RESPONSIBILITY ACCOUNTING SEGMENT REPORTING

PERFORMANCE EVALUATION IN A DECENTRALIZED FIRM

RA/ IMT /Dr ASHISH/ 2011

What is a Responsibility Center?

It is any part, segment, or subunit of a business that needs control.

RA/ IMT /Dr ASHISH/ 2011

What is Controllability?
It is the degree of influence that a specific manager has over costs, revenues, or other items in question. A controllable cost is any cost that is primarily subject to the influence of a given responsibility center manager for a given time period.
RA/ IMT /Dr ASHISH/ 2011 3

What is a responsibility accounting system?

A responsibility accounting system measures the results of responsibility centers according to information managers need to operate their centers.

RA/ IMT /Dr ASHISH/ 2011

There are several advantages inherent in the use of

responsibility centers and responsibility accounting.

A responsibility center approach helps make a large, diversified organization manageable.

Appropriate control of an entity with several varied components may be otherwise

impossible.
The responsibility center method drives decision-making down to the level of the

respective centers.

RA/ IMT /Dr ASHISH/ 2011

RESPONSIBILITY ACCOUNTING ILLUSTRATION 1 BURGER LTD HAS OPENED MORE THAN 200 STORES WITHIN THE PAST 5 YEARS, 80% OF WHICH ARE FRANCHISED ie THEY ARE INDEPENDENTLY OWNED. TWO OF THE COMPANIES UNITS IE NORTHSIDE AND SOUTHSIDE ARE AMONG THE FASTEST GROWING STORES. BOTH ARE CONSIDERING TO EXPAND THEIR MENU TO INCLUDE PIZZA. THE PURCHASE OF THE EQUIPMENT WOULD COST $1,80,000 PER STORE. THE CURRENT INVESTMENT IN THE NORTHSIDE STORE TOTALS $8,90,000, ITS REVENUES ARE $ 11,00,500 AND EXPENSES ARE $ 9,24,420. EXPANSION OF NORTHSIDES MENU SHOULD INCREASE PROFIT BY $30,600.

RA/ IMT /Dr ASHISH/ 2011

THE CURRENT INVESTMENT IN THE SOUTHSIDE STORE TOTALS $ 17,40,000, ITS REVENUES ARE $ 17,60,800 AND EXPENSES ARE $ 14,96,680.
ADDING PIZZA TO SOUTHSIDES MENU SHOULD INCREASE ITS PROFITS BY $ 30600.

BURGER LTD EVALUATES ITS MANAGERS BASED ON RETURN ON INVESTMENT. MANAGERS OF INDIVIDUAL STORES HAVE RESPONSIBILITY OVER PIZZA EXPANSION. A. CALCULATE THE RETURN ON INVESTMENT FOR BOTH STORES USING CURRENT NUMBERS FOR EXPANSION PROJECT AND FOR THE STORES AFTER EXPANSION.

RA/ IMT /Dr ASHISH/ 2011

B. ASSUMING A 14% COST OF CAPITAL, CALCULATE THE RESIDUAL

INCOME FOR BOTH STORES BEFORE AND AFTER POTENTIAL EXPANSION. THE

C.

WILL BURGER LTD. STORES CHOOSE TO EXPAND.

D.

WILL

THE ANSWER CHANGE IF THE STORES WERE AND OWNED BY VALUE MAXIMISING

FRANCHISED INVESTORS ?

RA/ IMT /Dr ASHISH/ 2011

.SOLUTION RETURN ON INVESTMENT BEFORE AND AFTER PIZZA EXPANSION

NORTHSIDE ROI BEFORE PIZZA REVENUE EXPENSES NET INCOME ASSETS ROI ROI FROM PIZZA ONLY INCREASED PROFITS FROM PIZZA EXPANSION COST ROI OF THE PROJECT ROI AFTER PIZZA $ 30,600 1,80,000 17% $ 30,600 1,80,000 17% $11,00,500 9,24,420 $1,76,080 8,90,000 19.78% $ 17,60,800 14,96,680 $ 2,64,120 17,40,000 15.17% SOUTHSIDE

