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10-1

10

Division
Performance
Measurement
Prepared
Preparedby
by

Douglas
DouglasCloud
Cloud

Pepperdine
PepperdineUniversity
University

10-2

Objectives
Objectives
Explain some of the advantages and
After
reading
this
After
reading
this
disadvantages of decentralization.
you
should
chapter,
you
should
Describe thechapter,
commonly used
measures of
be
able
to:
be
able
to: of investment
evaluating the performances
centers and their managers.
Describe how performance evaluation
methods can encourage managers to act
against the best interests of the company.
Continued
Continued

10-3

Objectives
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
Decentralization
Decentralization
refers
refers to
to companies
companies
that
that give
give managers
managers
broad
broad authority.
authority.

10-5

Some
Some Benefits
Benefits of
of
Decentralization
Decentralization
Promotes better decision making
Able to react quicker
Increases motivation
Prepares managers as future leaders
of the company

10-6

Problems
Problems with
with Decentralization
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
Managerial Accounting
Accounting Issues
Issues
Related
Related to
to Decentralization
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
Measures of
of Performance
Performance
Three principal measures to measure
divisions:
Income
Return on Investment (ROI)
Residual Income (RI)

10-9

Measures
Measures of
of Performance
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 divisions expenses usually include some
charges for services provided by central
headquarters.
Continued
Continued

10-10

Measures
Measures of
of Performance
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
Return on
on Investment
Investment
Divisional income
ROI =
Divisional investment
ROI
ROI isis the
the most
most frequently
frequently used
used criterion
criterion for
for
divisional
divisional performance
performance measurement.
measurement.

10-12

Expanded
Expanded ROI
ROI Formula
Formula
ROI =

Income
Sales

Return on sales
(ROS)

Sales
Investment
Investment
turnover

10-13

ROI
ROI Example
Example
Rockwell (in million)
ROI =
ROI =

Income
Sales
$636
$7,151

ROI =

8.9%

ROI =

10.0%

Sales
Investment
$7,151
$6,390
1.12

10-14

Residual
Residual Income
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
A Residual
Residual Income
Income Example
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
A Residual
Residual Income
Income Example
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
ROI Versus
Versus RI
RI
Using ROI to evaluate
divisions can encourage
them to reject good
investments and accept
poor investments.

10-18

ROI
ROI Versus
Versus RI
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)

23.8%

300,000
$1,300,000

10-19

ROI
ROI Versus
Versus RI
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
ROI Versus
Versus RI
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
ROI Versus
Versus RI
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
ROI Versus
Versus RI
RI
New ROI =

$200,000 + $15,000
$2,000,000 + $100,000

$215,000
$2,100,000

New ROI = 10.2%


The
The company
company should
should reject
reject the
the
investment,
investment, but
but the
the manager
manager will
will accept
accept
because
because divisional
divisional ROI
ROI increases.
increases.

10-23

Investment
Investment
Bandan, Inc. (in millions of dollars)
Division
A
B
C Unallocated
Investment
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Plant and equipment-net of depreciation
Investments
Total assets

Total

$ 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
Continued

Investment
Investment
Bendan, Inc. (in millions of dollars)
Division
A
B
C Unallocated
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

10-24

Total
$1,200
650
$ 550
260
$ 290
60
$ 230

Investment
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

10-25

10-26

Investment
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
Continued

28.4%

Investment
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
$0
$45 $106
$149

10-27

10-28

The
The Subject
Subject of
of Evaluation
Evaluation
Division
Division or
or Manager
Manager
Internal ranking
Historical comparisons
Industry averages
Budgets

10-29

Transfer
Transfer Pricing
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
Transfer Pricing
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
Transfer Pricing
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
Transfer Pricing
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
Transfer Pricing
Pricing
Incremental Cost

Such prices are theoretically best from the


companys 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
Transfer Pricing
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
Multinational Companies
Companies
Special
Special Problems
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
The End
End

10-37