Financial and Managerial

Accounting

Wild, Shaw, and Chiappetta

Fifth Edition
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 22

Decentralization and
Performance Evaluation
 Conceptual Learning
Objectives
C1: Distinguish between direct and indirect expenses
and identify bases for allocating indirect expenses
to departments.
C2: Appendix 22A: Explain transfer pricing and
methods to set transfer prices.
C3: Appendix 22B: Describe allocation of joint costs
across products.

22-3
Analytical Learning Objectives
A1: Analyze investment centers using return on
total assets, residual income, and balanced
scorecard.
A2: Analyze investment centers using profit
margin and investment turnover.
A3: Analyze investment centers using the
balanced scorecard.
A4: Compute cycle time and cycle efficiency,
and explain their importance to production
management.

22-4
 Procedural Learning
Objectives

P1: Prepare a responsibility report for a

cost center.
P2: Allocate indirect expenses to
departments.
P3: Prepare departmental income
statements and contribution reports.

22-5
C1

Responsibility Accounting
Primary
goals

Provide
Provide information
information To
To control
control costs
costs and
and
for
for managers
managers toto use
use expenses
expenses and
and assist
assist
in
in performance
performance with
with evaluating
evaluating
evaluation
evaluation of
of managers’
managers’
departments.
departments. performance.
performance.
22-6
C1 Information for
Departmental Evaluation
The
The accounting
accounting system
system provides
provides information
information
about
about resources
resources used
used and
and outputs
outputs achieved.
achieved.

Managers use this information to:

 Control operations.
 Appraise performance.
 Allocate resources.
 Plan strategy.
22-7
C1 Information for
Departmental Evaluation
The
The type
type of
of accounting
accounting information
information provided
provided
depends
depends onon whether
whether the
the department
department is
is aa .. .. ..

Profit Cost Investment

center center center

Evaluated Evaluated
Evaluatedon
Evaluatedononability
ability Evaluated
Evaluatedon on
on
to their
theiruse
useof
togenerate
generaterevenues
revenues ability
abilityto
to
of
in center
centerassets
assetsto
inexcess
excessofof control to
expenses. controlcosts.
costs. generate
generateincome.
income.
expenses.
22-8
C1

Responsibility Accounting
An accounting system that
provides information . . .

Relating to the To evaluate

responsibilities of managers on
individual managers. controllable items.

22-9
C1

Controllable Costs
Costs are controllable I’m in
if the manager
control
has the power to
determine, or strongly
influence, the amounts
incurred.
A manager’s
performance
evaluation should be
based on controllable
costs.
22-10
C1
Distinguishing between Controllable
vs. Direct Costs
Direct costs are traced to departments, but may
not be controllable by the department manager.
 Example: Department managers usually
have no control over their own salaries.

Controllable costs are identified with a particular

manager and a definite time period.
 All costs are controllable at some level of management if
the time period is long enough.

When evaluating managers’ performances, we should use

data reflecting their departments’ outputs along with their
controllable costs and expenses.
22-11
P1
Responsibility Accounting
Successful
Successfulimplementation
implementationofofresponsibility
responsibilityaccounting
accountingmay
mayuse
useorganization
organizationcharts
charts
with
withclear
clearlines
linesofofauthority
authorityand
andclearly
clearlydefined
definedlevels
levelsofofresponsibility.
responsibility.
ItItuses
usesthe
theconcept
conceptofofcontrollable
controllablecosts
coststotoassign
assignmanagers
managersthe theresponsibility
responsibilityfor
for
costs
costsand
andexpenses
expensesunder
undertheir
theircontrol.
control.

B o a r d o f D ir e c to r s

P r e s id e n t

V ic e P r e s id e n t V ic e P r e s id e n t V ic e P r e s id e n t
o f F in a n c e o f O p e r a tio n s o f M a r k e tin g

S to re M a n a g e r

D e p a rtm e n t M a n a g e r
22-12
P1 Responsibility Accounting
Performance Reports
Amount of detail varies according
to level in organization.

The vice president

A department A store manager
of operations
manager receives
receives
receives detailed summarized summarized
reports. information from information from
each department. each store.
22-13
P1 Responsibility Accounting
Performance Reports

To be of maximum benefit,
responsibility reports should . . .
 Be timely.
 Be issued regularly.
 Be understandable.
 Compare budgeted
and actual amounts.

