Chapter 23 Performance Evaluation for Decentralized Operations Study Guide Solutions Fill-in-the-Blank Equations. Exercises

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1 Chapter 23 Performance Evaluation for Decentralized Operations Study Guide Solutions Fill-in-the-Blank Equations 1. Service department expense 2. Income from operations 3. Profit margin 4. Invested assets 5. Variable cost per unit 6. Transfer price Exercises 1. Determine if each of the following is a characteristic of decentralized operations. a. Many managers of a company making decisions for their division. Yes b. Managers are more able to focus on the needs of customers by division. Yes c. Managers report daily to top management regarding changes and decisions to be made for each division. No 2. A new company is trying to decide whether to use centralized or decentralized operations. All branches will be fairly close together, and top management will have access to each branch when needed and to supervise. To be aware of the operations, management would like to make the most of the decisions. Would you suggest centralized or decentralized operations? Centralized operations 1

2 2 Chapter Due to recent expansion, the management of a company is trying to decide if centralized or decentralized operations would be best. Due to recent location openings, many new managers were hired, but top management is unsure of the customer demographics of the area. Would you suggest retaining centralized operations or switching to decentralized operations? Switching to decentralized operations Strategy: Under centralized operations, top management has responsibility for all decisions, meaning all decisions are made in one central location. However decentralized operations allow for many managers to make decisions for the division for which they are responsible. Since managers are able to experience first-hand the operations of their division, the managers are able to adapt to customer preferences and develop better relationships. 4. The marketing manager of a company looks to find the best marketing opportunities with the lowest cost for the company. Is this an example of a cost center, profit center, or investment center manager? Cost center manager 5. A production manager identifies ways to increase profits by increasing revenue or decreasing costs, which may include retiring out-of-date machinery and acquiring newer models. Is this an example of a cost center, profit center, or investment center manager? Investment center manager 6. The regional manager of a firm looks for ways to branch into new markets or cut costs for the division in order to increase profits. Is this an example of a cost center, profit center, or investment center manager? Profit center manager Strategy: A cost manager is responsible solely for the costs of the division, while profit center managers responsibility also include the revenues earned. Investment center managers incur the most responsibility, over revenues, costs, and investments in assets.

3 Performance Evaluation for Decentralized Operations 3 7. For the month of May in 2015, the Mixing Department of the West Plant incurred the following costs: factory wages, $27,500; materials, $10,600; utilities, $4,100; depreciation, $1,200; and supervisor salaries, $9,750. Prepare the supervisor s responsibility accounting report if the department had the budgeted amounts shown below. Factory wages 2,500 hours at $10.00 per hour Materials 6,000 units at $1.50 per unit Utilities $4,150 Depreciation $1,200 Supervisor salaries $9,500 Budget Performance Report Supervisor, Mixing Department West Plant For the Month Ended May 31, 2015 Budget Actual Over Budget Under Budget Factory wages $25,000 $27,500 $2,500 Supervisor salaries 9,500 9, Materials 9,000 10,600 1,600 Utilities 4,150 4,100 $50 Depreciation 1,200 1,200 $48,850 $53,150 $4,350 $50 8. For the same month as in Exercise 7, the Bottling Department of the West Plant had the same budget as the Mixing Department, but incurred the following costs: factory wages, $22,750; supervisor salaries, $9,750; materials, $10,000; utilities, $3,950; and depreciation, $1,200. Prepare the supervisor s responsibility accounting report for the department and identify the costs that are over budget. Budget Performance Report Supervisor, Bottling Department West Plant For the Month Ended May 31, 2015 Budget Actual Over Budget Under Budget Factory wages $25,000 $22,750 $2,250 Supervisor salaries 9,500 9,750 $ 250 Materials 9,000 10,000 1,000 Utilities 4,150 3, Depreciation 1,200 1,200 $48,850 $47,650 $1,250 $2,450 The supervisor salaries are over budget by $250 and the materials used are over budget by $1,000.

4 4 Chapter Use the information in Exercises 7 and 8 to prepare the responsibility accounting report for the manager of the West Plant if administration budgeted costs of $10,500 and was over budget by $650. Budget Performance Report Manager, West Plant For the Month Ended May 31, 2015 Budget Actual Over Budget Under Budget Administration $ 10,500 $ 11,150 $ 650 Mixing Department 48,850 53,150 4,300 Bottling Department 48,850 47,650 $1,200 $108,200 $111,950 $4,950 $1,200 Strategy: A budget performance report compares budgeted and actual costs. By having columns for the amount over or under budget, the users of the information can easily identify which costs should be investigated. As the area reported increases, the report gives less detail. For example, the individual costs will be listed for a department, while the costs of each department will be listed for a plant, and the costs of each plant for the production of the company. 10. Determine if a profit center manager of a division of a picture frame manufacturer has control over each of the following costs and expenses. a. Cost of materials used for the division s production department Yes b. Sales goals for the division s top selling product Yes c. Cost of employees hourly wage in the department Yes

