Chapter 10

Decentralization

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Decentralization in Organizations

Benefits of
Top management
Decentralization freed to concentrate
on strategy.
Lower-level managers
gain experience in
decision-making. Decision-making
authority leads to
job satisfaction.
Lower-level decision
often based on
better information.
Lower-level managers
can respond quickly to
customers.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Decentralization in Organizations
May be a lack of
coordination among
autonomous
Lower-level managers
managers.
may make decisions
without seeing the
“big picture.”
Disadvantages of
Decentralization
Lower-level manager’s
objectives may not
be those of the
organization. May be difficult to
spread innovative ideas
in the organization.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Cost, Profit, and Investments Centers

Cost Profit Investment

Center Center Center

Cost, profit,
and investment
centers are all Responsibility
known as Center
responsibility
centers.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Cost, Profit, and Investments Centers

Cost Center
A segment whose
manager has
control over costs,
but not over
revenues
or investment
funds.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Cost, Profit, and Investments Centers

Profit Center Revenues

A segment whose Sales

manager has Interest

Other
control over both
costs and Costs
revenues, Mfg. costs

but no control over Commissions

Salaries
investment Other
funds.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Cost, Profit, and Investments Centers

Corporate Headquarters
Investment Center
A segment whose
manager has
control over costs,
revenues, and
investments in
operating assets.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Responsibility Centers
Investment
Centers Superior Foods Corporation
Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manager Product Manager Product Manager

Bottling Plant Warehouse Distribution

Cost
Centers
Manager Manager Manager

Superior Foods Corporation provides an example of the

various kinds of responsibility centers that exist in an
organization.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Responsibility Centers

Superior Foods Corporation

Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manager Product Manager Product Manager

Bottling Plant Warehouse Distribution

Profit
Manager Manager Manager
Centers
Superior Foods Corporation provides an example of the
various kinds of responsibility centers that exist in an
organization.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Responsibility Centers

Superior Foods Corporation

Corporate Headquarters
President and CEO

Operations Finance Legal Personnel

Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manager Product Manager Product Manager

Bottling Plant Warehouse Distribution

Cost
Centers
Manager Manager Manager

Superior Foods Corporation provides an example of the

various kinds of responsibility centers that exist in an
organization.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Decentralization and Segment Reporting
An Individual Store

A segment is any Quick Mart

part or activity of an
organization about A Sales Territory

which a manager
seeks cost,
revenue, or profit
data. A segment A Service Center
can be . . .

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Traceable and Common Fixed Costs

In segment reports, traceable

fixed costs should be distinguished
from common fixed costs.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Identifying Traceable Fixed Costs
Traceable costs arise because of the existence
of a particular segment and would disappear over
time if the segment itself disappeared.

No computer No computer
division means . . . division manager.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Identifying Common Fixed Costs
Common costs arise because of the overall
operation of the company and would not disappear
if any particular segment were eliminated.

No computer We still have a

division but . . . company president.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Learning Objective
LO1

To compute the return

on investment (ROI)
and show how changes
in sales, expenses, and
assets affect an
organization’s ROI.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 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.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Net Book Value vs. 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

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Return on Investment (ROI) Formula
Net operating income
ROI =
Average operating assets

Net operating income

Margin =
Sales

Sales
Turnover =
Average operating assets

ROI = Margin  Turnover

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Increasing ROI
There are three ways to increase ROI . . .
Reduce
Expenses
Increase Reduce
Sales Assets

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Increasing ROI – An Example
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 =
Sales
× Average operating assets
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Increasing ROI – An Example

ROI = Margin  Turnover

Net operating income Sales
ROI =
Sales
× Average operating assets

ROI = $30,000 $500,000

×
$500,000 $200,000

ROI = 6%  2.5 = 15%

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 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.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Increasing Sales Without an
Increase in Operating Assets

ROI = Margin  Turnover

Net operating income Sales
ROI =
Sales
× Average operating assets

ROI = $42,000 $600,000

×
$600,000 $200,000

ROI = 7%  3.0 = 21%

ROI increased from 15% to 21%.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Decreasing Operating Expenses with no
Change in Sales or Operating Assets
Assume that Regal’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.
© The McGraw-Hill Companies, Inc., 2007
McGraw-Hill /Irwin
 Decreasing Operating Expenses with no
Change in Sales or Operating Assets

