Chapter 11 – Lecture Notes
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Chapter 11
Lecture Notes
Chapter theme: Managers in large organizations have to
delegate some decisions to those who are at lower levels in
the organization. This chapter explains how responsibility
accounting systems, return on investment (ROI),
residual income, operating performance measures, and
the balanced scorecard are used to help control
decentralized organizations.
I. Decentralization in organizations
A. A decentralized organization does not confine
decision-making authority to a few top executives;
rather, decision-making authority is spread
throughout the organization. The advantages and
disadvantages of decentralization are as follows:
i. Advantages of decentralization
1. It enables top management to concentrate
on strategy, higher-level decision making,
and coordinating activities.
2. It acknowledges that lower-level managers
have more detailed information about local
conditions that enable them to make better
operational decisions.
3. It enables lower-level managers to quickly
respond to customers.
4. It provides lower-level managers with the
decision-making experience they will need
when promoted to higher level positions.
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5. It often increases motivation, resulting in
increased job satisfaction and retention, as
well as improved performance.
ii. Disadvantages of decentralization
1. Lower-level managers may make decisions
without fully understanding the “big
picture.”
2. There may be a lack of coordination among
autonomous managers.
a. The balanced scorecard can help
reduce this problem by communicating
a company’s strategy throughout the
organization.
3. Lower-level managers may have objectives
that differ from those of the entire
organization.
a. This problem can be reduced by
designing performance evaluation
systems that motivate managers to
make decisions that are in the best
interests of the company.
4. It may be difficult to effectively spread
innovative ideas in a strongly decentralized
organization.
II. Responsibility accounting
A. Responsibility accounting systems link lower-level
managers’ decision-making authority with
accountability for the outcomes of those decisions.
The term responsibility center is used for any part of
an organization whose manager has control over, and
is accountable for cost, profit, or investments. The
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three primary types of responsibility centers are cost
centers, profit centers, and investment centers.
i. Cost center
1. The manager of a cost center has control
over costs, but not over revenue or
investment funds.
a. Service departments such as
accounting, general administration,
legal, and personnel are usually
classified as cost centers, as are
manufacturing facilities.
b. Standard cost variances and flexible
budget variances, such as those
discussed in Chapters 10 and 11, are
often used to evaluate cost center
performance.
ii. Profit center
1. The manager of a profit center has control
over both costs and revenue.
a. Profit center managers are often
evaluated by comparing actual profit to
targeted or budgeted profit.
iii. Investment center
1. The manager of an investment center has
control over cost, revenue, and
investments in operating assets.
a. Investment center managers are
usually evaluated using return on
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investment (ROI) or residual income,
as discussed later in this chapter.
III. Evaluating investment center performance – return on
investment
Learning Objective 1: Compute return on investment
(ROI) and show how changes in sales, expenses, and
assets affect ROI.
A. Key concepts/definitions
i. Investment center performance is often
evaluated using a measure called return on
investment (ROI), which is defined as
follows:
Net operating income
ROI Average operating assets
=
ii. Net operating income is income before taxes
and is sometimes referred to as EBIT (earnings
before interest and taxes). Operating assets
include cash, accounts receivable, inventory,
plant and equipment, and all other assets held
for operating purposes.
1. Net operating income is used in the
numerator because the denominator consists
only of operating assets.
2. The operating asset base used in the formula
is typically computed as the average of the
assets between the beginning and the end of
the year.
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iii. Net book value versus gross cost
1. Most companies use the net book value
(i.e., acquisition cost less accumulated
depreciation) of depreciable assets to
calculate average operating assets.
a. With this approach, ROI
mechanically increases over time as
the accumulated depreciation
increases. Replacing a fully-
depreciated asset with a new asset will
decrease ROI.
2. An alternative to net book value is the gross
cost of the asset, which ignores
accumulated depreciation.
a. With this approach, ROI does not grow
automatically over time, rather it stays
constant. Replacing a fully-
depreciated asset does not adversely
affect ROI.
B. Understanding ROI
i. Du Pont pioneered the use of ROI and
recognized the importance of looking at the
components of ROI, namely margin and
turnover.
1. Margin is computed as shown and is
improved by increasing unit sales,
increasing selling prices, or reducing
operating expenses. The lower the operating
expenses per dollar of sales, the higher the
margin earned.
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2. Turnover is computed as shown. It
incorporates a crucial area of a manager’s
responsibility – the investment in operating
assets. Excessive funds tied up in operating
assets depress turnover and lower ROI.
Helpful Hint: Emphasize that both margin and turnover
affect profitability. As an example, ask students to
compare the margins and turnovers of grocery stores to
jewelry stores. In equilibrium, every industry should
have roughly the same ROI. Groceries, because of their
short shelf life, have high turnovers relative to fine
jewelry. If the ROIs are to be comparable in grocery
stores and in jewelry stores, the margins would have to
be higher in jewelry stores.
ii. To illustrate how to increase ROI, assume that
Regal Company reports the results shown:
1. Given this information, its current ROI is
15%.
2. Suppose that Regal’s manager invests in a
$30,000 piece of equipment that increases
sales by $35,000 while increasing operating
expenses by $15,000.
a. In this case, the ROI increases from
15% to 21.8%.
C. Criticisms of ROI
i. Just telling managers to increase ROI may not
be enough. Managers may not know how to
increase ROI in a manner that is consistent
with the company’s strategy.
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1. This is why ROI is best used as part of a
balanced scorecard.
ii. A manager who takes over a business segment
typically inherits many committed costs over
which the manager has no control. This may
make it difficult to assess this manager relative
to other managers.
iii. A manager who is evaluated based on ROI may
reject investment opportunities that are
profitable for the whole company but that
would have a negative impact on the manager’s
performance evaluation.
Helpful Hint: When discussing the criticisms of ROI
and other measures of profitability, ask students to play
the role of a manager who anticipates a short tenure.
This manager will want to increase ROI as quickly as
possible. Ask students to list the activities that could be
undertaken to increase ROI that, in reality, would hurt
the company as a whole.
IV. Residual income
Learning Objective 2: Compute residual income and
understand its strengths and weaknesses.
A. Defining residual income
i. Residual income is the net operating income
that an investment center earns above the
minimum required return on its assets.
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