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Responsibility Accounting

Pros and Cons of


Decentralization

Pros
Better

information, leading to better decisions


Faster response to changing circumstances
Increased motivation for managers
Excellent training for future leaders

Pros and Cons of


Decentralization

Cons
Costly

duplication of activities
Lack of goal congruence

Goal Congruence
Goal congruence
means that as people
work to achieve their
own goals, they also
work to achieve the
goals of the
company.
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Responsibility Accounting
A responsibility accounting system generates
reports to employees, including managers,
about the performance of their assigned
responsibility.

Types of responsibility centers


Cost center
Revenue center
Profit center
Investment center
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Cost Centers

A cost center is a segment whose manager


is responsible for costs but not for revenues.
Examples:
Manufacturing cells
Office of the CEO
Legal department
Accounting department
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Profit and Investment Centers


A profit center is a segment whose
manager is responsible for revenues as
well as costs.
An investment center is a segment whose
manager is responsible not only for
revenues and costs, but also for the
investment required to generate profits.

Performance Evaluation Criteria


Selecting criteria to measure and evaluate
performance is important because the criteria
influence managers actions. YOU GET
WHAT YOU MEASURE! The most common
deficiencies in performance measures are:

using a single measure that emphasizes only


one objective of the organization; and
using measures that either misrepresent or fail
to reflect the organizations objectives or the
employees responsibilities.
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Managerial Accounting Issues


Related to Decentralization
The need to develop methods of
evaluating performance that work to the
benefit of the company as a whole.
The need to develop transfer prices that
produce decisions in the best interest of
the company.

Measures of Performance
Companies use four principal measures to
evaluate divisions:
Income
Return on Investment (ROI)
Residual Income (RI)
Economic Value Added (EVA)

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ROI Formula
ROI = Divisional income/Divisional
investment
Companies define and measure divisional
income and divisional investment in various
ways.

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Alternative ROI Formula


ROI = Profit margin x Turnover
Profit Margin = Divisional income/Divisional sales
Turnover = Divisional sales/Divisional investment

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An ROI Example
2002
Divisional sales
Divisional income (NOPAT)
Average divisional as sets
2003
Divisional sales
Divisional income (NOPAT)
Average divisional assets

Alpha Division Beta Div


$10,000$60,000
1,0002,500
6,00017,500
$17,500$60,000
1,2502,750
6,00017,500

Cost of capital is 10 percent


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NOPAT
NOPAT is net operating profit after tax
Equals net income plus interest net of tax
Relates income to assets utilized to
generate that income
Does not consider the effect of using
financial leverage (debt) on the rate of
return
Is consistent with return on assets from
Acct 284

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Return on Sales and Turnover


Comparisons
Profit margin
Turnover
ROI

Alpha Alpha
2002
2003
10.0%
7.1%
1.667 2.917
16.7% 20.7%

Beta
2002
4.2%
3.429
14.4%

Beta
2003
4.6%
3.429
15.8%

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A Residual Income Example


Residual income = NOPAT (Assets x RRR)
RRR = required rate of return
AlphaAlphaBeta
Beta20022003
20022003
Divisional operating assets$6,000$6,000$17,500 $17,500
Divisional operating income$1,000$1,250$2,500$2,750
Minimum return
6006001,750
1,750
Residual income
$400$650$750 $1,000
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Comparison of ROI versus RI


AlphaAlpha Beta
Beta
2002
2003
2002
2003
Return on investment 16.7% 20.7% 14.4% 15.8%
Residual income
$400
$650
$750 $1,000

Which method would you prefer?

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ROI Versus RI

Using ROI to evaluate


divisions can encourage
them to reject good
investments and accept
poor investments.

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ROI, RI and Goal Congruence


ROI evaluation will encourage managers
to accept any opportunity above the
current ROI
RI will encourage managers to accept any
opportunity above the cost of capital.
Which gives better goal congruence?
Which would encourage growth?

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Economic Value Added

Same calculation as residual income but adjusts


for capitalization of Research and development
costs and other accounting distortions
R & D is then amortized against income
Gives managers the incentive to spend R & D
Other adjustments to income that are designed
to encourage certain behaviors are often
incorporated into performance evaluation
techniques.
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Whole Foods Market


Whole foods markets uses EVA analysis
http://www.wholefoodsmarket.com/investor
/eva.html
Date:5/2/2006

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We use Economic Value Added ("EVA") to evaluate our business decisions


and as a basis for determining incentive compensation. In its simplest
definition, EVA is equivalent to net operating profits after taxes minus a
charge for the cost of capital necessary to generate those profits. We
believe that one of our core strengths is our decentralized culture, where
decisions are made at the store level, close to the customer. We believe this
is one of our strongest competitive advantages, and that EVA is the best
financial framework that team members can use to help make decisions that
create sustainable shareholder value.
We use EVA extensively for capital investment decisions, including
evaluating new store real estate decisions and store remodeling proposals.
We are turning down projects that do not add long-term value to the
Company. The EVA decision-making model is also enhancing operating
decisions in stores. Our emphasis is on EVA improvement, as we want to
challenge our teams to continue to innovate and grow EVA in new ways. We
believe that opportunities always exist to increase sales and margins, to
lower operating expenses and to make investments that add value in ways
that benefit all of our stakeholders. We believe that focusing on EVA
improvement encourages continuous improvement of our business.

