Performance Evaluation, Variable

Costing and Decentralization

Learning Objectives

1. Explain how and why firms choose to decentralize.

2. Explain the difference between absorption and variable costing. Prepare segmented
income statements.
3. Compute and explain return on investment (ROI).
4. Compute and explain residual income and economic value added (EVA).
5. Explain the role of transfer pricing in a decentralized firm. 6. (Appendix) Explain
the uses of the Balanced Scorecard and compute cycle time, velocity, and
manufacturing cycle efficiency (MCE).

CHAPTER OUTLINE

1. DECENTRALIZATION AND RESPONSIBILITY ACCOUNTING

The traditional organization chart, with its pyramid shape, illustrates the lines of
responsibility flowing from the CEO down through the vice-presidents to middle- and
lower-level managers. Contemporary practice is moving toward a flattened
hierarchy, and emphasizing teams is consistent with decentralization.

Decentralization is the practice of delegating or decentralizing decision-making

authority to lower levels.

A. Reasons for Decentralization

Reasons for using a decentralized organizational structure include:

Gathering and using local information. Focusing of central management.

Decentralization allows top management to concentrate on firmwide problems,
strategic planning, and decision making.

Training and motivating managers.

Enhanced competition.

B. Responsibility Center
A responsibility center is a segment of a business whose manager is accountable for
specified sets of activities. Four types of responsibility centers are:

cost center—the manager is responsible only for costs

revenue center—the manager is responsible only for sales (revenues)

profit center—the manager is responsible for both revenues and costs

investment center—the manager is responsible for revenues, costs, and investments

2. MEASURING THE PERFORMANCE OF PROFIT CENTERS USING

SEGMENTED INCOME STATEMENTS
A. Variable versus Absorption Costing

Profit centers are evaluated based on income (revenues minus expenses). However,
how the income is measured is important for evaluation purposes.

Two ways of calculating income are:

1. Variable costing: assigns only variable manufacturing costs to the product cost
(direct materials, direct labor, and variable manufacturing overhead).

2. Full or absorption costing: assigns all manufacturing costs to the product (direct
materials, direct labor, variable manufacturing overhead, and fixed manufacturing
overhead).

Absorption costing is required for externa l financial reporting and income tax
purposes.

Variable costing is used for interna l reporting to management because it provides

information that is useful for planning, control, and decision making.

Product and period costs under absorption and variable costing are summarized
below:
Product costs: direct materials (DM) direct materials (DM)
direct labor (DL) direct labor (DL)
variable overhead (VOH) variable overhead (VOH)
fixed overhead (FOH)

Period costs: variable selling expenses fixed overhead (FOH)

fixed selling expenses variable selling expenses
variable administrative expenses fixed selling expenses
fixed administrative expenses variable administrative expenses
fixed administrative expenses

The following diagram illustrates the flow of manufacturing costs using absorption costing:

ABSORPTION COSTING

Work in Process Finished Goods Cost of Goods Sold

The following diagram illustrates the flow of manufacturing costs using variable
costing:

VARIABLE COSTING

Work in Process Finished Goods Cost of Goods Sold Period Cost

B. Inventory Valuation

The main difference between the two methods relates to how fixed manufacturing
overhead is recorded.

When using absorption costing, fixed manufacturing overhead is considered a

product cost, included in inventory and expensed when the inventory is sold.

When using variable costing, fixed manufacturing overhead is no t included in

inventory but is expensed in the period it is incurred.

The ending finished goods inventory values for absorption and variable costing will
differ by the amount of fixed manufacturing costs included in ending inventory.

Cornerstone 11-1: How to Compute Inventory Cost Under Absorption

and Variable Costing

See Mowen and Hansen text for demo problems.

C. Income Statements Using Variable and Absorption Costing

Under absorption costing, costs are classified by functio n as:

1. manufacturing costs (both fixed and variable)

2. selling and administrative costs (both fixed and variable)

The format used when costs are classified by function for absorption costing is:

Sales
– Cost of goods sold (Manufacturing costs)
= Gross margin
– Selling and administrative expenses
= Net income

When variable costing is used, costs are classified by behavior as:

1. variable costs

variable manufacturing

variable selling and administrative

2. fixed costs

fixed manufacturing

fixed selling and administrative

The format used for a variable-costing income statement follows:

Sales
– Variable expenses:
Variable cost of goods sold
Variable selling and administrative
= Contribution margin
– Fixed expenses:
Fixed overhead
Fixed selling and administrative
= Net income