TOTAL INCOME
TOTAL ASSETS TOTAL ROI

$ 2,06,680
10,70,000 19.32% RA/ IMT /Dr ASHISH/ 2011

$ 2,94,720
19,20,000 15.35% 9

B. RESIDUAL INCOME BEFORE AND AFTER THE PIZZA EXPANSION.

COST OF CAPITAL RESIDUAL INCOME BEFORE PIZZA NET INCOME $ 1,76, 080 $ 2,64,120 NORTHSIDE 14% SOUTHSIDE 14%

ASSETS x 14%
RESIDUAL INCOME RESIDUAL INCOME OF PIZZA ONLY INCREASED PROFITS FROM PIZZA LESS : 14% X EXPANSION COST RESIDUAL INCOME RESIDUAL INCOME AFTER PIZZA NET INCOME 14 % x ASSETS RESIDUAL INCOME

1,24,600
$ 51,480

2,43,600
$ 20,520

$ 30,600 ( 25,200) $ 5,400

$ 30,600 (25,200) $ 5,400

$ 2,06,680 1,49,800 $ 56,880 RA/ IMT /Dr ASHISH/ 2011

$ 2,94,720 2,68,800 $ 25,920 10

.C. THE TWO UNITS CURRENTLY HAVE DIFFERENT ROIs. THE SMALLER NORTHSIDE STORE IS EARNING AN ROI OF JUST UNDER 20% ; THE LARGER SOUTHSIDE STORE IS EARNING AN ROI OF JUST OVER 15%.

SINCE THE ROI OF THE PROJECT IS 17% , ADDING THE PROJECT TO THE NORTHSIDE STORE LOWERS ITS AVERAGE ROI WHILE ADDING THE PROJECT TO THE SOUTHSIDE STORE RAISES ITS AVERAGE ROI.

THEREFORE THE NORTHSIDE MANAGER WILL NOT WANT TO ADD PIZZA TO THE MENU SINCE ITS AVERAGE ROI WOULD DROP AS A

RESULT .

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11

THE SOUTHSIDE MANAGER HOWEVER WOULD WANT TO ADD IT SINCE THE STORE ROI WOULD SUBSEQUENTLY RISE.

IF THE STORES WERE FRANCHISED UNITS, THE OWNERS DEFINITELY WOULD EXPAND. THE ROI OF THE PIZZA IS HIGHER THAN THE COST OF CAPITAL. THUS , A POSITIVE RESIDUAL INCOME FOR THE PROJECT IS ENSURED.
AS LONG AS THE RESIDUAL INCOME IS POSITIVE , ANY FRANCHISE OWNER WOULD JUMP AT THE OPPORTUNITY. FRANCHISE OWNERS WOULD NOT CARE WHETHER THE STORE

AVERAGE ROI DROPPED AS LONG AS THE RESIDUAL INCOME INCREASED.

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. Measuring divisional profitability Ideally focus should be on relative measures (profitability) rather than absolute measures of profit.

Relative profitability measures:

1. Return on investment (ROI) 2. Residual income (RI) 3. Economic value added (EVA )

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Return on investment
Profit Investment ROI Division A 1m 4m 25% Division B 2m 20m 10%

Division B earns higher profits but A is more profitable

ROI is a relative measure of performance that can be compared with other investments.
A major disadvantage of ROI is that managers may be motivated to make decisions that make the company worse off.

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. Investment project available Controllable contribution Return on the proposed project ROI of divisions at present Division X 10 million 2 million 20% 25% Division Y 10 million 1.3 million 13% 9%

The overall cost of capital for the company is 15%

The manager of X would be motivated not to invest ( RETURN ON PROPOSAL IS LESS THAN RETURN OF DIVISION) and the manager of Y would be motivated to invest. ROI may also motivate managers to make incorrect asset disposal decisions.

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. Residual income

Controllable residual income = Controllable profit less a cost of capital charge on the investment controllable by the manager. It is claimed that RI is more likely to encourage goal

congruence
Proposed investment Controllable profit Cost of capital charge (15%) Residual income
Division X (m) 10 2 1.5 +0.5 Division Y (m) 10 1.3 1.5 0.2

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The manager of division X is motivated to invest and the manager of division Y is motivated not to invest. RI also enables different cost of capital percentages to be applied to different investments that have different levels of risk. If RI is used it should be compared with budgeted/target levels which reflect the size of the divisional investment. Empirical evidence indicates that RI is not widely used.

