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417
chapter
23(9)
Evaluating Decentralized
Operations
______________________________________________
OPENING COMMENTS
least in part, using accounting data.
The chapter opens with a discussion of decentralized operations. It also illustrates transfer pricing under
After studying the chapter, your students should be able to:
1. Describe the advantages and disadvantages of decentralized operations.
2. Prepare a responsibility accounting report for a cost center.
3. Prepare responsibility accounting reports for a profit center.
scorecard for an investment center.
5. Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer
pricing may be used by decentralized segments of a business.
ADM: Describe and illustrate the use of profit margin, investment turnover, and ROI in evaluating
whether a company should expand through franchised or owner-operated stores
KEY TERMS
Chapter 23(9) Evaluating Decentralized Operations 418
balanced scorecard
controllable expenses
controllable revenues
cost center
cost price approach
DuPont formula
investment center
investment turnover
market price approach
negotiated price approach
profit center
profit margin
residual income
return on investment (ROI)
responsibility accounting
service department charges
transfer price
STUDENT FAQS
Why is decentralized management used when the managers usually don’t have the experience or
training?
What is the best type of responsibility accounting center and why?
What are considered invested assets on the balance sheet?
Does management actually use all these formulas to determine if a company is doing well or not?
Besides comparing to years in the past for a company, where do you get industrial averages?
OBJECTIVE 1
Describe the advantages and disadvantages of decentralized operations.
SYNOPSIS
All major planning and operating decisions are made by top management in a centralized company. In a
decentralized company, managers of separate divisions or units are delegated operating responsibility.
The division managers are responsible for planning and controlling the operations of their divisions.
Decentralization is an advantage because maintaining daily contact with all operations and maintaining
operational expertise is difficult in a large company. Delegating responsibility allows managers to
develop expertise and work closely with customers. A disadvantage of decentralization is that decisions
made by one division manager may negatively affect the profits of the company. For example, managers
of competing divisions may start a price war that would decrease the profits of both divisions. In a
decentralized business, managers have areas of responsibility called responsibility centers. The process of
measuring and reporting data for the center is called responsibility accounting. Three types of
responsibility centers are cost, profit, and investment centers.
Chapter 23(9) Evaluating Decentralized Operations 419
Key Terms and Definitions
Responsibility Accounting—The process of measuring and reporting operating data by areas of
responsibility.
Relevant Check Up Corner and Exhibits
Exhibit 1—Advantages and Disadvantages of Decentralized Operations
SUGGESTED APPROACH
You can cover this objective by using Transparency Master (TM) 23(9)-1, which lists the advantages and
disadvantages of decentralized operations.
As an alternative, ask your students to describe the advantages and disadvantages of a management
position in a decentralized firm. TM 23(9)-2 provides a manager’s job description. Read this description
to your class and ask them to point out any positive or negative aspects of the job.
Possible response: The decentralized operation of the real estate company allows the local office to react
to the local market and needs of the agents. Every market will be different and to apply blanket
advertising and management policies to each office would not be an effective way to maximize the
potential of the local market. Possible disadvantages could be technology and communications. Allowing
each individual office to make its own separate technology decisions could result in incompatibility
issues. Other disadvantages include the local office making decisions that are contradictory to the overall
goals of the corporation.
CLASS DISCUSSION—Centralization versus Decentralization
Ask your students to characterize businesses they have worked for as either centralized or decentralized.
Ask them to explain how they made that determination.
LECTURE AID—Responsibility Centers
Objective 1 introduces the three types of responsibility centers. These are listed and described on TM
23(9)-3. Review this information with your students. Ask your students whether their parents view them
as a cost, profit, or investment center.
TM 23(9)-4 presents various divisions/departments that would be found in a typical department store.
Give your students a couple of minutes to read through the list and determine whether they would
organize each unit as an investment, profit, or cost center. Ask them to share their answers with the class.
Possible response to TM 23(9)-4:
1. Each of the five stores in the chain—Profit center or Investment center (see below)
2. Accounting department—Cost center
3. Ladies clothing department—Profit center
Chapter 23(9) Evaluating Decentralized Operations 420
4. Furniture department—Profit center
5. Credit and collection department—Cost center
As students share their answers, emphasize the level of authority given to the manager of each unit based
on the type of responsibility center. For example, if your students determine that each store in the chain
should be an investment center, each store manager must have authority to make decisions regarding
costs, sales strategies, and fixed assets purchased by his or her store (within company guidelines). If
stores are considered profit centers, the store manager may have authority to control costs and sales
strategies, but he or she would not make decisions regarding the purchase or disposal of fixed assets.
