|
Performance Evaluation, Variable
Costing and Decentralization
Learning Objectives
1. Explain how and why firms choose to decentralize.
2. Explain the difference between absorption and variable costing. Prepare segmented income statements.
3. Compute and explain return on investment (ROI).
4. Compute and explain residual income and economic value added (EVA).
5. Explain the role of transfer pricing in a decentralized firm. 6. (Appendix) Explain the uses of the Balanced Scorecard and compute cycle time, velocity, and manufacturing cycle efficiency (MCE).
CHAPTER OUTLINE
1. DECENTRALIZATION AND RESPONSIBILITY ACCOUNTING
- The traditional organization chart, with its pyramid shape, illustrates the lines of responsibility flowing from the CEO down through the vice-presidents to middle- and lower-level managers. Contemporary practice is moving toward a flattened hierarchy, and emphasizing teams is consistent with decentralization.
- Decentralization is the practice of delegating or decentralizing decision-making authority to lower levels.
A. Reasons for Decentralization
- Reasons for using a decentralized organizational structure include:
- Gathering and using local information. Focusing of central management. Decentralization allows top management to concentrate on firmwide problems, strategic planning, and decision making.
- Training and motivating managers.
- Enhanced competition.
B. Responsibility Center
- A responsibility center is a segment of a business whose manager is accountable for specified sets of activities. Four types of responsibility centers are:
- cost center—the manager is responsible only for costs
- revenue center—the manager is responsible only for sales (revenues)
- profit center—the manager is responsible for both revenues and costs
- investment center—the manager is responsible for revenues, costs, and investments
2. MEASURING THE PERFORMANCE OF PROFIT CENTERS USING SEGMENTED INCOME STATEMENTS
A. Variable versus Absorption Costing
- Profit centers are evaluated based on income (revenues minus expenses). However, how the income is measured is important for evaluation purposes.
- Two ways of calculating income are:
- 1. Variable costing: assigns only variable manufacturing costs to the product cost (direct materials, direct labor, and variable manufacturing overhead).
- 2. Full or absorption costing: assigns all manufacturing costs to the product (direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead).
- Absorption costing is required for externa l financial reporting and income tax purposes.
- Variable costing is used for interna l reporting to management because it provides information that is useful for planning, control, and decision making.
- Product and period costs under absorption and variable costing are summarized below:
Product costs: |
direct materials (DM)
direct labor (DL)
variable overhead (VOH)
fixed overhead (FOH)
|
direct materials (DM)
direct labor (DL)
variable overhead (VOH)
|
Period costs: |
variable selling expenses
fixed selling expenses
variable administrative expenses
fixed administrative expenses
|
fixed overhead (FOH)
variable selling expenses
fixed selling expenses
variable administrative expenses
fixed administrative expenses
|
The following diagram illustrates the flow of manufacturing costs using absorption costing:
ABSORPTION COSTING
Work in Process Finished Goods Cost of Goods Sold
- The following diagram illustrates the flow of manufacturing costs using variable costing:
VARIABLE COSTING
Work in Process Finished Goods Cost of Goods Sold Period Cost
B. Inventory Valuation
- The main difference between the two methods relates to how fixed manufacturing overhead is recorded.
- When using absorption costing, fixed manufacturing overhead is considered a product cost, included in inventory and expensed when the inventory is sold.
- When using variable costing, fixed manufacturing overhead is no t included in inventory but is expensed in the period it is incurred.
- The ending finished goods inventory values for absorption and variable costing will differ by the amount of fixed manufacturing costs included in ending inventory.
Cornerstone 11-1: How to Compute Inventory Cost Under Absorption and Variable Costing
- See Mowen and Hansen text for demo problems.
C. Income Statements Using Variable and Absorption Costing
Under absorption costing, costs are classified by functio n as:
1. manufacturing costs (both fixed and variable)
2. selling and administrative costs (both fixed and variable)
The format used when costs are classified by function for absorption costing is:
When variable costing is used, costs are classified by behavior as:
1. variable costs
- variable manufacturing
- variable selling and administrative
2. fixed costs
- fixed manufacturing
- fixed selling and administrative
The format used for a variable-costing income statement follows:
Sales
– Variable expenses:
Variable cost of goods sold
Variable selling and administrative
= Contribution margin
– Fixed expenses:
Fixed overhead
Fixed selling and administrative
= Net income
Cornerstone 11-2: How to Prepare Income Statements Under Absorption and Variable Costing
- See Mowen and Hansen text for demo problems.
D. Production, Sales, and Income Relationships
- When sales equal production, income is the same under variable and absorption costing.
- Production, sales, and income relationships are summarized below:
..................If ...........................................Then
Production > Sales Absorption net income > Variable net income
Production < Sales Absorption net income < Variable net income
Production = Sales Absorption net income = Variable net income
- The difference between absorption-costing income and variable-costing income results from differences in the timin g of the recognition of fixed manufacturing overhead costs as an expense. Variable costing always recognizes the period’s fixed overhead as an expense.
