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Chapter 9: Performance Measurement In Decentralized Organizations
Managers In Large Organizations Have To Delegate Some Decisions To Those Who Are At Lower Levels
In The Organization.
This Chapter Explains How Responsibility Accounting Systems, Return On Investment (ROI), Residual
Income, Operating Performance Measures, And The Balanced Scorecard Are Used To Help Control
Decentralized Organizations.
A Decentralized Organization Does Not Confine
Decision-Making Authority To A Few Top Executives; Rather, Decision-Making Authority Is Spread
Throughout The Organization.
The Advantages Of Decentralization Are As Follows:
It Enables Top Management To Concentrate On Strategy, Higher-Level Decision-Making, And
Coordinating Activities.
It Acknowledges That Lower-Level Managers Have More Detailed Information About Local
Conditions That Enable Them To Make Better Operational Decisions.
It Enables Lower-Level Managers To Quickly Respond To Customers.
It Provides Lower-Level Managers With The Decision-Making Experience They Will Need
When Promoted To Higher-Level Positions.
It Often Increases Motivation, Resulting In Increased Job Satisfaction And Retention,
As Well As Improved Performance. The Disadvantages Of Decentralization Are
As Follows:
Lower-Level Managers May Make Decisions Without Fully Understanding The "Big Picture."
There May Be A Lack Of Coordination Among Autonomous Managers. The Balanced Scorecard
Can Help Reduce This Problem By Communicating A Company's Strategy Throughout The Organization.
Lower-Level Managers May Have Objectives That Differ From Those Of The Entire Organization.
This Problem Can Be Reduced By Designing Performance Evaluation Systems That Motivate Managers
To Make Decisions Which Are In The Best Interests Of The Company.
It May Be Difficult To Effectively Spread Innovative Ideas In A Strongly Decentralized
Organization. This Problem Can Be Reduced Through The Effective Use Of Intranet Systems,
That Enable Globally Dispersed Employees To Electronically Share Ideas.
Responsibility Accounting Systems Link Lower-Level Managers' Decision-Making Authority With Accountability
For The Outcomes Of Those Decisions.
The Term Responsibility Center Is Used For Any Part Of An Organization Whose Manager
Has Control Over, And Is Accountable For Cost, Profit, Or Investments.
The Three Primary Types Of Responsibility Centers Are Cost Centers, Profit Centers,
And Investment Centers.
The Manager Of A Cost Center Has Control Over Costs, But Not Over Revenue Or Investment
Funds.
Service Departments Such As Accounting, General Administration, Legal, And Personnel Are Usually
Classified As Cost Centers, As Are Manufacturing Facilities.
Standard Cost Variances And Flexible Budget Variances, Such As Those Discussed In An Earlier
Chapter, Are Often Used To Evaluate Cost Center Performance.
The Manager Of A Profit Center Has Control Over Both Costs And Revenue.
Profit Center Managers Are Often Evaluated By Comparing Actual Profit To Targeted Or
Budgeted Profit.
An Example Of A Profit Center Is A Company's Cafeteria.
The Manager Of An Investment Center Has Control Over Cost, Revenue, And Investments In Operating
Assets.
Investment Center Managers Are Often Evaluated Using Return On Investment (ROI) Or Residual
Income (Discussed Later In This Chapter).
An Example Of An Investment Center Would Be The Corporate Headquarters.
Learning Objective 1: Compute Return On Investment (ROI) And Show How Changes In Sales, Expenses,
And Assets Affect ROI.
An Investment Center's Performance Is Often
Evaluated Using A Measure Called Return On Investment (ROI).
ROI Is Defined As Net Operating Income Divided By Average Operating Assets.
Net Operating Income Is Income Before Taxes And Is Sometimes Referred To As Earnings Before
Interest And Taxes (EBIT).
Operating Assets Include Cash, Accounts Receivable, Inventory, Plant And Equipment, And All Other
Assets Held For Operating Purposes.
Net Operating Income Is Used In The Numerator Because The Denominator Consists Only Of Operating
Assets.
The Operating Asset Base Used In The Formula Is Typically Computed As The Average Of The
Operating Assets (Beginning Assets + Ending Assets/2).
Most Companies Use The Net Book Value (I.E., Acquisition Cost Less Accumulated Depreciation)
Of Depreciable Assets To Calculate Average Operating Assets.
With This Approach, ROI Mechanically Increases Over Time As The Accumulated Depreciation
Increases.
Replacing A Fully Depreciated Asset With A New Asset Will Decrease ROI.
An Alternative To Using Net Book Value Is The Use Of The Gross Cost Of The Asset, Which
Ignores Accumulated Depreciation.
With This Approach, ROI Does Not Grow Automatically Over Time, Rather It Stays Constant; Thus,
Replacing A Fully Depreciated Asset Does Not Adversely Affect ROI.
Dupont Pioneered The Use Of ROI And Recognized The Importance Of Looking At The Components
Of ROI, Namely Margin And Turnover.
Margin Is Computed As Shown And Is Improved By Increasing Sales Or Reducing Operating
Expenses.
The Lower The Operating Expenses Per Dollar Of Sales, The Higher The Margin Earned.
