Business Product Cost Profit Report

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         edit Master title   24
      Evaluation for
      Decentralized
       Operations

                             1
                             title style
Click to edit Master you should
After studying this chapter,
be able to:
1. List and explain the advantages and
   disadvantages of decentralized
   operations.
2. Prepare a responsibility accounting
   report for a cost center.
3. Prepare responsibility accounting
   reports for a profit center.
                                           2
                             title style
Click to edit Master you should
After studying this chapter,
be able to:
4. Compute and interpret the rate of return
   on investment, the residual income, and
   the balanced scorecard for an
   investment center.
5. Explain how the market price, negoti-
   ated price, and cost price approaches to
   transfer pricing may be used by
   decentralized segments of a business.      3
                                   24-1
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         Objective 1
      List and explain the
        advantages and
        disadvantages of
    decentralized operations.

                                   4
Decentralized Operations                 24-1
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          Separating a business into
          divisions or operating units
         and delegating responsibility
           to unit managers is called
               decentralization.


                                         5
Advantages of Decentralization                   24-1
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  It allows managers to focus on acquiring
   expertise in their areas of responsibility.
  Decentralizing decision making provides
   excellent training for managers.
  Decentralization helps managers create good
   customer relations by responding quickly to
   customers’ needs.
  Managers often become more creative in
   suggesting operating and product
   improvement.                                  6
Disadvantages of Decentralization                 24-1
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    Decisions made by one manager may
     negatively affect the profitability of the
     entire company.
    A potential disadvantage is duplication
     of assets and costs in operating divisions
     (e.g., each manager of a product line
     might have a separate sales force and
     administrative staff ).


                                                  7
Responsibility Accounting                  24-1
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       In a decentralized business, an
     important function of accounting is
          to assist unit managers in
       evaluating and controlling their
        areas of responsibility, called
            responsibility centers.


                                           8
                                       24-1
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   Responsibility accounting is the
  process of measuring and reporting
    operating data by responsibility
   centers. Three common types of
      responsibility centers are—
          Cost Centers
          Profit Centers
          Investment Centers
                                       9
                                                   24-1
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 The three centers differ in their scope of
 responsibility, as shown below:
Cost Center    Profit Center     Investment Center
                 Revenue           Revenue
Cost           – Cost            – Cost
                 Profit            Profit
                                   Investment in
                                     assets

                                                   10
                                                   10
                                   24-2
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         Objective 2
    Prepare a responsibility
    accounting report for a
         cost center.

                                   11
Responsibility Accounting for         24-2
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Cost Centers



         In a cost center, the unit
               manager has
            responsibility and
         authority for controlling
            the costs incurred.

                                      12
        Responsibility Accounting   24-2
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        Reports for Cost Centers




(Continued)

                                    13
                                    13
    Responsibility Accounting                         24-2
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    Reports for Cost Centers




    from Manager, Plant A Budget Performance Report   14
                                                      14
                   (Continued)
    Responsibility Accounting                         24-2
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    Reports for Cost Centers




                                                To Vice
                                                President’s
                                                Budget
                                                Performance
                                                Report
     from Supervisor, Department 1, Plant A’s
           Budget Performance Report
                                                     15
                                                     15
                     (Continued)
     Responsibility Accounting                       24-2
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     Reports for Cost Centers
   To Manager, Plant A’s Budget Performance Report




                                                     16
                                                     16
                    (Concluded)
                                                            24-2

    Click to edit Master title style
Example Exercise 24-1

   Nuclear Power Company’s costs were over budget by
   $24,000. The Power Company is divided into the
   North and South regions. The North Region’s costs
   were under budget by $2,000. Determine the amount
   that the South Region’s cost was over or under budget.
Follow My Example 24-1

   $26,000 over budget ($24,000 + $2,000)


   For Practice: PE 24-1A, PE 24-1B                         17
                                                            17
                                   24-3
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         Objective 3
    Prepare responsibility
   accounting reports for a
        profit center.

