CHAPTER 10. Decenvalized Performerce Evaluation 1. What are the fo . Other than the one(s) mentioned in the text, give an exam ple of an action that management might take fo improve financial performance in the short run that could prove. detrimental in the Tong run. Explain the balanced scorecard approach to performance evaluation. What advantages does this approach have over csing only financial measurements? dimensions ofa balanced scorecard? ‘What does cach dimension represent?” Why must a company consider its incentive and reward system when implementing a balanced scorecard approach? ‘Why are incentive systems that emphasize long-term performance more consistent with a balanced scorecard approach? ‘What is a transter price? Explain way two managers employed by the same com ‘pany may be diametrically opposed to each other when ‘considering a transfer price. Explain the meaning of minimum and maximum transfer prices and identify who (the buyer or the seller} would determine each, ‘What is the market-price method of transfer pricing? How does excess capacity affect a transfer price? Deseribe the cost-based method of transfer pricing. ‘What are negotiated transfer prices? Explain two possible disadvantages of allowing managers to negotiate a transfer price 1. Explain how centralized! and decentralized companies 1S, differ, What are the advantages and disadvantages of cach? 2, Why does decentralization create the need for responsibil ity accounting in an organization? 16. What isthe controllability principle and why is it eruia toresponsibiity accountng? 4. Name the four types of responsibility centers and describe 17 the managers responsibilities and authority in each 5. Briefly explain the diference heween segment margin 1% and net operating income 6. Why are profi center managers evaluated on segment margin instead of net operating income? 11. How do investment coner managers differ from profit center managers? 20. 8. What role do return on investment and resid inom = play in responsibility accounting? i 9, Return on investment may be separated into two compo rents. Name them and describe what each can tell you. 1. Explain how relying on retur on investment for perfor" mance evaation of investment center managers could toad to goal incongrvence i 11, How is residual income east? au 12, What benefit does residual income offer in comperson to 3 return on investment when evaluating performance’? 38. 13, How does EVA differ fom residual income? het 14, What ae the primary limitations of financial measures of performance? MULTIPLE CHOICE 1, Sally Thorne i a prott center manager for ABC Com pany’s Phoenix district. Last year, her performance evalu ation was based on the opeaiing performance of ABC's entire Southvest region. This aviation of a. The hnudle rte principle 4 by. the conroliability principle «. The balanced scorecard approach 4. Negotiated wanser pricing rules 2. Responsibility centers include a. Cost centers ¢: Invesiment centers. by. Profit center, a. Allof these, 5 3. Which ofthe following statements is rue? fa. A profit center manager is responsible for investing ‘company asses. , A cost center manager should be evaluated based on sales revenue. . A profit center manager should be evaluated based on return on investment |. An investment center manager is responsible for costs, revenue, and the investment of assets, Which of the following is most likely to be classified as a cost center manager? 1. Accounting manager, Db. Sales manager. ce. Regional manager, 4. All of these are cost center managers. Return on investment and residual income are useful for evaluating, ‘a, Cost center managers, b. Revenue center managers. ¢, Profit center managers. 4. Iavestment center managers.CHAPTER 10 Decentralized Performance Evaluation 6. EVA isa variation of: a. Residual income ’b. Retarn on investment © The DuPont method 4. All of the above, Raymond Calvin is an investment center manager for XYZ Corp. and is evaluated solely on the return on investment for his division. Which of the following will improve Ruy- smiond’s evaluation? ‘a. Increasing the amount invested in assets while keeping, ‘operating income the same, , Increasing the amount of operating income while keep- ing invested assets the same. €. Projects may be rejected based on return on investment ‘even though they produce positive residual income, 4. Both b and e, 9. Which ofthe following is not a component ofthe balanced scorecard method of measuring performance? a. Customer perspective, . Management perspective, . Learning and grovth perspective. 