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chapter
23(8)
Performance Evaluation for
Decentralized Operations
______________________________________________
OPENING COMMENTS
Chapter 23(8) applies responsibility accounting to cost, profit, and investment centers. The chapter
demonstrates the responsibility accounting reports that are used to evaluate department or division
performance. This provides an excellent opportunity to remind your students that managers are judged, at
least in part, using accounting data.
The chapter opens with a discussion of decentralized operations. It also illustrates transfer pricing under
the market price, negotiated price, and cost price approaches.
After studying the chapter, your students should be able to:
2. Prepare a responsibility accounting report for a cost center.
4. Compute and interpret the rate of return on investment, the residual income, and the balanced
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.
KEY TERMS
balanced scorecard
controllable expenses
controllable revenues
418 Chapter 23(8) Performance Evaluation for Decentralized Operations
cost center
cost price approach
DuPont formula
investment center
investment turnover
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
Chapter 23(8) Performance Evaluation for Decentralized Operations 419
Key Terms and Definitions
• Responsibility Accounting - The process of measuring and reporting operating data by areas of
responsibility.
Relevant Example Exercises and Exhibits
• Exhibit 1 – Advantages and Disadvantages of Decentralized Operations
SUGGESTED APPROACH
You can cover this objective by using Transparency Master (TM) 23(8)-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(8)-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.
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(8)-3. Review this information with your students. Ask your students whether their parents view them
as a cost, profit, or investment center.
TM 23(8)-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(8)-4:
2. Accounting department – Cost center
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
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 Example Exercises and Exhibits
• Example Exercises 23(8)-1 Budgetary Performance for Cost Center
• Exhibit 2 – Cost Centers in a University
• Exhibit 3 – Responsibility Accounting Reports for Costs Centers
SUGGESTED APPROACH
Managers of cost centers are evaluated by comparing actual costs against budgeted or standard costs. A
responsibility report shows a cost center’s actual and budgeted costs, as well as the amount by which the
center is over or under budget.
Chapter 23(8) Performance Evaluation for Decentralized Operations 421
GROUP LEARNING ACTIVITY—Responsibility Accounting
TM 23(8)-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(8)-6 shows budget performance reports for the accounting departments that report to the
controller. Divide your class into small groups and instruct each group to prepare the responsibility
accounting report that would be given to the corporate controller. A solution is displayed on TM 23(8)-7.
OBJECTIVE 3
Prepare responsibility accounting reports for a profit center.
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).
• Service Department Charges - The costs of services provided by an internal service department
and transferred to a responsibility center.
Relevant Example Exercises and Exhibits
• Example Exercises 23(8)-2 Service Department Charges
• Example Exercises 23(8)-3 Income from Operations for Profit Center
• Exhibit 4 – Service Department Charges to NEG Divisions
• Exhibit 5 – Divisional Income Statements—NEG
422 Chapter 23(8) Performance Evaluation for Decentralized Operations
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
GROUP LEARNING ACTIVITY—Evaluating Profit Centers
Handout 23(8)-1 presents information for Watson Clothiers, a business that operates stores in two cities.
Ask your students to use the information to prepare divisional income statements using the concept of
responsibility accounting. Under responsibility accounting, only controllable revenues and expenses are
listed. You may want to refer your students to the sample statement presented in Exhibit 5 in the text. The
solution is presented on TM 23(8)-8.
Handout 23(8)-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
evaluate their performance. In theory, these costs should appear only on a consolidated income statement
for the entire company.
CLASS DISCUSSION—Controllable and Noncontrollable Indirect Costs
The following is a list of miscellaneous questions regarding the charging of indirect costs. Use these to
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
responsibility centers? (Answer: yes. There are many university services that could be directly
3. What would be an appropriate activity base for charging central telephone services to departments
within an organization? (Answer: number of phone lines)
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 assts. 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
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
authority to make decisions that affect not only costs and revenues but also the fixed assets
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
424 Chapter 23(8) Performance Evaluation for Decentralized Operations
Relevant Example Exercises and Exhibits
• Example Exercises 23(8)-4 Profit Margin, Investment Turnover, and ROI
• Example Exercises 23(8)-5 Residual Income
• 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.
DEMONSTRATION PROBLEM—Return on Investment
The formula for rate of return on investment (ROI) is as follows:
Income from Operations
ROI Invested Assets
=
Assume two divisions of a manufacturing company had the following sales, income from operations, and
invested assets.
DuPont formula as follows:
Chapter 23(8) Performance Evaluation for Decentralized Operations 425
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%
Stress that Divisions A and B have managed costs of goods sold and operating expenses to achieve an 18
percent profit. However, Division B has made more sales relative to its assets than Division A. Division B
is using its assets more efficiently, bringing in more return on the company’s investment.
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:
Residual Income = Income from Operations – Minimum Acceptable Income
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.
426 Chapter 23(8) Performance Evaluation for Decentralized Operations
INTERNET ACTIVITY—Balanced Scorecard
The balanced scorecard emphasizes that financial and nonfinancial measures are both important in
(2) Customer Service, (3) Internal Processes, and (4) Financial Performance.
Choose an organization (such as your college or university) and ask students to develop at least one
measure in each of the four components of the balanced scorecard. For example, a measure in the
innovation and learning category might be the number of classrooms converted for multimedia
presentations.