                                   18
Responsibility Accounting for             24-3
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Profit Centers



         In a profit center, the unit
       manager has the responsibility
          and the authority to make
       decisions that affect both costs
       and revenues (and thus profits).

                                          19
                                      24-3
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     Controllable revenues are
    revenues earned by the profit
   center. Controllable expenses
   are costs that can be influenced
   (controlled) by the decisions of
     the profit center managers.

                                      20
Service Department Charges                        24-3
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           Services provided by internal
        centralized service departments are
         often more efficient than services
      contracted with outside providers. An
      internal service cost is called a service
                department charge.

                                                  21
                                   24-3
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                                   22
                                   22
NEG Example                                        24-3
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    NEG’s expenses for the year ended Decem-
    ber 31, 2008 for each service department are
    as follows:
         Purchasing                $400,000
         Payroll Accounting         255,000
         Legal                      250,000
            Total                  $905,000

                    (Continued)                    23
                                                   23
NEG Example                                       24-3
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   The activity base for each service depart-
   ment is a measure of the services performed.
   For NEG, the following applies:
   Purchasing             Number of purchase
                          requisitions
   Payroll Accounting Number of payroll
                          checks
   Legal                  Number of billed
                          hours
                    (Continued)                   24
NEG Example                                              24-3
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                    Service Usage
                      Purchasing
Theme Park Division       25,000 purchase requisitions
Movie Production Division 15,000
Total                     40,000 purchase requisitions

         $400,000
                             = $10 per purchase requisition
40,000 purchase requisitions

                       (Continued)                       25
                                                         25
NEG Example                                              24-3
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                    Service Usage
                 Payroll Accounting
 Theme Park Division             12,000 payroll checks
 Movie Production Division        3,000
 Total                           15,000 payroll checks
         $255,000
                             = $17 per payroll check
   15,000 payroll checks

                       (Continued)                       26
                                                         26
NEG Example                                               24-3
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                    Service Usage
                            Legal
  Theme Park Division                  100 billed hours
  Movie Production Division            900
  Total                              1,000 billed hours
               $250,000
                             = $250 per hour
              1,000 hours

                       (Continued)                        27
                                                          27
     Service Department                 24-3
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     Charges to NEG Divisions




                                        28
                                        28
                          (Concluded)
                                                      24-3

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Example Exercise 24-2
   The centralized legal department of Johnson
   Company has expenses of $60,000. The
   department has provided a total of 2,000 hours
   of service for the period. The East Division has
   used 500 hours of legal service during the
   period, and the West Division has used 1,500
   hours. How much should it be charged for
   legal services?

                                                      29
                                                      29
                                                          24-3

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Follow My Example 24-2

   Manufacturing Division Service Charge for Legal
   Department:
   $15,000 = 500 billed hours x ($60,000/2,000 hours)

   Sales Division Service Charge for Legal Department:
   $45,000 = 1,500 billed hours x ($60,000/2,000 hours)



                                                          30
                                                          30
  For Practice: PE24-2A, PE24-2B
Profit Center Reporting                       24-3
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          The income from operations is a
               measure of a manager’s
           performance. In evaluating the
          profit center manager, the income
        from operations should be compared
                 over time to a budget.


                                              31
     Divisional Income             24-3
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     Statement—NEG




                                   32
                                   32
                                                             24-3

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Example Exercise 24-3
   Using the data for the Johnson Company from Example
   Exercise 24-2 (click the button in the lower left-hand
   corner to go to EE 24-2; type ―33‖ and press ―Enter‖ to
   return to this slide), along with the data given below,
   determine the divisional income from operations for the
   East and West Divisions.
                                    East        West
                                 Division Division
         Sales                   $300,000 $800,000
         Cost of goods sold        165,000 420,000
         Selling expenses           85,000 185,000
                                                             33
                                                             33
                                                          24-3

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Follow My Example 24-3
                                 East Region West Region