22-14
C1

Direct and Indirect Expenses

t s.
Direct expenses are os
e c
incurred for the sole l
llab $
benefit of a specific t r o $$
on
department. C

ts s.
Indirect expenses co
benefit more than one ble
lla
department and are ntro $$$
allocated among c o
Un
departments benefited.

22-15
P2 Illustration of Indirect
Expense Allocation
Classic Jewelry, a retail store, pays its janitorial service
$300 per month to clean its store. Management
allocates this cost to its three departments according
to the floor space each occupies.

22-16
P2 Illustration of Indirect
Expense Allocation
Classic Jewelry, a retail store, pays its janitorial
service $300 per month to clean its store.
Management allocates this cost to its three
departments according to the floor space each
occupies.

22-17
P2 Illustration of Indirect
Expense Allocation
Classic Jewelry, a retail store, pays its janitorial
service $300 per month to clean its store.
Management allocates this cost to its three
departments according to the floor space each
occupies.

22-18
P2
Bases for Allocating
Service Department Costs (Exhibit 22.3)
Service department costs are shared, indirect
expenses that support the activities of two or
more production departments.

22-19
P2 Service Department Costs
Question
ABCO
ABCO allocates
allocates its
its $300,000
$300,000 personnel
personnel cost
cost to
to
operating
operating departments
departments based
based on
on the
the number
number of of
employees
employees in in each
each department.
department. The
The Assembly
Assembly
Department
Department has has 100
100 employees
employees and
and the
the Packing
Packing
Department
Department has has 150
150 employees.
employees. What
What amount
amount of of
cost
cost is
is allocated
allocated toto the
the Assembly
Assembly Department?
Department?
a.
a. $100,000
$100,000
b.
b. $120,000
$120,000
c.
c. $150,000
$150,000
d.
d. $180,000
$180,000

22-20
P2 Service Department Costs
Question
ABCO
ABCO allocates
allocates its
its $300,000
$300,000 personnel
personnel cost
cost to
to
operating
operating departments
departments based
based onon the
the number
number of of
employees
employees in in each
each department.
department. TheThe Assembly
Assembly
Department
Department has has 100
100 employees
employees andand the
the Packing
Packing
Department
Department has has 150
150 employees.
employees. WhatWhat amount
amount of of
cost
cost is
is allocated
allocated toto the
the Assembly
Assembly Department?
Department?
a.
a. $100,000
$100,000 Assembly percentage
b.
b. $120,000
$120,000 = 100 ÷ (100 + 150) = 40%
c.
c. $150,000
$150,000 40% of $300,000 = $120,000
d.
d. $180,000
$180,000

22-21
P3 Preparing Departmental
Income Statements
Allocating costs to operating
departments and preparing
departmental income statements
involve four steps:

1. Accumulating revenues and direct expenses by department.

2. Allocating indirect expenses across departments

3. Allocating service department expenses to operating departments.

4. Preparing departmental income statements.

22-22
P3 Departmental Expense
Allocation Spreadsheet (Exhibit 22.6)
Expense General Purch- Hard- House- Appli-
Allocation Account Office asing ware wares ances
Base Balance Dept Dept Dept Dept Dept.
Direct expenses
Salaries expense Payroll $ 51,900 $ 13,300 $ 8,200 $ 15,600 $ 7,000 $ 7,800
Depreciation - equip Depn records 1,500 $ 500 $ 300 $ 400 $ 100 $ 200
Supplies expense Requisitions 900 200 100 300 200 100
Indirect expenses
Rent expense Floor space 12,000 600 600 4,860 3,240 2,700
Utilities expense Floor space 2,400 300 300 810 540 450
Advertising expense Sales 1,000 500 300 200
Insurance expense Val. Of ins assets 2,500 400 200 900 600 400
Total dept. expenses $ 72,200 $ 15,300 $ 9,700 $ 23,370 $ 11,980 $ 11,850
Service dept. expenses
General Office Dept Sales (15,300) 7650 4590 3060
Purchasing Dept Purchase Orders (9,700) 3,880 2,630 3,190
Total expenses allocated $ 72,200 $ 0 $ 0 $ 34,900 $ 19,200 $ 18,100

22-23
P3 Departmental Expense
Allocation Spreadsheet
Expense Allocation to Departments
General Purch- Hard- House- Appli-
Allocation Total Office asing ware wares ances
Base Expense Dept. Dept. Dept. Dept Dept.
Direct expenses
Salaries Payroll $ 51,900 $ 13,300 $ 8,200 $ 15,600 $ 7,000 $ 7,800
Depreciation Exp - Equip Depn Records 1,500 500 300 400 100 200
Supplies Requisitions 900 200 100 300 200 100

Step 1: Direct expenses are traced to service departments

and sales departments without allocation.