- Absorption costing recognizes as an expense only the fixed overhead attache d to the units sold.
- The difference in incomes can be calculated as the change in the number of units in inventory multiplied by the fixed overhead rate per unit.
Absorption-costing income - Variable-costing income = Fixed overhead rate * Change in total units in inventory
Absorption-costing income - Variable-costing income = Fixed overhead rate * (Units produced – Units sold)
E. The Treatment of Fixed Factory Overhead in Absorption Costing
- Under absorption costing, fixed factory overhead is:
1. assigned to units produced, and
2. expensed when the units to which it is attached are sold.
- Applied fixed overhead is the fixed manufacturing overhead assigned to production using a predetermined fixed overhead rate.
- The difference between applied fixed overhead and actual fixed overhead equals over- or underapplied fixed overhead.
Over- or underapplied fixed overhead = Applied fixed overhead – Actual fixed overhead
- If applied fixed overhead exceeds actual fixed overhead, fixed overhead is overapplied.
- If applied fixed overhead is less than actual fixed overhead, fixed overhead is underapplied.
- If over- or underapplied fixed overhead is immaterial in amount, it is closed to Cost of Goods Sold.
F. Evaluating Profit-Center Managers
- A manager’s performance is often evaluated based on the profit of the organizational units he or she controls. In general, if a manager’s performance is evaluated based on income, then managers have the right to expect the following (assuming all other things are equal):
1. If sales revenue increases, income should increase.
2. If sales revenue decreases, income should decrease.
3. If sales revenue remains the same, income should remain the same.
- Variable costing always results in the expected association between sales and income.
- Absorption income is affected by the level of inventory and does not always result in the expected association between sales and income.
G. Segmented Income Statements Using Variable Costing
- A segment is a subunit of an organization and can be a division, product line, sales territory, or plant.
- Segmented reporting is the process of preparing financial performance reports for segments within a firm.
- Segment reports can be prepared for any level of the organization: division, product line, plants within a division, and so on.
- Segmented reports prepared using variable costing produce better evaluations and decisions than those prepared on an absorption-costing basis.
H. Segmented Reporting: Variable-Costing Basis
- A comparison of the formats for a variable-costing income statement and a segmented income statement using variable costing follows:
| Variable-Costing Income Statement |
Variable-Costing Segmented Income Statement |
| Sales |
Sales |
– Variable expenses:
|
– Variable expenses:
|
Variable cost of goods sold
|
Variable cost of goods sold
|
Variable selling and administrative
|
Variable selling and administrative
|
| = Contribution margin |
= Contribution margin |
– Fixed expenses:
|
– Direct fixed expenses:
|
Fixed overhead
|
Direct fixed overhead
|
Fixed selling and administrative
|
Direct selling and administrative
|
| = Net income |
= Segment margin (or Product margin) |
| |
– Common fixed expenses:
|
| |
Common fixed overhead
|
| |
Common selling and administrative
|
|
= Net income |
Direct fixed expenses are fixed costs that are directly traceable to a particular segment and arise because of the existence of that segment.
Direct fixed expenses are avoidabl e because they would be eliminated or avoided if the segment is eliminated.
Common fixed expenses are fixed costs that benefit more than one segmen t and are not directly traceable to a particular segment. An example of a common fixed cost would be the corporate president’s salary.
Common fixed costs continue to be incurred even if one of the segments is eliminated.
The segment contribution margin (sales less variable costs) provides information useful in making short-run operating decisions such as accepting or rejecting orders at special prices.
Segment margin is the segment contribution margin remaining after covering the direct fixed costs of the segment. Segment margin is the amount the segment contributes toward covering the firm’s common fixed costs and generating profit. Thus, variable costing enables management to evaluate each segment’s contribution to overall firm performance.
The segment margin (sales less variable costs less direct fixed costs) provides information useful in assessing the long-run profitability of a segment.
If a segment does not affect the sales of other segments, the segment margin is the amount by which the firm’s profits would change if the segment were eliminated.
Cornerstone 11-3: How to Prepare a Segmented Income Statement
- See Mowen and Hansen text for demo problems.
3. MEASURING THE PERFORMANCE OF INVESTMENT CENTERS USING ROI
Since it is possible for a division to perform well or poorly irrespective of the efforts of its manager, companies try to separate the evaluation of the segment from the evaluation of the segment manager.
Three methods used to evaluate division performance of investment centers are:
return on investment (ROI)
residual income (RI)
economic value added (EVA)
A. Return on Investment
- Return on investment (ROI), the most common measure of performance for an investment center, is calculated as follows:
ROI = Operating income/Average operating assets
- Operating assets are those assets used to generate operating income, usually including cash, receivables, inventories, property, plant, and equipment.
