Performance Evaluation and Decentralization: Discussion Questions
Performance Evaluation and Decentralization: Discussion Questions
1. In centralized decision making, decisions are 7. Yes, residual income and EVA can be
made at the very top level, and lower-level negative. This means that the company earned
managers are responsible for implementing less than its minimum cost of capital or, in the
these decisions. For decentralized decision case of EVA, its actual cost of capital.
making, decisions are made and implemented
by lower-level managers. 8. A transfer price is the price charged for goods
that are transferred from one division of an
2. Decentralization is the delegation of decision- organization to another.
making authority to lower levels.
9. One policy is a market price where the transfer
3. Reasons for decentralization include access to price equals the price at which the product
local information, cognitive limitations, more would sell in a competitive market outside of
timely responses, focusing of central the organization. A second policy is a cost-
management, training, and motivation. based price where the transfer price equals
some measure of the product’s cost plus a
4. Margin reveals how much sales revenue markup above cost. A third policy is a
remains as operating income (after subtracting negotiated price where the transfer price
expenses). Turnover reveals how many sales
equals an amount that is negotiated between
dollars result from each dollar invested in the buyer and seller of the product.
operating assets. Margin = Operating
income/Sales and Turnover = Sales/Average 10. The Balanced Scorecard is a strategic
operating assets. By breaking ROI into margin management system that defines a strategic-
and turnover, more information is available to based responsibility accounting system. It
assess performance. Knowledge of margin translates an organization’s mission and
and turnover gives more insight into why the strategy into operational objectives and
ROI may change from one period to the next. performance measures for four different
5. ROI (1) encourages managers to pay attention perspectives: the financial perspective, the
to the relationships among sales, expenses, customer perspective, the internal business
and investment; (2) encourages cost process perspective, and the learning and
efficiency; and (3) discourages excessive growth (infrastructure) perspective.
investment in operating assets. Increased
11. The financial perspective describes the
profitability can be achieved (all else being
economic consequences of actions taken in
equal) by increasing revenues, decreasing
expenses, or lowering investment. the other three perspectives. The customer
perspective defines the customer and market
6. Residual income is equal to operating income segments in which the business unit will
minus the minimum cost of capital multiplied by compete. The internal business process
the average operating assets. EVA (economic perspective describes the internal processes
value added) requires the company to needed to provide value for customers and
calculate its actual cost of capital and use it as owners. The learning and growth
the minimum cost of capital in the residual (infrastructure) perspective defines the
income calculation. In addition, EVA always capabilities that an organization needs to
uses after-tax income. create long-term growth and improvement.
Sales $2,900,000
3. Turnover = = = 2.32
Average operating assets $1,250,000
Alternatively,
Operating income
ROI =
Average operating assets
$150,000
=
$1,250,000
= 0.12, or 12 percent
1. The full cost transfer price is $1,080. Vtori Division would be delighted with that
price, but Grad Division would refuse to transfer since $1,440 could be earned
in the outside market.
2. The market price is $1,440. Both Vtori and Grad 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).
3. Minimum transfer price = $1,440 – $240 = $1,200
This price is set by Grad Division, the selling division.
Maximum transfer price = $1,440
This price is the market price and is set by Vtori Division, the buying division.
Yes, both divisions would be willing to accept a transfer price within the
bargaining range. Precisely what the transfer price would be depends on the
negotiating skills of the Grad and Vtori division managers.
1. Processing time is equal to theoretical cycle time. That is, if everything goes
smoothly and there is no wasted time, it takes 6 minutes to produce one unit.
Nonprocessing time, therefore, must be the difference between actual cycle
time (which includes some waste) and theoretical cycle time.
Processing time = Theoretical cycle time = 6 minutes
Nonprocessing time = Actual cycle time – Theoretical cycle time
= 7.5 – 6 = 1.5 minutes
Processing time
2. MCE =
Processing time + Nonprocessing time
6
= = 0.8, or 80 percent
6 + 1.5
Exercise 12–7
a. Cost centre
b. Investment centre
c. Revenue centre
d. Profit centre
e. Investment centre
Exercise 12–8
1. Sales $18,000,000
Less expense 12,375,000
Operating income $ 5,625,000
Operating income
2. Margin = = $5,625,000/$18,000,000 = 0.3125, or 31.25%
Sales
Sales
Turnover = = $18,000,000/$7,200,000 = 2.50
Average operating assets
Exercise 12–9
Exercise 12–10
1. Year 1 Year 2
Margin:
$8,910,000/$148,500,000 0.06, or 6%
$8,112,500/$162,250,000 0.05, or 5%
Turnover
$148,500,000/$337,500,000 0.44
$162,250,000/$405,625,000 0.40
2. ROI must have been smaller than 5 percent, because residual income is
negative.
