Unit 9: Performance Evaluation
This unit describes how businesses use managerial accounting to evaluate company performance – for the entire company, their organizational departments, and their individual employees. How do you evaluate the productivity of each division manager in a decentralized company? How well does each division use the company's assets to create profits? Responsibility accounting assumes someone is responsible for every cost the company incurs. They often base the compensation they give their managers on the financial performance of the divisions they manage. We will consider the issues Game Products encounters when it evaluates the performance of three divisional managers who oversee sporting goods, board games, and computer games.
Completing this unit should take you approximately 3 hours.
Upon successful completion of this unit, you will be able to:
- define decentralized organization and explain advantages and disadvantages of decentralizing;
- differentiate among the three types of responsibility centers;
- explain responsibility accounting and why it is useful for a decentralized organization;
- calculate and interpret segmented net income to evaluate performance;
- calculate and interpret return on investment (ROI) to evaluate performance; and
- calculate and interpret residual income (RI) to evaluate performance.
9.1: Control Operations in Decentralized Organizations
Read the introduction to Chapter 11. When you have finished, click on the link at the top right and read Section 1. Game Products, Inc. has experienced significant growth in volume, market area and products. It is now operating internationally and has three broad product lines board games, computer game making, and sporting goods. Games Inc. has three distinct marketing areas and three distinct product lines. Management decided to decentralize its operation and needed to revamp its management information system to provide relevant and timely information about its different product lines in its different location. Decentralization has both pros and cons.
9.2: Establishing Responsibility Centers
Responsibility centers can be based on such attributes as sales regions, product lines, or services offered. In Game Inc. case there are three responsibility centers based on product line. The purpose of establishing responsibility centers within organizations is to hold managers responsible for only the assets, revenues, and costs they can control. The level of control a manager has over a segment’s assets, revenues, and costs will help determine the type of responsibility center used for each manager.
With this approach responsibility centers are allocated budgets and their revenues and costs (variable and fixed) are tracked. Each center has a responsibility income statement. Responsibility center expenses are allocated to direct variable costs and direct fixed costs. The responsibility center contribution margin is determined by reducing revenue by variable costs. Subtracting allocated fixed costs from the contribution margin yields the responsibility margin.
9.3: Evaluating Investment Centers
Games Inc. President’s starting point for evaluating investment centers is with reviewing segmented income for each investment center (or division). Segmented income is segment revenues minus segment expenses. She is interested in the level of profit that each of the three divisions generates, and segmented income gives her this information, but as you will see there are limitations to using this method solely.
Games Inc. will also consider the Return on Investment (ROI) generated by each division as an evaluative metric. ROI is one of the most common measures of performance for managers responsible for investment centers. ROI is a basic measure but the method of its calculation can vary between organizations – like different types/brands of peanut butter.
A further evaluative metric that Games Inc. can use is residual income. Residual income (RI) provides a measure of income that is available to the whole organization. A manager’s goal is to increase her RI from year to year. Most organizations that use RI also use ROI. Using both measures has the benefit of comparing one division to another by using ROI and minimizes the conflict between company goals and division goals by using RI.
9.4: Game Products Inc. Wrap-Up
Mandy Dwyer, the President of Game Products, Inc., meets with her management accountant and goes over his work. They chose three metric to help with controlling their decentralized divisional operation – net income, profit margin ratio, and ROI. Their final step is to integrate these performance measures with a compensation plan for their operations managers.
Unit 9 Conclusion
In this unit, you learned how you can apply management accounting techniques to decentralized organizations. The main focus is how to evaluate "investment centers" using such techniques as the development of a segmented income statement and the application of performance metrics to these segmented accounts. In the next unit, you learn how to prepare a Cash Flow, one of the most vital tools in management accounting.