Organizational Design, Responsibility Accounting, and Evaluation of ...

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Organizational Design, Responsibility Accounting, and Evaluation of Divisional Performance Student Tutorial Irwin/McGraw-Hill Ryerson

© McGraw-Hill Ryerson Limited, 2001

Decentralized Organizations And Responsibility Accounting

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Mostorganizations organizationsare aredivided dividedinto intosmaller smallerunits, units,divisions, divisions, Most segments, business businessunits, units,work workcenters, centers,or ordepartments departments segments, whichhave haveparticular particularresponsibilities responsibilities which Whendo doyou youhave haveGOAL GOALCONGRUENCE? CONGRUENCE? When Whenthe themanagers managersof ofsubunits subunitsthroughout throughout When theorganization organizationhave haveincentives incentivesto toperform perform the inthe thecommon commoninterest interestof ofthe theorganization organization in BEHAVIOURALCONGRUENCE CONGRUENCE BEHAVIOURAL Performanceevaluation evaluationand andincentive incentivesystems systemsare are Performance designedto toencourage encourageemployees employeesto tobehave behaveas asififtheir their designed goalsare arecongruent congruentwith withorganizational organizationalgoals. goals. goals

Irwin/McGraw-Hill Ryerson


Decentralized Organizations And Responsibility Accounting GOAL GOAL CONGRUENCE CONGRUENCE

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BEHAVIOURAL BEHAVIOURAL CONGRUENCE CONGRUENCE

RESPONSIBILITY RESPONSIBILITY ACCOUNTING ACCOUNTING

Various Variousconcepts conceptsand andtools toolsused used to tomeasure measurethe theperformance performance of ofpeople peopleand andthe thedepartments departments in inorder orderto tofoster fostergoal goal or orbehavioural behaviouralcongruence congruence Irwin/McGraw-Hill Ryerson


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Centralization Vs. Decentralization Centralized Centralized Organizations Organizations


Decentralized Decentralized Organizations Organizations


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Centralization Vs. Decentralization Centralized Centralized Organizations Organizations

Decentralized Decentralized Organizations Organizations

Decisionsare are Decisions handeddown downfrom from handed thetop top echelon echelonof of the management management andsubordinates subordinates and carrythem themout out carry

Decisionsare are Decisions madeat at made divisionaland and divisional departmentallevels levels departmental



Benefits And Costs Of A Decentralized Organization BENEFITS ! Subunit managers are specialists ! Autonomy in decision making !

! !

!

provides managerial training Managers with decision making authority usually exhibit greater motivation Delegating provides time relief to upper-level managers Empowering employees draws on the knowledge and expertise of those closest to operations Delegating to the lowest level enables a timely response to opportunities and problems


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COSTS ! Managers sometimes have a

narrow focus of their own units’ performance rather than the organization’s overall goals ! The narrow focus may cause managers to tend to ignore the consequences of their actions on the organization’s other subunits ! Some tasks or services may be duplicated unnecessarily


Decentralized Organizations And Responsibility Accounting Question #1

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Which of of the thefollowing followingis ismore morecharacteristic characteristicof ofaa Which decentralizedthan thanaacentralized centralizedorganization? organization? decentralized A. Quick Quickresponse responsetime timeto tochanges changes in in local local A. conditions conditions B. The Thefirm firmfaces facesaarelatively relativelystable stableenvironment environment B. C. The Thefirm firmis isrelatively relativelysmall small C. D. There Thereis islittle littleincentive incentivefor forlower lowerlevel level D. management to tomake makedecisions decisions management




19-8

Which Which of of the thefollowing followingis ismore morecharacteristic characteristicof ofaa decentralized decentralizedthan thanaacentralized centralizedorganization? organization? A. A. Quick Quickresponse responsetime timeto tochanges changes in in local local conditions conditions B. B. The Thefirm firmfaces facesaarelatively relativelystable stableenvironment environment C. C. The Thefirm firmis isrelatively relativelysmall small D. D. There Thereis islittle littleincentive incentivefor forlower lowerlevel level management management to tomake makedecisions decisions




19-9

Which Which of of the thefollowing followingis ismore morecharacteristic characteristicof ofaa decentralized decentralizedthan thanaacentralized centralizedorganization? organization? A. A. Quick Quickresponse responsetime timeto tochanges changes in in local local conditions conditions B. B. The Thefirm firmfaces facesaarelatively relativelystable stableenvironment environment C. C. The Thefirm firmis isrelatively relativelysmall small D. D. There Thereis islittle littleincentive incentivefor forlower lowerlevel level management management to tomake makedecisions decisions IfIfthe theenvironment environment was wasstable, stable,one oneperson personcould could run run the theworld. world. ItIt is isinstability instabilitythat thatgives givesrise riseto tothe theneed need for forlocal localdecision-making. decision-making. Try Tryagain. again. Irwin/McGraw-Hill Ryerson



