10-1 division performance measurement prepared by douglas cloud pepperdine university prepared by...
DESCRIPTION
10-3 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. ObjectivesObjectivesTRANSCRIPT
10-1
Division Division Performance Performance MeasurementMeasurement
Prepared by Douglas Cloud
Pepperdine University
1010
10-2
Explain some of the advantages and disadvantages of decentralization.
Describe the commonly used measures of evaluating the performances of investment centers and their managers.
Describe how performance evaluation methods can encourage managers to act against the best interests of the company.
ObjectivesObjectives
After reading this After reading this chapter, you should chapter, you should
be able to:be able to:
ContinuedContinued
10-3
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.
ObjectivesObjectives
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DecentralizationDecentralization
Decentralization refers to companies that give managers
broad authority.
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Some Benefits of Decentralization
Promotes better decision making
Able to react quicker
Increases motivation
Prepares managers as future leaders of the company
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Problems with DecentralizationProblems with 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.
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Managerial Accounting IssuesManagerial Accounting IssuesRelated to DecentralizationRelated to 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.
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Measures of PerformanceMeasures of Performance
• Income
• Return on Investment (ROI)
• Residual Income (RI)
Three principal measures to measure divisions:
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Measures of PerformanceMeasures of 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 division’s expenses usually include some charges for services provided by central headquarters.
ContinuedContinued
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Measures of PerformanceMeasures of 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.
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Return on InvestmentReturn on Investment
ROI =Divisional income
Divisional investment
ROI is the most frequently used criterion for divisional performance measurement.
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Expanded ROI FormulaExpanded ROI Formula
ROI =IncomeSales
xSales
Investment
Return on salesReturn on sales(ROS)(ROS)
Investment Investment turnoverturnover
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ROI ExampleROI Example
Rockwell (in million)
ROI =IncomeSales
xSales
Investment
ROI =$636
$7,151x
$7,151$6,390
ROI = 8.9% x 1.12
ROI = 10.0%
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Residual IncomeResidual 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
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A Residual Income ExampleA Residual Income ExampleDivision 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%
Division A Division BInvestment $1,000,000 $10,000,000Division income $ 200,000 $ 1,500,000(Investment x
minimum ROI) 100,000 1,000,000Residual income $ 100,000 $ 500,000
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A Residual Income ExampleA Residual Income ExampleDivision 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%
Division A Division BInvestment $1,000,000 $10,000,000Division income $ 200,000 $ 1,500,000(Investment xminimum ROI) 180,000 1,800,000Residual income $ 20,000 $ (300,000 )
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ROI Versus RI
Using ROI to evaluate divisions can encourage
them to reject good investments and accept
poor investments.
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ROI Versus RIDivision Q Example
Divisional profit:Current
$300,000From new project
75,000Total divisional profit
$375,000
Investment before new project $1,000,000Additional investment for the
project 300,000Total investment $1,300,000
($375,000 ÷ $1,300,000) 28.8%
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ROI Versus RIDivision Q Example
Divisional investment $1,000,000Minimum required ROI 20%Division profit $ 300,000Less minimum required 200,000Residual income $ 100,000
Without New Project
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ROI Versus RIDivision Q Example
Divisional investment $1,300,000Minimum required ROI 20%Division profit $ 375,000Less minimum required 260,000Residual income $ 115,000
With New Project
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ROI Versus 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?
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ROI Versus RI
New ROI =$200,000 + $15,000
$2,000,000 + $100,000=
$215,000
$2,100,000
New ROI = 10.2%
The company should reject the The company should reject the investment, but the manager will accept investment, but the manager will accept
because divisional ROI increases.because divisional ROI increases.
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InvestmentInvestment Bendan, Inc. (in millions of dollars)Bendan, Inc. (in millions of dollars)
Division A B C Unallocated Total
Investment
Cash $ 20 $ 30 $ 60 $ 30 $ 140Accounts receivable, net 60 80 90 230Inventory 100 180 240 520Prepaid expenses 10 10 20 20 60Plant and equipment--
net of depreciation 200 320 440 60 1,020Investments 10 --- --- 100 110Total assets $400 $620 $850 $210 $2,080
ContinuedContinued
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InvestmentInvestment Bendan, Inc. (in millions of dollars)Bendan, Inc. (in millions of dollars)
Division A B C Unallocated Total
Income
Sales $100 $400 $700 $1,200Variable costs 30 220 400 650Contribution margin $ 70 $180 $300 $ 550Direct fixed costs 30 90 140 260Divisional profit $ 40 $ 90 $160 $ 290Common fixed costs 60Income $ 230
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InvestmentInvestment Bendan, Inc. (in millions of dollars)Bendan, Inc. (in millions of dollars)
A B CCompany as
a WholeComputation of ROI:
Profit of segment $ 40 $ 90 $160 $ 230Investment 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 $ 230Required return (invest- ment x minimum return of 10%) 40 62 85 208
RI (profit – required return) $ 0 $ 28 $ 75 $ 22
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InvestmentInvestment Bendan, Inc. (in millions of dollars)Bendan, Inc. (in millions of dollars)
A B CCompany as
a WholeComputation of ROI:
Profit of segment $ 40 $ 90 $160 $ 230Total assets $400 $620 $850 $2,080Divisional liabilities 60 170 310 540Divisional investment $340 $450 $540 $1,540Unallocated liabilities 730
Total investment $340 $450 $540 $ 810ROI 11.8% 20.0% 29.6% 28.4%
ContinuedContinued
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InvestmentInvestment Bendan, Inc. (in millions of dollars)Bendan, Inc. (in millions of dollars)
A B CCompany as
a WholeComputation of RI:
Profit of segment $40 $ 90 $160 $ 230Required return (invest- ment x minimum return of 10%) 34 45 54 81
RI $ 6 $45 $106 $149
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The Subject of Evaluation—The Subject of Evaluation—Division or ManagerDivision or Manager
Internal ranking
Historical comparisons
Industry averages
Budgets
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Transfer PricingTransfer Pricing
Actual costs with or without a markup
Budgeted costs with or without a markup
Market-based prices
Incremental cost
Negotiated prices
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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.
Transfer PricingTransfer Pricing
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This method does not reward the selling manager if costs go up, and actually encourages the selling manager to keep costs down.
Budgeted Cost
Transfer PricingTransfer Pricing
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Market-Based Prices
Transfer PricingTransfer Pricing
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.
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Such prices are theoretically best from the company’s viewpoint when the selling division is operating below capacity.
Incremental cost can be as low as the variable cost of the goods or services.
Incremental Cost
Transfer PricingTransfer Pricing
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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.
Negotiated Prices
Transfer PricingTransfer Pricing
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Multinational CompaniesMultinational CompaniesSpecial ProblemsSpecial Problems
Evaluating performanceMore complicated reporting needsCurrency translation problemsLittle or no on-site supervision by the home-office managersSignificant cultural and language barriers
Transfer pricingForeign taxesCurrency translation problems
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The End
Chapter 10Chapter 10
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