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Copyright  2001 McGraw-Hill Ryerson
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Student Centre Cost Management
Strategies for Business Decisions
First Canadian Edition, Hilton/Maher/Selto/Sainty

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Chapter 19: Org Design, Responsibility Accounting, Evaluation Divisional Performance

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    Chapter Outlines

    1. Cost Management Challenges. Chapter 19 offers five cost management challenges.

      1. As companies grow, what is the best way to manage them? What are some benefits and costs of decentralization?

      2. How can a responsibility accounting system foster goal or behavioural congruence for an organization?

      3. What are the major types of responsibility accounting centres?

      4. What is the key feature of activity-based responsibility accounting?

      5. How is investment centre performance typically measured?

    2. Learning Objectives – This chapter has eight learning objectives.

      1. Chapter 19 explains the role of responsibility accounting in fostering goal or behavioural congruence.

      2. The chapter lists several benefits and costs of decentralization.

      3. It describes the distinguishing characteristics of responsibility centres and the various types: a cost centre, a discretionary cost centre, a revenue centre, a profit centre and an investment centre.

      4. Chapter 19 shows how to prepare a performance report for various responsibility centres.

      5. The chapter demonstrates how to compute an investment centre's return on investment (ROI), residual income (RI), and economic value added (EVA).

      6. It explains how a manager can improve ROI by increasing either the sales margin or capital turnover.

      7. The chapter describes the pros and cons of using ROI and RI as divisional performance measures.

      8. Chapter 19 explains various approaches for measuring a division's income and invested capital.

    3. Most large organizations are divided into smaller units, each of which is assigned particular responsibilities. The people placed in charge of these units should be motivated to strive toward the goals that the organization wants to achieve. Goal congruence results when managers of subunits throughout an organization have incentives to perform in the common interest. Ideally, members of an organization have such a strong team spirit that goal congruence is a natural outcome of that spirit. In most cases, however, employees must be motivated to behave as if their personal goals were congruent with organizational goals through a set of performance evaluation and incentive systems. This results in behavioural congruence. Responsibility accounting, which is comprised of the tools and concepts used to measure performance of people and departments, is used to foster behavioural congruence. The fundamental purpose of a responsibility accounting system is to reap the benefits of decentralization, while minimizing the costs of decentralization.

      1. Decentralization of large organizations became necessary as organizations became too large and complex to be under the authority of just a few people. A centralized organization has a small group of decision makers at the top. Subordinates carry out the decisions as they are handed down, but the subordinates do not participate in any decision making. A decentralized organization, on the other hand, allows people at lower levels of management to make key decisions in the subunits that they are responsible for. Top management makes the major, strategic decisions. Decentralization has some benefits, but also has some costs.

      2. Large organizations benefit from decentralization the most if there is a system in place to ensure that lower-level managers will do a good job without day-to-day oversight of their activities. Six benefits of decentralization are as follows. (1) Decentralization allows managers with particular skills to manage those parts of the organization where those skills are needed. This eliminates the need for top managers to be skilled in all areas of operation. (2) Giving managers autonomy and responsibility prepares them for higher-level management positions. (3) Managers with decision-making authority usually exhibit greater motivation than those who merely follow directions of others. (4) Delegating decisions to lower-level managers frees up time of higher-level managers to make strategic decisions instead of being bogged down in daily decision-making. (5) Empowering employees to make decisions makes use of their knowledge and expertise of day-to-day operations. (6) Delegating decision-making authority to lower levels allows an organization to respond on a timely basis to opportunities and problems that arise.

      3. In addition to the benefits of decentralization, there are also some costs. They are as follows. (1) Managers may have a narrow focus on their own unit's performance instead of the overall goals of the organization. (2) If managers have a narrow focus on their subunit, they may ignore the consequences of their actions on other subunits. (3) Decentralized organizations run the risk of having duplication of tasks or services. For instance, a decentralized organization that authorizes departments to purchase their own office equipment may find that two departments, right next to each other purchase copiers, when the two departments probably could have shared one.

    4. Responsibility accounting is a systematic way to ensure that workers in an organization will work toward achieving the organization's goals. The basis of a responsibility accounting system is the designation of each subunit as a particular type of responsibility centre. A responsibility centre is a subunit in an organization whose manager is held accountable for specified financial and nonfinancial results of the subunit's activities. There are five types of responsibility centres.

