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Performance Evaluation, Variable
Costing, and Decentralization
Management Accounting: The Cornerstone for
Business Decisions
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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).
Learning Objectives
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).
Comment on Decentralization and
Responsibility Centers◙ Companies organize around
responsibility centers◙ This is what organization charts
represent◙ Can become cumbersome for
decision making◙ Organizations can choose to
centralize or decentralize◙ Most organizations are a mix of
both
What are some reasons to decentralize?
1. It is easier to gather and use local information
2. It allows for focusing of central management
3. It provides training and motivation for segment managers
4. It enhances competition by exposing business segments to market forces
Illustrate Centralization Vs. Decentralization
Illustration of PepsiCo's Decentralized Divisions
Match Definitions
Cost Center
Revenue Center
A responsibility center in which the manager is only accountable for sales
A responsibility center in which the manager is accountable for both revenues and costs
Investment Center
Profit Center
A responsibility center in which the manager is accountable for revenues, costs and investments
A responsibility center in which the manager is only accountable for costs
Complete the Chart
What type of accounting information is use for measuring performance?
Capital
Center Cost Sales Investment Other
Cost
Revenue
Profit
Investment
XX X
X X
X X X X
Differentiate Between Product and Period
Costs
Complete Chart
How are product and period cost classified under absorption and variable costing? Insert the word “Product” or “Period” were appropriate
Costing Method
Absorption Variable
Direct materials Product Product
Direct labor Product Product
Variable overhead Product Product
Fixed overhead Product PERIOD
Selling expenses Period Period
Administrative expenses Period Period
How to compute inventory cost under absorption &
variable costing.During the most recent year, Fairchild
company had the following data associated with the product it makes.
Units in beginning inventory 0Units produced 12,000Units sold ($325 each) 10,000Variable costs per unit:
Direct materials $60Direct labor 90Variable overhead 60
Fixed costs:Fixed overhead per unit produced $25Fixed selling and administrative 100,000
11-1
REQUIRED:1. How many units are in ending inventory?
2. Using absorption costing, calculate the per-unit product cost. What is the value of ending inventory?
3. Using variable costing, calculate the per-unit product cost. What is the value of ending inventory?
Calculations:1. Units in ending inventory = Units in beginning
inventory + Units produced – Units sold
= 0 + 12,000 – 10,000 = 2,000
11-1
How to compute inventory cost under absorption &
variable costing.
How to compute inventory cost under absorption & variable
costing.11-1
2. Absorption costing 3. Variable costing
Direct materials $ 60 Direct materials $ 60
Direct labor 90 Direct labor 90
Variable overhead 60 Variable overhead 60
Fixed overhead 25 Unit product cost $ 210
Unit product cost $ 235
Value of ending inventory = 2,000 x $235 = $470,000
Value of ending inventory = 2,000 x $210 = $420,000
How to prepare income statements under
absorption & variable costing.
11-2
During the most recent year, Fairchild company had the following data associated with the product it makes.
Units in beginning inventory 0Units produced 12,000Units sold ($325) 10,000Variable costs per unit:
Direct materials $60Direct labor 90Variable overhead 60
Fixed costs:Fixed overhead per unit produced $25Fixed selling and administrative 100,000
REQUIRED:1. Calculate the cost of goods sold under absorption
costing2. Calculate the cost of goods sold under variable
costing3. Prepare an income statement under absorption
costing4. Prepare an income statement under variable costing
Calculation:1. Cost of goods sold = Absorption product cost x Units
sold= $235 x 10,000 = $2,350,000
2. Cost of goods sold = Variable product cost x Units sold= $210 x 10,000 = $2,100,000
How to prepare income statements under
absorption & variable costing.
11-2
How to prepare income statements under
absorption & variable costing.
11-2
3. Fairchild Company
Absorption-Costing Income Statement
Sales ($325 x 10,000) $3,250,000
Cost of goods sold 2,350,000
Gross Margin $ 900,000
Less: Selling & Administrative Expenses 100,000
Net income $ 800,000
How to prepare income statements under
absorption & variable costing.
11-24. Fairchild Company
Variable-Costing Income Statement
Sales ($325 x 10,000) $3,250,000
Less: Variable expenses:
Variable cost of goods sold 2,100,000
Contribution Margin $1,150,000
Less: Fixed expenses:
Fixed overhead $300,000
Fixed selling & administrative 100,000 400,000
Net income $ 750,000
Review the Relationships Between Production,
Sales & Income
IF THEN
1. Production > Sales Absorption net income > Variable net income
2. Production < Sales Absorption net income < Variable net income
3. Production = Sales Absorption net income = Variable net income
How to prepare a segmented income
statement.Audiomatronics, Inc., produces MP3 players and
DVD players in a single factory. The following information was provided for the following year.
MP3 Players DVD PlayersSales $400,000 $290,000Variable cost of good sold 200,000 150,000Direct fixed cost 30,000 20,000A 5% sales commission is paid for each of the two
product lines. Direct fixed selling and administrative expense was estimated to be $10,000 for the MP3 line and $15,000 for the DVD line.
Common fixed overhead for the factory was estimated at $100,000; common selling and administrative expense was estimated to be $20,000.
11-3
How to prepare a segmented income
statement.REQUIRED: Prepare a variable costing segmented income statement for Audiomatronics, Inc., for the coming year.