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Economic value added (EVA) .

During the 1990 s RI was refined and renamed EVA

EVA = Conventional divisional profit based on GAAP Accounting adjustments Cost of capital charge on divisional assets
2000 Colin Drury

Conventional divisional profit based on principles outlined for measuring divisional managerial and/or economic profits. Adjustments intended to convert historic accounting profit to an approximation of economic profit.

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Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital.
EVA After-tax = operating income Weighted average cost of capital Total capital employed

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EVA Example Amount Mortgage bonds Unsecured bonds Common stock Total $ 2,000,000 3,000,000 10,000,000 $15,000,000 0.098 After-Tax Weighted Percent x Cost = Cost 0.133 0.200 0.667 0.048 0.060 0.120 0.006 0.012 0.080

Weighted average cost of capital

$15,000,000 x .098 = $1,470,000

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EVA Example (continued) Furmans EVA is calculated as follows: After-tax profit Less: Weighted average cost of capital EVA

$1,583,000 1,470,000 $ 113,000

The positive EVA means that the firm., earned operating profit over and above the cost of the capital used.

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Assets .to be included in the investment base

Assets to be included must be specified for ROI, RI and EVA To measure the managerial performance only controllable assets should be included in the investment base. To measure economic performance all assets, and possibly an allocation of some corporate assets, should be included.

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Addressing the dysfunctional consequences of short-term financial performance measures

Financial performance measures can encourage managers to become short-term oriented and seek to boost short-term profits at the expense of long-term profits. Approaches for reducing the short-term orientation: 1. Divisional performance evaluated on the basis of economic income (PV of future cash flows). 2. Adopt EVA incorporating many accounting adjustments. 3. Lengthen the measurement period. 4. Do not rely excessively on financial measures and incorporate nonfinancial measures that measure those factors that are critical to the longterm success of the organization. (i.e.adopt a Balanced Scorecard Approach)

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How do centralized and decentralized firms differ?

In centralized firms, decision making occurs at top levels, implementation at lower levels. Decentralized firms allow lowerlevel managers to make and implement decisions.

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ILLUSTRATION 2 THE BUSINESS STAFF OF THE LEGAL FIRM FRAMPTON ,DAVIS AND SMYTHE HAS CONSTRUCTED THE FOLLOWING REPORT WHICH BREAKS DOWN THE FIRMS OVERALL RESULTS FOR LAST MONTH IN TERMS OF ITS TWO MAIN BUSINESS SEGMENTS FAMILY LAW AND

COMMERCIAL LAW:

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TOTAL

FAMILY LAW

COMMERCIAL LAW $6,00,000

.
REVENUES FROM CLIENTS $ 10,00,000 $ 4,00,000

LESS VARIABLE EXPENSES

2,20,000

1,00,000

1,20,000

CONTRIBUTION MARGIN

7,80,000

3,00,000

4,80,000

LESS TRACEABLE FIXED EXPENES

6,70,000

2,80,000

3,90,000

SEGMENT MARGIN

1,10,000

20,000

90,000

LESS COMMON FIXED EXPENES

60,000

24,000

36,000

NET OPERATING INCOME

50,000

(4,000)

54,000

RA/ IMT /Dr ASHISH/ 2011

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HOWEVER THIS REPORT IS NOT QUITE CORRECT .THE EXPENES ( IN THE NATURE OF COMMON FIXED EXPENSES ) SUCH AS MANAGERS SALARY , GENERAL ADMINISTRATIVE EXPENSES AND GENERAL FIRM ADVERTISING HAVE BEEN ALLOCATED TO THE

TWO SEGMENTS BASED ON REVENUE FROM CLIENTS.

REQUIRED; 1. REDO THE SEGMENT REPORT , ELIMINATE THE ALLOCATION OF COMMON FIXED EXPENSES .