4. Intemal business processes perspective. 10. ‘Transfer price could be based on: a. Variable costs, ‘€. Decreasing the amount invested in assots while keeping Full enet ‘operating income the same, fe) Mackes price 4. Bither bore, 4. Any of the above. Which of the following statements is true? ‘a, Return on investment considers a company’s hurdle rate for investments b. Residual income considers a company’s hurdle rato for investments MIN-EXERCISES 10-1 Using Terms to Complete Sentencs Evaluation ‘Use the following terms to complete the sentences tha follow; terms may be used once, more than ‘once, oF not at al: Congruence Controllability pri Customer Decentralization Decrease eonomic value added (EVA) External market price Financial Full cost Tncongruence |. Managers of a(n) income. ‘Suboptimal decisions and duplication of resources are considered disadvantages of ‘A positive __results when managers invest in projects that eara more than the hurdle rate, ‘The __ perspective focuses on processes required to meet customer needs through mea: sures such as on-time delivery and quality. 5. The _ states that managers should be held responsible only for what they can control ___ measures the economic wealth that is ereated when a company's after-tax operating income exceeds its cost of capital . The ___ perspective typically contains leading indicators, which are measures that reflect future performance. ‘A change inthe investment turnover ratio from 1.5 to 3.2 will ‘The maximum transfer price is the. ). Goal _resuits when there is conflict between a manager and the organization as a whole! 10 10-4, 10.2, 10-3, 10-4, 10-5, 10-6 Increase ple Internal business Investment ‘Learning and growth Profit Residual income (RI) Responsibility accounting Return on investment (ROD, Sales revenue ‘Transfer pricing ‘conter are evaluated based on measures such as ROI and residual the division’s ROLCHAPTER 10 Decentaized Posformance Evaluation 499 {10-2 Describing Difference in Centralized and Decentralized Organizations Lo 104 ‘Lupe Bomes recently graduated from college und received job offers in management from two different companies, The positions are similar in terms of ttl, salary, and benefits, but the com- panies vary in organizational structure. Alpha Company is centralized while Beta Company is ‘ecenttalized. Explain to Lupe what he ean infer about each company and how itis likely to affect his position within each one. 10-3 Describing Structure of Real-World Organizations Responsibility Centers 1010.2 Responsibility centers can be created ina varity of ways. Give a real-world example of a company whose responsibility centers would likely be created on the basis of ench of the following: func tional area, product line, and geographic area, 110-4 Applying Balanced Scorecard to Real-World Company 1010.3, Consider the manager of your local Applebee's restaurant. Using a balanced scorecard approach, identify three measures for each of the four dimensions of the balaneed scorecard. 10-5 Applying Balanced Scorecard to Online Company 1010.3 Choose a company that has en online sales segment; it can be a company that operates entirely coline or a brick-and-mortar store with an oafine site, Assuming a balanced scorecard approach, jdeatify five specific measures that the company could use to measure pecformance from the cus omer perspective, For each measure identified, indicate how that information would he obtained. | Mt0-6 Calculating Return on Investment, Residual Income Lo 10-4, 10.5, Violet Company has sales of $520,000, net operating income of $310,000, average invested assets of $940,000, and hurdle rate of 10 percent, Calculate Violets return on investment and its resi. va income, 510-7 Calculating Return on Investment, Residual Income 1010-4, 40.5 ‘Myrtle Company has sales of $140,000, cost of goods sold of $70,000, operating expenses of $720,000, average invested assets of $400,000, aud a hurdle rate of 6 percent. Calculate Myrte’s return on investment and its residual income, }10-8 Calculating Retum on Investment, Residual Income 10 10.4, 105 “Augusta Cosp’s Golf Division has sales of $200,000, cost of goods sold of $105,000, operat expenses of $35,000, average invested asscts of $900,000, and a hurdle rate of 12 percent, Caleu- Tate the Golf Division's retura on investment and its tesidual income. 