chapter 12

net operating income

(not net income) ...this is income before interest and taxes and is sometimes referred to as EBIT (earnings before int. and taxes). this also makes the numerator consistent with denominator.

3 ways managers influence cost distortion

1) failure to trace costs directly to a specific segment when it is feasible to do so. 2) use of inappropriate bases for allocating costs. 3) the allocation of common costs to segments

disadvantages to decentralization

1) lower-level managers may make decisions without fully understanding the big picture. 2)coordination may be lacking 3)lower-level managers may work with different incentives than that of the organizations 4) spreading of innovative ideas may be more difficult. other managers may not get the shared idea, adopt it, by other parts of the organization, that would get done in a more centralized organization.

advantages to decentralization

1)Top management can focus on more important issues: overall strategy. 2) decentralizing gives authority to those who have the most up-to-date information about day-to-day operations (lower-level managers) 3) allows organizations to respond more quickly to customers and changes in operating environment. 4)trains lower-level managers for higher-level jobs. 5)increases lower-level managers empowerment by motivating them, increasing job satisfaction.

any increase in ROI must involve at least 1 of these

1)increased sales 2)reduced operating expenses 3)reduced operating assets

Return on investment formula (ROI)

= Net operating income / Average operating assets. the higher the business segments return investment (ROI), the greater the profit earned per dollar invested in the segments operating assets.When looking at ROI, its also important to pay close attention to margin and turnover.

segment margin

Displays how much each division is contributing the companies profits - within the contribution format income statement.

ROI (performance analyzing)

ROI = Margin x tunover margin = Net operating income / sales turnover = sales / average operating assets

Cost Center

a business segment in which managers have control over cost but no control over revenue or investments. They are to minimize cost while providing the level of products and services demanded by other parts of the organization. Evaluated by comparing actual costs to how much costs should have been for the level of output during the period. standard cost variances and flexible budgets are used to discuss costs center performance.

common fixed cost

a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. even if a segment were entirely eliminated, there would be no change in true common fixed cost. any allocation of common costs to segments reduces the value of the segment margin as a measure of long-run segment profitability and segment performance.

segment

a part or activity of an organization which managers would like cost, revenue, or profit data.

economic value added (EVA)

an adaption of residual income that has been adopted by many companies. under EVA, companies often modify their accounting principles in various ways.

responsibility center

any business segment whose manager has control over cost, revenues, or investments in operating assets. (509)

segment margin

best representation of long-term profitability of a segment...(subtract traceable fixed cost from contribution margin)

profit center

business segment in which managers have control over both costs and revenues, but not investments. evaluated by comparing actual profit to targeted or budgeted profit.

a balanced scoreboard

consists of an integrated set of performance measures tat are derived from and support the organizations strategy. a strategy is essentially a theory about how to achieve the organizations goals.

decentralized organization

decision making is spread throughout the organization, ensuring that not all decision making responsibilities rest on the few top executives. All large organizations fall between the spectrum of being radically decentralized or centralized.

segmented reporting

effective decentralization requires this.

4 groups of balanced scoreboard (531)

financial customer internal business processes learning and growth (all about continual improvement)

Traceable fixed cost

fixed cost that is incurred because of the existence of the segment - if the segment never exist, the fixed cost wouldn't have incurred. If the segment were eliminated, the fixed cost would disappear as well. common why to determine is a cost is traceable...only those costs that would disappear over time if the segment itself disappeared.

operating assets

includes cash, accounts receivable, inventory, plant and equipment & all other assets held for operating purposes. All assets that are non-operating are not included.

investment center

manager has control over cost, revenue, and investments in operating assets. managers often evaluated using return on investment ( ROI) or residual income measure.

net book value

most companies use this when calculating operating assets (acquisition cost less accumulated depreciation). consequently, ROI mechanically increases over time: by decreasing denominator of ROI calculation (depreciation) the ROI increases over time. If new equipment is purchased, the ROI with decrease as a result...

criticisms of ROI

read page 526...essential!

residual income (equation)

residual income = net operating income - (average operating assets x minimum required rate of return)

formulas looked at when evaluating investment center's performance

return on investment (ROI), Residual Income

Motivation and Residual Income

see page 528...important...

turn over

this incorporates a crucial area of a managers responsibility - the investment in operating assets. Excessive funds tied up in operating assets (cash, A.C., inventories, plant and equipment. and other assets) depress turnover and lower ROI. inefficient use of operating assets can be just as much of a drag on profitability as excessive operating expenses, which depress margin.

gross cost of assets

this is an option that can be used rather than net book value for assets. this reports assets at the acquisition rate, not accounting for depreciation.

margin

this is ordinarily improved by increasing sales or reducing operating expenses, including CGS & admin exp. the lower the operating expenses per dollar of sales, the higher the margin earned. Some managers look too much at margin and not at turnover

residual income

this is the net operating income that an investment center earns above the minimum required return on its operating assets.

Residual income or EVA

when these are used as a performance measure, the objective needs to be maximizing the total amounts of residual income or EVA, not ROI. if you want to maximize ROI, break down each product except the single product with highest RIO.