19-10

Which Which of of the thefollowing followingis ismore morecharacteristic characteristicof ofaa decentralized decentralizedthan thanaacentralized centralizedorganization? organization? A. A. Quick Quickresponse responsetime timeto tochanges changes in in local local conditions conditions B. B. The Thefirm firmfaces facesaarelatively relativelystable stableenvironment environment C. C. The Thefirm firmis isrelatively relativelysmall small D. D. There Thereis islittle littleincentive incentivefor forlower lowerlevel level management management to tomake makedecisions decisions IfIfthe thefirm firmis issmall, small,then thenwhy whywould wouldwe wewant wantto to delegate delegateauthority authorityto to middle middlemanagement? management? Try Try again. again. Irwin/McGraw-Hill Ryerson



19-11

Which of of the thefollowing followingis ismore morecharacteristic characteristicof ofaa Which decentralizedthan thanaacentralized centralizedorganization? organization? decentralized A. Quick Quickresponse responsetime timeto tochanges changes in in local local A. conditions conditions B. The Thefirm firmfaces facesaarelatively relativelystable stableenvironment environment B. C. The Thefirm firmis isrelatively relativelysmall small C. D. There Thereis islittle littleincentive incentivefor forlower lowerlevel level D. management to tomake makedecisions decisions management Why Whywould wouldyou youwant want to toput put decision-making decision-making authority authorityin inthe thehands handsof ofunmotivated unmotivated management? management? Try Tryagain. again. Irwin/McGraw-Hill Ryerson


Responsibility Accounting

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Thepurpose purposeof ofaaRESPONSIBILITY RESPONSIBILITYACCOUNTING ACCOUNTINGsystem systemis isto to The ensurethat thateach eachmanager managerand andworker workerin inthe theorganization organizationis is ensure strivingtoward towardthe theoverall overallgoals goalsset setby bytop topmanagement management striving RESPONSIBILITYCENTER CENTERis isaasubunit subunitin inan anorganization organization AARESPONSIBILITY whosemanager manageris isheld heldaccountable accountablefor forspecified specifiedfinancial financial whose andnonfinancial nonfinancialresults resultsof ofthe thesubunit’s subunit’sactivities activities and

Cost Cost Center Center

Discretionary Discretionary Cost Cost Center Center Irwin/McGraw-Hill Ryerson

RESPONSIBILITY RESPONSIBILITY CENTERS CENTERS

Revenue Revenue Center Center

Investment Investment Center Center

Profit Profit Center Center


Responsibility Accounting

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RESPONSIBILITYCENTERS CENTERS RESPONSIBILITY • well-defined input-output relationships

• well-defined input-output relationships Cost Center Center • the manager Cost isresponsible responsiblefor forthe thecost costof ofactivities activities • the manager is Discretionary ••input-output input-output relationships relationshipsare arenot notwell wellspecified specified Discretionary CostCenter Center ••the themanager manageris isresponsible responsiblefor forthe thecost costof ofactivities activities Cost

Revenue •• the themanager manageris isresponsible responsiblefor forthe therevenue revenueof ofthe the Revenue subunit Center subunit Center Profit Profit •the themanager manageris isresponsible responsiblefor forthe thesubunit’s subunit’sprofit profit • Center Center Investment ••the themanager manageris isresponsible responsiblefor forthe theprofit profitand andthe the Investment investedcapital capitalused usedto togenerate generatethe theprofit profit Center invested Center



Organization Chart: Outback Outfitters, Ltd.

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Managers

Responsibility center Investment President center

Outback Outfitters, Ltd. Koala camp gear division

Vicepresident

Investment center

Sydney plant

General plant manager

Profit center

Sales dept. manager

Revenue center

Production department

Production dept. manager

Cost center

Packaging work center

Supervisor of work center

Cost center

Sales department



Performance Report

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performancereport reportshows showsthe thebudgeted budgetedand andactual actualamounts amounts AAperformance ofkey keyfinancial financialresults resultsappropriate appropriate of forthe thetype typeor orresponsibility responsibilityinvolved involved for BUDGETED BUDGETED amounts amounts ofkey key of financial financial results results

