Transcript 10-1 Division Performance Measurement Prepared by Douglas Cloud Pepperdine University 10-2 Objectives  Explain some of the advantages and reading this disadvantagesAfter of decentralization. chapter, you should  Describe the commonly used measures.

10-1
Division
Performance
Measurement
Prepared by
Douglas Cloud
Pepperdine University
10-2
Objectives
 Explain some of the advantages and
reading this
disadvantagesAfter
of decentralization.
chapter, you should
 Describe the commonly used measures of
be able to:
evaluating the performances of investment
centers and their managers.
 Describe how performance evaluation
methods can encourage managers to act
against the best interests of the company.
Continued
10-3
Objectives
 Describe variations in measuring income and
investments.
 Explain how evaluating a division is different
from evaluating the manager of the division.
 Explain the problems in developing transfer
pricing policies.
 Describe performance evaluation problems
specific to multinational companies.
10-4
Decentralization
Decentralization
refers to companies
that give managers
broad authority.
10-5
Some Benefits of
Decentralization
 Promotes better decision making
 Able to react quicker
 Increases motivation
 Prepares managers as future leaders
of the company
10-6
Problems with 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.
10-7
Managerial Accounting Issues
Related to 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.
10-8
Measures of Performance
Three principal measures to measure
divisions:
• Income
• Return on Investment (ROI)
• Residual Income (RI)
10-9
Measures of 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
10-10
Measures of 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.
10-11
Return on Investment
Divisional income
ROI =
Divisional investment
ROI is the most frequently used criterion for
divisional performance measurement.
10-12
Expanded ROI Formula
ROI =
Income
x
Sales
Sales
Investment
Return on sales
(ROS)
Investment
turnover
10-13
ROI Example
Rockwell (in million)
Income
ROI =
Sales
$636
ROI =
$7,151
ROI =
8.9%
ROI =
10.0%
x
x
x
Sales
Investment
$7,151
$6,390
1.12
10-14
Residual 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
10-15
A Residual Income 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%
Investment
Division income
(Investment x
minimum ROI)
Residual income
Division A
$1,000,000
$ 200,000
Division B
$10,000,000
$ 1,500,000
100,000
$ 100,000
1,000,000
$ 500,000
10-16
A Residual Income 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%
Investment
Division income
(Investment x
minimum ROI)
Residual income
Division A
$1,000,000
$ 200,000
Division B
$10,000,000
$ 1,500,000
180,000
$ 20,000
1,800,000
$ (300,000 )
10-17
ROI Versus RI
Using ROI to evaluate
divisions can encourage
them to reject good
investments and accept
poor investments.
10-18
ROI Versus RI
Division Q Example
Divisional profit:
Current
From new project
Total divisional profit
$300,000
75,000
$375,000
Investment before new project
Additional investment for the
project
Total investment
$1,000,000
($375,000 ÷ $1,300,000)
28.8%
300,000
$1,300,000
10-19
ROI Versus RI
Division Q Example
Without
New Project
Divisional investment
Minimum required ROI
Division profit
Less minimum required
Residual income
$1,000,000
20%
$ 300,000
200,000
$ 100,000
10-20
ROI Versus RI
Division Q Example
With New
Project
Divisional investment
Minimum required ROI
Division profit
Less minimum required
Residual income
$1,300,000
20%
$ 375,000
260,000
$ 115,000
10-21
ROI Versus 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?
10-22
ROI Versus RI
New ROI =
$200,000 + $15,000
$2,000,000 + $100,000
=
$215,000
$2,100,000
New ROI = 10.2%
The company should reject the
investment, but the manager will accept
because divisional ROI increases.
10-23
Investment
Bendan, Inc. (in millions of dollars)
Division
A
B
C Unallocated Total
Investment
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Plant and equipment-net of depreciation
Investments
Total assets
$ 20 $ 30 $ 60
60
80
90
100 180 240
10
10
20
$ 30
20
$ 140
230
520
60
200 320 440
10
----$400 $620 $850
60
100
$210
1,020
110
$2,080
Continued
10-24
Investment
Bendan, Inc. (in millions of dollars)
Division
A
B
C Unallocated Total
Income
Sales
Variable costs
Contribution margin
Direct fixed costs
Divisional profit
Common fixed costs
Income
$100 $400 $700
30 220 400
$ 70 $180 $300
30
90 140
$ 40 $ 90 $160
$1,200
650
$ 550
260
$ 290
60
$ 230
10-25
Investment
Bendan, Inc. (in millions of dollars)
Company as
a Whole
A
B
C
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 (investment x minimum return
of 10%)
40
62
85
208
RI (profit – required return) $ 0 $ 28 $ 75
$ 22
10-26
Investment
Bendan, Inc. (in millions of dollars)
Company as
a Whole
A
B
C
Computation of ROI:
Profit of segment
$ 40
$ 90 $160
$ 230
Total assets
$400
$620 $850
$2,080
Divisional liabilities
60
170
310
540
Divisional investment
$340
$450 $540
$1,540
Unallocated liabilities
730
Total investment
$340
$450 $540
$ 810
ROI
11.8% 20.0% 29.6%
Continued
28.4%
10-27
Investment
Bendan, Inc. (in millions of dollars)
Company as
a Whole
A
B
C
Computation of RI:
Profit of segment
$40
$ 90 $160
$ 230
Required return (investment x minimum return
of 10%)
34
45
54
81
RI
$6
$45 $106
$149
10-28
The Subject of Evaluation—
Division or Manager
 Internal ranking
 Historical comparisons
 Industry averages
 Budgets
10-29
Transfer Pricing
Actual costs with or without a
markup
Budgeted costs with or without a
markup
Market-based prices
Incremental cost
Negotiated prices
10-30
Transfer 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.
10-31
Transfer 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.
10-32
Transfer 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.
10-33
Transfer 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.
10-34
Transfer 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.
10-35
Multinational Companies
Special 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
10-36
Chapter 10
The End
10-37