22-24
P3 Departmental Expense
Allocation Spreadsheet
Of a total of 12,000 square feet, the service departments occupy 1,500
square feet each, the Hardware Department occupies 4,050 feet,
Housewares 2,700, and Appliances 2,250.

Expense Allocation to Departments

General Purch- Hard- House- Appli-
Allocation Total Office asing ware wares ances
Base Expense Dept. Dept. Dept. Dept Dept

Utilities Floor space $ 2,400 $ 300 $ 300 $ 810 $ 540 $ 450

1,500 ft x $2,400 = $300

12,000 ftto both the service and the
Step 2: Indirect expenses are allocated
operating departments based on floor space occupied.
22-25
P3 Departmental Expense
Allocation Spreadsheet
Expense General Purch- Hard- House- Appli-
Allocation Account Office asing ware wares ances
Base Balance Dept Dept Dept Dept Dept.
Direct expenses
Salaries Expense Payroll $ 51,900 $ 13,300 $ 8,200 $ 15,600 $ 7,000 $ 7,800
Depreciation - Equip Depn records 1,500 500 300 400 100 200
Supplies Expense Requisitions 900 200 100 300 200 100
Indirect expenses
Rent Expense Floor space 12,000 600 600 4,860 3,240 2,700
Utilities Expense Floor space 2,400 300 300 810 540 450
Advertising Expense Sales 1,000 500 300 200
Insurance Expense Val. Of ins assets 2,500 400 200 900 600 400
Total dept. expenses $ 72,200 $ 15,300 $ 9,700 $ 23,370 $ 11,980 $ 11,850
Service dept. expenses
General Office Dept Sales (15,300) 7,650 4,590 3,060
Purchasing Dept Purchase Orders (9,700) 3,880 2,630 3,190
Total expenses Allocated $ 72,200 $ 0 $ 0 $ 34,900 $ 19,200 $ 18,100

Step 3: The Service department total expenses (original direct expenses + allocated indirect expenses) from
the two service departments are allocated to three remaining operating or sales departments.
22-26
P3
Departmental Income Statements
(Exhibit 22.15)

         

  Hardware Housewares Appliances  

  Dept. Dept. Dept. Combined
Sales $ 119,500 $ 71,700 $ 47,800 $ 239,000
Cost of goods sold 73,800 43,800 30,200 147,800
Gross profit on sales $ 45,700 $ 27,900 $ 17,600 $ 91,200
Operating expenses       0
Salaries expense $ 15,600 $ 7,000 $ 7,800 $ 30,400
Depreciation expense 400 100 200 700
Supplies expense 300 200 100 600
Rent expense 4,860 3,240 2,700 10,800
Utilities expense 810 540 450 1,800
Advertising expense 500 300 200 1,000
Insurance expense 900 600 400 1,900
Share of general office expense 7,650 4,590 3,060 15,300
Share of purchasing expenses 3,880 2,630 3,190 9,700
Total operating expenses $ 34,900 $ 19,200 $ 18,100 $ 72,200
Net income (loss) $ 10,800 $ 8,700 $ (500) $ 19,000
         
          22-27
P3

Departmental Income Statement

         

  Hardware Housewares Appliances  

  Dept. Dept. Dept. Combined
Sales $ 119,500 $ 71,700 $ 47,800 $ 239,000
Cost of goods sold 73,800 43,800 30,200 147,800
Gross profit on sales $ 45,700 $ 27,900 $ 17,600 $ 91,200
Operating expenses      
Salaries expense $ 15,600 $ 7,000 $ 7,800 $ 30,400
Depreciation expense Direct 400 100 200 700
Supplies expense 300 200 100 600
Rent expense 4,860 3,240 2,700 10,800
Utilities expense 810 540 450 1,800
Advertising expense Indirect 500 300 200 1,000
Insurance expense 900 600 400 1,900
Share of general office expense 7,650 4,590 3,060 15,300
Share of purchasing expenses 3,880 2,630 3,190 9,700
Total operating expenses $ 34,900 $ 19,200 $ 18,100 $ 72,200
Net income $ 10,800 $ 8,700 $ (500) $ 19,000
         