10-9 Impact of New Investment on ROI, Residual Income 10 10-4, 10.5 “The Wester Division of Claremont Company hd net operating income of $135,000 and average invested assets of $560,000, Claremont has a required rate of return of 15 percent. Western has an ‘opportunity to increase opecating income by $12,000 with 2 $108,000 investment in assots. Com: ppule Western Division's return on investment and residual income currently and if it undertakes the project. 10-40 Describing Transfer Pricing Implications 1010-2, 106 "Assume that your cousin Matilda Plores manages a Tocal glass shop that was recently bought by & ‘company that produces custom picture frames. As a result, Matilda will soon be providing glass to the Frame Division. She has heard upper management mention a transfer price but does not under- Stand what this term means or hove it might affect her division. Briefly explain transfer pricing to Matilda and how it will impact her division’s performance in the future, 10-44 Identifying Minimum, Maximum Transfer Prices 10106 Peppertree Company has two divisions, East and West, Division East manufactures a component that Division West uses. ‘The vasiable cost 10 produce this component is $2.00 per unit; full east is $2.75, The component sels op the open market for $3.10. Assuming Division Bast has excess capacity, what i the lowest price Division East wil accept for the component? What isthe highest price that Division West will pay for it? 10-12 Calculating Cost-Plus Transfer Price Lo 10-6 ‘Medlock Company has two divisions, Wheel and Chassis, The Wheel Dvision manufactures a wheel assembly that the Chassis Division uses. The variable cost to produce this assembly is $4.00 per unit; full cast i $5.00, The component sells on the open market for $9.00. What will the trans fer price be if Medlock uses a pricing rule of variable cost plus 60 percent?450 CHAPTER 10 Decentralized Performance Evaluation 10 10-6 M1013 Negotiating Transfer Prices ‘Tuckey Company is considering allowing the managers of its two divisions to negotiate a transfer price for the component that Division A manufactures and sells to Division B. Idemify the range of possible transfer prices that could result from the negotiation. Brieily describe benefits and possible negative consequences of allowing the managers to negotiate a twansfer price EXERCISES 10 10-4, 40-2, 10-3 10-1 Explaining Relationships among Decentralization, Responsibility Accounting, Controllability, Balanced Scorecard Assume you are the vice president of operations fora local company. Your company is in the pro- ‘cess of convesting from a small, centralized organization in which its president makes all decisions toa lager, geographically dispersed one with decentralized decision-making authority, Requi Write a brief memo to other company managers explaining how decentralization, responsibility ‘accounting, controllability, and the balanced scorecard method of performance evalation are all related, Include the most obvious changes the managers are likely to see as this transition takes place and how it wil impact their performance evaluations in the fuure 1010-2 10-2 Identifying Responsibility Center Types Match the most likely type of responsibility center classification to each ofthe following positions. ‘You may use a classification once, more than ones, or not at all Possible Responsibility © Sales manager a. Cost center Regional manager ». Revenue center ‘Company president ©. Profit center Purchasing manager 4. Favestment center ‘Human resources manager Production facility manager 4010-4 10-3 Finding Unknowns Using Return on Investment, Profit Margin, Investment Turnover Fleetwood Company recently had a computer malfunction and lost @ portion of its accounting seconds. The company has reconstructed some ofits financial performance measurements, includ- ing components ofthe return on investment calculations, Required: Help Fleetwood rebuild its information database by completing the following table: Return on tavestmant Profit Massin stant Furover 2 5% 19 18% 2 20 2% 5% 2 23% 2 15 1010-4 £10-4 Finding Unknowns Using Return on Investment, Profit Margin, Investment Turnover Krall Company recently had a computer malfunction and lost a portion of its accounting records ‘The company has reconstructed some ofits financial performance measurements including com: ponents of the eturn on investment calculations,CHAPTER 10. Docenvatzes Peifornance Evaustion