VARIANCE VARIANCE

ACTUAL ACTUAL amounts amounts ofkey key of financial financial results results

Managementby byexception exceptionis isused usedto tocontrol controlan anorganization’s organization’s Management operationseffectively effectively operations Managementby byexception exceptionmeans meansmanagement managementonly onlyfollows followsup up Management onthe themost mostsignificant significantvariances variances on



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Activity-Based Responsibility Accounting

Focuson onthe the Focus financialperformance performance financial measuresof ofcost, cost, measures revenues,and andprofit profit for forthe the revenues, subunitsof ofthe theorganization organization subunits


Activity-based Activity-based responsibilitysystems systemsfocus focus responsibility not only onlyon onthe thecost costof of not performingactivities activitiesbut buton on performing theactivities activitiesthemselves themselves the


How Does Responsibility Accounting Affect Behaviour The Theproper properfocus focusof ofaa responsibility responsibilitysystem system is isinformational informational

Causing Causingmanagers managersto toreact react constructively constructivelyand andstrive strivefor for improved improvedperformance performance

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Some Someorganizations organizationsuse use performance performancereports reportsthat that distinguish distinguishbetween betweencontrollable controllableor or uncontrollable uncontrollablecosts costsor orrevenues revenues Identifying Identifyingcosts costsas ascontrollable controllable or oruncontrollable uncontrollableis isnot notalways always easy. easy. Many Manycosts costsare areinfluenced influencedby by more morethan thanone oneperson person

AAresponsibility responsibilityaccounting accounting system systemdoes doesnot notemphasize emphasize blame blame


Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort shortrun run become becomecontrollable controllablein inthe the long longrun run © McGraw-Hill Ryerson Limited, 2001

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Decentralized Organizations And Responsibility Accounting - Question #2 Which of of the thefollowing followingis isnot not true trueabout aboutresponsibility responsibility Which accounting? accounting? A. A. B. B.

Costsare areclassified classifiedon onthe thebasis basisof ofcontrollability controllability Costs Identifyingcosts costsas ascontrollable controllableor oruncontrollable uncontrollable Identifying isnot not always alwayseasy easy is C. Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort short C. runbecome becomecontrollable controllablein inthe thelong longrun run run D. Many Manycosts costsare areinfluenced influencedby byone oneperson person D. E.AAresponsibility responsibilityaccounting accountingsystem systemdoes doesnot not E. emphasizeblame blame emphasize



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Costsare areclassified classifiedon onthe thebasis basisof ofcontrollability controllability Costs Identifyingcosts costsas ascontrollable controllableor oruncontrollable uncontrollable Identifying isnot not always alwayseasy easy is C. Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort short C. runbecome becomecontrollable controllablein inthe thelong longrun run run D. Many Manycosts costsare areinfluenced influencedby byone oneperson person D. E.AAresponsibility responsibilityaccounting accountingsystem systemdoes doesnot not E. emphasizeblame blame emphasize That’strue, true,but but itit doesn’t doesn’t help helpus usto to answer answer That’s thequestion. question. Try Tryagain. again. the Irwin/McGraw-Hill Ryerson


19-20


Costsare areclassified classifiedon onthe thebasis basisof ofcontrollability controllability Costs Identifyingcosts costsas ascontrollable controllableor oruncontrollable uncontrollable Identifying isnot not always alwayseasy easy is C. Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort short C. runbecome becomecontrollable controllablein inthe thelong longrun run run D. Many Manycosts costsare areinfluenced influencedby byone oneperson person D. E.AAresponsibility responsibilityaccounting accountingsystem systemdoes doesnot not E. emphasizeblame blame emphasize Ofcourse courseitit isn’t isn’t easy, easy, but butitit isn’t isn’t right righteither. either. Of Tryagain. again. Try Irwin/McGraw-Hill Ryerson


19-21


Costsare areclassified classifiedon onthe thebasis basisof ofcontrollability controllability Costs Identifyingcosts costsas ascontrollable controllableor oruncontrollable uncontrollable Identifying isnot not always alwayseasy easy is C. Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort short C. runbecome becomecontrollable controllablein inthe thelong longrun run run D. Many Manycosts costsare areinfluenced influencedby byone oneperson person D. E.AAresponsibility responsibilityaccounting accountingsystem systemdoes doesnot not E. emphasizeblame blame emphasize theyaren’t aren’tcontrollable controllablein in the theshort short run, run,we we IfIfthey can’t hold holdsomeone someoneresponsible. responsible. Try Tryagain. again. can’t Irwin/McGraw-Hill Ryerson