      1. A cost centre is a subunit whose manager is responsible for the cost of an activity for which a well-defined relationship exists between inputs and outputs. In manufacturing, production departments are usually designated as cost centres.

      2. A discretionary cost centre is a subunit whose manager is held accountable for costs where the input-output relationship is not well defined. Support departments in organizations are discretionary cost centres.

      3. A revenue centre is a subunit whose manager is held accountable for the revenue attributed to the subunit. The manager of Ladies Dresswear in a department store is a revenue centre manager.

      4. A profit centre is a responsibility centre where the manager is responsible for profits. Since profits are obtained by subtracting costs from revenues, the manager of a profit centre is accountable for both costs and revenues.

      5. An investment centre has a manager who is accountable for the subunit's profits as well as invested capital used to generate its profits. A division of a large corporation is typically designed as an investment centre. Managers of investment centres usually have the authority to make some capital investment decisions. Some organizations use the terms profit centre and investment centre interchangeably.

    5. Performance reports are prepared by the manager of each responsibility centre. A performance report shows budgeted and actual amounts of key financial results appropriate for the type of responsibility centre involved. The performance report for a cost centre of a manufacturing facility would contain budgeted and actual activity, and then would report cost variances, as described in Chapters 16 and 17. A manager of a revenue centre would complete a performance report showing budget and actual information, and would include variances like those presented in Chapter 18 (sales variances). This performance report might also summarize customer profitability. A performance report is completed and submitted to the next higher-level manager. The lower-level manager's subunit is a part of the higher-level manager's larger subunit.

      1. Responsibility accounting, budgeting, and variance analysis are closely related. The flexible budget provides the benchmark against which actual revenues, expenses and profits are compared.

      2. Contemporary cost management systems extend the basic measures of financial performance of cost, revenue and profit by incorporating activity-based analysis of costs, revenues and profits. Activity-based responsibility accounting directs management attention to costs and revenues, and also places emphasis on activities.

    6. The purpose of having a responsibility accounting system is to elicit certain types of behaviour. Unless the system is developed and used properly, an organization runs the risk of eliciting inappropriate behaviour.

      1. The proper focus of a responsibility accounting system is information. One danger in having a responsibility accounting system where managers must explain unfavourable outcomes is that there may be some sense that unfavourable outcomes should be blamed on managers. If this is how managers feel about the responsibility accounting system, they may take steps to manipulate data, or undermine it in other ways.

      2. A performance report is even more informative if the costs and revenues are split between those that are controllable by the reporting manager, and those that are not controllable. Segregating costs or revenues is not an easy task, but to the extent it can be done, it aids higher-level managers to more accurately evaluate the performance of lower-level managers.

      3. The best result of a responsibility accounting system is one that motivates the desired behaviour of managers. For instance, the sales manager, whose main focus is on making sales, may be motivated to accept rush orders without regard to the additional production costs that might result. A responsibility accounting system that charges the sales manager for the production costs of an expedited order might be more careful about making promises of fast delivery to customers.

    7. Although managers of cost, revenue and profit centres are evaluated based on controlling costs or achieving revenue or profit goals, the highest-level responsibility centre, an investment centre is probably given the closest scrutiny by top management. In addition to the fact that these managers' performance reports include the results of lower-level units, they are held accountable for the effective use of investment resources. There are three common measures of performance for managers of investment centres. They are return on investment, residual income, and economic value added.

      1. Return on investment (ROI) is the most commonly used measure of investment centre performance. It is calculated as: ROI = Income/Invested capital ROI makes different investment centres in an organization comparable to each other. Absolute dollar amounts of profit can be misleading. Suppose two investment centres generated $10 million and $20 million in profits. Just looking at the profits, it appears that the second subunit's performance was better than the first. But suppose it took investments of $100 million and $400 million to generate those profits. The ROI for the first investment centre is 10%, while the ROI for the second investment centre is only 5%.

        1. The ROI can be expressed in a different way. An alternative calculation is:

            ROI = (Income/Sales Revenue) * (Sales Revenue/Invested capital)
          By cancelling out the sales revenue terms, ROI can be more readily calculated. However, it is useful to determine ROI using the longer expression because it highlights the fact that the return on investment is actually earned for two reasons. The longer expression is sometimes referred to as the DuPont model.
          1. Income/Sales revenue is called sales margin. This part of ROI shows how much of the profit was generated as a percentage of sales revenue. Clearly, the higher this percentage is, the higher the return on investment will be.
          2. Sales revenue/Invested capital is called capital turnover. This expression shows how much revenue is generated for every dollar of capital investment. A higher number for this expression implies that invested capital is being used effectively.

