MAS 8909 Decentralization AND Performance Evaluation PDF

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CPARCPA REVIEW SCHOOL OF THE PHILIPPINESM a n i l aMANAGEMENT ADVISORY SERVICESDECENTRALIZATION AND PERFORMANCE EVALUATIONRESPONSIBILITY ACCOUNTINGRESPONSIBILITY ACCOUNTING – a system of accounting wherein costs and revenues are accumulated and reported by levels of responsibility or by responsibili...

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CPAR CPA REVIEW SCHOOL OF THE PHILIPPINES Manila

MAS 8909

MANAGEMENT ADVISORY SERVICES

DECENTRALIZATION AND PERFORMANCE EVALUATION RESPONSIBILITY ACCOUNTING RESPONSIBILITY ACCOUNTING – a system of accounting wherein costs and revenues are accumulated and reported by levels of responsibility or by responsibility centers within the organization. Responsibility center (also called accountability center) a clearly identified part or segment of an organization that is accountable for a specified function or set of activities. any part of the organization that a particular manager is responsible for

– –

TYPES OF RESPONSIBILITY CENTERS: a. Cost Center (or expense center) – a segment of an organization in which managers are held responsible for the costs or expenses incurred in the segment. b. Revenue Center – where management is responsible primarily for revenues. c. Profit Center – a segment of the organization in which the manager is held responsible for both revenues and costs. d. Investment Center – a segment of the organization where the manager controls revenues, costs, and investments. The center’s performance is measured in terms of the use of the assets as well as the revenues earned and the costs incurred. CLASSIFICATIONS OF COSTS IN RESPONSIBILITY ACCOUNTING 1. 2. 3.

By responsibility center By cost type, as to controllability By specific cost items or cost elements within each classification in (1) and (2).

RESPONSIBILITY vs. ACCOUNTABILITY Responsibility has two facets, (1) the obligation to secure results, and (2) the obligation to report back the results achieved to higher authority. Accountability denotes the obligation to report results achieved to higher authority. THE CONCEPT OF DECENTRALIZATION Decentralization refers to the separation or division of the organization into more manageable units wherein each unit is managed by an individual who is given decision authority and held accountable for his decisions. • •

Goal congruence – all members of an organization have incentives to perform for a common interest. Sub-optimization – occurs when one segment of a company takes action that is in its own best interests, but is detrimental to the firm as a whole.

BENEFITS OF DECENTRALIZATION 1. 2. 3. 4. 5. 6. 7.

Better access to local information Cognitive limitations More timely response Focusing of central management Training and evaluation Motivation Enhanced competition.

COSTS OF DECENTRALIZATION 1. Some decisions made in one sub-unit may bring about negative effect to the other sub-units or the organization as a whole. 2. Decentralization necessitates a more elaborate reporting system hence, the costs of gathering and reporting of data increase. 3. Job duplication or overlapping of functions is usually encountered in a decentralized set-up.

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MEASURING THE PERFORMANCE OF INVESTMENT CENTERS Performance measures for investment centers usually attempt to assess how well managers are utilizing invested assets of the division to produce profits by relating operating profits to assets. Return on investment (ROI) is the most common measure of performance for investment centers. ROI can be defined as follows: ROI =

Operating Income Average Operating Assets

Operating income refers to earnings before interest and taxes. Operating assets include all assets acquired to generate operating income, including cash, receivables, inventories, land, buildings, and equipment. The ROI formula can also be broken down into the product of margin and turnover. Margin is the ratio of operating income to sales. Turnover is defined as sales divided by average operating assets. ROI =

Margin x Turnover

or ROI =

Operating Income Sales

x

Sales Average Operating Assets

Three advantages of using ROI to evaluate the performance of investment centers: 1. It encourages managers to pay careful attention to the relationships among sales, expenses, and investment, as should be the case for a manager of an investment center. 2. It encourages cost efficiency. 3. It discourages excessive investment in operating assets.

