Chapter 11 Notes

Chapter 11: Performance Measurement and Responsibility Accounting

11-1: Performance, Measurement, and Responsibility Accounting

• Evolution of Accounting:

  • Accounting has evolved from basic bookkeeping to providing information for decision-making.
  • Initially focused on recording business transactions for creditors and banks.
  • Developed into a system for allocating resources and assisting owner-managers.

• Shift in Focus:

  • Early accounting was cruder, lacking attestation and focusing on bookkeeping.
  • Modern accounting emphasizes measurement, analysis, and providing insights to various users (managers, analysts, employees, auditors, etc.).
  • Accounting information is used for control, management decisions, and external reporting.

• Key Principles:

  • Accounting relies on generally accepted principles and rules.
  • It provides assurance and disclosure, especially for publicly traded companies.
  • The pace of accounting development has been rapid, driven by the needs of businesses and investors.

11-2: Decentralization in Organizations

• Centralization vs. Decentralization:
  • Organizations vary in the degree to which they centralize or decentralize decision-making authority.
  • Centralization concentrates decision-making at the top.
  • Decentralization distributes decision-making throughout the organization.

11-3: Benefits and Disadvantages of Decentralization

• Benefits of Decentralization:

  • Top Management Focus: Allows top management to concentrate on strategy.
  • Better Information: Lower-level decisions are often based on better information.
  • Quick Response: Enables quick responses to customers.
  • Managerial Experience: Provides lower-level managers with decision-making experience.
  • Job Satisfaction: Increases job satisfaction through decision-making authority.

• Disadvantages of Decentralization:

  • Lack of Big Picture: Lower-level managers may make decisions without seeing the "big picture."
  • Coordination Issues: May lead to a lack of coordination among autonomous managers.
  • Conflicting Objectives: Lower-level manager’s objectives may not align with those of the organization.
  • Innovation Spread: Can be difficult to spread innovative ideas throughout the organization.

11-4: Responsibility Accounting

• Core Principle:
  • A manager should be held responsible only for items they can actually control.

11-5: Responsibility Centers

• Types of Responsibility Centers:
  • Cost Center: Responsible for costs (e.g., accounting department head).
  • Profit Center: Responsible for revenues and costs (e.g., manager of an individual store).
  • Investment Center: Responsible for revenues, costs, and investments (e.g., VP for North American operations).

11-6: Learning Objective 11-1: Return on Investment (ROI)

• Compute ROI and show how changes in sales, expenses and assets affect ROI.

11-7: Return on Investment (ROI)

• Definition:

  • ROI is a performance measure indicating the profit earned per dollar invested in operating assets.
  • A higher ROI suggests greater profitability.

• Formula:

  • ROI = \frac{\text{Net operating income}}{\text{Average operating assets}}

11-8: Return on Investment (ROI) - Components

• Decomposition of ROI:

  • ROI can be broken down into Margin and Turnover.

• Formulas:

  • Margin = \frac{\text{Net operating income}}{\text{Sales}}
  • Turnover = \frac{\text{Sales}}{\text{Average operating assets}}
  • ROI = Margin \times Turnover

• Interpretation:

  • Margin reflects profitability.
  • Turnover reflects efficiency in using assets.

11-9: Computing ROI - Example

• Regal Company Example:

  • Net operating income = $30,000
  • Average operating assets = $200,000
  • Sales = $500,000
  • Operating expenses = $470,000

• Calculation:

  • ROI = \frac{$30,000}{$500,000} \times \frac{$500,000}{$200,000} = 6\% \times 2.5 = 15\%

11-10: Investing in Operating Assets - Impact on ROI

• Scenario:

  • Regal’s manager invests in $30,000 of equipment, increasing sales by $35,000 but also increasing operating expenses by $15,000.

• New Data:

  • Net operating income: $30,000 → $50,000
  • Average operating assets: $200,000 → $230,000
  • Sales: $500,000 → $535,000
  • Operating expenses: $470,000 → $485,000

11-11: Investing in Operating Assets - ROI Increase

• New ROI Calculation:

  • ROI = \frac{$50,000}{$535,000} \times \frac{$535,000}{$230,000} = 9.35\% \times 2.33 = 21.8\%

• Observation:

  • ROI increased from 15% to 21.8% due to the investment.

11-12: In-Class Exercise - ROI Calculation

• BR Company Data:

  • Sales = $500,000
  • Net operating income = $25,000
  • Average operating assets = $200,000

• Question:

  • What is the company's return on investment (ROI)?

