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Performance Measurement in
Decentralized Organizations
Chapter 10
Centralization and Decentralization
• Decentralization is the process of delegating decision
making authority down the organization hierarchy.
• In today’s competitive environment where technology,
customer tastes, and competitors’ strategies are
constantly changing, decentralization :
• Allows motivated and well-trained organization members
to identify changing customer tastes quickly
• Gives front-line employees the authority and responsibility
to develop plans to react to these changes
• Highly centralized organizations tend not to respond
effectively or quickly to their environments.

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Decentralization in Organizations
Lower-level decisions often based on
better information.
Benefits of
Decentralization Lower level managers can respond
quickly to customers.

Decision-making authority leads to job

satisfaction.

Top management freed to concentrate

on strategy.

Lower-level managers gain experience

in decision-making.

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Decentralization in Organizations

May be a lack of coordination among

Autonomous managers.

Lower-level managers may make

decisions without seeing the “big picture.”

Lower-level manager’s objectives may not

be those of the organization.
Disadvantages of
Decentralization
May be difficult to spread innovative ideas
in the organization.

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From Task to Results Control

• In decentralization, control moves----

from task control to results control

where people are where people are

told what to do told to use their skill,
knowledge, and
creativity to improve
results

Decentralization is the phenomenon that prompted

the development and use of internal financial control
in organizations.

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Responsibility Centers
• A responsibility center is an organization unit for which
a manager is held accountable.

• Organizations use financial control to provide a summary

measure of how well their responsibility centers are
working.

• The accounting report prepared for a responsibility center

should reflect the degree to which the responsibility
center manager controls revenue, cost, profit, or return
on investment.

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Cost, Profit, and Investment Centers

Cost Profit
Investment
Center Center
Center

Cost, profit, and

investment
centers are all
known as Responsibility
responsibility Center
centers.

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Cost Center
A segment whose manager has control
over costs, but not over revenues or
investment funds.

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Profit Center

Revenues
A segment whose
Sales
manager has control
Interest
over both costs and
Other
revenues,
Costs
but no control over
investment funds. Mfg. costs
Commissions
Salaries
Other

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Investment Center
A responsibility center in which the manager and other
employees control revenues, costs, and the level of
investment in the responsibility center.

• For example, between 1970 and 2000 General Electric

acquired many businesses
• Including aircraft engines, medical systems, power systems,
transportation systems, consumer products, industrial systems,
broadcasting, plastics, specialty materials, and financial services
• Senior executives at General Electric developed a management
system that evaluated these businesses as independent
operations – in effect as investment centers

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Responsibility Center

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Learning Objective 1

Compute return on
investment (ROI) and
show how changes in
sales, expenses, and
assets affect ROI.

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Fortune 1000 Survey

Most important Financial Performance Measure:

Income (profit) in comparison with budget: 49% Ch9
ROA/ROI/ROE: 29%
Ch10
Residual Income/Economic Value Added: 14%
Return on Sales: 3%
Other: 5%

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Return on Investment (ROI) Formula

Income before interest

and taxes (EBIT)

Net operating income

ROI =
Average operating assets

Cash, accounts receivable, inventory,

plant and equipment, and other
productive assets.

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Net Book Value versus Gross Cost
Most companies use the net book value of
depreciable assets to calculate average
operating assets.

Acquisition cost
Less: Accumulated depreciation
Net book value

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Understanding ROI
Net operating income
ROI = Average operating assets

Net operating income

Margin =
Sales
Sales
Turnover =
Average operating assets

ROI = Margin × Turnover

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Understanding ROI

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Increasing ROI
There are three ways to increase ROI . . .
 Reduce
 Increase Expenses  Reduce
Sales Assets

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Calculating ROI
Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000

What is Regal Company’s ROI?

ROI = Margin × Turnover

Net operating income Sales
ROI = × Average operating assets
Sales
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Calculating ROI

ROI = Margin × Turnover

Sales
ROI = Net operating income × Average operating assets
Sales

ROI = $30,000 ×
$500,000
$500,000 $200,000

ROI = 6% × 2.5 = 15%

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Quick Check 1
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%

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Quick Check 2
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. If the
manager of the division is evaluated based on
ROI, will she want to make an investment of
$100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No

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Quick Check 3
The company’s required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000 per
year?
a. Yes
b. No

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(1) Investing in Operating Assets to
Increase Sales
Assume 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.

Regal Company reports the following:

Net operating income $ 50,000
Average operating assets $ 230,000
Sales $ 535,000
Operating expenses $ 485,000
Let’s calculate the new ROI.
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(1) Investing in Operating Assets to
Increase Sales

ROI = Margin × Turnover

Net operating income Sales
ROI = × Average operating assets
Sales

ROI = $50,000 ×
$535,000
$535,000 $230,000

ROI = 9.35% × 2.33 = 21.8%

ROI increased from 15% to 21.8%.

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(2) Increasing Sales Without an
Increase in Operating Assets
 Regal's manager was able to increase sales to
$600,000, while operating expenses increased
to $558,000.
 Regal's net operating income increased to
$42,000.
 There was no change in the average operating
assets of the segment.

Let’s calculate the new ROI.

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(2) Increasing Sales Without an
Increase in Operating Assets

ROI = Margin × Turnover

Net operating income Sales
ROI = × Average operating assets
Sales

ROI = $42,000 ×
$600,000
$600,000 $200,000

ROI = 7% × 3.0 = 21%

ROI increased from 15% to 21%.