Two disadvantages of using ROI are: 1. It discourages managers from investing in projects that would decrease the divisional ROI but would increase the profitability of the company as a whole. (Generally, projects with an ROI less than a division’s current ROI would be rejected.) 2. It can encourage myopic behavior, in that managers may focus on the short run at the expense of the long run. Residual income (RI) - the difference between operating income and the minimum peso return required on a company’s operating assets. The equation for RI can be expressed as follows: RI = Operating Income − (Minimum Rate of Return x Operating Assets) ECONOMIC VALUE ADDED (EVA) – a more specific version of residual income. It represents the segment’s true economic profit because it measures the benefit obtained by using resources in a particular way. After-tax operating income (EBIT x[1 – Tax Rate]) Less desired income (After-tax WACC* x [Total assets – Current liabilities]) Economic Value Added (EVA) * WACC = Weighted average cost of capital

xx xx xx

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TRANSFER PRICING TRANSFER PRICE – the monetary value or the price charged by one segment of a firm for the goods and services it supplies to another segment of the same firm. OBJECTIVES OF TRANSFER PRICING 1. To facilitate optimal decision-making. 2. To provide a basis in measuring divisional performance. 3. To motivate the different department heads in improving their performance and that of their departments. APPROACHES FOR DETERMINING TRANSFER PRICE: 1. Negotiated transfer price 2. Cost-based transfer price 3. Market-based transfer price General Rules in Choosing a Transfer Price • •

•

The maximum price should be no greater than the lowest market price at which the buying segment can acquire the goods or services externally. The minimum price should be no less than the sum of the selling segment’s incremental costs associated with the goods or services plus the opportunity cost of the facilities used. A good should be transferred internally whenever the minimum transfer price (set by the selling division) is less than the maximum transfer price (set by the buying division). By using this rule, total profits of the firm are not decreased by an internal transfer.

THE BALANCED SCORECARD: STRATEGIC-BASED CONTROL The Balanced Scorecard is a strategic management system that defines a strategic-based responsibility accounting system. Strategy is defined as choosing the market and customer segments the business unit intends to serve, identifying the critical internal and business processes that the unit must excel at to deliver the value propositions to customers in the targeted market segments, and selecting the individual and organizational capabilities required for the internal, customer, and financial objectives. The Balanced Scorecard translates an organization’s mission and strategy into operational objectives and performance measures for four different perspectives: the financial perspective, the customer perspective, the internal business process perspective, and the learning and growth (infrastructure) perspective. Common characteristics of balanced scorecards a. It should be possible, by examining a company’s balanced scorecard, to infer its strategy and the assumptions underlying that strategy. b. The balanced scorecard should emphasize continuous improvement rather than just meeting present standards or targets. c. Some of the performance measures on the balanced scorecard should be non-financial. d. The scorecards for individuals should contain only those performance measures they can actually influence. e. The ultimate objectives of the organization are usually financial, but better financial results cannot be attained without improving customers’ perceptions of the company’s products and services. In order to improve customers’ perceptions of products and services, it is usually necessary to improve internal business processes so that the products and services are actually better. And in order to improve the business processes, it is necessary that employees learn. The balanced scorecard as a motivation and feedback mechanism. The performance measures on the balanced scorecard provide motivation and feedback for improving.

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The Financial Perspective The financial perspective establishes the long- and short-term financial performance objectives. The financial perspective is concerned with the global financial consequences of the other three perspectives. Thus, the objectives and measures of the other perspectives must be linked to the financial objectives. The financial perspective has three strategic themes: revenue growth, cost reduction, and asset utilization. Customer Perspective The customer perspective is the source of the revenue component for the financial objectives. This perspective defines and selects the customer and market segments in which the company chooses to compete. Process Perspective To provide the framework needed for this perspective, a process value chain is defined. The process value chain is made up of three processes: the innovation process , the operations process, and the post sales process .