19-22


Costsare areclassified classifiedon onthe thebasis basisof ofcontrollability controllability Costs Identifyingcosts costsas ascontrollable controllableor oruncontrollable uncontrollable Identifying isnot not always alwayseasy easy is C. Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort short C. runbecome becomecontrollable controllablein inthe thelong longrun run run D. Many Manycosts costsare areinfluenced influencedby byone oneperson person D. E.AAresponsibility responsibilityaccounting accountingsystem systemdoes doesnot not E. emphasizeblame blame emphasize



19-23


Costsare areclassified classifiedon onthe thebasis basisof ofcontrollability controllability Costs Identifyingcosts costsas ascontrollable controllableor oruncontrollable uncontrollable Identifying isnot not always alwayseasy easy is C. Some Somecosts coststhat thatare arenot not controllable controllablein inthe theshort short C. runbecome becomecontrollable controllablein inthe thelong longrun run run D. Many Manycosts costsare areinfluenced influencedby byone oneperson person D. E.AAresponsibility responsibilityaccounting accountingsystem systemdoes doesnot not E. emphasizeblame blame emphasize That’sjust just silly. silly. Of Ofcourse courseitit emphasizes emphasizes That’s blame. That’s That’sthe thepoint, point,isn’t isn’t it? it? Try Tryagain. again. blame. Irwin/McGraw-Hill Ryerson


Motivating Desired Behaviour

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Organizations Organizationsoften oftenuse usethe theresponsibility responsibilityaccounting accountingsystem system to tomotivate motivateactions actionsconsidered considereddesirable desirable by byupper-level upper-levelmanagement management Sometimes Sometimesthe theresponsibility responsibilityaccounting accountingsystem systemcan cansolve solve behavioural behaviouralproblems problemsand andpromote promoteteamwork teamwork Potential Potential PotentialCosts Costsof of PotentialBenefits Benefitsof of Accepting Accepting AcceptingRush RushOrder Order AcceptingRush RushOrder Order Disrupted Satisfied Disruptedproduction production Satisfiedcustomers customers More Greater Moresetups setups Greaterfuture futuresales sales Higher Highercosts costs Need Needfor foroutsourcing outsourcing The modified Production Sales Productionmanager manager Salesmanager manager looks looksonly onlyat atcosts costs responsibility system looks looksonly onlyat atbenefits benefits made the sales manager look at both the costs and benefits Irwin/McGraw-Hill Ryerson


19-25

Measuring Performance In Investment Centers Largesubunits subunitsare areusually usuallydesignated designatedas asINVESTMENT INVESTMENTCENTERS CENTERS Large Themanager manageris isheld heldaccountable accountablefor forthe the INVESTMENT INVESTMENTCENTER’S CENTER’S The profitsand andthe thecapital capitalinvested investedto toearn earnthat thatprofit profit profits Theretail retailsales salesmanager manager The Approvesthe the Approves overallpricing pricing overall policiesin in policies theretail retail the division’sstores stores division’s

Hasthe theautonomy autonomy Has tosign signcontracts contracts to to buy buy to merchandise merchandise forresale resale for

These decisions influence the organization’s profit Irwin/McGraw-Hill Ryerson

Hasthe theauthority authorityto to Has tobuild buildnew newstores stores to rentspace spacein in rent shoppingcenters, centers, shopping orclose closeexisting existing or stores stores These decisions influence the amount of capital invested in the division © McGraw-Hill Ryerson Limited, 2001

Return On Investment As A Performance Measure Sales revenue Income Invested capital

Mail Order Koala Camp Division Gear Division Retail Division $350,000,000 $405,000,000 $960,000,000 14,000,000 45,000,000 48,000,000 70,000,000 300,000,000 480,000,000

Return Returnon oninvestment investment(ROI) (ROI)==

Mail-order division Koala Camp Gear division Retail division Irwin/McGraw-Hill Ryerson

19-26

Income Invested capital $14,000,000 $70,000,000 $45,000,000 $300,000,000 $48,000,000 $480,000,000

Income Income Invested Investedcapital capital = Return on Investment (ROI) = 20% = 15% = 10% © McGraw-Hill Ryerson Limited, 2001

19-27

Factors Underlying ROI Measuresthe the percentage percentageof of Measures eachsales salesdollar dollarthat that each remainsas asprofit profitafter afterall all remains expensesare arecovered covered expenses

Sales Sales Margin Margin

Income Income = X Sales revenue Return on investment = Invested Capital Sales revenue Invested capital

Capital Capital Turnover Turnover Focuseson onthe the Focuses numberof ofsales sales number dollarsgenerated generated dollars byeach eachdollar dollarof of by investedcapital capital invested Irwin/McGraw-Hill Ryerson