OBJECTIVE 2
Prepare a responsibility accounting report for a cost center.
SYNOPSIS
A cost center manager has the responsibility for controlling costs; this manager does not make decisions
regarding sales or fixed assets. Responsibility accounting for cost centers focuses on the controlling and
reporting of costs. Budget performance reports that report budgeted and actual costs are normally
prepared for each cost center. These reports enable managers to identify the departments responsible for
major differences.
Key Terms and Definitions
Cost Center—A decentralized unit in which the department or division manager has
responsibility for the control of costs incurred and the authority to make decisions that affect
these costs.
Relevant Check Up Corner and Exhibits
Exhibit 2—Cost Centers in a University
Exhibit 3—Responsibility Accounting Reports for Costs Centers
Check Up Corner 23(9) – Cost Center Responsibility Measures
SUGGESTED APPROACH
center is over or under budget.
You may use the reports illustrated in Exhibit 3 in the text to review responsibility accounting reports. As
an alternative, ask students to generate a responsibility accounting report using the following Group
Learning Activity.
Chapter 23(9) Evaluating Decentralized Operations 421
GROUP LEARNING ACTIVITY—Responsibility Accounting
TM 23(9)-5 provides the organization chart for the accounting function of a corporation. Use this chart to
illustrate that cost centers may exist within cost centers.
TM 23(9)-6 shows budget performance reports for the accounting departments that report to the
This exercise will allow you to emphasize that upper-level managers receive summarized cost data. When
reviewing TM 23(9)-7, ask your students which departments the controller should question regarding
their performance. You could also ask one or more students to assume the position of a department
manager and explain his or her department’s performance to the corporate controller.
OBJECTIVE 3
SYNOPSIS
A profit center manager has the responsibility and authority for making decisions that affect revenues and
costs and, thus, profits. The manager of the profit center does not make decisions regarding the fixed
assets invested in the center. Responsibility accounting for profit centers focuses on reporting revenues,
expenses, and income from operations. This reporting takes the form of income statements. Controllable
Key Terms and Definitions
Controllable Expenses—Costs that can be influenced by the decisions of a manager.
Controllable Revenues—Revenues earned by the profit center.
Profit Center—A decentralized unit in which the manager has the responsibility and the
authority to make decisions that affect both costs and revenues (and thus profits).
and transferred to a responsibility center.
Relevant Check Up Corner and Exhibits
Exhibit 4—Service Department Charges to NEG Divisions
Exhibit 5—Divisional Income Statements—NEG
Check Up Corner 23(9)-2 – Profit Center Responsibility Reporting
Chapter 23(9) Evaluating Decentralized Operations 422
SUGGESTED APPROACH
Under responsibility accounting, profit centers should be evaluated based only on revenues and expenses
that can be controlled by the manager. Controllable expenses include expenses incurred directly by the
department or the division, as well as service department charges. A charge allocated to a profit center
from a service department (such as Personnel or Maintenance) is an example of an indirect expense. That
Use the Group Learning Activity below to cover the preparation of divisional income statements for profit
centers.
GROUP LEARNING ACTIVITY—Evaluating Profit Centers
Handout 23(9)-1 presents information for Watson Clothiers, a business that operates stores in two cities.
solution is presented on TM 23(9)-8.
Handout 23(9)-1 includes a service department expense that is not controllable by Watson’s store
managers. Under the concept of responsibility accounting, this expense should not appear on divisional
income statements. Any cost incurred that is not under the store manager’s authority should not be used to
for the entire company.
You may want to point out that, unfortunately, many organizations allocate uncontrollable charges to
departments or divisions. This often leads to frustration for managers who must explain costs that are
beyond their control.
CLASS DISCUSSION—Controllable and Noncontrollable Indirect Costs
spark discussion.
1. Why would an organization charge indirect service costs to the departments that use these services?
2. Should any university administrative overhead be charged to academic departments or other
repairs and maintenance.)
3. What would be an appropriate activity base for charging central telephone services to departments
Chapter 23(9) Evaluating Decentralized Operations 423
4. Give an example of a noncontrollable cost for a manager of a McDonald’s franchise. (Answer:
Corporate advertising would not be controllable.)
OBJECTIVE 4
Compute and interpret the rate of return on investment, the residual income, and the
balanced scorecard for an investment center.