      2. Improving a division's ROI can be accomplished by increasing sales margin or by increasing capital turnover. It is useful to look at the DuPont model expression of ROI to see what needs to be done to improve profitability. Suppose sales revenues are increased but income and invested capital are held constant? ROI will be exactly the same as before. Thus, increasing sales without increasing profits will not increase overall profitability.

        1. Increasing income is the most obvious way to increase ROI, but it is not an easy way. Income can be increased by either increasing revenues (higher sales) or by decreasing costs. Income can also be increased by raising prices, but selling less product. In this case, total revenue is held constant but income is higher.

        2. The other way to increase ROI is to raise capital turnover. It should be noted that, turnover could be increased by raising sales revenue or lowering invested capital. However, if revenue is raised without raising income as well, or lowering invested capital as well, there will be no effect on ROI. Decreasing invested capital is a challenging goal. Large chunks of invested capital are committed, long-term, fixed assets. These cannot be easily eliminated.

        3. Although ROI is widely used as a performance measure, it has one important drawback. Since managers are evaluated based on their division's ROI, there may be some disincentives for managers to make capital investments that are good for the organization as a whole, but not good as it relates to divisional ROI. For instance, if a manager'' division has an ROI of 15%, and a capital investment has a ROI of 11%, the new ROI for the division would become something less than 15%. Thus, even if an ROI of 11% is acceptable for the organization as a whole, because it exceeds organizational cost of capital, the manager might be tempted to reject it because of the effect it would have on his or her division's ROI.

        4. There is an ethical component to the situation just described. Recall, the responsibility accounting system is supposed to motivate behavioural congruence for the good of the organization. In the situation just described, the manager would be tempted to reject a viable investment option because of the effect on his or her own interests. This is especially true if bonuses, promotions, or even one's job could be at risk if divisional ROI declines.
          ___This highlights the dangers of using just one performance measure. Residual income or economic value added are other performance measures that may be used to supplement ROI.

      3. An alternative performance measure for investment centres is residual income (RI). ROI is computed without regard to the cost of capital. Residual income looks at the profitability of a prospective capital investment based on how much income remains after accounting for the organization's cost of capital. If residual income with the proposed investment is higher than residual income is without the investment, then the proposed capital project should be accepted.
        ___Residual income is calculated as:

          RI = Investment centre's profit – (investment centre's invested capital * Imputed interest rate)
        The imputed interest rate is the firm's cost of acquiring investment capital.

        1. Residual income is a dollar amount, not a percentage like ROI. This is, in fact, one of the drawbacks of using it. Since RI gives an absolute dollar amount, it cannot be used to evaluate different investment centres with differing investment decisions to make. A very large division with RI of $40,000 for a project should not be evaluated the same as a very small division with RI of $20,000 (the first project is probably not twice as beneficial as the second).

        2. RI and ROI should both be used for different purposes, or in conjunction with each other.

      4. Economic value added (EVA) is the third measure used to evaluate performance of investment centres. EVA is: Investment centre's after-tax operating income – [(Investment centre's total assets – Investment centre's current liabilities) * Weighted-average cost of capital)].
        ___EVA is similar to residual income, except for three things. First, income tax effects are explicitly incorporated into the calculations by using the after-tax operating income, and by using the after-tax cost of debt capital. Second, an investment centre's current liabilities are subtracted from total assets. Third, the weighted average cost of capital is used instead of an imputed interest rate. The weighted average cost of capital WACC) takes into account the two sources of long-term capital – debt and equity. WACC is calculated as:

          [(After-tax cost of debt capital) * (Market value of debt) + (Cost of equity capital) * (Market value of equity)] divided by (Market value of debt + market value of equity)

        1. The EVA is expressed as a dollar amount. The advantage of calculating EVA is that it evaluates overall performance of the division like ROI does, but it tells top management fairly readily when a division is in trouble. If the EVA is negative, it means the division is a financial drain on the company's resources. It sounds an alarm that management can respond to immediately.

    8. ROI, RI, and EVA all use profit and invested capital in their formulas. This raises the question of how to measure divisional profit and invested capital. There are various ways to do this.

      1. There are several ways to measure an investment centre's capital. Here are some considerations.

        1. Asset balances (or invested capital) may be averages of beginning and ending balances. ROI, RI and EVA are measures of performance over a period of time, while asset balances are measured at one point in time. Average asset balance is used because it, at least, gives a simple measure of the asset base over the time period being evaluated.