5 Performance Evaluation for Decentralized Operations A profit center manager of a company s eastern sales division is looking at decreasing the following costs: direct labor, utilities, and purchasing, which is allocated by the number of requisitions. To do so, the manager plans to do the following: increase efficiency in production to decrease the number of hours needed, thus decreasing the direct labor and utilities and ordering larger quantities each purchase to decrease the number of purchase orders. Are all of the costs the manager would like to decrease controllable costs? Yes, because he has the power to decrease the number of purchase orders. 12. The profit manager of a company would like to decrease the following costs: legal, purchasing, and direct labor. The company allocates legal by hours billed and purchasing by number of purchase orders. The company requires that each division meet with the lawyer for at least twenty hours but allows the manager to make purchase orders. Are all costs the manager would like to decrease controllable costs? No, the legal expenses are not controllable costs because the company requires a certain number of hours. Strategy: Profit center managers have responsibility for controllable revenues and expenses. Controllable revenues are the revenues earned by the manager s profit center. Controllable expenses include the expenses incurred by the manager s profit center that the manager has the ability to change. Service department charges are controllable by the profit center manager if the profit center manager is able to control how much of the service is used, usually the activity base of the service department charge.

6 6 Chapter Lazy Day Chairs has two divisions, South and North. The company s service departments include Purchasing, Advertising, and Research and Development, which allocate expenses by number of purchase requisitions, number of advertising promotions, and number of hours, respectively. The Purchasing Department incurred expenses of $24,000, while Advertising incurred $14,000, and Research and Development incurred $16,000. Using the information shown below, allocate the service department expenses among the divisions. Service Usage Division Purchasing Advertising Research and Development South 1,200 Purchase requisitions 25 Promotions 3,200 Hours North 1, Total 3, ,000 Charge Rates $8 $24,000/3,000 $140 $14,000/100 $4 $16,000/4,000 Service Department South North Total Purchasing $ 9,600 $14,400 $24,000 Advertising 3,500 10,500 14,000 R&D 12,800 3,200 16,000 Total $25,900 $28,100 $54, Prepare the divisional income statements for the year ending December 31, 2015, for Lazy Day Chairs using the information in Exercise 13. The South Division earned revenues of $152,600 while North earned revenues of $175,800. South incurred operating expenses of $49,100 while North incurred expenses of $62,300. Lazy Day Chairs Divisional Income Statements For the Year Ended December 31, 2015 South Division North Division Revenues $152,600 $175,800 Operating expenses 49,100 62,300 Income from operations before service department charges $103,500 $113,500 Less service department charges Research and Development $ 12,800 $ 3,200 Purchasing 9,600 14,400 Advertising 3,500 10,500 Total service department charges $ 25,900 $ 28,100 Income from operations $ 77,600 $ 85,400

7 Performance Evaluation for Decentralized Operations Clean It Corp. has two sales divisions, CleanPro and Magic Clean. The service departments of the company include Payroll Accounting, Research and Development, and Legal, which all allocate expenses by number of payroll checks, hours, and hours billed. Service departments incurred the following expenses: Payroll Accounting, $12,000; Research and Development, $28,000; and Legal, $20,000. Use the information below to allocate the service department expenses among the divisions. Service Usage Division Payroll Accounting Research and Development Legal CleanPro 3,400 Payroll checks 480 Hours 350 Hours billed Magic Clean 2, Total 6, Charge Rates $2 $12,000/6,000 $35 $28,000/800 $40 $20,000/500 Service Department CleanPro Magic Clean Total Payroll Accounting $ 6,800 $ 5,200 $12,000 R&D 16,800 11,200 28,000 Legal 14,000 6,000 20,000 Total $37,600 $22,400 $60, Use the information in Exercise 15 to prepare the divisional income statement for Clean It Corp. for the year ending September 30, The Clean Pro division earned revenues of $125,200 and incurred operating expenses of $50,150. The Magic Clean division earned revenues of $105,300 and incurred operating expenses of $47,300. Clean It Corp. Divisional Income Statements For the Year Ended September 30, 2015 CleanPro Magic Clean Revenues $125,200 $105,300 Operating expenses 50,150 47,000 Income from operations before service department charges $ 75,050 $ 58,300 Less service department charges Research and Development $ 16,800 $ 11,200 Legal 14,000 6,000 Payroll Accounting 6,800 5,200 Total service department charges $ 37,600 $ 22,400 Income from operations $ 37,450 $ 35,900

