Chapter 11: Performance Measurement in Decentralized Organizations

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Benefits of decentralization in organizations:

Top management freed to concentrate on strategy

Lower-level decisions often based on better information

Lower level managers can respond quickly to customers

Lower-level managers gain experience in decision-making

Decision-making authority leads to job satisfaction

Disadvantages of decentralization in organizations:

Lower-level managers may make decisions without seeing the "big picture"

May be a lack of coordination among autonomous managers

Lower-level manager's objectives may not be those of the organization

May be difficult to spread innovative ideas in the organization

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Responsibility Accounting:

Cost, profit, and investment centers are all known as Responsibility Centers

A cost center is a segment whose manager has control over costs, but not over revenues or investment funds

A profit center is a segment whose manager has control over both costs and revenues, but no control over investment funds

An investment center is a segment whose manager has control over costs, revenues, and investments in operating assets

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Learning objective 1 (Compute return on investment and show how changes in sales, expenses, and assets affect ROI)

Formula: ROI = Net operating income / Average operating assets

Net operating income = Income before interest and taxes

Average operating assets = Cash, accounts receivable, inventory, planet and equipment, and other productive assets

Most companies use the net book value of depreciable assets to calculate average operating assets

Acquisition cost - Accumulated depreciation = Net book value

Understanding return on investment (ROI)

ROI = Net operating income / Average operating assets

Margin = Net operating income / Sales

Turnover = Sales / Average operating assets

In other words... ROI = Margin x Turnover

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Increasing ROI: An example

Regal Company reports the following:

Net operating income = $30,000

Average operating assets = $200,000

Sales = $500,000

Operating expenses = $470,000

Calculate ROI using both Margin and Turnover.

ROI = (Net operating income / Sales) X (Sales/Average operating assets)

ROI = (30,000/500,000) x (500,000/200,000)

ROI = 0.06 x 2.5

ROI = 0.15 (15%)

Investing in Operating Assets to Increase Sales: An Example

An invest in a $30,000 piece of equipment increases sales by $35,000 and increases operating expenses by $15,000.

Regal Company reports the following:

Net operating income = $50,000

Average operating assets = $230,000

Sales = $535,000

Operating expenses = $485,000

Calculate the new ROI.

ROI = (Net operating income / Sales) x (Sales/Average operating assets)

ROI = ($50,000/$535,000) x ($535,000 / $230,000)

ROI = 0.0935 x 2.33

ROI = 0.2178 (21.8%)

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Criticisms of ROI:

In the absence of the balanced scorecard, management may not know how to increase ROI.

Managers often inherit many committed costs over which they have no control.

Managers evaluated on ROI may reject profitable investment opportunities.

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Learning objective 2 (Compute residual income and understand its strengths and weaknesses):

Residual income is net operating income above some minimum return on operating assets

Residual income = Net operating income - (Average operating assets x Minimum required rate of return)

ROI measures net operating income earned relative to the investment in average operating assets

Residual income measures net operating income earned less the minimum required return on average operating assets

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Residual income: An example

The Retail Division of Zephyr, Inc reported the following:

Average operating assets = $100,000

Required return = 20%

Currently earned: $30,000

Calculate the residual income.

Residual income = Net operating income - (Average operating assets x Minimum required rate of return)

Residual income = $30,000 - (100,000 x 20%)

Residual income = $30,000 - $20,000

Residual income = $10,000

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Motivation and residual income:

Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

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Quick Checks (solve these on your own in your hand-written notes):

Quick check 1

Redmond Awnings reported the following:

Net operating income = $60,000

Average operating assets = $300,000

Required rate of return = 15%

Calculate the division's ROI.

Quick check 2

Using ROI, would the manager of Redmond Awnings want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? Why or why not?

Quick check 3

Using ROI, would the company want the manager of Redmond Awnings to make the same investment mentioned? Why or why not?

Quick check 4

Using the same information from quick check 1, what is the division's residual income?

Quick check 5

Using residual income, would the manager of Redmond Awnings make the investment mentioned in quick check 2? Why or why not?

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Divisional comparisons and residual income:

The residual income approach cannot be used to compare the performance of divisions of different sizes.