11-3
Calculation: MP3 Players DVD Players Total
Sales $ 450,000 $ 320,000 $ 770,000
Variable cost of goods sold (225,000) (160,000) (385,000)
Variable selling expense (22,500) (16,000) (38,500)
Contribution margin $ 202,500 $ 144,000 346,500
Less: direct fixed expenses:
Direct fixed overhead (30,000) (20,000) (50,000)
Direct sell & admin (10,000) (15,000) (25,000)
Segment margin $ 162,500 $ 109,000 $ 271,500
Less: common fixed expenses
Common fixed overhead (100,000)
Common sell & admin (20,000)
Net income $ 151,500
List Three Ways Investment Centers are
Evaluated
Match Definitions
ROI
Ave. Operating Assets
Sales / Average operating assets
Operating income / Sales
Turnover
Margin
Operating income / Average operating assets
(Beginning net book value + Ending net book value) / 2
How to calculate average operating assets, margin,
turnover & ROI.Celimar Company’s Eastern Division earned
operating income of $60,000 on Sales of $600,000. At the beginning of the year the net book value of the assets were $305,700, while at the end of the year they were $354,300.
REQUIRED: For the Eastern Division calculate:
1. Average operating assets2. Margin3. Turnover4. ROI
11-4
Calculation:1. Average operating assets = (Beginning
assets + ending assets) / 2 = ($305,700 + $354,300) / 2 = $330,000
2. Margin = Operating income / Sales = $60,000 / $600,000 = 10% or 0.10
3. Turnover = Sales / Average operating assets = $600,000 / $330,000 = 1.82 times
4. ROI = Margin x Turnover = .10 x 1.82 = 18.2% or 0.182OR ROI = Operating income / Average operating assets = $60,000 / $330,000 = 18.2%
How to calculate average operating assets,
margin, turnover & ROI.11-4
What are three advantages of ROI?
1. It encourages managers to focus on the relationship among sales, expenses and investment, as should be the case for a manager of an investment center.
2. It encourages a manager to focus on cost efficiency.
3. It encourages a manager to focus on operating asset efficiency.
How to calculate residual income.
Celimar Company’s Eastern Division earned operating income of $60,000 on Sales of $600,000. At the beginning of the year the net book value of the assets were $305,700, while at the end of the year they were $354,300. Celimar requires a minimum rate of return of 12%.
REQUIRED: For the Eastern Division calculate:1.Average operating assets2.Residual incomeCalculation:1. Average operating assets = (Beginning assets +
ending assets) / 2 = ($305,700 + $354,300) / 2 = $330,000
2. Residual income = Operating income = - (Minimum rate of return x Average operating assets) = $60,000 – (0.12 x $330,000) = $60,000 - $39,600 = $20,400
11-5
How to calculate EVA.11-6
Sales $600,000
Cost of goods sold 330,000
Gross Margin $270,000
Less: Sell & Admin Exp. 210,000
Operating income $ 60,000
Less: Income taxes @30% 18,000
Net income $ 42,000
Celimar Company’s Eastern Division earned net income last year as shown in the following income statement:
Total capital employed equaled $330,000. Celimar’s actual cost of capital is 10%.
REQUIRED: Calculate EVA for Eastern Division
Calculation:EVA = After-tax operating income –
(Actual percentage cost of capital x Total capital employed)
= $42,000 – (10% x $330,000)= $42,000 - $33,000= $9,000
How to calculate EVA.11-6
Discuss Transfer Pricing
◙ This represents the charge Bravo Division pays Romeo Division for the use of Romeo Division’s output.
◙ It represents a complex issue.◙ It becomes an emotionally charged
issue since performance measurement is affected by the value established for the transfer price.
◙ A company can not make a profit from itself. Real profits come from selling to third parties.
Define the three ways to set transfer prices.
How to calculate transfer prices.
Omni, Inc., has a number of divisions, including Indigo Division, a producer of microcircuit boards and Lima Division a producer of controllers for heating and controlling manufacturers.
Indigo produces the bk-912 model that can be used by Lima Division in the production of its control systems for regulating heating and air conditioning systems. The market price of the bk-912 is $15 and the full cost is $8
REQUIRED:1. If Omni, Inc. has a transfer pricing policy that
requires transfer at full cost, what would the transfer price be? Do you suppose that Indigo and Lima would choose to transfer at that price?
11-7
2. If Omni, Inc. has a transfer pricing policy that requires transfer at market price, what would the transfer price be? Do you suppose that Indigo and Lima would choose to transfer at that price?
3. Now suppose that Omni, Inc., allows negotiated transfer pricing and that Indigo Division can avoid a $3 selling expense by selling to Lima Division. Which division sets the minimum transfer price, and what is it? Which division sets the maximum transfer price and what is it? Do you suppose that Indigo and Lima Divisions would choose to transfer somewhere in the bargaining range?
How to calculate transfer prices.11-7
Calculations:1. The full cost transfer price is $8. Lima
Division would be delighted with that price, but Indigo Division would refuse to transfer since $15 could be earned in the outside market.
2. The market price is $15. Both Indigo and Lima divisions would be willing to transfer at that price (since neither division would be worse off than if it bought/sold in the outside market).
How to calculate transfer prices.11-7
3. Minimum transfer price = $15 - $3 = $12The price is set by Indigo Division, the selling division.Maximum transfer price = $15This price is the market price and is set by Lima Division, the buying division.
Yes, both divisions would be willing to a accept a transfer price within the bargaining range. Precisely what the transfer price would be depends on the negotiating skills of the Indigo and Lima Division managers.
How to calculate transfer prices.11-7