vestinent___ Margin Invested Assets | f $ 700,000 $1,400,000 7 "(500,000 / 41400,000 ‘500,000 510.5 Calculating Return on Investment, Residual Income, Determining Effect of 10 10-4, 10-5 ‘Changes In Sales, Expenses, Invested Assets, Hurdle Rate on Each ~ Solano Company has sales of $500,000, cost af goods sold of $370,000, other operating expenses ‘of $50,000, average invested assets of $1,600,000, and a hurdle rate oF 6 percent, Required: ‘Determine Solano's return on investment (ROI), investment turnover, profit margin, and resid ual income, ‘Several possible changes that Solano could face in the upcoming year follow. Determine ‘cach seenario's impact on Soleno’s ROL and residual income. (Note: Treat each scenario independently.) ‘a. Company sales and cost of goods sold increase by 30 percent. 1. Operating expenses decrease by $10,000. Operating expenses increase by 20 percent, 4d. Average invested assets inerease by $300,000. fe. Solano changes its hurdle rate to 12 percent. 10-6 Calculating Return on Investment, Residual Income, Determining Effect of 10 10-4, 405 ‘Changes in Sales, Expenses, Invested Assets, Hurdle Rate on Each ‘Kaler Company has sales of $1,210,000, cost of goods sold of $735,000, other operating expenses ‘of $148,000, average invested assets of $3,400,000, and a hurdle rate of 12 percent. Required: 1. Determine Kaler’s return on investment (ROD, investment tumover, profit margin, and resié- ual income. 2. Several possible changes that Kaler could face in the upcoming year follow. Determine ‘cach scenario’s impact on Kaler’s ROL and residual income. (Note: Treat each scenario independently.) .- Company sales and cost of goods sold increase by 15 percent, ‘Operating expenses increase by $73,000. ‘Operating expenses decrease by 10 percent. . Average invested assots decrease by $285,000. Kater changes its hurdle rate to 9 percent. 10-7 Evaluating Managerial Performance Using Return on Investment, Residual Income LO 10-4, 10-5 ‘Orange Corp. has two divisions: Fruit and Flower, The following information for the past year is available for each division: Sates revenve Cost of goods sold and operating expenses Net operating income Average tnveston assets Orange hus established a hurdle rate of 12 percent.Lo 10-4, 10.5 10 10.4, 10.5 alized Performance Evaluation Required: 1, Compute each division's return on investment (ROD and residual income for lst yea: Deter ‘mine Which manager seems to be performing better. 2 Suppose Orange is investing in new technofogy that wil increase each division's operating income by $144,000, The total investment required is $1,600,000, which will be split evenly between the two divisions, Calculate the ROI and return on investinent for each division after the investment is made. Determine whether both managers will support the investment. Explain how their suppost will iffer depending on which performance measuse (ROI or residual investment is used 10-8 Evaluating Managerial Performance Using Return on Investment, Residual Income Lake Company has three divisions: Peak, View, and Grand, ‘The company has a hurdle rate of 6 percent. Selected operating data forthe three divisions follow: Posi iow Grane Sates revenu| 325,000 $220,000, 298,000 Cost of goods sold 216,000 123,009 202,000 Miscellaneous operating expenses 45,000 36.000 39,000 Average mvesiec assets 1.109.000 990,000 (000,000 Required: 1. Compate the return on investment for each division 2 Compate the residual income for each division, 10-9 Developing Balanced Scorecard Choose a company with which you regularly do business. Assume you have been hired as a consi tant (o help overhaul its performance evaluation system, Required: 1. Briefly outline a balanced scorecard approach that could be used to evaluate the performance of the company’s managers, 2. Por each of the four perspectives, identify three metrics thet could be part of the balanced scorecard 3. Explain the reasoning behind cach metric that you chose 10-10 Determining the Impact of Various Transactions on Investment Tumover, ROI, Residual Income, and Profit Margin Poseidon Corporation manufactures a variety of gear for water sports. Poseidon has three divi- sions: Lake, River, and Ocean. Each division is managed as an investment center, Duting the cut rent year, the Ocean division experienced the following transactions: 4. A special order was accepted at 2 selling price significantly Jess than the otdinary selling price. The sale will