SYNOPSIS
An investment center manager has the responsibility and the authority to make decisions that affect not
only costs and revenues but also the assets invested in the center. Because investment center managers
have these additional responsibilities for revenue and expenses, income from operations is part of their
reporting. In addition, since they are responsible for the assets, two additional measures, rate of return on
investment and residual income, are reported. Rate of return on investments (ROI) is computed as: rate of
return on investment (ROI) = income from operations/invested assets. To analyze return on investment
across divisions, the DuPont formula is used. This formula views the rate of return on investment as the
product of profit margin and investment turnover. Using this method, the rate of return on investment is
calculated as: rate of return on investment = profit margin × investment turnover or additionally as: rate of
return on investment = (income from operations/sales) × (sales/invested assets). The ROI is also useful in
deciding where to invest additional assets or expand operations. The minimum acceptable income from
operations is computed by multiplying the company minimum rate of return by the invested assets. The
major advantage of residual income as a performance measure is that it considers both the minimum
acceptable rate of return, invested assets, and the income from operations for each division. A balanced
scorecard is a set of multiple performance measures for a company. This scorecard usually includes
measures for financial performance, customer service, innovation and learning, and internal processes.
The balanced scorecard attempts to identify the underlying nonfinancial drivers, or causes, of financial
performance.
Key Term and Definitions
Balanced Scorecard—A performance evaluation approach that incorporates multiple
performance dimensions by combining financial and nonfinancial measures.
DuPont Formula—An expanded expression of return on investment determined by multiplying
the profit margin by the investment turnover.
Investment Center—A decentralized unit in which the manager has the responsibility and
available to the center.
Investment Turnover—A component of the rate of return on investment, computed as the ratio
of sales to invested assets.
Profit Margin—A component of the rate of return on investment, computed as the ratio of
income from operations to sales.
acceptable income from operations.
Return on Investment (ROI)—A measure of managerial efficiency in the use of investments in
assets, computed as income from operations divided by invested assets.
Chapter 23(9) Evaluating Decentralized Operations 424
Relevant Check Up Corner and Exhibits
Exhibit 6—Divisional Income Statements—DataLink Inc.
Exhibit 7—Residual Income
Exhibit 8—Residual Income—DataLink, Inc.
Exhibit 9—The Balanced Scorecard
Exhibit 10—Balanced Scorecard Performance Measures
SUGGESTED APPROACH
Remind students that investment centers are evaluated as if they were separate companies. Both
profitability and efficiency in the use of assets must be judged. Most companies prepare a report that
shows income from operations by investment center to evaluate profitability. Rate of return on investment
or residual income is used to gauge asset efficiency.
residual income for performance evaluation.
DEMONSTRATION PROBLEM—Return on Investment
The formula for rate of return on investment (ROI) is as follows:
Income from Operations
ROI Invested Assets
invested assets.
Income Invested
Sales from Operations Assets
Division A $500,000 $ 90,000 $400,000
Division B 800,000 144,000 600,000
From this calculation, it appears that Division B is providing a greater return on the company’s
investment than Division A. This greater return could occur for one of two reasons: (1) Division B is
more profitable or (2) Division B is using its assets more efficiently. To determine the underlying reason
for Division B’s performance, the rate of return on investment equation can be expanded using the
DuPont formula as follows:
Chapter 23(9) Evaluating Decentralized Operations 425
Income from Operations Sales
ROI Sales Invested Assets
or
ROI = Profit Margin Investment Turnover
Ask your students to use the DuPont formula to calculate profit margin and investment turnover for both
divisions. This analysis should yield the following information:
Profit Investment Rate of Return
Margin Turnover on Investment
Division A 18% 1.25 22.5%
Division B 18% 1.33 24.0%
DEMONSTRATION PROBLEM—Residual Income
Residual income is the amount by which income from operations exceeds the minimum income
considered acceptable by top management. The minimum acceptable income is normally determined by
multiplying a minimum rate of return by the division’s invested assets. The following equations may help
your students remember these relationships:
Minimum Acceptable Income = Invested Assets Minimum Rate of Return
Ask your students to calculate the residual income for Divisions A and B, assuming that the company’s
minimum rate of return is 15 percent.
Controllable Minimum
Operating Acceptable Residual
Income Income Income
Division A $ 90,000 – $60,000 = $30,000
Division B $144,000 – $90,000 = $54,000
income.