Turnover Is Computed As Shown.
It Incorporates A Crucial Area Of A Manager's Responsibility -- The Investment In Operating
Assets.
Excessive Funds Tied Up In Operating Assets Depress Turnover And Lower ROI.
Assume That Regal Company Reports Net Operating Income Of $30,000; Average Operating Assets
Of $200,000; Sales Of $500,000; And Operating Expenses Of $470,000.
What Is Regal Company's ROI?
Given This Information, Its Current ROI Is 15%.
The Fourth Way To Increase ROI Is To Invest In Operating Assets To Increase Sales.
Assume That Regal's Manager Invests $30,000 In A Piece Of Equipment That Increases Sales
By $35,000 While Increasing Operating Expenses By $15,000.
Let's Calculate The New ROI.
In This Case, The ROI Increases From 15% To 21.8%.
Just Telling Managers To Increase ROI May
Not Be Enough.
Managers May Not Know How To Increase ROI In A Manner That Is Consistent With The Company's
Strategy.
This Is Why ROI Is Best Used As Part Of A Balanced Scorecard.
A Manager Who Takes Over A Business Segment Typically Inherits Many Committed Costs Over
Which The Manager Has No Control.
This May Make It Difficult To Assess This Manager Relative To Other Managers.
A Manager Who Is Evaluated Based On ROI May Reject Investment Opportunities That Are Profitable
For The Whole Company But That Would Have A Negative Impact On The Manager's Performance
Evaluation.
Learning Objective Number 2 Is To Compute Residual Income And Understand Its Strengths
And Weaknesses.
Residual Income Is The Net Operating Income That An Investment Center Earns Above The
Minimum Required Return On Its Assets.
Economic Value Added (EVA) Is An Adaptation Of Residual Income.
We Will Not Distinguish Between The Two Terms In This Class.
The Equation For Computing Residual Income Is As Shown.
Notice That This Computation Differs From ROI.
ROI Measures Net Operating Income Earned Relative To The Investment In Average Operating Assets.
Residual Income Measures Net Operating Income Earned Less The Minimum Required Return On
Average Operating Assets.
Assume The Information For A Division Of Zephyr, Inc., Is As Follows.
The Retail Division Of Zephyr, Inc., Has Average Operating Assets Of $100,000 And Is Required
To Earn A Return Of 20% On These Assets.
In The Current Period, The Division Earns $30,000.
Let's Calculate Residual Income.
The Residual Income Of $10,000 Is Computed By Subtracting The Minimum Required Return
Of $20,000 From The Actual Income Of $30,000.
The Residual Income Approach Encourages Managers To Make Investments That Are Profitable For
The Entire Company But That Would Be Rejected By Managers Who Are Evaluated Using The ROI
Formula.
It Motivates Managers To Pursue Investments Where The ROI Associated With Those Investments
Exceeds The Company's Minimum Required Return But Is Less Than The ROI Being Earned By The
Managers.
Redmond Awnings, A Division Of Wrap-Up Corp., Has A Net Operating Income Of $60,000 And
Average Operating Assets Of $300,000.
The Required Rate Of Return For The Company Is 15%. What Is The Division's ROI?
The ROI Is 20%.
If The Manager Of The Division Is Evaluated Based On ROI, Will She Want To Make An Investment
Of $100,000 That Would Generate Additional Net Operating Income Of $18,000 Per Year?
No, She Would Not Want To Invest In This Project Because Its Return Is 18%, Which Would Reduce
Her Division's ROI From 20% To 19.5%.
The Company's Required Rate Of Return Is 15 Percent.
Would The Company Want The Manager Of The Redmond Awnings Division To Make An Investment
Of $100,000 That Would Generate Additional Net Operating Income Of $18,000 Per Year?
Yes, She Would Want To Invest In This Project Because The Return On The Investment Exceeds
The Minimum Required Rate Of Return.
Review This Question.
What Is The Division's Residual Income?
The Residual Income Is $15,000.
If The Manager Of The Redmond Awnings Division Is Evaluated Based On Residual Income, Will
She Want To Make An Investment Of $100,000 That Would Generate Additional Net Operating
Income Of $18,000 Per Year?
Yes, She Would Want To Invest In This Project Because It Will Increase The Residual Income
By $3,000.
The Residual Income Approach Has One Major Disadvantage.
It Cannot Be Used To Compare The Performance Of Divisions Of Different Sizes.
Recall That The Retail Division Of Zephyr Had Average Operating Assets Of $100,000,
A Minimum Required Rate Of Return Of 20%, Net Operating Income Of $30,000, And Residual
Income Of $10,000.
Assume That The Wholesale Division Of Zephyr Had Average Operating Assets Of $1,000,000,
A Minimum Required Rate Of Return Of 20%, Net Operating Income Of $220,000, And Residual
Income Of $20,000.
The Residual Income Numbers Suggest That The Wholesale Division Outperformed The Retail
Division Because Its Residual Income Is $10,000 Higher.
However, The Retail Division Earned An ROI Of 30% Compared To An ROI Of 22% For The Wholesale
Division.
The Wholesale Division's Residual Income Is Larger Than The Retail Division Simply Because
It Is A Bigger Division.