Actual ROI = $170,250/3,625,000 = 0.047, or 4.7% (rounded)
Exercise 12–12
Exercise 12–13
3. The Tana Division is creating wealth (i.e., the cost of making the income is lower
than the income) since its EVA is positive. The Rabinur Division is destroying
wealth (i.e., the cost of making the income is higher than the income) since its
EVA is negative.
4. S.P.R.’s management can increase Rabinur Division’s EVA by doing any of the
following items:
Increase the after-tax operating profit that is generated from using the
same amount of invested capital (i.e., find ways to “do more with the same
level of capital”)
Continue to generate the same after-tax operating profit, but use less
capital to do so (i.e., find ways to “do the same thing but with less
capital”)
Continue to generate the same after-tax operating profit using the same
amount of capital, but with a lower cost of capital (i.e., obtain capital more
cheaply)
It is up to the management team to decide which of these three general
strategies should be pursued and which specific actions should be
implemented for the chosen strategy.
Exercise 12–15
1. The buying division would be motivated to set the maximum transfer price,
which in this case is the installation division. The minimum transfer price is set
by the selling division, which in this case is the EV charger manufacturing
division.
2. Full cost transfer price = $290
3. The installation division would love to have a transfer price of $290 per EV
charger (remember, it is currently paying $400 per EV charger). However, the
manufacturing division will refuse to transfer at that price because it can sell all
the EV chargers it can produce in the outside market for $400.
Exercise 12–16
1. The maximum transfer price, set by the installation division, is $400. The
installation division would not pay any more than $400 because that is the price
it currently pays to outside suppliers.
2. The minimum transfer price, set by the EV charger manufacturing division, is
$400. Remember that this division is operating at capacity and can sell all that
it makes to outside buyers for $400.
3. If the transfer takes place, the transfer price will be $400. No, it does not matter
whether or not the transfer takes place, since the transfer price would be equal
to the outside market price. Managers of each division will be indifferent to
internal transfers of EV chargers at this price.
2. The minimum transfer price, set by the manufacturing division, is $175. In this
case, only variable costs of $175 per EV charger are relevant because the
manufacturing division has excess capacity.
Exercise 12–18
1. The manager of the puree division would not accept a lower selling price than
the market price of $22. Assuming that the finishing division can purchase the
apple sauce from another supplier, the manager of the finishing division would
not accept a higher price than the market price, which is $22.
3. Clearly the manager of the puree division would prefer to transfer the apple
sauce using the market price for a division operating income of $2.8 million. As
a result, the income for the finishing division is $800,000.
Meanwhile the finishing division manager would prefer to use the full cost plus
10 percent resulting in an operating income of $600,000 for the puree division
and $3 million for the finishing division.
Exercise 12–19
(30,000 hours) (60 minutes per hour)
1. Theoretical cycle time =
150,000 units
= 12 minutes per unit
Exercise 12–21
Processing time
2. MCE =
Processing time + Nonprocess ing time
9
= = 0.6
9+6
Exercise 12–22
1. Processing time = Theoretical cycle time = 18 minutes per unit
Processing time
2. MCE =
Processing time + Nonprocessing time
18
= = 0.90
18 + 2
Although the investment is less than Cucina’s minimum rate of return of 8%,
accepting the investment will increase the division ROI from 5% to 5.8%. Since
division ROI is the basis of the manager’s performance evaluation, the manager
will likely accept an investment that would not be in the company’s long-term
financial interests.
Problem 12–26
1. Year 1 Year 2 Year 3
ROI 8.00% 6.97% 6.30%
Margin 12.00% 11.00% 10.50%
Turnover 0.67 0.63 0.60
The ROI increased because assets turned over at a higher rate (sales increased
more than total expenses increased) and per-unit expenses decreased.
The ROI increased because assets turned over at a higher rate (sales increased
and the amount of assets decreased) and per-unit expenses decreased. Both
margin and turnover increased.
Problem 12–27
$90,000
1. Air conditioner ROI = = 12.0%
$750,000
$82,080
Turbocharger ROI = = 15.2%
$540,000
3. The manager will choose the turbocharger, but not the air conditioner.
While the residual income is positive in all four cases, the manager will choose
the turbocharger, but not the air conditioner, since the residual income is
highest for that alternative.
Based on residual income, both investments are profitable. The manager will
choose to invest in both the air conditioner and the turbocharger. In this case,
the minimum required return on investment, 10 percent, is lower than the ROIs
of both projects. Therefore, both projects are profitable, and the highest
residual income is earned by investing in both.
$310,000
2. Margin: = 0.0899, or 8.99% (rounded)
$3,450,000
$3,450,000
Turnover: = 1.15
$3,000,000
ROI = 1.15 × 8.99% = 0.1034, or 10.34% (rounded)
The difference between ROI computed here and ROI in Requirement 1 is due to
rounding.
$310,000 + $57,500
3. = 10.5%
$3,000,000 + $500,000*
$600,000 + $400,000
*
2
Because ROI with the investment is larger than ROI without it, the manager will
approve the investment.
