CPAR CPA REVIEW SCHOOL OF THE PHILIPPINES Merle MAS 8709 MANAGEMENT ADVISORY SERVICES DECENTRALIZATION AND PERFORMANCE EVALUATION RESPONSIBILITY ACCOUNTING RESPONSIBILITY ACCOUNTING - a system of accounting wherein costs and revenues are accumulated and reported by levels of responsibilty or by responsibility centers within the organization Responsibility center (also called accountability center) a clearly identified part or segment of an organization that is accountable for a specified function or set of activities = any part of the organization shat a particular manager is responsible for TYPS OF RESPONSIBILITY CENTERS: a. Cost Center (or expense renter) — a segment of an organization in which managers are held responsible forthe costs or expenses incurred in the segment. ». Revenue Center - where management is responsibie primarily for revenues ‘c. Profit Center ~ a segment of the organization in which the manager is held responsible for both revenues and costs. 4. Investment Center—a segment of the organization where the manager controls revenues, costs, and investments. The center's performance is measured in terms of the use of the assets as well as the revenues eamed and the costs incurred CLASSIFICATIONS OF COSTS IN RESPONSIBILITY ACCOUNTING 4. By responsibilty center 2. By cost type, as to controllability 3. By specific cost items or cost elements within each classification in (1) and (2). RESPONSIBILITY vs. ACCOUNTABILITY Responsibility has two facets, (1) the obligation to secure results. and (2) the obligation to report back the results achieved to higher authority. ‘Accountability denotes the obligation to report results achieved to higher authority THE CONCEPT OF DECENTRALIZATION Decentralization refers to the separation or division of the organization into more manageable units wherein each unit is managed by an individual who is giver decision authority and held accountable for his decisions. Goal congruence - all members of an organization have incentives to perform for a common interest. + Sub-optimization - occurs when one segment of @ company takes action that is in its own best interests, but is detrimental to the firm as a whole. BENEFITS OF DECENTRALIZATION Better access to local information Cognitive limitations . More timely response Focusing of central management Training and evaluation Motivation Enhanced competition. COSTS OF DECENTRA IZATION 1, Some decisions made in one sub-unit may bring anout negative effect to the other sub-units or the organization as a whole. 2. Decentralization necessitates a more elaborate reporting system henice, the costs of gathering and reporting of data increase. 3. Job duplication or overlapping of functions is usually encountered in a decentralized set-up,MAS 8709 DECENTRALIZATION AND PERFORMANCE EVALUATION Page 2 of 14 MEASURING THE PERFORMANCE OF INVESTMENT CENTERS Ferformance measur:s for investment centers usually attempt to assess how well managers are utilizing invested assets of the division to produce profits by relating operating profits to assets. Return on investment (ROI) is the most common measure of performance for investment centers. ROI ‘can be defined as follows: ror = ——Operating Income _ Average Operating Assets Operating income refers to earnings before interest and taxes, Operating assets include all assets acquired to generate operating income, including cash, receivables, inventories, land, buildings, and equipment. The ROT formula can also be broken down into the product of margin and turnover, Margin is the ratio Cf operating income to sales. Turnoveris defined as sales divided by average operating assets. ROI = Margin x Turnover cr ror = —Wvevating Income Sales Sales ‘Average Operating Assets Three advantages of using ROI to evaluate the performance of investment centers: 1, Tt encourages managers to pay careful attention to the relationships among sales, expenses, and investment, as should be the case for a manager of an investment center. 2. It encourages cost efficiency. 3. It discourages excessive investment in operating assets. Wo disadvantages of using ROI are: 1. It discourages managers from investing in projects that would decrease the divisional ROI but would increase the profitabiity of the company as a whole. (Generally, projects with an ROI less than a division’s current ROI Would be rejected.) 2. Itcan encourage myopic behavior, in that managers may focus on the short run at the expense of the long run. Residual income (RI) - the differerce between operating income and the minimum peso return required ‘on a company's operating assets. The equation for RI can be expressed as follows: RI = Operating Income ~ (Minimum Rete of Return x Operating Assets) ECONOMIC VALUE ADDED (EVA) - a more specific version of residual income. It represents the segment’s true economic profit because it measures the benefit obtained by using resources in a particular way. ‘After-tax operating income (EBIT x{1 ~ Tax Rate]) x Less desired income (After-tax WACC x [Total assets ~ Non-interest-bearing Current liabilities]) xx Fconomic Value Added (EVA) xm * WACC = Weighted average cost of capital TRANSFER PRICING ‘TRANSFER PRICE - the rionetary valve or the price charged by one segment of a firm for the goods and services it suoplies to another segment of the same firm. OBJECTIVES OF TRANSFER PRICING 1. To facilitate optimal decision-making 2. To provide a basis in measuring divisional performance. 3. To motivate the different department heads in improving their performance and that of their departments.MAS 8709 DECENTRALIZATION AND PERFORMANCE EVALUATION Page 3 of 14 ! APPROACHES FOR DETERMINING TRANSFER PRICE: 1. Negotiated transfer price 2. Cost-based tiansfer price 3. Market-based transfer price General Rules in Choosing a Transfer Price ‘* The maximum price should be no greater than the lowest market price at which the buying segment can acquire the goods or services externally. ‘* The minimum price should be no less than the sum of the selling segment's incremental costs associated with the goods or services plus the opportunity cost ofthe facilities used. * good should be transferrec internally whenever the minimum transfer price (set by the selling division) is less than the maximum transfer price (set by the buying division). By using this ‘ule, total profits of the firm are not decreased by an internal transfer. ‘THE BALANCED SCORECARD: STRATEGIC-BASED CONTROL ‘The Balanced Scorecard is a strategic management system thal defines a strategic-based responsibility ‘accounting systera. ‘Strategy’ defined as choosing the market and customer segments the business unit intends to serve, identifying the critical internal and business processes that the unit must excel at to deliver the value Propositions to customers in the targeted market segments, and selecting the individual and ‘organizational capabilities required for the internal, customer, and financial objectives. The Balanced Scorecard translates an organization's mission and strategy into operational Objectives and performance measures for four different perspectives: the financial perspective, the customer perspective, the internal business process perspective, and the learning and growth (infrastructure) perspective. Common characteristics of balanced scorecards It should be possible, by examining a company’s balanced scorecard, to infer its strategy and the assumptions underiying that strategy. b. ‘The balanced scorecard should emphasize continuous improvement rather than just meeting present standards or targets. c. Some of the performance measures on the balanced scorecard should be non-financial. 4. The scorecards for individuals should contain only those performance measures they can actually influence. €. The ultimate objectives of the organization are usually financial, but better financial results cannot + be attained without improving customers’ perceptions of the company’s products and services. In Corder to improve customers’ perceptions of products and services, itis usually necessary to improve internal business processes so that the products and se-vices are actually better. And in order to improve the business processes, it is necessary thiat employees learn. | ‘The balanced scorecard as a motivation and feedback mechanism. The performance measures on ‘the balanced scorecard provide motivation and feedback for improving. ‘The Financial Perspective The financial perspective establishes the long- and short-term financial performance objectives. ‘The financial perspective is concerned with the global financial consequences of thé other three Perspectives. Thus, the objectives and measures of the other perspectives must be linked to the financial objectives. The financial perspective has three strategic themes: revenue growth, cost reduction, and asset utilization. Customer Perspective ‘The customer perspectives the source of the revenue component for the financial objectives. This Derspecive defines and selects the customer and merket segments in which the company chooses compete,