Performance Evaluation

 is the basis of a management control system. Periodic comparisons of the actual costs, revenues
and investments with the budgeted costs, revenues and investments can help management in
taking decisions about future allocations.
 should be done in respect of all responsibility centers (i.e., cost centers, profit centers and
investment centers) to ascertain their level of performance.
 The best way to encourage managers to achieve the desired level of performance is to measure
their performance in comparison to budgeted results.

Responsibility Accounting
 is an internal system of accounting in which costs are assigned to various managerial levels
according to where control of the costs is deemed to rest, with managers being held responsible
for the difference between actual and budgeted results.
 It involves the assigning and delegating to responsible organizational units the duty to control
costs and expenses, generating revenues and profit, and acceptable return on investments and
evaluating performance based on established standards through verifiable and timely reports.
 4 Elements of Responsibility Accounting:
1. Assigning responsibility,
2. Establishing performance measures or benchmarks,
3. Evaluating performance, and
4. Assigning rewards.
 is an internal reporting system that supports decentralization of decision making and generation
of information specific to the center. Resources, revenues, and costs are accumulated and
reported by levels of responsibility or by responsibility centers within the organization.

Decentralization vs Centralization
Decentralization
 is the delegation of authority and responsibility to supervisors or mid-level management.
 it refers to the creation of divisions or segments of an organization to become more manageable
sub-units in the organization.
 It is managed by the supervisor delegated to decide and held accountable for his decisions.
 Although a company is decentralized, it should practice Goal Congruence.
 Decentralization works in a small, medium, and large-scale business organizations.
 the transfer of authority, responsibility, and decision-making rights from the top to the bottom of
an organization.
 Organizational segments - are classified into responsibility centers headed by a manager who
is assigned a corresponding authority, responsibility and accountability in business operations.

Centralized Decision Making

 leaves decision making too few top-level managements. Decision is cascaded to lower-level
management for implementation.
 Usually this works for Micro-business organization.
 that which decision-making rests exclusively to top management.

ADVANTAGES AND DISADVANAGES OF DECENTRALIZATION

The advantages of decentralization are:
1. It helps top management recognize and develop managerial talent.
2. It allows managerial performance to be comparatively evaluated.
3. It can often lead to greater job satisfaction and provides job enrichment.
4. It makes the accomplishment of organizational goals and objectives easier.
5. It reduces decision-making time.
6. It allows the use of management by exception.

The disadvantages of decentralization are:

1. It can result in a lack of goal congruence or sub-optimization by subunit managers.
2. It requires more effective communication abilities because decision making is removed from
the home office.
3. It can create personnel difficulties upon introduction, especially if managers are unwilling or
unable to delegate effectively.
4. It can be extremely expensive, including costs of training and of making poor decisions.

Responsibility Centers
 is any segment, department, unit, section or division in a business organization headed by a
manager who has been delegated authority, responsibility and accountability in business. The
types of responsibility centers are as follows:
1. COST CENTER: A responsibility center in which a manager has only the authority to
control cost.
2. REVENUE CENTER: An organizational unit whose manager is solely responsible for
generating revenues.
3. PROFIT CENTER: A responsibility centers whose manager is responsible for generating
revenues and controlling expenses.
4. INVESTMENT CENTER: An organizational unit whose manager is responsible for
acquiring, using, and disposing of assets in order to maximize return on assets.

Performance Evaluation Models

Responsibility center managers are evaluated as follows:

COST CENTER:

 Standard Costs Variance Analysis

REVENUE CENTER:

 Revenue Variance Analysis

PROFIT CENTER:

 Segment Margin Analysis

INVESTMENT CENTER:

 Return on Investment
 Residual Income model
 Economic Value-Added model
 Return on Equity and Market Value added.