2. SHOW IN BOTH AMOUNT AND PERCENTAGE , THE FIRM AS A WHOLE AND FOR EACH OF THE SEGMENTS ; WOULD THE FIRM BE BETTER OFF FINANCIALLY IF THE FAMILY LAW SEGMENT WERE DROPPED.?
( MANY OF THE FIRMS COMMERCIAL LAW CLIENTS ALSO USE THE FIRM FOR THEIR
FAMILY LAW REQUIREMENT SUCH AS FOR DRAWING UP OF WILL.) RA/ IMT /Dr ASHISH/ 2011 27

2.THE

FIRMS

ADVERTISING

AGENCY HAS

PROPOSED

AN

AD

CAMPAIGN TARGETTED AT BOOSTING THE REVENUES OF THE FAMILY LAW SEGMENT. THE AD CAMPANIGN WOULD COST $ 20,000. AND THE ADVERTISING

AGENCY CLAIMS THAT IT WOULD INCREASE FAMILY LAW REVENUES

BY $ 1,00,000. THE MANAGING PARTNER OF FRAMPTON , DAVIS AND SMYTHE BELIEVES THIS INCREASE IN BUSINESS COULD BE ACCOMODATED

WITHOUT ANY INCREASE IN FIXED EXPENSES.

WHAT EFFECT WOULD THIS AD CAMPAIGN HAVE ON THE FAMILY LAW SEGEMENT MARGIN AND ON OVERALL NEW OPERATING INCOME OF THE FIRM?

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SOLUTION

THE CORRECTED SEGMENTED INCOME STATEMENT APPEARS BELOW:

TOTAL AMOUNT

TOTAL PERCENT

FAMILY LAW AMOUNT

FAMILY LAW PERCENT 100% 25% 75% 70% 5%

COMME RCIAL LAW AMT 6,00,000 1,20,000 4,80,000 3,90,000 90,000

COMMER CIAL LAW PERCENT 100% 20% 80% 65% 15%

REVENUES FROM CLIENTS LESS VARIABLE EXPENSES CONTRIBUTION MARGIN LESS TRACEABLE FIXED EXPENSES SEGMENT MARGIN LESS COMMON FIXED EXPENSES NET OPERATING INCOME

10,00,000 2,20,000 7,80,000 6,70,000 1,10,000 60,000 $ 50,000

100% 22% 78% 67% 11% 6% 5%

4,00,000 1,00,000 3,00,000 2,80,000 20,000

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THE FIRM WOULD NOT BE FINANCIALLY BETTER OFF IF THE FAMILY

LAW PRACTICE WERE DROPPED . THE FAMILY LAW SEGMENT IS COVERING ALL OF ITS OWN COSTS AND IS CONTRIBUTING $ 20,000 PER MONTH TO COVER THE COMMON FIXED EXPENSES FOR THE FIRM. WHILE THE SEGMENT MARGIN AS A PERCENT OF SALES IS MUCH LOWER FOR FAMILY LAW THAN FOR COMMERCIAL LAW ,IT IS STILL PROFITABLE . MOREOVER FAMILY LAW MAY BE A SERVICE THAT THE FIRM MUST PROVIDE TO ITS COMMERCIAL CLIENTS IN ORDER TO REMAIN COMPETITIVE.

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2. THE AD CAMPANIGN WOULD BE EXPECTED TO ADD $ 55,000 TO

THE FAMILY LAW SEGMENT AS FOLLOWS: INCREASED REVENUE FROM CLIENTS FAMILY LAW CONTRIBUTION MARGIN RATIO INCREMENTAL CONTRIBUTION MARGIN LESS COST OF AD CAMPAIGN INCREASED SEGMENT MARGIN $ 1,00,000 X 75% 75,000 20,000 $ 55,000.

SINCE THERE WOULD BE NO INCREASE IN FIXED EXPENSES ( INCLUDING COMMON FIXED EXPENSES ) , THE INCREASE IN OVERALL NET OPERATING INCOME SHOULD ALSO BE $55,000.

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RESPONSIBILITY CENTERS
Major types of responsibility centers are:
Cost centers
Manager responsible for cost only

Revenue center
Manager responsible for sales only

Profit center
Manager responsible for sales & costs

Investment center
Manager responsible for sales, costs, & capital investment
RA/ IMT /Dr ASHISH/ 2011 32

Responsibility Centers
Cost Center Segment has control over the incurrence of costs.
Revenue Center
Segment is responsible for the revenue of a unit.