Cycle time is the time required to produce one unit of product. Velocity is the number of units that can be produced in a given period of time (e.g., units per hour). Learning/Innovation and Growth Perspective The learning and growth perspective is the source of the capabilities that enable the accomplishment of the other three perspectives’ objectives. SOME INTERNAL BUSINESS PROCESS PERFORMANCE MEASURES. a. Delivery Cycle Time. This is the total elapsed time between when an order is placed by a customer and when it is shipped to the customer. Part of this time is wait time that occurs before the order is placed into production. b. Throughput (Manufacturing Cycle) Time. This is the total elapsed time between when an order is initiated into production and when it is shipped to the customer. It consists of process time, inspection time, move time, and queue time. The only element that adds value is processing time. Inspection time, move time, queue time, and their associated activities do not add value and should be minimized. c.

Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time (i.e., process time) to total throughput time. It represents the percentage of time an order is in production in which useful work is being done. The rest of the time represents nonvalue-added time (i.e., inspection time, move time, and queue time).

Manufacturing Cycle Efficiency (MCE) can be found as follows: MCE

=

Processing time Processing time + Move Time + Inspection Time + Wait time

QUALITY COST MEASUREMENT:

Quality-linked activities are those activities performed because poor quality may or does exist. Costs of quality are costs that exist because poor quality may or does exist. Control activities are performed by an organization to prevent or detect poor quality. Control costs are the costs of performing control activities. There are two broad categories of control costs: prevention costs and appraisal costs. Prevention costs are incurred to prevent poor quality in the products or services being produced. Appraisal costs are incurred to determine whether products and services are conforming to their requirements or customer needs.

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Failure activities are performed by an organization or its customers in response to poor quality. Failure costs are the costs incurred by an organization because failure activities are performed. There are two broad categories of failure costs: internal failure costs and external failure costs. Internal failure costs are incurred because products and services do not conform to specifications or customer needs and the nonconformance is detected prior to being delivered to outside parties. External failure costs are incurred because products or services fail to conform to requirements or satisfy customer needs and the nonconformance is detected after being delivered to outside parties. PRODUCTIVITY MEASUREMENT Productivity – measures the relationship between actual inputs used (both quantities and costs) and actual outputs produced.

Partial productivity – compares the quantity of output produced with the quantity of an individual input used. Partial Productivity =

𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑖𝑛𝑝𝑢𝑡 𝑢𝑠𝑒𝑑

Total Factor Productivity – the ratio of quantity of output produced to the costs of all inputs used based on current period prices. Total factor productivity =

𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝑎𝑙𝑙 𝑖𝑛𝑝𝑢𝑡𝑠 𝑢𝑠𝑒𝑑

EXERCISES:

1. ROI and RI with manufacturing costs. Dekuryente Motor Company makes electric cars and has only two products, the Theena and the Xander. To produce the Theena, Dekuryente Motor employed assets of P13,500,000 at the beginning of the period, and P13,400,000 of assets at the end of the period. Other costs to manufacture the Theena include the following: Direct materials Setup Production

P3,000 per unit P1,300 per setup-hour P415 per machine-hour

General administration and selling costs total P7,340,000 for the period. In the current period, Dekuryente Motor produced 10,000 Theena cars using 6,000 setup-hours and 175,200 machine-hours. Dekuryente Motor sold these cars for P12,000 each.

REQUIRED: 1. Assuming that Dekuryente Motor defines investment as average assets during the period, what is the Return on Investment for the Theena division? 2. Calculate the residual income for the Theena if Dekuryente Motor has a required rate of return of 12% on investments.

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2. The Sporty Company produces a wide variety of sports equipment. Its newest division, Golf Pro, manufactures and sells a single product— AccuClub, a golf club that uses global positioning satellite technology to improve the accuracy of golfers’ shots. The demand for AccuClub is relatively insensitive to price changes. The following data are available for Golf Pro, which is an investment center for Sporty: Total annual fixed costs P30,000,000 Variable cost per AccuClub P 500 Number of AccuClubs sold each year 150,000 Average operating assets invested in the division P48,000,000

REQUIRED: 1. Compute Golf Pro’s ROI if the selling price of AccuClubs is P720 per club. 6.25% 2. If management requires an ROI of at least 25% from the division, what is the minimum selling price that the Golf Pro Division should charge per AccuClub? P780 3. Assume that Sporty judges the performance of its investment centers on the basis of RI rather than ROI. What is the minimum selling price that Golf Pro should charge per AccuClub if the company’s required rate of return is 20%? P764 3. Selected sales and operating data for three divisions of different structural engineering firms are given as follows:

Sales Average operating assets Net operating income Minimum required rate of return

DIVISION A DIVISION B DIVISION C P12,000,000 P14,000,000 P25,000,000 3,000,000 7,000,000 5,000,000 600,000 560,000 800,000 14% 10% 16%

REQUIRED: 1.