19-28

Factors Underlying ROI Return on investment =

Income Income Sales revenue = X Invested Capital Sales revenue Invested capital

Focuseson onthe thenumber numberof ofsales sales Focuses dollarsgenerated generatedby byeach eachdollar dollarof of dollars investedcapital capital invested

Sales Margin Mail-order division Koala Camp Gear division Retail division


$14,000,000 $350,000,000 $45,000,000 $405,000,000 $48,000,000 $960,000,000

Measuresthe the percentage percentageof ofeach each Measures salesdollar dollarthat thatremains remainsas as sales profitafter afterall allexpenses expensesare arecovered covered profit

X X X X

Capital Turnover $350,000,000 $70,000,000 $405,000,000 $300,000,000 $960,000,000 $480,000,000

= 20% = 15% = 10%


Improving A Division’s ROI Retail division’s ROI

Sales margin

10%

5%

Current retail division ROI

X

19-29

Capital turnover 2

Increase sales price while selling less quantity Increase sales margin Improved retail division ROI

or decrease expenses

14%

7%

Increase sales revenues or reduce the division’s invested capital Improved retail division ROI


15%

2 Increase capital turnover

5%

3


19-30

Return on Investment CookevilleCorporation Corporationhas hasprovided providedthe thefollowing followinginformation: information: Cookeville Sales: $1,000,000 $1,000,000 Sales: Income: $250,000 $250,000 Income: Assets: $5,000,000 $5,000,000 Assets:

ComputeCookeville Cookeville Compute Corporation’sProfit Profit Corporation’s Margin Margin ComputeCookeville Cookeville Compute Corporation’sAsset Asset Corporation’s TurnoverRatio Ratio Turnover


? ? © McGraw-Hill Ryerson Limited, 2001

19-31


ComputeCookeville Cookeville Compute Corporation’sProfit Profit Corporation’s Margin Margin

$250,000÷÷ $1,000,000 $1,000,000==25% 25% $250,000

ComputeCookeville Cookeville Compute Corporation’sAsset Asset $1,000,000 $1,000,000÷÷ $5,000,000 $5,000,000==20% 20% Corporation’s TurnoverRatio Ratio Turnover



19-32


ComputeCookeville CookevilleCorporation’s Corporation’sReturn Returnon on Compute Investment Investment

? Irwin/McGraw-Hill Ryerson


19-33


ComputeCookeville CookevilleCorporation’s Corporation’sReturn Returnon on Compute Investment Investment

Profit Margin Margin ×× Asset Asset Turnover Turnover == ROI ROI Profit 25% ×× 20% 20% == 5% 5% 25%



Residual Income As A Performance Measure Cost of investment in CIM = $50,000,000

19-34

Results in annual operating savings of $5,500,000

Return on investment Increase in divisional profit 5,500,000 11% in new equipment = Increase in invested capital = $50,000,000 = The company’s cost of capital = 10%

Koala Camp Gear Division’s Return on Investment Without Investment in New Equipment $45,000,000 $300,000,000 = 15%

With Investment in New Equipment $45,000,000 + $5,500,000 $300,000,000 + $50,000,000 < 15%

Averaging the new investment with that already in place reduces the division’s overall ROI Irwin/McGraw-Hill Ryerson


Residual Income As A Performance Measure

19-35

KoalaCamp CampGear GearDivision’s Division’sResidual ResidualIncome Income Koala WithoutInvestment Investmentin in Without NewCIM CIMEquipment Equipment New Divisiona l profit Le ss impute d intere st cha rge : Inve ste d capita l X im pute d intere st ra te

WithInvestment Investmentin in With NewCIM CIMEquipment Equipment New

$45,000,000

$300,000,000 x

$50,500,000

$350,000,000

.10

x

Im pute d inte re st cha rge

30,000,000

Re sidua l cha rge

$15,000,000

.10

35,000,000 $15,500,000

Investment in new equipment raises residual income by $500,000 Irwin/McGraw-Hill Ryerson


Residual Income As A Performance Measure

19-36

Comparisonof of Residual ResidualIncome: Income: Two TwoDivisions Divisions Comparison Mail-Order Mail-Order Division Division Divisiona l profit Le ss impute d intere st cha rge : Inve ste d capita l X im pute d intere st ra te

$45,000,000

$300,000,000 x

$50,500,000

$350,000,000

.10

x

Im pute d inte re st cha rge

30,000,000

Re sidua l cha rge

$15,000,000


KoalaCamp Camp Koala GearDivision Division Gear

.10

35,000,000 $15,500,000

The Koala Camp Gear division’s residual income is much higher simply because it is larger than the mail-order division © McGraw-Hill Ryerson Limited, 2001