11-13: Learning Objective 11-2: Residual Income

• Compute residual income and understand its strengths and weaknesses.

11-14: Residual Income

• Definition:

  • Residual income is the net operating income earned less the minimum required return on average operating assets.
  • The goal is to maximize the total amount of residual income.

• Formula:

  • Residual\ Income = Net\ Operating\ Income - (Average\ Operating\ Assets \times Minimum\ Required\ Rate\ of\ Return)

11-15: Residual Income - Example

• Zephyr, Inc. - Retail Division:

  • Average operating assets = $100,000
  • Required rate of return = 20%
  • Operating income = $30,000

• Calculation:

  • Minimum required return = $100,000 * 20% = $20,000
  • Residual income = $30,000 - $20,000 = $10,000

11-16: In-Class Exercise - Residual Income Calculation

• BR Company - Division A Data:

  • Sales = $300,000
  • Net operating income = $50,000
  • Average operating assets = $200,000
  • Minimum required rate of return = 15%

• Question: What is the amount of residual income?

11-17: Motivation and Residual Income

• Key Benefit:
  • Residual income encourages managers to make profitable investments that might be rejected if using ROI alone.

11-18: Motivation and Residual Income - Example

• Scenario:

  • A manager is considering a new machine costing $60,000, expected to generate an additional $10,000 in operating income.

• Current Division Data:

  • Operating income = $20,000
  • Average operating assets = $100,000
  • Required rate of return = 15%

• Analysis with New Project:

  • Average operating assets: $100,000 → $160,000
  • Net operating income: $20,000 → $30,000
  • Minimal required return: $15,000 → $24,000
  • Residual income: $5,000 → $6,000

• Conclusion: If evaluated on Residual Income, the manager would accept the project.

11-19: Motivation and Residual Income - ROI Perspective

• ROI Calculation:

  • Current ROI = \frac{$20,000}{$100,000} = 20\%
  • New Project ROI = \frac{$30,000}{$160,000} = 18.8\%

• Conclusion: If evaluated on ROI, the manager would reject the project because 18.8% < 20%.

11-20: Motivation and Residual Income - ROI vs. Residual Income

• Key Insight:
  • Managers evaluated on ROI might reject projects with a return below their current ROI, even if the return is above the company's minimum required rate of return.
  • Residual income avoids this issue, encouraging investments that add value to the company.

11-21: Disadvantage of Residual Income

• Comparability Issue:

  • Residual income cannot be directly used to compare the performance of divisions with different sizes.

• Example:

  • Retail Division:
    • Operating assets = $100,000
    • Required rate of return = 20%
    • Operating income = $30,000
    • Residual income = $10,000
  • Wholesale Division:
    • Operating assets = $1,000,000
    • Required rate of return = 20%
    • Operating income = $220,000
    • Residual income = $20,000

11-22: Learning Objective 11-3: Transfer Pricing

• Objective: Define transfer pricing and related concepts.

11-23: Key Concepts/Definitions - Transfer Price

• Definition:

  • A transfer price is the price charged when one division of a company provides goods or services to another division of the same company.

• Example:

  • Grocery Storehouse owns a Plantations division and a Grocery division.
  • The price for oranges transferred from Plantations to Grocery is the transfer price.

11-24: Three Primary Approaches to Transfer Pricing

• Approaches:

  1. Negotiated Transfer Prices: Prices determined through discussions between buying and selling divisions.
  2. Cost-Based Transfer Prices: Prices set at cost (variable or full absorption cost).
  3. Market-Based Transfer Prices: Prices based on external market prices.

• Objective:

  • The fundamental goal is to motivate managers to act in the best interests of the overall company.

11-25: Negotiated Transfer Prices

• Definition:

  • A negotiated transfer price is the result of discussions between the selling and buying divisions.

• Advantages:

  1. Preserves the autonomy of the divisions.
  2. Managers have the best information for negotiation.

• Limits:

  • Upper limit: Determined by the buying division (what they'd pay externally).
  • Lower limit: Determined by the selling division (their cost or opportunity cost).

11-26: Negotiated Transfer Prices - Example Data

• Scenario:

  • West Coast Plantations (Seller) and Grocery Mart (Buyer) are both owned by Grocery Storehouse.

• Seller (West Coast Plantations) Data:

  • Orange harvest capacity: 10,000 units per month
  • Variable cost per crate: $10
  • Fixed costs: $100,000 per month
  • Selling price to outside market: $25 per unit

• Buyer (Grocery Mart) Data:

  • Purchase price from outside supplier: $20 per unit
  • Monthly needs: 1,000 units

11-27: Negotiated Transfer Prices - Buyer's Perspective

• Grocery Mart's Decision:

  • Buy from West Coast Plantations if the price is less than or equal to what they'd pay an outside supplier.