$310,000 + $57,500
4. Margin: = 9.13%
$3,450,000 + $575,000
$3,450,000 + $575,000
Turnover: = 1.15
$3,000,000 + $500,000
The margin has increased, and the turnover ratio has stayed the same.
1. Patricia should not reduce the price charged to Fred if she can sell all she
produces. It does not matter whether the two divisions trade internally or not.
2. The minimum price is $34 ($24 + $4 + $6), and the maximum is $55. Yes, Patricia
should consider the transfer, since her division’s income will increase by
$132,000 [= 12,000($45 – $34)].
3. The transfer price would be $56.70 (= $42 × 1.35). No, the transfer would not
occur, since the transfer price is higher than the outside price that Fred would
have to pay.
Problem 12–30
2. The transfer price should be the market price of $12. This is the minimum price
for the components division and the maximum price for the PSF division.
3. Unless the PSF division is able to increase the price of Model SC67, the manager
will discontinue production and will not purchase any of the components. (The
cost of producing the scanner will increase from $38 to $43.50, a cost greater
than the current selling price of $42.)
4. All 40,000 units of Component Y34 will be sold externally at the market price of
$12 per unit.
5. Sales $480,000
Variable expenses 160,000
Contribution margin $320,000
The contribution margin decreases by $540,000. Cam made the wrong decision.
1. Minimum: $26
Maximum: $31
$26 + $31
2. Negotiated transfer price = = $28.50
2
In terms of full cost-plus markup,
$28.50 = $20 + (markup percentage × full cost)
Markup = $28.50 – $20 = $8.50
$8.50
Markup percentage = = 0.425, or 42.5%
$20
4. The two divisions would renegotiate because the buying division would
probably be able to buy the necessary part at a lower price from another
supplier. The auxiliary components division might have to reduce its price.
Problem 12–32
$2,700,000
1. Theoretical rate =
600,000
= $4.50 per minute
Theoretical conversion cost per unit = $4.50 × 30
= $135
2. Applied conversion cost per unit = $4.50 × 40 = $180
60
Note: = 40 minutes used per unit
1.5
3. An incentive exists to reduce product cost by reducing cycle time. For example,
current cycle time is 40 minutes per unit. If cycle time could be reduced to 30
minutes per unit, conversion costs would be reduced from $180 per unit to $135
per unit, reducing the unit product cost by $45. Reducing cycle time increases
the ability to meet deliveries on time as well as increasing the ability of the firm
to respond quickly to customer demands.
1. a. Customer
b. Internal business process
c. Financial
d. Financial
e. Learning and growth
f. Internal business process
g. Customer
h. Internal business process
i. Learning and growth
j. Customer
k. Financial
The manager of Alpha division has mistakenly included the fixed costs as part
of her calculation of the added benefit of producing and selling the additional
8,000 units at $30 per unit. Since the factory has the capacity to produce 50,000
units and is currently only producing 40,000 units, adding the additional 8,000
units would not increase fixed costs. Therefore, producing and selling the
additional 8,000 units at $30 would increase her ROI rather than reduce it.
*
© CPA Ontario.
1. Since Ajax is operating at full capacity, the opportunity cost of sales to Naxos
is the selling price of $7.50. Therefore, do not recommend that Ajax supply
Naxos at $5 per unit.
Profit to Pylos if Ajax does not make the transfer of part 123:
Revenue $7.50
Variable costs 4.25
Net contribution $3.25
Case 12–36
$1,870,000
1. ROI based on initial estimates = = 11.99% (rounded)
$15,600,000
$2,340,000
ROI based on Mel’s estimates = = 15%
$15,600,000
2. Jason is definitely facing an ethical dilemma. While it is true that the sales and
expense projections are estimates, they are the best ones available to him. If he
uses a sales revenue projection from the top end of the range, he will be
deliberately basing the ROI estimate on a highly unlikely sales figure. Sales and
expense projections are not fantasy figures; they are supposed to be
management’s best estimate of what will actually happen. If Jason prepares the
report in accordance with Mel’s desires, he will be knowingly fabricating data.
One might wonder whether or not Mel’s offer to “back up” Jason is sufficient to
let Jason off the hook. It is not. If Mel wants the false projections badly enough,
let him sign them. Jason may have thought he had his dream job, but it is about
to turn into a nightmare. Companies don’t take kindly to employees who lie, and
this lie is sure to come out. If the project is approved, and the sales do not
approach $2.5 million, you can bet that the vice-president of sales will be quick
to point out that she predicted a range of $1.5 million to $2.5 million. Mel will
surely pin the blame directly on Jason, the one whose name is on the report.
3. Jason should prepare the report using the figures he thinks are most
descriptive of the project’s potential. He should feel free to include information
about the predicted range of sales and to point out any other information that
reflects favourably on the project. If Mel continues to pressure Jason, then
Jason might consider approaching more senior management or looking for
another job.