19-37

Residual Income As A Performance Measure The TheByrdstown ByrdstownCorporation Corporationhas hasthe thefollowing followingtwo twodivisions: divisions: DIVISION DIVISION DIVISIONAA DIVISIONBB Sales $1,500,000 $2,000,000 Sales $1,500,000 $2,000,000 -Total 500,000 1,000,000 -Totalvariable variablecosts costs 500,000 1,000,000 -Total 250,000 500,000 -Totalfixed fixedcosts costs 250,000 500,000 Average 2,000,000 3,000,000 Averageassets assetsinvested invested 2,000,000 3,000,000 Assume Assumeaa10% 10%target targetreturn returnon oninvestment investment Compute Computedivisional divisionalresidual residualincome income



19-38

Residual Income As A Performance Measure Sales Sales -Totalvariable variablecosts costs -Total -Totalfixed fixedcosts costs -Total Averageassets assetsinvested invested Average 2,000,000 10% == 2,000,000 XX 10% 3,000,000 10% == 3,000,000 XX 10% ResidualIncome Income Residual


DIVISIONAA DIVISION $1,500,000 $1,500,000 500,000 500,000 250,000 250,000 $750,000 $750,000 $200,000 $200,000 $550,000 $550,000

DIVISIONBB DIVISION $2,000,000 $2,000,000 1,000,000 1,000,000 500,000 500,000 $500,000 $500,000 $300,000 $300,000 $200,000 $200,000


19-39

Residual Income As A Performance Measure Sales Sales -Totalvariable variablecosts costs -Total -Totalfixed fixedcosts costs -Total Averageassets assetsinvested invested Average 2,000,000 10% == 2,000,000 XX 10% 3,000,000 10% == 3,000,000 XX 10% ResidualIncome Income Residual

DIVISIONAA DIVISION $1,500,000 $1,500,000 500,000 500,000 250,000 250,000 $750,000 $750,000 $200,000 $200,000 $550,000 $550,000

DIVISIONBB DIVISION $2,000,000 $2,000,000 1,000,000 1,000,000 500,000 500,000 $500,000 $500,000 $300,000 $300,000 $200,000 $200,000

Assumethat thatDivision DivisionBBhas hasthe theopportunity opportunityto tomake makean an Assume investmentin inan anasset assetcosting costing$500,000 $500,000which whichwill willsave save investment $55,000. Assume Assumean anincome incomeof of$500,000. $500,000. $55,000.



Residual Income As A Performance Measure Cost of investment in CIM = $500,000

19-40

Results in annual operating savings of $55,000

Return on investment Increase in divisional profit 55,000 11% in new equipment = Increase in invested capital = $500,000 = The company’s cost of capital = 10%

Division B’s Return on Investment Without Investment in New Equipment $500,000 $3,000,000 = 16.67%

With Investment in New Equipment $500,000 + $50,000 $3,000,000 + $500,000 =15.7%

Averaging the new investment with that already in place reduces the division’s overall ROI Irwin/McGraw-Hill Ryerson


19-41

Residual Income As A Performance Measure Sales Sales Totalvariable variablecosts costs --Total Totalfixed fixedcosts costs --Total Averageassets assetsinvested invested Average 3,000,000 10% == 3,000,000 XX 10% $500,000 ++$500,000 ResidualIncome Income Residual

DIVISIONBB DIVISION $2,000,000++ $55,000 $55,000==$2,055,000 $2,055,000 $2,000,000 1,000,000 1,000,000 1,000,000 1,000,000 500,000 500,000 500,000 500,000 $500,000 $555,000 $500,000 $555,000 $300,000 $300,000 $3,500,000 $3,500,000 10% $350,000 $350,000 XX 10% $200,000 $205,000 $200,000 $205,000

Theinvestment investmentincreases increasesresidual residualincome income The Irwin/McGraw-Hill Ryerson


19-42

Economic Value Added (EVA) As A Performance Measure Whatdoes doesan anEVA EVAanalysis analysistell tellus? us? What Howmuch muchshareholder shareholderwealth wealthis isbeing beingcreated created How

Two sources of long-term capital: debt and equity Investment Investment WeightedEconomic Investment center’s aftercenter’s average - center’s X value = tax operating current cost of added total assets profit liabilities capital

Howdoes doesEVA EVAdiffer differfrom fromresidual residualincome? income? How Irwin/McGraw-Hill Ryerson