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(3) Decreasing Operating Expenses with no
Change in Sales or Operating Assets
Assume that Regale's manager was able to reduce
operating expenses by $10,000, without affecting
sales or operating assets. This would increase net
operating income to $40,000.
Regal Company reports the following:
Net operating income $ 40,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 460,000

Let’s calculate the new ROI.

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(3) Decreasing Operating Expenses with no
Change in Sales or Operating Assets

ROI = Margin × Turnover

Net operating income Sales
ROI = × Average operating assets
Sales

ROI = $40,000 $500,000

×
$500,000 $200,000

ROI = 8% × 2.5 = 20%

ROI increased from 15% to 20%.

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(4) Decreasing Operating Assets with no
Change in Sales or Operating Expenses
Assume that Regale's manager was able to reduce
inventories by $20,000 using just-in-time
techniques, without affecting sales or operating
expenses.
Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 180,000
Sales $ 500,000
Operating expenses $ 470,000
Let’s calculate the new ROI.
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(4) Decreasing Operating Assets with no
Change in Sales or Operating Expenses

ROI = Margin × Turnover

Net operating income Sales
ROI = × Average operating assets
Sales

ROI = $30,000 $500,000

×
$500,000 $180,000

ROI = 6% × 2.78 = 16.7%

ROI increased from 15% to 16.7%.

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Criticisms of ROI

In the absence of the balanced

scorecard, management may
not know how to increase ROI.

Managers often inherit many

committed costs over which
they have no control.

Managers evaluated on ROI

may reject profitable
investment opportunities.

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Learning Objective 2

Compute residual
income and understand
its strengths and
weaknesses.

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Residual Income - Another Measure of
Performance

Net operating income

above some minimum
return on operating
assets

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Calculating Residual Income

Residual
income
=
Net
operating -
income
(Average
operating
assets
×
Minimum
required rate of
return
)
This computation differs from ROI.
ROI measures net operating income earned
relative to the investment in average operating
assets.
Residual income measures net operating income
earned less the minimum required return on
average operating assets.
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Residual Income – An Example

• The Retail Division of Zephyr, Inc., has average

operating assets of $100,000 and is required to
earn a return of 20% on these assets.

• In the current period, the division earns $30,000.

Let’s calculate residual income.

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Residual Income – An Example

Operating assets $ 100,000

Required rate of return × 20%
Minimum required return $ 20,000

Actual income $ 30,000

Minimum required return (20,000)
Residual income $ 10,000

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Motivation and Residual Income

Residual income encourages managers to

make profitable investments that would
be rejected by managers using ROI.

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Quick Check 4
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000

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Quick Check 5
If the manager of the Redmond Awnings division
is evaluated based on residual income, will she
want to make an investment of $100,000 that
would generate additional net operating income
of $18,000 per year?
a. Yes
b. No

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Divisional Comparisons and Residual
Income
The residual
income approach
has one major
disadvantage.
It cannot be used
to compare the
performance of
divisions of
different sizes.

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Zephyr, Inc. - Continued
Recall the following
information for the Retail
Division of Zephyr, Inc.
Assume the following
information for the
Wholesale Division of
Zephyr, Inc.

Retail Wholesale
Operating assets $ 100,000 $ 1,000,000
Required rate of return × 20% 20%
Minimum required return $ 20,000 $ 200,000

Retail Wholesale
Actual income $ 30,000 $ 220,000
Minimum required return (20,000) (200,000)
Residual income $ 10,000 $ 20,000
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Zephyr, Inc. - Continued
The residual income numbers suggest that the Wholesale Division
outperformed the Retail Division because its residual income is
$10,000 higher. However, the Retail Division earned an ROI of 30%
compared to an ROI of 22% for the Wholesale Division. The
Wholesale Division ’ s residual income is larger than the Retail
Division simply because it is a bigger division.
Retail Wholesale
Operating assets $ 100,000 $ 1,000,000
Required rate of return × 20% 20%
Minimum required return $ 20,000 $ 200,000

Retail Wholesale
Actual income $ 30,000 $ 220,000
Minimum required return (20,000) (200,000)
Residual income $ 10,000 $ 20,000

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Learning Objective 3

Discuss the benefits and

limitations of financial
control.

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Financial Control at Ford Motor
In the 1940s, Ford Motor Corporation was in big trouble
as profits and sales were both falling.

In response to this crisis, Ford replaced the autocratic

secretive management style at Ford with a disciplined
system of financial control.

At the heart of this philosophy was the belief that

organizations could and should be controlled by financial
numbers and that a detailed knowledge of markets and
operations was unnecessarily for control.

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Benefits of Financial Control
• A relatively easy and inexpensive way for upper-level
managers to ensure that everything is working as they
had hoped.
• Consistent with the implementation of decentralized
forms of organization with largely autonomous
responsibility centers.
• Aggregate the effects of a broad range of operating
qualities and characteristics into a single measure, thus
reducing the possibility of conflicting signals about the
importance of the various operating indicators.

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The Problem…
By every financial measure during the 1970s, US
Steel, Xerox, and IBM dominated their markets.
Yet, by the mid-1980s, their positions were under
serious attack by competitors who achieved
higher quality, higher customer satisfaction,
higher levels of innovations and better business
models. These could not be measured by
financial means until it was too late.

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The Efficacy of Financial Control
• Critics of financial control have argued that:
• Financial information is delayed—and highly
aggregated—information about how well the
organization is doing in meeting its commitments to its
shareowners
• This information measures neither the drivers of the
financial results nor how well the organization is
doing in meeting its other stakeholders’
requirements

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End of Chapter 10 (Part I)

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