8 8 Chapter Shooz Manufacturing has two divisions, East and West. The service departments used by the divisions include Advertising, Facilities Management, and Purchasing. Advertising incurred total expenses of $22,000, while Facilities Management incurred $24,000 and Purchasing incurred $52,000. Advertising allocates costs by number of advertising promotions, while Facilities Management allocates costs by hours of assistance, and Purchasing allocates costs by number of purchase requisitions. Determine the costs to be allocated to each division using the information shown. Service Usage Division Advertising Facilities Management Purchasing East 450 Promotions 330 Hrs. of assistance 2,200 Purchase requisitions West ,800 Total ,000 Charge Rates $27.50 $22,000/800 $32.00 $24,000/750 $13.00 $52,000/4,000 Service Department East West Total Advertising $12,375 $ 9,625 $22,000 Facilities Management 10,560 13,440 24,000 Purchasing 28,600 23,400 52,000 Total $51,535 $46,465 $98,000 Strategy: First, determine the rate of the service department charges by dividing the expenses incurred by the total of the activity base. To allocate the expenses to each department, multiply the charge rate by the activity base of that department. As a check, make sure that the total charged to the departments equals the expenses incurred by the service department.

9 Performance Evaluation for Decentralized Operations Prepare Shooz Manufacturing s divisional income statements for the year ending December 31, 2015, using the information in Exercise 17. The East Division earned $194,700 of revenues and incurred $57,200 of operating expenses while the West Division earned $165,300 of revenue and incurred $41,500 of expenses. Shooz Manufacturing Divisional Income Statements For the Year Ended September 30, 2015 East West Revenues $194,700 $165,300 Operating expenses 57,200 41,500 Income from operations before service department charges $137,500 $123,800 Less service department charges Purchasing $28,600 $23,400 Advertising 12,375 9,625 Facilities management 10,560 13,440 Total service department charges $51,535 $46,465 Income from operations $85,965 $77,335 Strategy: A divisional income statement calculates the income from operations by division, with distinction between operating expenses and service department charges. Begin with revenues earned and subtract the operating expenses to arrive at the income from operations before service department charges. Next, subtract the service department charges allocated to the division to arrive at income from operations. 19. Use the operating income determined in Exercise 14 for Lazy Day Chairs to calculate the rate of return on investment for each division. The South Division owns $208,600 of invested assets while the North Division owns $230,000. Round percentages to two decimal places. Which division utilizes its assets more efficiently? Income from operations Invested assets Rate of return on investment South $77,600 $208, % North 85, , % Since the South Division generates a higher rate of return on investment, it utilizes its assets more efficiently to generate income.

10 10 Chapter Use the information in Exercises 14 and 19 to calculate each division of Lazy Day Chairs residual income. The company requires a 25% return for invested assets. Income from operations Invested assets Minimum acceptable income Residual income South $77,600 $208,600 $52,150 $25,450 North 85, ,000 57,500 27, Use the information shown below to calculate the profit margin, investment turnover, and rate of return on investment using the DuPont formula for the company in 2015 and Determine if changes in the rate of return on investment are favorable or unfavorable. Round answers to two decimal places Sales $ 456,000 $ 420,000 Income from operations 320, ,700 Invested assets 1,270,000 1,255,000 Profit margin Investment turnover Rate of return on investment The increase in the rate of return on investment is a favorable trend for the company. 22. Using the information in Exercise 21 and a 15% required rate of return, calculate the residual income. Minimum acceptable income $190,500 $188,250 Residual return 129, , Use the information in Exercise 18 to calculate the rate of return on investment for the divisions of Shooz Manufacturing. The East Division holds $120,000 of invested assets while the West Division holds $117,000. Round percentages to two decimal places. Income from operations Invested assets Rate of return on investment East $85,965 $120, % West 77, , %

11 Performance Evaluation for Decentralized Operations 11 Strategy: The rate of return on investment gives the income earned per dollar of invested assets. A higher rate of return indicates more efficiency in utilizing the invested assets by generating revenue and controlling costs. The rate of return on investment can be calculated by dividing income from operations by invested assets or using the DuPont formula. The DuPont formula multiplies the profit margin by the investment turnover, which is sales divided by invested assets. Profit margin is calculated by finding the ratio of income from operations to sales. 24. Use the information in Exercises 18 and 23 for Shooz Manufacturing to determine the residual income for each division. The company requires an 18% rate of return on invested assets. Income from operations Invested assets Minimum acceptable income Residual income East $85,965 $120,000 $21,600 $64,365 West 77, ,000 21,060 56,275 Strategy: Residual income determines the profit center manager s ability to produce excess income over a minimum acceptable amount of income in his department. The minimum acceptable income is what the company expects the division should produce with the amount of given assets and is calculated by multiplying the required rate of return by the amount of invested assets. The difference between the income from operations generated and the minimum acceptable income from operations is the residual income. 25. Determine if each of the following performance measures would be related to innovation and learning, internal processes, customer service, or financial performance on a balanced scorecard. a. Cost variances from budgeted amounts Financial performance b. Number of finished goods produced in a day Internal processes c. Number of new product lines Innovation and learning