The Paint Department in an automobile plant.

RA/ IMT /Dr ASHISH/ 2011

The Reservations Department of an airline.

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Responsibility Centers
Investment Center
Segment has control over profits and invested capital.

Profit Center Segment has control over both costs and revenues.

Company-owned restaurant RA/ in a fast-food chain.IMT /Dr ASHISH/ 2011

A division of a large corporation.

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Measuring Management Performance Evaluation Tool

Cost Center
Profit Center Investment Center

Cost standards
Contribution income statement

Rate of return on invested funds or residual income

35

RA/ IMT /Dr ASHISH/ 2011

What are 2 ways to calculate income & how do they differ?

2 ways to calculate income are by absorption costing & variable costing. They differ in the treatment of fixed overhead.
RA/ IMT /Dr ASHISH/ 2011 36

The difference between variable costing & absorption costing year to year is equal to the change in fixed overhead.
Under absorption costing, fixed overhead is assigned to inventory produced. Under variable costing, fixed overhead is a period expense.
RA/ IMT /Dr ASHISH/ 2011 37

SEGMENT: Definition

Is a subunit of a company of sufficient importance to warrant performance reports.

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. DIRECT FIXED EXPENSES:

Definition

Are fixed expenses directly traceable to a segment & therefore, avoidable. If segment eliminated, so are expenses.

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COMMON FIXED EXPENSES:

.

Definition

Are jointly caused by 2 or more segments. These expenses persist even if 1 segment is eliminated.

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ILLUSTRATION 3 THE MAGNETIC IMAGING DIVISION OF MEDICAL DIAGNOSTICS , HAS REPORTED THE FOLLOWING RESULSTS FOR THE LAST YEARS OPERATIONS SALES NET OPERATING INCOME AVERAGE OPERATING ASSETS REQUIRED $25 MILLION 3MILLION 10 MILLION

1. COMPUTE THE MARGIN, TURNOVER AND ROI FOR THE MAGNETIC

IMAGING DIVISION. 2. TOP MANAGEMENT OF MEDICAL DIAGNOSTICS INC HAS SET A MINIMUM REQUIRED RATE OF RETURN ON AVERAGE OPERATING ASSETS OF 25% . WHAT IS THE MAGNETIC IMAGING DIVISIONS RESIDUAL INCOME FOR THE YEAR?
RA/ IMT /Dr ASHISH/ 2011 41

SOLUTION
1. THE REQUIRED CALCULATIONS APPEAR BELOW MARGIN = NET OPERATING INCOME $ 30,00,000 / SALES $ 250,00,000 = 12%

ASSETS TURNOVER = SALES $ 250,00,000/ AVERAGE OPERATING ASSETS $ 100,00,000 = 2.5 ROI = MARGIN X TURNOVER

12% X 2.5
=30%
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2. THE RESIDUAL INCOME FOR THE MAGNETIC IMAGING DIVISION IS COMPUTED AS FOLLOWS: AVERAGE OPERATING ASSETS NET OPERATING INCOME $ 100,00,000 $ 30,00,000

MINIMUM REQUIRED RETURN ( 25% X 100,00,000) 25,00,000 RESIDUAL INCOME $ 5,00,000.

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ILLUSTRATION 4 THE BOOK AND GAME COMPANY HAS TWO BOOK STORES AUNTIEs and

MERLINS.
EACH STORE HAS MANAGERS WHO HAVE A GREAT DECISION AUTHORITY OVER THEIR STORE. ADVERTISING , MARKETING RESEARCH, ACQUISITION OF BOOKS, LEGAL SERVICES AND OTHER STAFF FUNCTIONS, ARE HANDLED BY A CENTRAL OFFICE. THE BOOK AND GAME COMPANY CURRENT ACCOUNTING SYSTEM ALLOCATES ALL COSTS TO THE STORES . RESULTS FOR 20X1 WERE

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ITEM

TOTAL COMPANY $ 7,00,000

AUNTIE $ 3,50,000

MERLIN $3,50,000

.
SALES REVENUE

COST OF MERCHANDISE SOLD

GROSS MARGIN OPERATING EXPENSES SALARIES AND WAGES SUPPLIES RENT AND UTILITIES DEPRICIATION ALLOCATED STAFF COST TOTAL OPERATING EXPENSES OPERATING INCOME ( LOSS)