 Revenue                         $300,000    $800,000
 Operating expenses               250,000*    605,000**
 Income from operations before
   service department charges    $ 50,000    $195,000
 Service department charges        15,000      45,000
 Income from operations          $ 35,000    $150,000
   *$165,000 + $85,000
  **$420,000 + $185,000

                                                          34
                                                          34
  For Practice: PE24-3A, PE24-3B
                                   24-4
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         Objective 4
    Compute and interpret the
   rate of return on investment,
   the residual income, and the
    balanced scorecard for an
         investment center.
                                   35
Responsibility Accounting for              24-4
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Investment Centers



       In an investment center, the unit
        manager has the responsibility
           and the authority to make
         decisions that affect not only
        costs and revenues, but also the
         assets invested in the center.

                                           36
     Divisional Income             24-4
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     Statements—DataLink Inc.




                                   37
                                   37
Rate of Return on Investment               24-4
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        One measure that considers the
        amount of assets invested in an
        investment center is the rate of
        return on investment (ROI) or
           rate of return on assets.


                                           38
                                           24-4
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 Rate of return on investment is one
 of the most widely used measures
 for investment centers and is
 computed as follows:
 Rate of Return
                = Income from Operations
 on Investment        Invested Assets
 (ROI)

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                                           39
                                   24-4
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Click to Revenues




                                   40
                                   40
                                     24-4
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                            Profit
                        Profit
                        Margin
           Investment                41
                                     41
            Turnover
                                               24-4
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                  Profit margin is the ratio
                     of of income from
                     operations to sales




                        Profit
                        Margin
           Investment                      42
                                           42
            Turnover
                                              24-4
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                            Investment
                          turnover is the
                          ratio of sales to
                          invested assets

                        Profit
                        Margin
           Investment                         43
                                              43
            Turnover
DuPont Formula                              24-4
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ROI = Income from Operation x      Sales
              Sales           Invested Assets



                 Profit        Investment
                 Margin         Turnover


                                            44
                                            44
DuPont’s Northern Division (ROI)             24-4
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 ROI = Income from Operation x      Sales
               Sales           Invested Assets
         $ 70,000        $560,000
ROI =                x
         $560,000        $350,000
ROI = 12.5% x 1.6

 ROI = 20%
                                             45
                                             45
DuPont’s Central Division (ROI)              24-4
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 ROI = Income from Operation x      Sales
               Sales           Invested Assets
          $ 84,000        $672,000
ROI =                 x
          $672,000        $700,000
ROI = 12.5% x 0.96

 ROI = 12%
                                             46
                                             46
DuPont’s Southern Division (ROI)             24-4
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 ROI = Income from Operation x      Sales
               Sales           Invested Assets
         $ 75,000        $750,000
ROI =                x
         $750,000        $500,000
ROI = 10% x 1.5

 ROI = 15%
                                             47
                                             47
DuPont’s Northern Division Proposal    24-4
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           Assume that the revenues
           of the Northern Division
            could be increased by
          $56,000 through increasing
           advertising to $385,000.


                                       48
Projected Impact of Change                              24-4
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 Revenues ($560,000 + $56,000)               $616,000
 Operating expenses                           385,000
 Income from operations before
   service department charges                $231,000
 Service department charges                   154,000
 Income from operations                      $ 77,000


                        Increase of $7,000              49
                                                        49
DuPont’s Northern Division (ROI)             24-4
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Revised


 ROI = Income from Operation x      Sales
               Sales           Invested Assets
         $ 77,000        $616,000
ROI =                x
         $616,000        $350,000
ROI = 12.5% x 1.76

 ROI = 22%
                                             50
                                             50
                                                      24-4

    Click to edit Master title style
Example Exercise 24-4

   Campbell Company has income from
   operations of $35,000, invested in assets of
   $140,000, and sales of $437,500. Use the
   DuPont formula to compute the rate of return
   on investment and show (a) the profit margin,
   (b) the investment turnover, and (c) the rate of
   return on investment.