12 12 Chapter Would each of the following be found in the innovation and learning, internal processes, customer service, or financial performance section of a balanced scorecard? a. Waste and scrap Internal processes b. Number of complaints Customer service c. Operating costs Financial performance 27. Determine if each of the following performance measures would be related to innovation and learning, internal processes, customer service, or financial performance on a balanced scorecard. a. Developing a new market Innovation and learning b. Employee turnover Innovation and learning c. Number of sales returns Customer service Strategy: The balanced scorecard provides nonfinancial information to management to determine if the company is meeting its goals. Innovation and learning includes measures related to new products provided to customers and training of employees. Customer service relates to items that would affect a customer s relationship with the company. Internal processes include the ability to produce the correct number of goods efficiently. Financial performance relates to numbers and ratios calculated from the income statement.

13 Performance Evaluation for Decentralized Operations The South Department of a company has the option to purchase 15,000 units of materials from outside suppliers for $20 per unit or from the company s North Department, which sells the products for $15 per unit to outsiders. The North Department currently produces and sells 40,000 units but has capacity to produce 60,000 units. The department incurs variable costs of $5 per units and total fixed costs of $25,000. Determine the change in income for each department using the following methods: a. Market price North $150,000 ($15 $5) 15,000 units Increase in profit South 75,000 ($20 $15) 15,000 units Decrease in costs b. Negotiated price of $17.50 North $187,500 ($17.50 $5) 15,000 units Increase in profit South 37,500 ($20 $17.50) 15,000 units Decrease in costs c. Cost approach using the variable product cost per unit North $0 ($5 $5) 15,000 units Increase in profit South 225,000 ($20 $5) 15,000 units Decrease in costs

14 14 Chapter The Red Department has the option to purchase 5,000 units of materials from outside suppliers for $25 per unit or the Blue Department of the company, which sells to outside buyers for $22 per unit. The Blue Department is currently at full capacity, producing and selling 25,000 units and incurring fixed costs of $28,000 and variable costs of $15 per unit. Determine the change in income for each department using the following methods: a. Market price Red $15,000 ($25 $22) 5,000 units Decrease in costs Blue 0 Increase in profits Since the Blue Department would sell the products for the same price, there will be no change in sales or costs incurred because it is producing at capacity. b. Negotiated price of $22.50 Red $12,500 ($25 $22.50) 5,000 units Decrease in costs Blue 2,500 ($22.50 $22) 5,000 units Increase in profits Since Blue would normally sell the products for $22 each, the increase in profits will be the increase in sales revenue because it will incur the same variable costs regardless of the price sold. c. Cost approach using the total cost per unit Red $44,400 ($25 $16.12) 5,000 units Decrease in costs Blue (29,400) ($16.12 $22) 5,000 units Decrease in profits Using the cost approach would decrease the selling price below what the Blue Department would normally sell the goods for to its current buyers, so the department s profits would actually decrease.

15 Performance Evaluation for Decentralized Operations The Purchasing Department can either buy 2,000 units of materials from outside suppliers for $15 per product or from the company s Production Department. The Production Department typically sells finished goods to outside buyers for $10 each. The Production Department is currently at capacity, producing and selling 10,000 products each period at a variable cost of $6 per product and incurring total fixed costs of $22,000. Determine the change in income for each department using the following methods: a. Market approach Purchasing $10,000 ($15 $10) 2,000 units Decrease in costs Production 0 Increase in profits Since the Production Department would sell the products for the same price, there will be no change in sales or costs incurred because it is producing at capacity. b. Negotiated price of $13.00 Purchasing $4,000 ($15 $13) 2,000 units Decrease in costs Production 6,000 ($13 $10) 2,000 units Increase in profits c. Cost approach using the variable cost per unit Purchasing $18,000 ($15 $6) 2,000 units Decrease in costs Production (8,000) ($6 $10) 2,000 units Decrease in profits Since the Production Department is currently producing and selling at capacity, the department would lose profit due to the decrease in selling price. Strategy: The different methods of setting transfer prices will cause various changes in income for the purchasing and supplying department. Under the market price approach, the cost is set by what the supplying department would sell the good to outsiders. Using the negotiated price approach, the purchasing and supplying departments negotiate a price between the variable costs to produce the unit and the market price. If the company uses the cost price approach, the selling price could be equal to the variable cost per unit, or the total costs per unit. Whether or not the supplying department is producing at capacity should also be considered when choosing which approach to use.