        2. How much of the asset base should be included for a division? Some companies use total assets. Other companies use total productive assets, excluding non-productive assets. A third view is that total assets less current liabilities should be used, based on the logic that current liabilities must be paid with current assets, so current assets should be reduced by this much. A fourth consideration is whether gross or net book values should be used. Using gross book value when a considerable portion of the asset base has been depreciated might distort results. This last consideration deserves more discussion.

          1. Net book value has two advantages over gross book value. First, it is consistent with balance sheet information prepared for financial reports, and allows for a more meaningful comparison of ROI measures across different companies. Second, net book value is more consistent with net income used in calculating ROI. The income figure deducts the current period's depreciation expense.
          2. Proponents of the use of gross book value argue that depreciation methods are arbitrary, and so they should not be included in performance measures. Perhaps a more compelling argument is that the net book value artificially inflates the ROI, RI and EVA over time. This being the case, managers might be motivated to hang on to old equipment too long, and they might be reluctant to acquire new, more efficient assets.

        3. The asset base for a division might also include allocated assets. For instance, divisions may have accounts receivable allocated when customers purchase product from several divisions.

      2. Choosing the method for measuring investment centre income is another concern for managers. One factor to consider is how controllable is the income attributed to a division? A division's net income figure may be derived from including several allocated expenses, like allocated income taxes, facility-level expenses allocated from corporate headquarters, interest expenses allocated from corporate headquarters, expenses traceable to the division but controlled by others, and general and facility-level expenses controllable by the division manager. An argument could be put forth that no allocated expenses beyond the control of the division manager should be factored into that manager's performance measures.

      3. One point to keep in mind when considering what information to use for estimating assets and income is that ROI, RI and EVA are used to evaluate managers' and divisions' performance. In evaluating the manager's performance, one should consider only costs and revenues that the manager can control. Evaluation of a division is done for a different purpose. The main purpose of evaluating a division is to see if it is viable in terms of profitability. Traceability of costs is more important than controllability.

      4. Even though costs like allocated income taxes, and other costs allocated from corporate headquarters are not controllable by division managers, they are routinely included in performance reports to remind division managers that there are other costs that must be covered by the profits of various divisions in order for the organization as a whole to be profitable.

      5. During periods of inflation, or for global companies operating in high-inflation countries, it could be justifiably argued that historical-cost asset valuation should be supplemented with replacement-cost asset values.

    9. ROI, RI, and EVA are all short-term performance measures, that evaluate performance one year at a time. An investment centre is comprised of the product of strategic decisions intended to benefit the organization over long periods of time. A correct evaluation of multiperiod strategic decisions is to look at a longer window of time.

      1. A more appropriate evaluation of a long-term investment is to perform a postaudit of an investment decision. The problem with this approach, however, is that strategic decisions are made on an ongoing basis, and are usually part of a bundle of investments that are used together.

      2. Another way to evaluate long-term investment is to use a balanced scorecard approach. The balanced scorecard is presented in Chapter 21.

    10. Large, decentralized non-profit organizations need to evaluate performance of divisions and managers just as much as for-profit organizations do. It is especially challenging to do this because the profit motive is not there to elicit efficient, productive activity. Often, managers of non-profit and government organizations are working there for reasons that are not purely financial. They may be less receptive to formal control procedures than their business counterparts. The goals of non-profit organizations may be less clear-cut than for –profit organizations. Some goals may contradict. For instance, an organization may have the goal of providing medical care to a rural, impoverished community. It may have another goal to stay within its budget. Clearly these goals conflict if the budgeted is fixed.

    11. Top management must be conscious of the need to modify its performance evaluation system in accordance with the changes in its organization. Some warning signals that may indicate a need to modify or add performance measures include: (1) a change in organizational strategy; (2) an absence of nonfinancial performance measures; (3) no measures associated with a critical process or success factor; (4) adoption of new technology or organization structure; (5) market share drop; (6) financial crisis; (7) reports that are ignored by managers; (8) managers motivated to do non-value-added tasks; (9) performance measures monitor only costs; (10) measures are all short-term in nature; (11) product has moved into a new phase of its life cycle; (12) measures do not tell how one can do better; (13) functional groups do not work well together; (14) measures are extremely precise; (15) measures are only internally focused; (16) managers and employees cannot articulate critical success factors for organization.


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