                                                      51
                                                      51
                                                24-4

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Follow My Example 24-4

                       $35,000
    a. Profit margin =          = 8%
                       $437,500
                             $437,500
    b. Investment turnover =          = 3.125
                             $140,000

    c. Rate of return on investment =
        8% x 3.125 = 25%
                                                52
                                                52
    For Practice: PE24-4A, PE24-4B
Residual Income                                24-4
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     Residual income is the excess of income
        from operations over a minimum
       acceptable income from operations.




                                               53
                                               53
                                                              24-4
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                                  Northern   Central    Southern
                                  Division   Division   Division
Income from operations            $70,000 $84,000 $75,000
Minimum acceptable income
from operations as a percent of
assets:
   $350,000 x 10%                  35,000
   $700,000 x 10%                            70,000
   $500,000 x 10%                                  50,000
Residual income                   $35,000 $14,000 $25,000

                                                             54
                                                             54
                                                   24-4

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Example Exercise 24-5

   The Wholesale Division of PeanutCo has
   income from operations of $87,000 and assets
   of $240,000. The minimum acceptable rate of
   return on assets is 12%. What is the residual
   income for the division?



                                                   55
                                                   55
                                                  24-4

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Follow My Example 24-5

      Income from operations           $87,000
      Minimum acceptable income
        from operations as a percent
        of assets: $240,000 x 12%      (28,800)
      Residual income                  $58,200



                                                  56
                                                  56
      For Practice: PE24-5A, PE24-5B
The Balanced Scorecard                     24-4
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      The balanced scorecard is a set of
     financial and nonfinancial measures
       that reflect multiple performance
           dimensions of a business.


                                           57
     The Balanced Scorecard        24-4
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                                   58
                                   58
                                   24-5
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         Objective 5
     Explain how the market
      price, negotiated price,
    and cost price approaches
    to transfer pricing may be
       used by decentralized
     segments of a business.
                                   59
Transfer Pricing                          24-5
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            When divisions transfer
         products or render services to
         each other, a transfer pricing
            is used to charge for the
              products or services.

                                          60
Three Methods of Transfer Pricing       24-5
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         1. Market price approach
         2. Negotiated price approach
         3. Cost price approach



                                        61
                                   24-5
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                                   62
                                   62
Market Price Approach                     24-5
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            Using the market price
        approach, the transfer price is
        the price at which the product
        or service transferred could be
            sold to outside buyers.

                                          63
     Income Statement—No           24-5
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     Transfers Between Divisions




                                   64
                                   64
Negotiated Price Approach               24-5
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        The negotiated price approach
           allows the managers of
         decentralized units to agree
        (negotiate) among themselves
            as to the transfer price.

                                        65
     Income Statements—            24-5
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     Negotiated Transfer Price




                                   66
                                   66
                                                             24-5

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Example Exercise 24-6

   The materials used by the Winston-Salem Division of
   the Fox Company are currently purchased from outside
   suppliers at $30 per unit. These same materials are
   produced by Fox’s Flagstaff Division. The Flagstaff
   Division can produce the materials needed by the
   Winston-Salem Division at a variable cost of $15 per
   unit. The division is currently producing 70,000 units,
   and has capacity of 100,000 units. The two divisions
   have recently negotiated a transfer price of $22 per unit
   for 30,000 units. By how much will each division’s
   income increase as a result of this transfer?             67
                                                             67
                                                           24-5

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Follow My Example 24-6

   Winston-Salem Division
   Change in sales                             $      0
   Decrease in variable costs (30,000
     units x ($30 – $22)                       (240,000)
   Increase in income                          $240,000
   Flagstaff Division
   Increase in sales (30,000 units x $22)      $660,000
   Increase in variable costs (30,000 x $15)    450,000
   Increase in income                          $210,000
                                                           68
                                                           68
   For Practice: PE24-6A, PE24-6B
Cost Price Approach                     24-5
  Click to edit Master title style
              Under the cost price
           approach, cost is used to
           set transfer prices. Cost
            may refer to either total
            product cost per unit or
             variable cost per unit.

                                        69

				
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