Decentralization and Performance Evaluation

ACCT 102 Lecture Notes – Chapter 22: DECENTRALIZATION AND PERFORMANCE EVALUATION Decentralization literally means “not centralized”. It means delegating authority to lower level managers. A company is organized into divisions or subunits with a varying degree of responsibilities. As a company grows, decentralization allows more effective management. Departmental Accounting Systems. The accounting system needs to be designed to provide information by division. If accounts are not maintained separately in the general ledger, a company must create a spreadsheet to determine departmental revenues and costs. Department Expense Allocation. Decentralization creates some accounting challenges. Management often wants information on profitability by department or division. This often involves allocating expenses, such as rent, to each department. Direct and Indirect Expenses – Direct expenses can be readily traced to a department and are for the sole benefit of that department. Indirect expenses usually are consumed by many departments. Allocating indirect expenses often involves judgment; there are no standard rules. For example, allocation of rent expense might be allocated to departments on the basis of the square footage each department occupies. Advertising costs could be allocated to revenue-generating departments based on each department’s percentage of total sales. Common types of “Centers” or units: ● Cost Centers – Managers are only responsible for controlling the costs incurred. Reports will typically compare actual costs to budgeted costs. See Exhibit 22.2 for an example. ● Profit Centers – Managers have responsibility and authority to make decisions that affect both costs and revenues (or profits.) Reports will typically be a modified income statement that contains only the controllable costs. A departmental income statement which includes both direct costs and allocated indirect costs is explained in Exhibit 22.11. Another approach to reporting profit center results is to prepare a Departmental Contribution to Overhead Report. An example of this report is illustrated in Exhibit 22.12. The departmental contribution to overhead is the gross profit earned by the profit center, less its direct costs. All indirect costs are not allocated and are presented below the departmental contribution to overhead line on the report. 1 ● Investment Centers. An investment center manager has the same responsibility as the profit center manager but with another added responsibility: acquiring and utilization of fixed assets. These investment centers are used in highly diversified companies, known as conglomerates. Conglomerates own individual companies, and view them as investments. These conglomerates want a return on investment from each of the companies they own. In addition to using income statements to assess performance, other measures are added which assess how well the assets are being utilized. The return on investment calculations are commonly used to assess performance. (Covered in Decision Insight Section of the chapter.) Basic ROI Expanded ROI (also known as DuPont Formula) Net Income Invested Assets = Profit Margin X Investment Turnover = Net Income Sales Sales X Invested Assets Profit margin–shows profitability and how much profit is earned on every dollar of sales. Investment Turnover– focuses on efficiency and how well assets are utilized to generate sales. Additionally, companies may also calculate the department’s residual income in evaluating division performance. Residual income is the difference between the division’s actual operating and the target net income. The target net income is calculated by multiplying a desired rate of return, express in a percent, by the division’s average invested assets. 2 Non-Financial Performance Measures use customer-based or other information to assess performance. Many companies use a “balanced scorecard” to measure performance. The balanced scorecard assesses performance from four different perspectives: 1. 2. 3. 4. Customer Internal processes Innovation and learning Financial For example, FedEx tracks on-time deliveries. Some airlines track on time flights. Walmart ask customers on credit card transaction screens whether they had a pleasant experience. The Gartner Group, a large research and consulting firm, estimates that over half of large companies based in the United States have adopted the balanced scorecard 3