not impact other sales because this was a one-time order and Ocean has excess capacity. The selling price was in excess of total vatiable costs, One of three production managers in the Ocean Division submitted his resignation. The posi- tion will ot be filled due to current efficiencies experienced in the production department. Due to the popularity of open-ocean swimming during the Olympics, the company’ experi- enced a surge in sales during the summer months, Sales returned to their normal level for the remainder ofthe year. 4. Equipment costing $500,000 was purchased to replace fully depreciated, obsolete equipment. The company's after-tax cost of capital increased from 8 percent to 10 percent, with no effect on the minimum required rate of return, J The company's effective tax rate decreased from 35 percent to 30 percent. Required: FFor each transaction listed in this exercise, determine the impact on investment turnover, return on. investment, residual income, and economic value added, Use the following table orginize yourCHAPTER 10. Decentatzed Pesfoumance Evaluation 483 answers, Use (I) for increase, (D) for decrease, (N) for no effect, or a question mark (2) if you're unable to determine the impact of the transaction, Bach transaction should be treated independently. Return on fnvestment Resa! Income Economic Value Added} 10-14 Deseribing Balanced Scorecard Objectives and Perspectives 1010.8 ‘Your brother-in-law, Fred Miles, has just taken a new position as the plant manager of a local pro- ction facility, He has been told that the company uses a balanced scorecard approach to evaluate its managers. Fred is not familias with this approech because his previous experience as # produe- tion manager focused only on whether the plant met the company’s budgeted production, Required: 1. Briefly explain to Fred how performance evaluations at his new company will differ from : those at his previous company. = 2, Give Fred five possible objectives that the new company will use, in addition to production level, to evaluate his performance. For each objective that you identify, be sure to indicate 2 plausible metric for measuring it 10-42 Understanding Transfer Price Importance 1010-6 Refer to B10-11. Suppose Fred's plant manufactures a component used by another division of the organization, Hic hes approached you for help in understanding why everyone seems to be making. ‘such a big deal about the transfer price that he plans to charge for the component. Fred's comment | was, “Transfer prices do not impact the amount of profit earned by the company a8 a whole, s0 they don't affect me. I don't care what transfer price is used.” Required: 1. Explain whether Fred is correct or incorrect, 2. Explain how the transfer price could affet Fred or someone he works with. E1043 Determining Different Types of Responsibility Centers Lo 10-2 ‘The University of Dental Health (UDH) is a state-run university focusing on the education and training of dentists, dental assistants, dental hygienists, and other dental professionals. UDH has, just hired a new controller who wants to organize UDH by responsibilty centers so that responsi- bility accounting can be, implemented. The controller has asked for your assistance in identifying. cach ofthe following UDH functions as either a cost center (C) ot a profit center (P). OH Center or Profit | ‘accountng ' Bookstore 3 Cafeterias Career services | Community workshops tproviding continuing professional education necessary for state censure) Cuntocial cervicas Financial aid ‘formation ecrnetogy Residence halls Sudent perking ts fee based) Universty newspaneriradio stationasa CHAPTER 10 _ecenkatzed Performance Evaluation 1040.6 10-44 Determining Transfer Price ‘The Molding Division of Cotwold Company manufactures 4 plastic casing used by the Assembly Division. This casing. is also sold to external customers for $25 per unit. Variable ‘costs for the casing are $12 per unit and fixed cost is $3 per unit. Cotwold executives would like for the Molding Division to transfer 8,000 units t0 the Assembly Division at price of $18 per uit Required: : 1, Assume the Molding Department is operating at full capacity, Explain whether it should 2 accept the transfer price proposed by management. : Identify the minimum transfer price that the Molding Division will accept and explain why, a 1040-6 E10-15 Determining Transfer Price Refer to the information presented in BI0-14. Assume that the Molding Division has enough ; excess capacity to accommodate the request. Required: ‘ 1. Explain whether the Molding Division should accept the $18 transfer price proposed by ‘management. ] 2. Calculate the effect on Molding Division's net income if it accepts the $18 transfer price. 