ROI = Margin  Turnover

Net operating income Sales
ROI =
Sales
× Average operating assets

ROI = $40,000 $500,000

×
$500,000 $200,000

ROI = 8%  2.5 = 20%

ROI increased from 15% to 20%.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Decreasing Operating Assets with no
Change in Sales or Operating Expenses
Assume that Regal’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.
© The McGraw-Hill Companies, Inc., 2007
McGraw-Hill /Irwin
 Decreasing Operating Assets with no
Change in Sales or Operating Expenses

ROI = Margin  Turnover

Net operating income Sales
ROI =
Sales
× Average operating assets

ROI = $30,000 $500,000

×
$500,000 $180,000

ROI = 6%  2.777 = 16.66%

ROI increased from 15% to 16.66%.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 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.
© The McGraw-Hill Companies, Inc., 2007
McGraw-Hill /Irwin
 Investing in Operating
Assets to Increase Sales

ROI = Margin  Turnover

Net operating income Sales
ROI =
Sales
× Average operating assets

ROI = $50,000 $535,000

×
$535,000 $230,000

ROI = 9.35%  2.33 = 21.8%

ROI increased from 15% to 21.8%.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 ROI and the Balanced Scorecard
It may not be obvious to managers how to increase sales,
decrease costs, and decrease investments in a way that is
consistent with the company’s strategy. A well constructed
balanced scorecard can provide managers with a road map that
indicates how the company intends to increase ROI.

Which internal business

process should be
improved?

Which customers should

be targeted and how will
they be attracted and
retained at a profit?
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 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.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Learning Objective
LO2

To compute residual
income and understand
the strengths and
weaknesses of this method
of measuring performance.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Residual Income – Another
Measure of Performance

Net operating income

above some minimum
return on operating
assets

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Calculating Residual Income

Net Average Minimum

Residual
= operating - operating  required rate of
income
income assets 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.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Residual Income – An Example

 The Retail Division of Zepher, 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.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 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

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Motivation and Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

Redmond Awnings, a division of Wrapup 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%

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

Redmond Awnings, a division of Wrapup 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% ROI = NOI/Average operating assets
c. 15% = $60,000/$300,000 = 20%
d. 20%

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

Redmond Awnings, a division of Wrapup

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

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

Redmond Awnings, a division of Wrapup

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 ROI = $78,000/$400,000 = 19.5%
b. No This lowers the division’s ROI from
20.0% down to 19.5%.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

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

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

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 ROI = $18,000/$100,000 = 18%
b. No The return on the investment exceeds
the minimum required rate of return.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

Redmond Awnings, a division of Wrapup 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

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

Redmond Awnings, a division of Wrapup 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 Net operating income
Required return (15% of $300,000)
$60,000
$45,000
d. $ 51,000 Residual income $15,000

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

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

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Quick Check 

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
Net operating income $78,000
b. No Required return (15% of $400,000) 60,000
Residual income $18,000

Residual income increases $3,000.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Divisional Comparisons
and Residual Income

The residual
income approach
has one major
disadvantage.
It cannot be used
to compare
performance of
divisions of
different sizes.

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 Zepher, Inc. - Continued
Recall the following Assume the following
information for the Retail information for the Wholesale
Division of Zepher, Inc. Division of Zepher, 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
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Zepher, 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
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Transfer Prices –
Key Concepts/Definitions

A transfer price is the price

charged when one segment of
a company provides goods or
services to another segment of
the company.

The fundamental objective in

setting transfer prices is to
motivate managers to act in the
best interests of the overall
company.
McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007
 Transfer Prices –
Key Concepts/Definitions

There are three primary

approaches to setting
transfer prices:
1. Negotiated transfer prices
2. Transfers at the cost to the
selling division
3. Transfers at market price

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007

 End of Chapter 10

McGraw-Hill /Irwin © The McGraw-Hill Companies, Inc., 2007