OBJECTIVE 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.
SYNOPSIS
When divisions transfer products or render services to each other, a transfer price is used to charge for the
products or services. Three common approaches to setting transfer prices are the market price, negotiated
price, and cost approach. The objective of setting a transfer price is to motivate managers to behave in a
manner that will increase the overall company income. The market price is the price at which the product
could be sold to outside buyers. If an outside market exists, the price is: transfer price = market price. The
Key Terms and Definitions
• Cost Price Approach - An approach to transfer pricing that uses cost as the basis for setting the
transfer price.
• Market Price Approach - An approach to transfer pricing that uses the price at which the
product or service transferred could be sold to outside buyers as the transfer price.
Chapter 23(8) Performance Evaluation for Decentralized Operations 427
• Negotiated Price Approach - An approach to transfer pricing that allows managers of
decentralized units to agree (negotiate) among themselves as to the transfer price.
• Transfer Price - The price charged one decentralized unit by another for the goods or services
provided.
Relevant Example Exercises and Exhibits
SUGGESTED APPROACH
Use the Lecture Aids that follow to introduce students to the subject of transfer pricing. A simple role-
playing activity can be effective in presenting the market price and negotiated price approach to transfer
pricing.
LECTURE AID—Transfer Pricing
In some cases, one division of a company may make products that are used by another division of that
same company. For example, General Motors has separate divisions that make automobile components
(such as engines, transmissions, and stereos). These divisions “sell” their component parts to divisions
Benefits of Transfer Pricing
1. Divisions can be evaluated as profit or investment centers.
To be a profit or investment center, a division must have the ability to earn revenue. Transfer pricing
428 Chapter 23(8) Performance Evaluation for Decentralized Operations
2. Divisions are forced to control costs and operate competitively.
For a division to show a profit, the transfer price received must exceed the cost to make a product.
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.
If a component part can be produced cheaper by an outside company than an internal division, that
part will be purchased from the outside. This forces the internal division to cut costs to the point that
it competes with outside firms or is discontinued. In addition, the division manufacturing the
ROLE PLAYING—Market and Negotiated Transfer Prices
To illustrate market and negotiated transfer prices, choose two students to participate in a role-playing
activity.
Explain to your students that they are managers of two divisions of a company that manufactures power
tools. One manages the division that produces the small engines that drive the tools. The other manages
the division that assembles the tools. Although the assembly division needs engines, it is free to purchase
them from the engine division or an outside company, wherever the best price can be obtained.
In private, tell the engine division manager that his or her engines require $35 of variable costs to
produce. They can be sold to outside companies for $50 per engine. Also tell the manager that his or her
division is operating at full capacity and can sell all the engines it makes to outside firms at $50 each if
the assembly division does not buy any of the engines.
Chapter 23(8) Performance Evaluation for Decentralized Operations 429
Next, privately tell the engine division manager to assume that his or her division is not producing at full
capacity. Therefore, he or she needs the assembly division’s business. Remind the student that his or her
division’s profits will be increased as long as the engines are sold for more than their variable cost of $35.
LECTURE AID—Transfer Pricing at Cost
Remind students that some companies transfer products at their cost. This cost may be the division’s
variable cost per unit or the total cost per unit. In addition, the products may be transferred at actual or
standard cost.
Handout 23(8)-1
PERFORMANCE REPORT FOR PROFIT CENTERS
Watson Clothiers, a retailer specializing in men’s and ladies’ career clothing, has stores in two
Ohio cities: Cincinnati and Columbus. These stores are evaluated as profit centers.
Sales and direct costs for the stores in the current year were as follows:
Cincinnati Columbus
Net sales $220,000 $380,000
Cost of goods sold 80,000 152,000
The following indirect costs were incurred by service departments at Watson Clothiers in the
current year:
General Administration $83,000
Personnel and Payroll 49,000
Advertising 67,000
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP - APC Bloom's EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 2 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 3 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 4 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 5 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 6 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge x
DQ 7 1 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 8 2 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 9 2 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
DQ 10 3 Easy 5 min. Analytic Measurement Incremental analysis Knowledge
PE 1A Lease or sell 1 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 1B Lease or sell 1 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 8A Bottleneck profit 3 Easy 10 min. Analytic Measurement Incremental analysis Application x
PE 8B Bottleneck profit 3 Easy 10 min. Analytic Measurement Incremental analysis Application x
EX 1 Differential analysis for a lease or sell decision 1 Easy 15 min. Analytic Measurement Incremental analysis Application x x
EX 14 Accepting business at a special price 1 Easy 15 min. Analytic Measurement Incremental analysis Application
EX 15 Decision on accepting additional business 1 Moderate 20 min. Analytic Measurement Incremental analysis Application x x
EX 16 Accepting business at a special price for a service company Moderate 20 min. Analytic Measurement Incremental analysis Application x x
PR 5A Product pricing using the cost-plus apprach concepts; differential analysis for accepting additional business 1,2,Appendix Challenging 1.5 hours Analytic Measurement Incremental analysis Application x
PR 6A Product pricing and profit analysis with bottleneck operations 3 Challenging 1.5 hours Analytic Measurement Incremental analysis Application x
PR 1B Differential analysis involving opportunity costs 1 Moderate 45 min. Analytic Measurement Incremental analysis Application x
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