Compute the return on investment (ROI) for each division.

2.

Compute the residual income (RI) for each division.

3.

Assume that each division is presented with an investment opportunity that would yield a 15% rate of return. a. If performance is being measured by ROI, which division or divisions will probably accept the opportunity? Reject? Why? b. If performance is being measured by RI, which division or divisions will probably accept the opportunity? Reject? Why?

4. Montante, Inc., has decided to use EVA to evaluate its performance. Last year, Montante had operating income before tax of P500,000. Two sources of financing were used by the company: P3 million of mortgage bonds paying 6 percent interest and P9 million in common stock, which was considered to be relatively more risky than other stocks, and had a risk premium of 10 percent. The rate on long-term treasury bonds is 4 percent. Montante, Inc., has P4,500,000 in total assets and P500,000 in current liabilities. It pays a marginal tax rate of 30 percent.

REQUIRED: 1. 2.

Calculate the weighted average cost of capital for Montante, Inc. Calculate EVA for Montante. Is Montante creating wealth or not?

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TRANSFER PRICING 5.

Woodworks Company’s Kitchen Cabinets Division produces a variety of wooden kitchen cabinets for which cabinet handles are used. The most frequently used cabinet handle is Model ABC which can be purchased from a number of outside suppliers for P5 each. The manager of the Kitchen Cabinets Division has approached the manager of the Handles Division and offered to buy 200,000 units of Model ABC handles. The Handles Division’s normal capacity for Model ABC is 500,000 units. At present, it produces and sells 300,000 units to the outside market for P5 each. It incurs variable cost per unit of P3 for Model ABC.

REQUIRED: a. What is the maximum transfer price that the Kitchen Cabinets Division would be willing to pay the Handles Division for the Model ABC Handles? b. What is the minimum price that the Handles Division would consider to produce the Model ABC handles for the Kitchen Cabinets Division? c. If the Handles Division is currently operating at capacity, so that it would have to reduce its sales to the outside customers should it decide to sell the handles being ordered by the Kitchen Cabinets Division, what should the minimum price be? d. If the Handles Division is currently operating at 85% of capacity, so that it would have to reduce its sales to the outside customers should it decide to sell the handles being ordered by the Kitchen Cabinets Division, what should the minimum price be? e. Refer to the original data. What transfer price should be set so that the benefits may be divided equally between the Kitchen Cabinets Division and the Handles Division?

6. GreenThumb, Inc., is a nursery products firm. It has three divisions that grow and sell plants: the Western Division, the Southern Division, and the Central Division. Recently, the Southern Division of GreenThumb acquired a plastics factory that manufactures green plastic pots. These pots can be sold both externally and internally. Company policy permits each manager to decide whether to buy or sell internally. Each divisional manager is evaluated on the basis of return on investment and EVA. The Western Division had bought its plastic pots in lots of 100 from a variety of vendors. The average price paid was P75 per box of 100 pots. However, the acquisition made Nay Sy, manager of the Western Division, wonder whether a more favorable price could be arranged. She decided to approach Flint, manager of the Southern Division, to see if he wanted to offer a better price for an internal transfer. She suggested a transfer of 3,500 boxes at P70 per box. Flint gathered the following information regarding the cost of a box of 100 pots: Direct materials P35 Direct labor 8 Variable overhead 10 Fixed overhead* 10 Total unit cost P63 Selling price

P75

Production capacity 20,000 boxes *Fixed overhead is based on P200,000/20,000 boxes.

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