Learning Objectives

1. Power Notes ChapterM7 Performance Evaluation for Decentralized Operations 1. Centralized and Decentralized Operations 2. Responsibility Accounting for Cost Centers 3. Responsibility Accounting for Profit Centers 4. Responsibility Accounting for Investment Centers 5. Transfer Pricing Learning Objectives C7

2. Power Notes ChapterM7 Performance Evaluation for Decentralized Operations Slide # Power Note Topics • 2 • 6 • 11 • 17 • 22 • Decentralized Operations • Accounting for Cost Centers • Accounting for Profit Centers • Accounting for Investment Centers • Transfer Pricing Note: To select a topic, type the slide # and press Enter.

3. Advantages of Decentralized Operations 1. Lower-level managers can react more quicklyto problems or changes in operations. 2. Lower-level managers are closer and more responsive to the customer’s needs. 3. The operation provides a better training groundfor managers. 4. Delegation improves employee morale. 5. Top managemjent is free to devote time to strategic planning.

4. Disadvantages of Decentralized Operations 1. Assets and operating costs are duplicated(e.g., each division has its own administrative staff). 2. Managers may pursue their own goals, instead of company goals.

5. Responsibility Centers Cost Centers Managers are held accountable for controlling costs. Managers are held accountable for costs and making decisions that impact revenuesfavorably. Managers are held accountable for costsand revenuesand are also held accountable for the efficient use of assets. Profit Centers Investment Centers

6. Cost Center Responsibility Accounting Budget Performance Report Vice-President, Production For the Month Ended October 31, 2003 Administration $ 19,500 $ 19,700 $ 200 Plant A 467,475 470,330 2,855 Plant B 395,225 394,300 $925 $882,200 $884,330 $3,550 $925 Over Under Budget Actual Budget Budget Each of the line items above will be supported by a cost center report.

7. Cost Center Responsibility Accounting Budget Performance Report Vice-President, Production For the Month Ended October 31, 2003 Administration $ 19,500 $ 19,700 $ 200 Plant A 467,475 470,330 2,855 Plant B 395,225 394,300 $925 $882,200 $884,330 $3,550 $925 Over Under Budget Actual Budget Budget This is supported by a cost center report for Plant A.

8. Cost Center Responsibility Accounting Budget Performance Report Manager, Plant A For the Month Ended October 31, 2003 Administration $ 17,500 $ 17,350 $150 Department 1 109,725 111,280 $1,555 Department 2 190,500 192,600 2,100 Department 3 149,750 149,100 650 $467,475 $470,330 $3,655 $800 Over Under Budget Actual Budget Budget This is shown on the production report.

9. Cost Center Responsibility Accounting Budget Performance Report Manager, Plant A For the Month Ended October 31, 2003 Administration $ 17,500 $ 17,350 $150 Department 1 109,725 111,280 $1,555 Department 2 190,500 192,600 2,100 Department 3 149,750 149,100 650 $467,475 $470,330 $3,655 $800 Over Under Budget Actual Budget Budget This is supported by a cost center report for Department 1.

10. Cost Center Responsibility Accounting Budget Performance Report Supervisor, Department 1—Plant A For the Month Ended October 31, 2003 Factory wages $ 58,100 $ 58,000 $150 Materials 32,500 34,225 $1,725 Supervisory salaries 6,400 6,400 Power and light 5,750 5,690 650 Depreciation 4,000 4,000 Maintenance 2,000 1,990 10 Insurance, taxes 975 975 $109,725 $111,280 $1,725 $170 Over Under Budget Actual Budget Budget This is shown on Plant A’s report.

11. Profit Center Responsibility Accounting Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2003 Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000 Income from operations $3,505,000 $2,095,000 Theme Movie Park Production Division Division Income from operations before service department charges.

12. Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2003 Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 Theme Movie Park Production Service Department Division Division These costs are charged to the divisions based on the activity base of the service department.

13. Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2003 Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 Theme Movie Park Production Service Department Division Division 25,000 purchase requisitions x $10 per requisition = $250,000 15,000 purchase requisitions x $10 per requisition = $150,000

14. Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2003 Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 Theme Movie Park Production Service Department Division Division 12,000 payroll checks x $17 per check = $204,000 3,000 payroll checks x $17 per check = $51,000

15. Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2003 Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 Theme Movie Park Production Service Department Division Division 100 hours x $250 per hour = $25,000 900 hours x $250 per hour = $225,000

16. Profit Center Responsibility Accounting Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2003 Theme Movie Park Production Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000 Income from operations before service department charges $3,505,000 $2,095,000 Less service dept. charges: Purchasing $ 250,000 $ 150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total service dept. charges $ 479,000 $ 426,000 Income from operations $3,026,000 $1,669,000

17. Investment Center Responsibility Accounting DataLink Inc. Divisional Income Statements For the Year Ended December 31, 2003 Revenues $560,000 $672,000 $750,000 Operating expenses 336,000 470,400 562,500 Income from operations before service dept. charges $224,000 $201,600 $187,500 Service department charges 154,000 117,600 112,500 Income from operations $ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Rate of return on investment 20% 12% 15% Northern Central Southern Division Division Division

18. Investment Center Responsibility Accounting Northern Central Southern Division Division Division Profit Margin Income from operations$ 70,000 $ 84,000 $ 75,000 Revenues (Sales) $560,000 $672,000 $750,000 Profit margin 12.5% 12.5% 10.0% Revenues (Sales) $560,000 $672,000 $750,000 Invested assets $350,000 $700,000 $500,000 Investment turnover 1.6 .96 1.5 Income from operations$ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Rate of return on investment 20% 12% 15% Investment Turnover Rate of Return (ROI)

19. Rate of Return on Investment DataLink Inc. Divisional Income Statements For the Year Ended December 31, 2003 Profit margin 12.5% 12.5% 10.0% Investment turnover x 1.6 x .96 x 1.5 Rate of return on investment 20% 12% 15% Northern Central Southern Division Division Division

20. Residual Income DataLink Inc. Divisional Income Statements For the Year Ended December 31, 2003 Income from operations $ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Minimum desired return 10.0% 10.0% 10.0% Minimum desired income$ 35,000 $ 70,000 $ 50,000 Residual income $ 35,000 $ 14,000 $ 20,000 Northern Central Southern Division Division Division How can Northern Division have the highest residual income when they have the lowest income from operations?

21. Nonfinancial Performance Measurement Nonfinancial performance measures combined with conventional financial measures provide a balanced performance perspective. 1. Measures of product quality 2. Customer complaints and warranty experience 3. Customer satisfaction and retention rates 4. Product availability and on-time performance 5. New product time to market and market share

22. Benefits of Transfer Pricing 1. Divisions can be evaluated as profit or investment centers. 2. Divisions are forced to control costsand operate competitively. 3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

23. Commonly Used Transfer Prices 1. Market price approach sets the price at which the product transferred could be sold to outside buyers. 2. Negotiated price approach allows decentralized managers to agree (negotiate) among themselves. 3. Cost price approachuses a variety of cost concepts for setting the transfer price. Commonly Used Transfer Prices Variable Cost per Unit $10 Full Cost per Unit $13 Market Price per Unit $20 Negotiated Price

24. Transfer Pricing—Negotiated Price Approach Assumptions 1. Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity. 2. Division N purchases 20,000 units of the same product at $20 per unit from an outside source. Variable Cost per Unit $10 Market Price per Unit $20 Negotiated Price If the division managers agree on a price of $18 per unit, how much will each division’s income increase? How much for the overall company? Division M Division N

25. Note: To see the topic slide, type 2 and press Enter. Power Notes ChapterM7 Performance Evaluation for Decentralized Operations This is the last slide in Chapter M7.