         
22-28
P3
Departmental Contribution to
Overhead (Exhibit 22.16)
         

  Hardware Housewares Appliances  

  Dept. Dept. Dept. Combined
Sales $ 119,500 $ 71,700 $ 47,800 $ 239,000
Cost of goods sold 73,800 43,800 30,200 147,800
Gross profit on sales $ 45,700 $ 27,900 $ 17,600 $ 91,200
Operating expenses      
Direct expenses        
Salaries expense $ 15,600 $ 7,000 $ 7,800 $ 30,400
Depreciation expense 400 100 200 700
Supplies expense 300 200 100 600
Total direct expenses 16,300 7,300 8,100 31,700
Departmental contributions        
to overhead $ 29,400 $ 20,600 $ 9,500 $ 59,500

Continued….
22-29
 P3 Departmental Contribution to
Overhead (Exhibit 22.16)
         

Departmental contributions        
to overhead $ 29,400 $ 20,600 $ 9,500 $ 59,500
Indirect expenses:
Rent expense       10,800
Utilities expense       1,800
Advertising expense       1,000
Insurance expense       1,900
Share of general office expense     15,300
Share of purchasing expenses     9,700
Total operating expenses       $ 40,500
Net income       $ 19,000
Contribution as percent of sales 24.6% 28.7% 19.9% 24.9%

22-30
A1 Financial Performance
Evaluation Measures
 One of the ways to evaluate
investment center managers is to use
a measure called return on investment
(or return on assets.)
 The formula for ROI is as follows:
ROI = Investment center net income
Investment center average invested assets

22-31
A1 Financial Performance
Evaluation Measures
 Another measure of evaluating
financial performance is by computing
the investment center’s residual
income.

Residual Investment center Target investment

income = -
net income center net income

22-32
A2

Investment Center – Analysis

 We can further examine investment

center performance by splitting down
return on investment into profit margin
and investment turnover:
ROI = Profit margin X Investment turnover
 This will provide further information on
the performance of the unit.

22-33
A2

Profit Margin
 The profit margin is the first
component in the expanded equation
and measures the income earned per
dollar of sales.

Profit margin = Investment center net income

Investment center sales

22-34
A2

Investment Turnover
 The investment turnover measures
how efficiently the company generates
sales from its invested assets.
 It is used in the second half of the
expanded ROI formula.
Investment = Investment center sales
turnover Investment center average assets

22-35
A3

Balanced Scorecard
 The balanced scorecard is a system of
performance measures, including
nonfinancial measures.
 It is used to assess company and division
performance based on four perspectives:
1. Customer: What do customer’s think of us?
2. Internal processes: Which of our operations are
critical to meeting customer needs?
3. Innovation and Learning: How can we improve?
4. Financial: What do our owners think of us?
22-36
A4
Cycle Time and Cycle
Efficiency
Manufacturing companies want to reduce the
time to manufacture their products and to
improve manufacturing efficiency.

Cycle time = Process time + Inspection time + Move time + Wait time

Process time: Time spent producing the product

Inspection time: Time spent inspecting
Move time: Time spent moving
Wait time: Time that an order or job sits with no
production applied to it.

22-37
 A4
Cycle Time and Cycle
Efficiency
Companies strive to reduce non-value-added
time to improve cycle efficiency.
Cycle efficiency = Value–added time
Cycle time

Value-added time Process time: Time spent producing the product

Inspection time: Time spent inspecting
Non-Value-added time Move time: Time spent moving
Wait time: Time that an order or job sits with
no production applied to it.

22-38
C2

Transfer Pricing
 Determining the price that should be
used to record transfers between
divisions in the same company is called
transfer pricing.
 These transactions are transfers within
the same company.
 Transfer prices can be used in cost,
profit, and investment centers.
22-39
C3
Joint Costs and Their
Allocation
 Most manufacturing processes involve joint costs,
which refer to costs incurred to produce or purchase
two or more products at the same time.
 Joint costs are allocated among the joint
products resulting from it.
 Two methods can be used:
(1) Physical basis
(2) Value basis

22-40
End of Chapter 22

22-41