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Over 500 leaders throughout the Company are on EVA-based


incentive compensation plans, of which the primary measure is EVA
improvement. EVA-based plans cover our senior executive
leadership, regional leadership and the store leadership team in all
stores. Incentive compensation for each of these groups is
determined based on relevant EVA measures at different levels,
including the total company level, the regional level, the store or
facility level, and the team level. We believe using EVA in a multidimensional approach best measures the results of decisions made
at different levels of the Company. We expect to continue to expand
the use of EVA as a significant component of our compensation
structure throughout the Company in the coming years.
The following table sets forth selected EVA information based on a
9% weighted average cost of capital and a 40% tax rate for the
fiscal years ended September 25, 2005 and September 26, 2004.(in
thousands)

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2005
Net operating profit after
tax (NOPAT)

Capital charge
EVA
Increase in EVA

2004

165,579 $

136,684

139,793

119,101

25,786

17,583

8,203 $

-*

* EVA calculations not updated in 2003, due to lease restatements.

The Company provides information regarding EVA as additional information


about its operating results. EVA is a measure not in accordance with, or an
alternative to, generally accepted accounting principles ("GAAP"). The
Company's management believes that this additional EVA information is useful
to shareholders, management, analysts and potential investors in evaluating
the Company's results of operations and financial condition. In addition,
management uses these measures for reviewing the financial results of the
Company and for budget planning and incentive compensation purposes. EVA
is calculated by subtracting a charge for the use of capital (capital charge) from
net operating profit after taxes ("NOPAT"). A reconciliation of GAAP net income
to NOPAT follows (in thousands):

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2005

GAAP net income

Provision for income taxes

2005

136,351 $

129,511

100,782

86,341

38,832

11,955

Net operating profit before


taxes (NOPBT)

275,965

227,807

Taxes (40%)

110,386

91,121

Interest expense and


other

NOPAT

165,579 $

136,686

Capital charge is calculated by multiplying weighted average EVA capital by our weighted average cost of capital. A reconciliation of total net
assets to ending EVA capital follows (in thousands):
2005
Total assets

Total liabilities

1,696,953

2004
$

1,370,882

537,648

523,589

1,159,305

847,293

87,919

171,305

Implied goodwill (from pooling-of-interest


transactions)

162,803

162,803

Other*

143,740

141,977

Net assets
Long-term debt and capital lease
obligations

EVA capital

1,553,767

1,323,378

* Accumulated components of net income not included in NOPAT

EVA is a registered trademark of Stern Stewart & Co.

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The Balanced Scorecard


An approach known as the balanced
scorecard has become popular
recently. This approach extends
performance evaluation from merely
looking at financial results to formally
incorporating measures that look at
customer satisfaction, internal
business processes, and the learning
and growth potential of the
organization.

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The Balanced Scorecard


(Continued)
The balanced scorecard asks four basic questions:
1. How do customers see us? (the customer perspective)
2. What must we excel at? (the internal business process
perspective)
3. Can we continue to improve and create value? (the
learning & growth perspective)
4. How do we look to stockholders? (the financial
perspective)

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Transfer Price
Sometimes a center with
no external customers is
made into an artificial
profit center. Then
transfer prices, which are
prices that one center
charges another center
within the company, are
needed.
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TRANSFER PRICING POLICIES


Transfer Pricing Methods
Actual costs with or without a markup
Budgeted costs with or without a markup
Market-based prices
Incremental cost
Negotiated prices

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Actual Cost
These transfer prices are not wise because
the selling manager has no incentive to keep
costs down.
Worse, a price that is actual costs plus a
percentage markup gives the selling manager
more profit the higher costs go.

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Budgeted Cost
This method does not
reward the selling
manager if costs go
up, and actually
encourages the
selling manager to
keep costs down.
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Market-Based Prices
This method is generally consider, the best.
The biggest problem is that an outside
market price may not exist.
The transfer price may be less than the market
price due to cost savings from selling internally.

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Incremental Cost
Such prices are theoretically best from the
companys viewpoint when the selling
division is operating below capacity.
Incremental cost can be as low as the variable
cost of the goods or services.

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Negotiated Prices
This method allows managers to bargain
with each other and alleviates some
problems that arise with other methods.
Normally will lead to the right outcome if
managers negotiate in good faith.
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