19-43

Weighted Average Cost Of Capital Weighted average cost of = capital

After-tax cost of debt capital

Cost of equity capital

Market value of equity

Market Market value + value of of debt equity

.063 .0972

Market value + of debt

$400,000,000

+

.12

$600,000,000

=

$400,000,000 + Irwin/McGraw-Hill Ryerson

$600,000,000 © McGraw-Hill Ryerson Limited, 2001

19-44

Economic Value Added For Outback Division Current Liabilities Mail-Order $6,000,000 Koala Camp Gear 5,000,000 Retail 9,000,000

Outback OutbackOutfitters Outfitters has has$20 $20million millionin in current currentliabilities liabilities

Investment Investment WeightedInvestment Economic center’s aftercenter’s average - center’s X = value tax operating current cost of total assets added profit liabilities capital Mail-order $14 X (1 - .30) Koala Camp Gear $45 X (1 - .30) Retail $48 X (1 - .30) -


[($ 70 - $6)

X .0972]

[($300 - $5) X .0972] [($480 - $9) X .0972]

= $3,579,200

= $2,826,000 =$(12,181,200)


19-45

Weighted Average Cost Of Capital After-tax cost of debt capital




ChattanoogaManufacturing ManufacturingCompany Companyhas hasthe thefollowing following Chattanooga capitalstructure structure capital Bonds-marketvalue value $5,000,000 Bonds-market $5,000,000 After-taxcost costof ofdebt debtcapital capital 6.5% After-tax 6.5% Commonstock-market stock-marketvalue value $10,000,000 Common $10,000,000 Costof ofequity equitycapital capital 10.0% Cost 10.0%



19-46

Weighted Average Cost Of Capital Weighted average cost of = capital

After-tax cost of debt capital



Market Market value + value of of debt equity

.065

.08833


$5,000,000

+

.10

$10,000,000

=

$5,000,000 Irwin/McGraw-Hill Ryerson

+

$10,000,000 © McGraw-Hill Ryerson Limited, 2001

19-47

Economic Value Added (EVA) As A Performance Measure Assumethe theChattanooga ChattanoogaManufacturing ManufacturingCompany Companyhas hastwo twodivisions divisions Assume withthe thefollowing followingdata: data: with After-Tax After-Tax Current Operating Total Current Operating Total Income Assets Liabilities Income Assets Liabilities DivisionA: A: $1,000,000 $5,000,000 8,000,000 Division $1,000,000 $5,000,000 $$ 8,000,000 DivisionB: B: $2,000,000 $1,000,000 $15,000,000 Division $2,000,000 $1,000,000 $15,000,000

Investment Investment WeightedEconomic Investment center’s aftercenter’s average - center’s X value = tax operating current cost of added total assets profit liabilities capital



19-48

Economic Value Added (EVA) As A Performance Measure Assumethe theChattanooga ChattanoogaManufacturing ManufacturingCompany Companyhas hastwo twodivisions divisions Assume withthe thefollowing followingdata: data: with After-Tax After-Tax Current Operating Total Current Operating Total Income Assets Liabilities Income Assets Liabilities DivisionA: A: $1,000,000 $5,000,000 8,000,000 Division $1,000,000 $5,000,000 $$ 8,000,000 DivisionB: B: $2,000,000 $1,000,000 $15,000,000 Division $2,000,000 $1,000,000 $15,000,000

DivisionA: A: Division DivisionB: B: Division


After-Tax After-Tax Operating Operating Income Income $5,000,000 -$5,000,000 $1,000,000 -$1,000,000

Current Current Liabilities Liabilities [($1,000,000 [($1,000,000 [($2,000,000 [($2,000,000

Total Total Assets Assets 8,000,000) XX -- $$ 8,000,000) $15,000,000) XX -- $15,000,000)

WACC WACC .08833] .08833] .08833] .08833]


19-49

Economic Value Added (EVA) As A Performance Measure


After-Tax After-Tax Operating Operating Income Income $5,000,000 -$5,000,000 $1,000,000 -$1,000,000

Current Current Liabilities Liabilities [($1,000,000 [($1,000,000 [($2,000,000 [($2,000,000


$5,000,000 $5,000,000 $1,000,000 $1,000,000

[$-7,000,000) -7,000,000) XX .08833] .08833] [$ [$-13,000,000 XX .08833] .08833] [$-13,000,000


$5,000,000 $5,000,000 $1,000,000 $1,000,000

---

---

618,310 618,310 1,148,290 1,148,290

Total Total Assets Assets 8,000,000) XX -- $$ 8,000,000) $15,000,000) XX -- $15,000,000)

== ==

WACC WACC .08833] .08833] .08833] .08833]

EVA EVA $4,381,690 $4,381,690 (148,290) $$ (148,290)