4,50,000
2,50,000

2,25,000
1,25,000

2,25,000
1,25,000

63,000 45,000 60,000 15,000 60,000 2,43,000 7000

30,000 22,500 40,000 7,000 30,000 1,29,500 (4500)

33,000 22,500 20,000 8,000 30,000 1,13,500 11,500

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EACH BOOKSTORE MANAGER MAKES DECISIONS THAT AFFECT

SALARIES AND WAGES , SUPPLIES AND DEPRICIATION. IN CONTRAST , RENT AND UTILITIES ARE BEYOND THE MANAGERS CONTROL BECAUSE THE MANAGERS DID NOT CHOOSE THE LOCATION OR THE SIZE OF THE STORE. SUPPLIES ARE VARIABLE COSTS. VARIABLE SALARIES AND WAGES ARE EQUAL TO TO 8% OF THE COST OF MERCHANDISE SOLD ; THE

REMAINDER OF SALARIES AND WAGES IS A FIXED COST.

RENT , UTILITIES AND DEPRICATION ALSO ARE FIXED COSTS. ALLOCATED STAFF COSTS ARE UNAFFECTED BY ANY EVENTS AT THE BOOKSTORE BUT THEY ARE ALLOCATED AS A PROPORTION OF SALES REVENUE.
RA/ IMT /Dr ASHISH/ 2011 46

1. USING THE CONTRIBUTION APPROACH , PREPARE A

PERFORMANCE REPORT THAT DISTINGUISHES PERFORMANCE OF EACH BOOKSTORE FROM THAT OF THE MANAGER. 2. EVALUATE THE FINANCIAL PERFORMANCE OF EACH BOOKSTORE. 3. EVALUATE THE FINANCIAL PERFORMANCE OF EACH MANAGER. BOOKSTORE

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ITEM SALES REVENUE VARIABLE COST COST OF MERCHANDISE SOLD SALARIES AND WAGES SUPPLIES TOTAL VARIABLE COST CONTRIBUTION MARGIN BY BOOKSTORE LESS : FIXED COST CONTROLLABLE BY BOOKSTORE MANAGER SALARIES AND WAGES DEPRICIATION TOTAL CONTROLLABLE FIXED COST CONTRIBUTION CONTROLLABLE BY MANAGERS LESS: FIXED COST CONTROLLABLE BY OTHERS RENT AND UTILITIES CONTRIBUTION BY BOOKSTORE

TOTAL COMPANY $ 700000 450000 36000 45000 531000 169000

AUNTIES $ 350000 225000 18000 22500 265500 84500

MERLINS $ 350000 225000 18000 22500 265500 84500

27000 15000 42000 127000

12000 7000 19000 65500

15000 8000 23000 61500

60000 67000 RA/ IMT /Dr ASHISH/ 2011

40000 25500

20000 41500 48

CONTRIBUTION BY BOOKSTORE LESS UNALLOCATED COST OPERATING INCOME

67000 60000 7000

2. THE FINANCIAL PERFORMANCE OF THE BOOKSTORE ( IE SEGMENTS OF THE COMPANY ) ARE BEST EVALUATED BY THE CONTRIBUTION PER BOOKSTORE . MERLINS HAS A SUBSTANTIALLY HIGHER

CONTRIBUTION , DESPITE EQUAL LEVELS OF SALES REVENUE IN THE TWO STORES. THE MAJOR REASON FOR THIS ADVANTAGE IS THE LOWER RENT AND UTILITIES PAID BY MERLINS.