4 1010-6 10-46 Determining Transfer Price Refer to the information presented in B10-14. Assume that the Molding Department has excess 3 capacity, but the Assembly Department requires the casing to be made from a specific blend of plastics. This would raise the variable cost per unit to $20, Required: 3 1. Explain whether the Molding Department should accept the $18 transfer price proposed by management, 2. Determine the minimum transfer price that it will accept, 3 3. Determine the mutually beneficial transfer price so that the two divisions equally split the 4 profits from the transfer, 1040-3 10-47 Matching Measures of Performance with the Correct Balanced Scorecard Perspective ‘Tho following isa list of various metrics used to measure performance. For each metric, identify the correct balanced scorecard perspective with which the metric is associated. For Learning and Growth, use LG; for Customer, vse C; for Financial, use F; and for Internal Business use TB, Each perspective may be used once, more than once, of not at all, ‘average stock pice Economic wae adced Employee turnover rates Q Manufacturing cycle time Market share | Numisr of days from produetlaunch to shot? Numer of detects Numer of new patent applications Percontage of repeat customers Percentage decrease in aperating costs Percentage of sales qenerated by new products Research and developmen spencing a percentage ofnet revenuesCHAPTER 10 Deconialized Perlounance Evaluation ass 10-18 Determining Minimum, Maximum, Negotiated Transfer Prices. 1010-6 Shaor is a lumber company that also manufactures custom cabinetry. Its made up of two divisions: Lumber and Cabinetry. The Lumber Division is responsible for harvesting and preparing lumber for use; the Cabinetry Division produces custom-ordered cabinetry. The lumber produced by the Lumber Division has a variable cost of $2.00 per linear foot and full cost of $3.00. Comparable quality wood sells on the open market for $6.00 per linear foot. Required: 1. _ Assume you are the manager ofthe Cabinetry Division, Determine the maximum amount you ‘would pay for lumber: : ‘Assume you are the manager of the Lumber Division. Determine the minimum amount you ‘would charge for the lumber if you have excess capacity, Repeat assuming, you have no excess capacity 3, Assume you are the president of Shew, Determine 2 mutually beneficial transfer price assum- ing there is excess capacity. Explain the possible consequences of simply leting the two division managers negotiate @ pice 10-49 Identifying Minimum, Maximum Transfer Prices, Determining Effect on Each LO 10-6 Division's Profit ‘Tulip Company is made up of two divisions: A and B. Division A produces a widget that Division B uses in the production of its product. Variable cost per widget is $0.75; full cost is $1.00. Com- parable widgets sell on the open market for $1.50 each, Division A can produce up to 2 million ‘widgets por year but is currently operating at only 50 percent capacity. Division B expects to use 100,000 widgets inthe current yea | Required: | L.Determine the minimum and maximum transfer prices 2, Calculate Tulip Company's total benefit of having the widgels transferred between these divisions. 3. If the transfor prie is set at $0.75 per unit, determine how much profit Division A will make ‘on the transfer. Determine how much Division B will save by not purchasing the widgets on the open market. 4, Ifthe transfer price is set at $1.50 per unit, determine how much profit Division A will make ‘on the transfer. Determine how much Division B will save by not purchasing the widgets on : the open market 5. * What transfer price would you recommend to spit the difference? 10.20 Identifying Balanced Scorecard Perspectives. Lo 10.3 Identify which perspective(s) of the balanced scorecard each of the following critical success fae tors relates to by placing an X in the appropriate cell, Bach success factor could relate to more than. one category. BALANCED SCORECARD PERSPECTIVES cess Factor Financial Customer Interonl Bs Leaming tical Su Coniston margin by product Guaity Employee empowerment Information systems capabilities, New markers Procucs innovation Procucsivty