DivisionBBis isnot notcreating creatingshareholder shareholderwealth wealth Division Irwin/McGraw-Hill Ryerson


What Is The Division’s Invested Capital? Totalassets assets Total

Appropriateififthe thedivision divisionmanager manager Appropriate hasconsiderable considerableauthority authorityin inmaking making has decisionsabout aboutall allof ofthe thedivision’s division’s decisions assets,including includingnonproductive nonproductiveassets assets assets,

Totalproductive productive Total assets assets

Appropriate if the division manager has been directed by top level management to keep nonproductive assets in progress, making it appropriate to exclude nonproductive assets from the measure of invested capital

Totalassets assetsless less Total currentliabilities liabilities current

Appropriate if the division manager has authority to secure short-term bank loans and other short-term credit


19-50


Assets - Gross Or Net Book Value

Net book value is acquisition value less accumulated depreciation

Current assets (cash, accounts receivable, inventories, etc.) $34,000,000 Long-lived assets (land, buildings, equipment, vehicles, etc.) Gross book value (acquisition cost) $304,000,000 Less: Accumulated depreciation 64,000,000 Net book value 240,000,000 Plant under construction 26,000,000 $300,000,000 Total assets

Curre nt a ssets Long-live d assets (at gross book value ) Pla nt unde r construction Tota l asse ts (at gross book va lue) Irwin/McGraw-Hill Ryerson

19-51

$34,000,000 304,000,000 26,000,000 $364,000,000

Gross book value is acquisition cost © McGraw-Hill Ryerson Limited, 2001

19-52

Net Book Value Versus Gross Book Value Advantagesof ofnet netbook book Advantages value;disadvantages disadvantages value; ofgross grossbook bookvalue value of Usingnet netbook bookvalue valuemaintains maintains !! Using

consistencywith withthe thebalance balance consistency sheetprepared preparedfor forexternal external sheet reportingpurposes purposes reporting Usingnet net book bookvalue valueto to !! Using measureinvested investedcapital capitalis isalso also measure moreconsistent consistentwith withthe the more definitionof ofincome, income,which whichis is definition thenumerator numeratorin inROI ROI the calculations calculations


Advantagesof ofgross grossbook book Advantages value;disadvantages disadvantages value; ofnet netbook bookvalue value of Theusual usualmethods methodsof of !! The

computingdepreciation depreciationare are computing arbitraryand andshould shouldnot notbe be arbitrary allowedto toaffect affectROI, ROI,residual residual allowed income,or orEVA EVAcalculations calculations income, Whenlong longlived livedassets assetsare are !! When depreciated,their theirnet netbook book depreciated, valuedeclines declinesover overtime time value resultingin inaamisleading misleading resulting increasein inROI, ROI,residual residual increase income,and andEVA EVAacross acrosstime time income,


Methods Of Measuring Investment-Center Income

19-53

The The key key issue issue is is controllability; controllability; the the choice choice involves involves the the extent extent to to which which uncontrollable uncontrollable items items are are allowed allowed to to influence influence the the income income measure measure Sales Sales revenue revenue Less: Less: unit-level, unit-level, batch-level, batch-level, product-level product-level and and customer-level customer-level expense expense == (1) (1) Divisional Divisional contribution contribution margin margin Less: Less: general general and and facility-level facility-level expenses expenses controllable controllable by by division division manager manager == (2) (2) Profit Profit margin margin controllable controllable by by division division manager manager Less: Less: general general and and facility-level facility-level expenses, expenses, traceable traceable to to division, division, but but controlled controlled by by others others == (3) (3) Profit Profit margin margin traceable traceable to to division division Less: Less: common common general general and and facility-level facility-level expenses, expenses, allocated allocated from from company company headquarters headquarters == (4) (4) Divisional Divisional income income before before interest interest and and taxes taxes Less: Less: Interest Interest expense expense allocated allocated from from company company headquarters headquarters == (5) (5) Divisional Divisional income income before before taxes taxes Less: Less: income income taxes taxes allocated allocated from from company company headquarters headquarters == (6) (6) Divisional Divisional net net income income Irwin/McGraw-Hill Ryerson


Alternatives To ROI, Residual Income And EVA ROI Residual Income EVA

19-54

Short-run performance measures

Multiperiod viewpoint

Takes into account the timing of cash flows in the investment


Actual divisional profit for a time period is compared to a flexible budget and variances are used to analyze performance

The division’s major investments are evaluated through a postaudit of the investment decisions


19-55

End of Chapter 19 At least my division did well. I wonder how the whole company did?