• Highest Possible Transfer Price:$20 per unit (the outside purchase price).

11-28: Negotiated Transfer Prices - Seller's Perspective (Idle Capacity)

• Scenario:West Coast Plantations has sufficient idle capacity (3,000 units) to meet Grocery Mart's demands (1,000 units) without sacrificing external sales.

• Lowest Possible Transfer Price: $10 per unit (the variable cost).

11-29: Negotiated Transfer Prices - Seller's Perspective (No Idle Capacity)

• Scenario:West Coast Plantations has no idle capacity and must sacrifice other customer orders (1,000 units) to meet Grocery Mart's demands.

• Lowest Possible Transfer Price: $25 per unit (the current selling price to the outside market).

11-30: Negotiated Transfer Prices - Seller's Perspective (Some Idle Capacity)

• Scenario:West Coast Plantations has some idle capacity (600 units) and must sacrifice some customer orders (400 units) to meet Grocery Mart’s demands (1,000 units)

• Lowest Possible Transfer Price:

  • Variable Cost + \frac{Total\ CM\ on\ Lost\ Sales}{#\ of\ units\ transferred}

  • $10 + \frac{($25 - $10) * 400}{1,000} = $16

11-31: Negotiated Transfer Prices - Summary

• Buyer's Perspective:

  • Highest possible transfer price: $20

• Seller's Perspective:

  • Sufficient idle capacity: Lowest possible transfer price = $10
  • No idle capacity: Lowest possible transfer price = $25
  • Some idle capacity: Lowest possible transfer price = $16

• Potential Outcomes:

  • $10 - $20: Deal Possible
  • No Deal Possible:
  • $16 - $20: Deal Possible

11-32: In-Class Exercise - Transfer Pricing

• TA Inc., Scenario:

  • Division A manufactures a connector that Division B could use.
  • Division A's capacity: 11,000 units
  • Selling price to outside market: $38
  • Variable cost per unit: $21

• Question:

  • Assume Division A has no idle capacity, what is the minimal price it should accept for connectors transferred to Division B?

11-33: No slide content

11-53: Learning Objective 12-3: Throughput Time, Delivery Cycle Time, and MCE

• Objective: Compute throughput time, delivery cycle time, and manufacturing cycle efficiency (MCE).

11-54: Delivery Performance Measures - Throughput Time

• Throughput Time (also called Manufacturing Cycle Time):

  • Process Time + Inspection Time + Move Time + Queue Time

• Process time: is the only value-added time.

• Example

  • Production Started 1/10 Goods Shipped 1/25
  • Throughput Time 15 days

11-55: Manufacturing Cycle Efficiency (MCE)

• Formula:
  • MCE = \frac{Value-added\ time\ (Process\ time)}{Throughput\ time}

11-56: Delivery Performance Measures - Delivery Cycle Time

• Delivery Cycle Time
  • Wait Time + Throughput Time
  • Wait Time = Order Received to Production Started
  • Throughput Time = Production Started to Goods Shipped
  • Example
    • Order Received 1/1
    • Production Started 1/10
    • Goods Shipped 1/25
    • Throughput Time 15 days
    • Delivery Cycle Time 25 days

11-57: In-Class Exercise - Time Calculations

• Narton Corp Data:

  • Wait: 3.0 days
  • Move: 0.5 days
  • Inspection: 0.4 days
  • Queue: 9.3 days
  • Process: 0.2 days

• Questions:

  • What is the throughput time?
  • What is the delivery cycle time?

11-58: In-Class Exercise - MCE Calculation

• Narton Corp Data and Question:
  • Using the same data, what is the Manufacturing Cycle Efficiency (MCE)? Process time is the only value-added time.
• Narton Corp Data:
  • Wait: 3.0 days
  • Move: 0.5 days
  • Inspection: 0.4 days
  • Queue: 9.3 days
  • Process: 0.2 days

Answer options are provided.

11-59: Chapter 11 Summary

• Summary of learning objectives:
  1. Compute ROI and show how changes in sales, expenses, and assets affect ROI.
  2. Compute residual income and understand its strengths and weaknesses.
  3. Understand Transfer Pricing.
  4. Compute throughput time, delivery cycle time, and manufacturing cycle efficiency (MCE).