Transcript ACC423: Mgt Acctg II DECENTRALIZATION AND PERFORMANCE MEASUREMENT By: E. P. Enyi, Ph.D, MBA, ACA, FAAFM, RFS, MFP, FIIA Head, Dept of Accounting, Covenant University, Ota, Nigeria.

ACC423: Mgt Acctg II
DECENTRALIZATION AND
PERFORMANCE
MEASUREMENT
By:
E. P. Enyi, Ph.D, MBA, ACA, FAAFM, RFS, MFP, FIIA
Head, Dept of Accounting, Covenant University,
Ota, Nigeria
DECENTRALIZATION
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Decentralization is the breaking down of the decision making process of an
organization into smaller semi-autonomous decision units such as cost
centers. It is the transfer of decision making from top management to lower
level management.
Total decentralization (where such exists) means minimum constraints and
maximum freedom for managers at the lower levels of an organization to
make decisions. Total centralization is the opposite. Most organizational
structures fall somewhere between the two extremes (Horngren, Bhimani,
Datar & Forster, 2005).
The essence of decentralization is the freedom for managers at lower levels
of the organization to make decisions.
BENEFITS OF DECENTRALIZATION
The following benefits are attributable to decentralization:
1. Creates greater responsiveness to local needs in terms of better information
about customers, competitors, suppliers, employees and factors that affect
performances;
2. Leads to quicker decision making as layer after layer of management control
is avoided in simple decisions requiring quick response.
3. Increases motivation as subunit managers are usually more highly motivated
when they can exercise greater individual initiative.
4. Aids management development and learning
5. Sharpens the focus managers as this is more concentrated on a smaller area
than a larger group.
DEMERITS OF DECENTRALIZATION
The following disadvantages are ascribed to over-decentralization of activities and
decision making in an organization:
1. It leads to suboptimal (or incongruent) decision making which arises when a
decision’s benefit to one subunit is more than offset by the costs or loss of
benefits to the organization as a whole.
2. Results in duplication of activities.
3. Focuses managers attention on the subunit rather than the organization as a
whole.
4. Increases costs of gathering information as a result maintaining independent
data bases for internal transfer pricing purposes.
TYPES OF DECENTRALIZATION
An organization may want to implement one of the following four types of
decentralization:
COST CENTRE
A cost-centre is a division which management is given the responsibility as to the
generation of costs only.
REVENUE CENTRE
A revenue centre is a division which management is given the responsibility for the
collection of revenue only.
PROFIT CENTRE
A profit centre is a division which management is given the responsibility to
generate both revenue and costs.
INVESTMENT CENTRE
This is a division which management is given the responsibility to invest in capital
projects and generate costs and revenue without recourse to the head office. This
is usually the case of local branches of multi-national companies.
DIVISIONAL PERFORMANCE EVALUATION
One of the major advantages of decentralization is the possibility of measuring the
individual abilities of the various divisional managers through the comparison of
their divisional performance with those of others as well as with the over-all
organizational performance.
There are two main methods measuring divisional performances; these are:
RETURN ON INVESTMENT (ROI)
Where the division takes the garb of an investment centre, the ROI method can
be employed in the performance evaluation. However, it must be pointed out here
that the ROI is not a very good measure of divisional managers’ performance as it
can lead to sub-optimal decision; instead, the residual income approach is
preferred. The ROI is measured as net income divided by the capital invested
(i.e. Net-Income / Capital Invested).
RESIDUAL INCOME
The residual income approach is used to more critically evaluate divisional
performance. It is defined as the controllable profit of a division, less the cost of
capital charged on controllable investment.
EXAMPLE:
NUASA Ltd., has two divisions, A and B. A summary of the annual reports from
the two divisions for the past year is given below. Given that the company’s cost of
capital is 12% per annum, appraise the two divisions and identify the most
profitable of the two.
Division A
Division B
N
N
240,000
400,000
Capital Invested
Turnover
765,000
Operating Costs
912,000
717,000
840,000
SOLUTION
Turnover
765,000
Less: Operating Costs
NET INCOME
Return On Investment
912,000
717,000
840,000
48,000
72,000
48/240 = 20%
72/400 = 18%
Using the ROI approach, division A seems to be more profitable.
Using the Residual Income Approach:
Division A
Division B
N
N
`
NET INCOME (Controllable Profit)
48,000
72,000
Less: Interest On Invested Capital @ 12%
28,800
48,000
RESIDUAL INCOME
19,200
24,000
NOTE
Invested Capital is 240,000 for A and 400,000 for B.
Conclusion
Though the two measures of performance produced rational bases for performance
evaluation, the ROI which is a relative measure tends to suggest that division A
performed better than B relative to the resources employed but the Residual Income
which is a more absolute measure states that division B brings in more money into
the organization than A.
There are other methods of measuring divisional performance and these are covered
under transfer pricing.