ACCT 212 CHAPTER 10

RESPONSIBILITY ACCOUNTING DECENTRALIZATION

A. Return on investment (ROI).

B. Residual income.

C. Transfer pricing.

SEGMENTS CLASSIFIED AS COST, PROFIT, AND INVESTMENT CENTERS

(Exhibit 10-1)

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RETURN ON INVESTMENT

Investment centers are often evaluated based on their return on investment (ROI), which is computed as follows:

or

ROI = Margin × Turnover

where:

EXAMPLE: Regal Company reports the following data for last year’s operations:

Net operating income............ $30,000Sales...................................... $500,000Average operating assets...... $200,000

A manager can improve ROI in three basic ways:

1. Increase sales.

2. Reduce expenses.

3. Reduce operating assets.

RESIDUAL INCOMEResidual income is the net operating income that an investment center earns above the

minimum rate of return on its operating assets.

EXAMPLE: Marsh Company has two divisions, A and B. Division A has $1,000,000 and Division B has $3,000,000 in average operating assets. Each division is required to earn a minimum return of 12% on its investment in operating assets.

Division A Division BAverage operating assets.......................................... $1,000,000 $3,000,000

Net operating income................................................ $  200,000 $  450,000Minimum required return:

12% × average operating assets............................       120,000       360,000 Residual income......................................................... $       80,000 $       90,000

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The residual income approach encourages managers to make profitable investments that would be rejected under the ROI approach.

EXAMPLE: Marsh Company’s Division A has an opportunity to make an investment of $250,000 that would generate a return of 16% on invested assets (i.e., $40,000 per year). This investment would be in the best interests of the company since the rate of return of 16% exceeds the minimum required rate of return. However, this investment would reduce the division’s ROI:

PresentNew

Project OverallAverage operating assets (a)...... $1,000,000 $250,000 $1,250,000Net operating income (b)............ $200,000 $40,000 $240,000ROI (b) ÷ (a).............................. 20.0% 16.0% 19.2%

On the other hand, this investment would increase the division’s residual income:

Average operating assets (a)...... $1,000,000 $250,000 $1,250,000

Net operating income (b)............ $200,000 $40,000 $240,000Minimum required return:

12% × (a)...............................   120,000   30,000   150,000 Residual income......................... $   80,000 $10,000 $   90,000

TRANSFER PRICING

A transfer price is the price charged when one segment (for example, a division) provides goods or services to another segment of the same company.

• Transfer prices are necessary to calculate costs in a cost, profit, or investment center.

• The buying division will naturally want a low transfer price and selling division will want a high transfer price.

• From the standpoint of the company as a whole, transfer prices involve taking money out of one pocket and putting it into the other.

• An optimal transfer price is one that leads division managers to make decisions that are in the best interests of the company as a whole.

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Solutions to Questions10-1 In a decentralized organization, decision making isn’t confined to a few top executives, but rather is spread throughout the organization with managers at various levels making key decisions relating to their own spheres of responsibilities.

10-2 The benefits of decentralization include: (1) relieving top management from day-to-day problem solving and allowing them to focus their time on broader issues; (2) better decisions, since decisions are made at the level where the problem is likely to be best understood; (3) quicker decisions by eliminating layers of decision making and approvals; (4) realistic training in decision making for lower-level managers; and (5) increased motivation and job satisfaction.

10-3 A cost center manager has control over cost, but not revenue or investment funds. A profit center manager has control over both cost and revenue. An investment center manager has control over cost and revenue and investment funds.

10-4 A segment is any part or activity of an organization about which management seeks cost or revenue data. Examples of segments include departments, sales territories, divisions, customers, and product lines.

10-5 Margin is the ratio of net operating income to total sales. Turnover is the ratio of total sales to average operating assets. The product of the two numbers is the ROI.

10-6 Residual income is the net operating income an investment center earns above the company’s minimum required rate of return on operating assets.

10-7 Investment center managers may reject otherwise profitable investment opportunities because they would reduce the division’s overall ROI. This can happen any time an investment center’s ROI exceeds the minimum required rate of return for the company. The residual income approach overcomes this problem since any project whose rate of return exceeds the company’s minimum required rate of return will generate an increase in the investment center’s residual income.

10-8 A transfer price is the price charged for a transfer of goods or services between units of the same organization, such as two departments or divisions. Transfer prices are needed for per-formance evaluation.

Brief Exercise 10-1 (15 minutes)

1.

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2.

3.

Brief Exercise 10-3 (15 minutes)

Net operating income........................................... £400,000Minimum required return: 16% × Average

operating assets of £2,200,000......................... £352,000Residual income.................................................... £48,000

Exercise 10-5 (45 minutes)

1. Computation of ROI.

Division A:

Division B:

Division C:

2. Division A Division B Division CAverage operating assets...... $1,500,000 $5,000,000 $2,000,000 Required rate of return.......... ×             15% ×             18% ×             12%   Required operating income.... $     225,000 $     900,000 $     240,000   Actual operating income........ $  300,000 $  900,000 $  180,000 Required operating income

(above)       225,000       900,000         240,000   Residual income..................... $       75,000 $                       0 $       (60,000)

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