labor Variable Overhead

Fixed overhead is treated as a period expense

Absorption Costing Income Statement

Assigns all manufacturing costs to the product
Direct Materials Direct Labor Variable Overhead Fixed Overhead

Fixed overhead is applied to the product using a predetermined overhead rate Required by generally accepted accounting principles (GAAP) for external reporting

Segmented Income Statements

Segment is a subunit of a company Divisions Departments Product lines Customer classes Fixed expenses are broken down into two categories: Direct fixed expenses
Directly traceable to a segment Jointly caused by two or more segments

Common fixed expenses

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Segment Margin
Sales

Variable Cost of Goods Sold

Variable Selling Expense Contribution Margin Direct fixed overhead Direct selling and administrative Segment Margin

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Objective # 3

Compute and explain return on investment.

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Return on Investment (ROI)

Formula: Operating Income Average Operating Assets

Earnings before income and taxes (EBIT)

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Return on Investment (ROI)

Formula: Operating Income Average Operating Assets

(Beginning assets + Ending assets) 2

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Return on Investment (ROI)

Alternative Formula:

Margin

Turnover

Operating Income Sales

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Return on Investment (ROI)

Alternative Formula:

Margin

Turnover

Sales Average Operating Assets

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Margin and Turnover

Margin
Ratio of operating income to sales Tells how many cents of operating income result from each dollar of sales Expresses the portion of sales that is available for interest, taxes, and profit

Turnover
Divides sales by average operating assets Tells how many dollars of sales result from every dollar invested in operating assets

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Advantages of ROI

Encourages managers to focus on

Relationship among:
Sales Expenses Investment

Cost efficiency Operating asset efficiency

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Disadvantages of ROI

Can produce a narrow focus on divisional profitability at the expense of profitability for the overall firm Encourages managers to focus on the short run at the expense of the long run

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Objective # 4

Compute and explain residual income and economic value added.

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Residual Income
Formula: Operating Income

Minimum rate of return x Average operating assets

Set by the company

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Residual Income
Formula: Operating Income

Minimum rate of return x Average operating assets

If residual income is less than zero, the company is earning less than the minimum rate of return

If residual income is exactly zero, the company is earning precisely the minimum rate of return
If residual income is greater than zero, the company is earning more than the minimum rate of return
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Advantages & Disadvantages of Residual Income

Advantages
It encourages managers to accept any project that earns about the minimum rate

Disadadvantages
Can encourage a short run orientation Residual income is an absolute measure of profitability
Direct comparison is difficult when level of investments differ

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Economic Value Added (EVA)

Formula: After-tax operating income Actual percentage cost of capital x Total capital employed

If EVA is positive then the company is creating wealth

If EVA is negative then the company is destroying wealth

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Advantages of EVA

Helps to encourage the right kind of behavior Relies on the true cost of capital Cost of capital is considered a corporate expense and is passed along to the overall income statement Makes investment seem free to the divisions so they want more

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Objective # 5

Explain the role of transfer pricing in a decentralized firm.

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Transfer Pricing

Price charged for a component by the selling division to the buying division of the same company Sale is a revenue to the selling division Sale is a cost to the buying division Transfer Pricing policies:
Market price Cost-based transfer pricing Negotiated transfer pricing

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Example
Transfer Pricing at a Negotiated Transfer Price: Minimum transfer price = $14 $3 = $11 This price is set by Alpha division (the selling division) Maximum transfer price = $14 This price is the market price and is set by Delta division (the buying division) Alpha and Delta will negotiate a price somewhere between $11 and $14
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