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3. THE FINANCIAL PERFORMANCE BY MANAGERS IS BEST JUDGED BY CONTRIBUTION CONTROLLABLE BY MANAGERS. BY THIS MEASURE THE PERFORMANCE OF AUNTIEs MANAGERS IS BETTER THAN THAT OF MERLINS. THE CONTRIBUTION MARGIN IS THE SAME FOR EACH STORE, BUT MERLINS MANAGERS PAID $ 4000 MORE IN

CONTROLLABLE FIXED COST THAN DID AUNTIEs MANAGERS. OF COURSE , THIS DECISION COULD BE BENEFICIAL IN THE LONG RUN. WHAT IS MISSING FROM EACH OF THESE SEGMENT REPORTS IS THE YEARS MASTER BUDGET AND A FLEXIBLE BUDGET WHICH WOULD BE

BEST BENCHMARK FOR EVALUATING BOTH BOOKSTORE AND

BOOKSTORE MANAGER.
RA/ IMT /Dr ASHISH/ 2011 50

Measuring the Performance of Investment Centers

Behavioral Aspects of EVA

Hardware Division
Sales Cost of goods sold Gross profit Divisional selling and administrative expenses Operating income $5,000,000 2,000,000 $3,000,000 2,000,000 $1,000,000

Software Division
$2,000,000 1,100,000 $ 900,000 400,000 $ 500,000

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Measuring the Performance of Investment Centers

The EVA for each division can be calculated as follows: Hardware Division Operating income Less: Cost of capital EVA $1,000,000 1,100,000 $ (100,000) Software Division $500,000 220,000 $280,000

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Measuring the Performance of Investment Centers

Behavioral Aspects of EVA

Tends to focus on long-run Discourages myopic behavior

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The Balanced Scorecard is a strategicbased performance management system that typically identifies objectives and measures for four different perspectives.

The financial perspective The customer perspective The process perspective The learning and growth perspective

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Basic Concepts of the Balanced Scorecard .

Process value analysis is fundamental to activitybased responsibility accounting, focuses on accountability for activities rather than costs, and emphasizes the maximization of systemwide performance instead of individual performance. Process value analysis is concerned with: (1) Driver analysis (2) Activity analysis (3) Performance measurement
RA/ IMT /Dr ASHISH/ 2011

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Strategic Alignment
.

ABM Implementation Model

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ILLUSTRATION 5

THE SALES MANAGER OF BOMBAY TEXTILES IS JUDGED BY THE

TOTAL SALES. EXCEEDING THE SALES BUDGETED IS CONSIDERED GOOD PERFORMANCE. THE SALES BUDGET AND THE COST DATA FOR THE CURRENT YEAR ARE SHOWN BELOW:

GARMENTS SALES BUDGET VARIABLE COST RS 450000 (225000)

LONG CLOTH RS 900000 (405000)

BEDSHEETS 1650000 495000

TOTAL RS 3000000 (1125000)

CONTRIBUTION
ACTUAL SALES

225000
1500000

495000
1200000

1155000
600000

1875000
3300000

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.THE ACTUAL PRICES WERE EQUAL TO BUDGETED PRICES AND

VARIABLE COST INCURRED WERE BUDGETED PER UNIT. REQUIRED: 1. DID THE SALES MANAGER PERFORM WELL? SUPPORT YOUR ANSWER WITH CALCULATIONS. 2. SUGGEST BETTER PERFORMANCE MEASUREMENT CRITERIA TO BE USED BY THE FIRM?

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SOLUTION

PERFORMANCE EVALAUTION REPORT Garment Long cloth Bed sheet Total

Sales Less Variable cost Contribution

Rs 15,00,000 Rs 12,00,000 7,50,000 (@50%) 7,50,000 5,40,000 (@45%) 6,60,000 55

Rs 6,00,000 Rs 33,00,000 1,80,000 (30%) 4,20,000 70 14,70,000 (@44.54%) 18,30,000 55.45

Contribution margin 50 ratio ( per cent)

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.1. APPARENTLY THE SALES MANAGER HAS PERFORMED WELL AS THE ACTUAL SALES HAS EXEEDED THE BUDGETED SALES BY RS 3,00,000 , BUT THE ACTUAL CONTRIBUTION IS LESS BY RS 45,000 THAN THE BUDGETED FIGURE. REASONS;

1. UNFAVOURABLE CHANGES IN THE SALES MIX , THE MOST PROFITABLE

PRODUCT , BED SHEET HAS THE LEAST SALES VOLUME AND THE RELATIVELY LESS PROFITABLE PRODUCTS HAVE MUCH HIGHER SALES VOLUME. AS A SEQUEL TO SUCH A CHANGE , THE WEIGHTED AVERAGE