B. Margin and Turnover
- ROI can be broken into two components:
ROI = Margin × Turnover
 × 
- Margin shows the amount of each dollar of net sales that is profit.
- Turnover compares a division’s investment in operating assets with the ability of those assets to generate revenues.
- Firms with a low profit margin, such as discount stores, may rely upon a high turnover to generate profits. Conversely, a firm with a low turnover, such as a fine jeweler, may rely upon high profit margins.
Cornerstone 11-4: How to Calculate Average Operating Assets, Margin, Turnover, and ROI
- See Mowen and Hansen text for demo problems.
C. Advantages of ROI
- Three positive results from using ROI are:
- It encourages managers to focus on the relationship among sales, expenses, and investment.
- It encourages managers to focus on cost efficiency.
- It encourages managers to focus on operating asset efficiency.
D. Disadvantages of the ROI Measure
- Two disadvantages associated with ROI are:
- It encourages managers to focus on the short run at the expense of the long run (myopic behavior). For example, a manager might cut research and development expenses in the short run to improve ROI, but the cuts may not be in the best long-term interests of the division.
- It discourages managers from investing in projects that would decrease the division’s 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 by the division manager.
4. MEASURING THE PERFORMANCE OF INVESTMENT CENTERS USING RESIDUAL INCOME AND ECONOMIC VALUE ADDED
A. Residual Income
- Residual Income (RI) is the difference between operating income and the minimum dollar return required on a company’s operating assets.
- RI is calculated as follows:
Residual Income = Operating income – (Minimum rate of return × Average operating assets)
Cornerstone 11-5: How to Calculate Residual Income
- See Mowen and Hansen text for demo problems.
- The minimum rate of return is the same as the hurdle rate for ROI.
- If residual income is greater than zero, the division is earning more than the minimum required rate or return.
B. Advantages of Residual Income
- Unlike ROI, the use of residual income encourages managers to accept any project that earns above the minimum rate of return.
C. Disadvantages of Residual Income
- Residual income, like ROI, can encourage a short-run orientation.
- Unlike ROI, residual income is not a relative measure of profitability, which makes it difficult to compare investments centers of different sizes (such as operating assets of $10,000,000 versus $1,000,000).
- One way to address this disadvantage is to use both ROI and residual income for performance evaluation.
D. Economic Value Added
- Economic value added (EVA) is a performance measure calculated as after-tax operating profit minus the total annual cost of capital.
- EVA is calculated as follows:
EVA = After-tax operating income – (actual percentage cost of capital × Total capital employed)
- Total capital employed includes:
- amounts paid for buildings, land, and machinery
- other expenditures meant to have a long-term payoff, such as research and development and employee training. These costs are included in total capital employed even if they are expensed as required by GAAP for financial accounting purposes.
- A positive EVA indicates that the company earned operating profit greater than the cost of the capital used. The company is creating wealth. If EVA is negative, then the company is destroying capital.
- Whereas ROI is a percentage rate of return, EVA is a dollar figure. EVA emphasizes after-tax operating profit and the actua lcost of capital.
- Stock prices follow EVA better than earnings per share or return on equity.
Using EVA for Individual Projects
- EVA can be calculated for individual projects as follows:
EVA = Project income – Cost of capital
= Project income – (Cost of capital % × Assets employed)
- Using EVA encourages managers to accept any project that earns above the minimum rate.
Cornerstone 11-6: How to Calculate EVA
- See Mowen and Hansen text for demo problems.
Behavioral Aspects of EVA
- EVA encourages managers to consider the cost of financial investment (the cost of capital) when making decisions. Therefore, EVA helps to encourage desirable behavior from division managers that an emphasis on operating income alone cannot.
5. TRANSFER PRICING
- Transfer prices are prices charged for goods transferred between two divisions of the same firm. The output of the selling division is used as input of the buying division.
A. Impact of Transfer Pricing on Divisions and the Firm as a Whole
- Transfer pricing affects the transferring divisions and the overall firm through its impact on:
- divisional performance measures
- firmwide profits, and
- divisional autonomy.
Impact on Divisional Performance Measures
- The price charged for transferred goods is revenue to the selling division and cost of goods sold to the buying division.
- Thus, profits and profit-based performance measures (ROI and EVA) of both divisions are affected by the transfer price.
Impact on Firmwide Profits
- While the actual transfer price nets out for the company as a whole, transfer pricing affects profits earned by the company as a whole if it affects divisional behavior.
- Divisions, acting independently, may set transfer prices that maximize divisional profits but adversely affect firmwide profits.
Impact on Autonomy
- Because transfer pricing decisions can affect firmwide profitability, top management is often tempted to intervene and dictate desirable transfer prices.
- If such intervention becomes a frequent practice, however, the organization has effectively abandoned decentralization and all of its advantages.
