Chapter Eleven: Performance Evaluation, Variable Costing, and Decentralization

Cornerstones of Managerial
Accounting 2e
Chapter Eleven
Performance Evaluation, Variable
Costing, and Decentralization
Mowen/Hansen
1
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation.
Thomson, the Star logo, and South-Western are trademarks used herein under
license.
Objective # 1
Explain how and why firms

choose to decentralize.
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Decentralization
• Delegating decision-making authority

• Why firms decentralize:
◦ Ease of gathering and using local information
∙ Central management may not understand local
conditions
◦ Focusing on central management from
detailed operations to strategic planning
◦ Training and motivating of segment managers
to prepare a new high-level managers
◦ Enhanced competition, exposing segments to
market forces, which allow each unit to act as
an autonomous business unit
• Achieved by creating Divisions
3
Divisions
• Differentiated by:
◦ Type of product or service provided
◦ Geographic lines
◦ Type of responsibility given to
divisional manager
∙ Responsibility Center is a segment of
business whose manager is
accountable for specified sets of
activities
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Types of Responsibility Centers
• Cost center
∙ Manager is responsible only for costs
• Revenue center
∙ Manager is responsible only for sales
• Profit center
∙ Manager is responsible for both
revenues and costs
• Investment center
∙ Manager is responsible for revenues,
costs, and investments
5
Measuring the Performance of
Profit Centers
• Preparation of segmented income

statements
◦ Two methods of computing income:
∙ Variable costing
∙ Full or Absorption costing
◦ Methods often lead to different operating
income figures
6
Objective # 2
Explain the difference between

absorption and variable costing,
and prepare segmented income
statements.
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Variable Costing Income Statement
• Assigns only variable manufacturing costs to

the product
◦ Direct Materials
◦ Direct Labor
◦ Variable Overhead
• Fixed overhead is treated as a period
expense
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Absorption Costing Income Statement
• Assigns all manufacturing costs to the product

◦ Direct Materials
◦ Direct Labor
◦ Variable Overhead
◦ Fixed Overhead
• Fixed overhead is applied to the product using
a predetermined overhead rate
• Required by generally accepted accounting
principles (GAAP) for external reporting
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Segmented Income Statements
• Segment is a subunit of a company
◦ Divisions
◦ Departments
◦ Product lines
◦ Customer classes
• Fixed expenses are broken down into two
categories:
◦ Direct fixed expenses
∙ Directly traceable to a segment
◦ Common fixed expenses
∙ Jointly caused by two or more segments
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Segment Margin
Sales
– Variable Cost of Goods Sold
– Variable Selling Expense
Contribution Margin
– Direct fixed overhead
– Direct selling and administrative
Segment Margin
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Objective # 3
Compute and explain return on

investment.
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Return on Investment (ROI)
Formula:
Operating Income ÷ Average Operating Assets
Earnings before income

and taxes (EBIT)
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Formula:
Operating Income ÷ Average Operating Assets
(Beginning assets + Ending assets) ÷ 2
14
Alternative Formula:
Margin x Turnover
Operating Income ÷ Sales
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Alternative Formula:
Margin x Turnover
Sales ÷ Average Operating Assets
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Margin and Turnover
• Margin
◦ Ratio of operating income to sales
◦ Tells how many cents of operating income
result from each dollar of sales
◦ Expresses the portion of sales that is
available for interest, taxes, and profit
• Turnover
◦ Divides sales by average operating assets
◦ Tells how many dollars of sales result
from every dollar invested in operating
assets
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Advantages of ROI
• Encourages managers to focus on
◦ Relationship among:
∙ Sales
∙ Expenses
∙ Investment
◦ Cost efficiency
◦ Operating asset efficiency
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Disadvantages of ROI
• Can produce a narrow focus on divisional

profitability at the expense of profitability for
the overall firm
• Encourages managers to focus on the short
run at the expense of the long run
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Objective # 4
Compute and explain residual

income and economic value
added.
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Residual Income
Formula:
Minimum rate of return x
Operating Income –
Average operating assets
Set by the company
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Residual Income
Formula:
Minimum rate of return x
Operating Income –
Average operating assets
If residual income is less than zero, the company is earning

less than the minimum rate of return
If residual income is exactly zero, the company is earning

precisely the minimum rate of return
If residual income is greater than zero, the company is earning
more than the minimum rate of return
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Advantages & Disadvantages of
Residual Income
• Advantages
◦ It encourages managers to accept any project
that earns about the minimum rate
• Disadadvantages
◦ Can encourage a short run orientation
◦ Residual income is an absolute measure of
profitability
∙ Direct comparison is difficult when level of investments
differ
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Economic Value Added (EVA)
Formula:
After-tax
operating Actual percentage cost of capital
–
income x Total capital employed
If EVA is positive then the company is creating wealth
If EVA is negative then the company is destroying wealth
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Advantages of EVA
• Helps to encourage the right kind of behavior

• Relies on the true cost of capital
• Cost of capital is considered a corporate expense
and is passed along to the overall income statement
• Makes investment seem free to the divisions so
they want more
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Objective # 5
Explain the role of transfer

pricing in a decentralized firm.
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Transfer Pricing
• Price charged for a component by the selling

division to the buying division of the same
company
• Sale is a revenue to the selling division
• Sale is a cost to the buying division
• Transfer Pricing policies:
◦ Market price
◦ Cost-based transfer pricing
◦ Negotiated transfer pricing
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Example
Transfer Pricing at a Negotiated Transfer Price:

Minimum transfer price = $14 – $3 = $11
This price is set by Alpha division (the
selling division)
Maximum transfer price = $14

This price is the market price and is set by
Delta division (the buying division)
Alpha and Delta will negotiate a price
somewhere between $11 and $14
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Cornerstones of Managerial

Explain how and why firms

• Delegating decision-making authority

• Preparation of segmented income

Explain the difference between

• Assigns only variable manufacturing costs to

• Assigns all manufacturing costs to the product

Compute and explain return on

Operating Income ÷ Average Operating Assets

Earnings before income

Operating Income ÷ Average Operating Assets

(Beginning assets + Ending assets) ÷ 2

Operating Income ÷ Sales

Sales ÷ Average Operating Assets

• Can produce a narrow focus on divisional

Compute and explain residual

Set by the company

If residual income is less than zero, the company is earning

If residual income is exactly zero, the company is earning

If EVA is positive then the company is creating wealth

If EVA is negative then the company is destroying wealth

• Helps to encourage the right kind of behavior

Explain the role of transfer

• Price charged for a component by the selling

Transfer Pricing at a Negotiated Transfer Price:

Maximum transfer price = $14

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