CONTRIBUTION MARGIN BASED ON PLANNED MIX WHICH WAS 62.5 PER

CENT (RS 18,75,000 + RS 30,00,000) HAS DECREASED TO 55.45 PER CENT. 2. IN REAL TERMS THE SALES MANAGER DID NOT PERFORM BETTER THAN THE PLANNED.
RA/ IMT /Dr ASHISH/ 2011 60

3. THE SALES MANAGERS PERFORMANCE SHOULD BE JUDGED BY THE FOLLOWING CRITERIA: SALES REVENUE LESS BUDGETED VARIABLE COST OF PRODUCTION AND ACTUAL

SELLING COST.

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.ILLUSTRATION 6 HOME COMFORTS LTD DEALS IN THREE PRODUCTS : ACE , NICE AND GRACE AND THESE ARE SOLD DIRECTLY BY SALESMEN IN

THREE ZONES PRIME , EXTENTION AND OUTREACH.

THE RESPONSIBILITY FOR SALES PROMOTION RESTS WITH THE HEADQUATERS AND SO THE OVERALL CONTROL OF DISTRIBUTION AND SALES. COST OF SALES AS PER CENT OF SALES ARE ACE 85, NICE 80, GRACE 75. DETAILS OF SALES AND SELLING AND DISTRIBUTION EXPENSES FOR THE YEAR ARE AS FOLLOWS:

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ZONES

PRODUCTS

SALES

S&D EXPENSES ALLOCATED DIRECTLY RS 63990 84465 47160

PRIME

ACE NICE GRACE

RS 900000 900000 450000

TOTAL
EXTENTION ZONE ACE NICE GRACE TOTAL OUTREACH ZONE ACE NICE GRACE TOTAL

2250000
675000 450000 225000 1350000 225000 180000 495000 900000

195615
46710 47700 23940 118350 18900 15165 66375 100440

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.SELLING AND DISTRIBUTION EXPENSES AT HEADQUARTERS ARE :

OFFICE EXPENSES ADVERTISEMENT OTHER EXPENSES RS 94500 RS 135000 RS 121500

ADVERTISEMENT COST ARE ALLOCATED TO ZONES AND PRODUCTS ON THE BASIS OF SALES. OFFICE EXPENSES AND OTHER EXPENSES ARE APPORTIONED EQUALLY TO THE ZONES OR THE PRODUCTS WHILE COMPUTING THE PROFIT OR LOSS FOR THE ZONES OR THE PRODUCTS AS THE CASE MAY BE. REQUIRED

A COMPARATIVE PROFIT AND LOSS STATEMENT , PRESENTING ZONAL

PERFORMANCE AS DISTINCT FROM PRODUCT PERFORMANCE.
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SOLUTION EVALUATION OF ZONAL PERFORMANCE

PARTICULAR SALES REVENUE LESS COST OF SALES PRIME ZONE RS 22,50,000 EXTENTION ZONE RS 13,50,000 OUTREACH ZONE RS 9,00,000 TOTAL RS 45,00,000

ACE (0.85)
NICE (0.8) GRACE (0.75) TOTAL GROSS PROFIT / MARGIN LESS SELLING AND DISTRIBUTION EXPENSES DIRECT COST ( ALLOCATED ) ADVERTISEMENT ( APPORTIONED IN SALES RATIO 225:135:90) OFFICE EXPENSES ( APPORTIONED EQUALLY ) OTHER EXPENSES (EQUALLY ) TOTAL SELLING AND DISTRIBUTION COST NET PROFIT/ LOSS

7,65,000
7,20,000 3,37,500 18,22,500 4,27,500

5,73,750
3,60,000 1,68,750 11,02,500 2,47,500

1,91,250
1,44,000 3,71,250 7,06,500 1,93,500

15,30,000
12,24,000 8,77,500 36,31,500 8,68,500

1,95,615 67,500 31,500 40,500 3,35,115 92,385

1,18,350 40,500 31,500 40,500 2,30,850 16,650

1,00,440 27,000 31,500 40,500 1,99,440 (5940)

4,14,405 1,35,000 94,500 1,21,500 7,65,405 1,03,095

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Examples of Quality Costs by Category

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