B. The Transfer Pricing Problem
- The transfer pricing problem concerns finding a transfer pricing system that simultaneously satisfies the following three objectives:
1. Accurate performance evaluation. No one divisional manager should benefit at the expense of another.
2. Goal congruence. Divisional managers are motivated to select actions that maximize firmwide profits.
3. Divisional autonomy. Central management should not interfere with the decision-making freedom of divisional managers.
- Although direct intervention by central management to set specific transfer prices may not be advisable, general transfer pricing guidelines or policies may be useful.
C. Transfer Pricing Policies
- In a decentralized organization, top management sets the transfer pricing policy, but divisions decide whether or not to transfer.
- Several transfer pricing policies used in practice are:
- Market price
- cost-based transfer price
- negotiated transfer prices
D. Market Price
- If there is a perfectly competitive outside market for the transferred goods, the optimal transfer price is the market price. (In a perfectly competitive market, the selling division can sell all it wishes at the prevailing market price.)
- The opportunity cost approach also identifies the market price as the optimal transfer price.
- The minimum transfer price for the selling division is the market price, because the selling division receives the market price whether it sells the product internally or externally.
- The maximum transfer price for the buying division is the market price, because the buying division pays the market price whether it purchases the product internally or from an outside supplier.
E. Cost-Based Transfer Prices
- Three types of cost-based transfer prices are:
- full cost
- full cost plus markup, and
- variable cost plus fixed fee.
- If cost-based transfer prices are used, standard cost s should be used in order to avoid passing on the inefficiencies of one division to another.
F. Negotiated Transfer Prices
- If a perfectly competitive market for the transferred goods exists, the optimal transfer price is the market price.
- If a perfectly competitive market for the transferred goods does no t exist, a negotiated transfer price may be a practical alternative.
The opportunity cost approach to transfer pricing identifies:
- the minimum transfer price, which is the transfer price that would leave the selling division indifferent between selling the goods to an outside party or transferring the goods to an internal division
- the maximum transfer price, which is the transfer price that would leave the buying division indifferent between buying the goods from an outside party or purchasing from an internal division
- Opportunity costs for the buying division and selling division form the upper and lower boundaries for the transfer price.
Minimum Transfer Price |
Maximum Transfer Price |
|
|
Opportunity Cost for Selling Division |
Opportunity Cost for Buying Division |
- The selling division wants a high transfer price that will increase its income. The buying division wants a low transfer price that will increase its income.
Avoidable Distribution Costs
- If the selling division avoids costs such as distribution costs by selling internally, the opportunity cost to the selling division is the market price minus the avoidable cost.
Minimum Transfer Price |
Maximum Transfer Price |
|
|
Market Price Less Selling
Division’s Avoidable Costs |
Market Price |
Excess Capacity
- When the selling division has excess capacity, a bargaining range exists.
- The lower limit of the bargaining range is the selling division’s incremental costs. This is the minimum the selling division would be willing to accept.
- The upper limit of the range is the lower of:
- the buying division’s outside purchase price, or
- the transfer price that results in a zero contribution margin on the goods for the buying division.
- This is the maximum amount the buying division would be willing to pay.
Disadvantages of Negotiated Transfer Prices
- Three disadvantages of negotiated transfer prices are as follows:
1. One divisional manager who has private information may take advantage of another divisional manager.
2. Performance measures may be distorted by the negotiating skills of managers.
3. Negotiation can consume considerable time and resources.
Advantages of Negotiated Transfer Prices
- Negotiated transfer prices can help achieve the three objectives of:
- goal congruence
autonomy, and
- accurate performance evaluation.
- If negotiation helps insure goal congruence, top management is not as likely to intervene and divisional autonomy is not diminished.
- If the negotiating skills of managers are comparable or if the firm views negotiating skills as an important part of being a manager, concerns about accurate performance evaluation are avoided.
Cornerstone 11-7: How to Calculate Transfer Prices
- See Mowen and Hansen text for demo problems.
6. APPENDIX: THE BALANCED SCORECARD: BASIC CONCEPTS
- The Balanced Scorecard is a strategic responsibility accounting system that translates an organization’s mission and strategy into operational objectives and performance measures for four different perspectives:
1. Financial perspective, which describes the economic consequences of actions taken in the other three perspectives
2. Customer perspective, which defines the customer and market segments in which the business operates
3. Internal business process perspective, which describes the internal processes needed to provide value for customers and owners
4. Learning and growth (infrastructure) perspective, which defines the capabilities that an organization needs to create long-term growth and improvement: employee capabilities, information systems capabilities, and employee attitudes of motivation, empowerment, and alignment
Cornerstone 11-8: How to Compute Cycle Time and Velocity
Cornerstone 11-9: How to Calculate MCE
- See Mowen and Hansen text for demo problems.
|