RESPONSIBILITY CENTERS COMPARED:

 Controllable And Non-Controllable Costs
Controllable Cost Non-Controllable Cost
 these are costs which may be directly regulated at a  This is a cost that cannot be altered based on a
given level of managerial authority and time-frame. personal business decision or need. The costs are
Controllability goes with authority, the higher the allocated by the top management to several
authority the more the controllable costs.
departments or branches. (Reminder that there is a
 A segment manager has direct control over short- run
costs. top-level mgt.)
 Most common example of controllable or short-  Examples include: depreciation, insurance,
run cost is variable cost. administrative overhead allocated and rent
 As much as possible, consider only controllable cost allocated just to name a few. While
when evaluating segment manager performance. This controllable costs can be altered in the short
is a cost that can be altered based on a business run, uncontrollable costs can be altered in
decision or need. These costs have a direct relationship the long run.
with a product, department or function.
 Controlled by another
 Examples include: direct labor, direct materials,
donations, training costs, bonuses, subscriptions
 Nature of cost (E.g.: Fixed)
and sues, and overhead costs just to name a few.

Direct/Traceable and Common Fixed Cost

Direct/Traceable Fixed Cost Common Fixed Cost (Unavoidable fixed,

Allocated fixed)
 is a fixed cost that is avoidable if a segment or
division is discontinued. Or, it is the fixed cost  is a fixed cost necessary to sustain operations of
directly identified to operate a segment of an multiple segments. It cannot be directly identified
organization. In Relevant costing it is called to a specific segment or division. The fixed cost
“Avoidable fixed cost”. will continue even if a division is closed.
 “Traceable fixed costs” is relevant when  Moreover, it is not controllable by a specific
evaluating a responsibility center. manager. Since common fixed cost is neither
avoidable nor controllable, it is ignored in
performance evaluation and in decision making.
However, it is deducted against revenues when
computing for operating income under Financial
Accounting.
 In Cost Accounting, specifically under Joint and
By-product costing, common fixed cost is
allocated to the joint products to determine the
unit cost of a finished good.
 Illustration 1:
The supervisor of Department 9 purchases supplies, authorizes repairs and maintenance service,
and hires labor for the department. Various costs for the month of January are given below:

A. Sales salaries and commissions B. Salary, supervisor of Dept. 9

C. Factory heat and light D. General office salaries

E. Depreciation, factory F. Supplies, Dept. 9

G. Repairs and maintenance, Dept. 9 H. Factory insurance

I. Labor cost, Dept. 9 J. Salary of factory superintendent

Required:

1. List the costs that can be controlled by the Supervisor of Department 9. F, G, I

2. List the costs that can be directly identified with Department 9. B, F, G, I
3. List the cost that will have to be allocated to the factory departments. C, E, H, J
4. List the costs that do not pertain to factory operations. A, D

Summary:

1. Cost Center:
 Standard cost variance analysis is used in evaluating a
cost center.
 Please refer to your previous management accounting
subject on Standard Cost Variances for detailed
 discussion and presentation.

2. Profit Center:

Segment Contribution Margin (SCM) Segment Income (Sl) or Segment

 This is a short-run test of profitability.
Margin
 This tool is used if there is no avoidable fixed cost.  This is a long-run test of profitability because it considers
Continue operating the profit center as long as Avoidable Fixed cost in evaluating performance.
contribution margin is positive.  This is far more superior than contribution margin. It
measures how much is contributed to recover common
SCM = Total Revenues - Total Variable Cost fixed cost and company profit. Continue operations as
long as segment income is positive.

Sl = Segment Contribution Margin - Avoidable Fixed Cost

Alternative Approach: if Net Operating Income (Nl) is given:

Sl = Net Operating Income + Common Fixed Cost

SEGMENT REPORTING
 Business segment reporting breaks out a company's financial data by company divisions,
subsidiaries, or other kinds of business segments. In an annual report, business segment
reporting provides an accurate picture of a public company's performance to its shareholders.
 Management uses business segment reporting to evaluate the income, expenses, assets, and
liabilities of each business division to assess its general health— including profitability and
potential pitfalls.
 A segment is a component of a business that generates its own revenues and creates its own
product, product lines, or service offerings. In general, if a unit of a business can be lifted out of
the larger company and remain a self- sufficient entity, then it may be classified as a business
segment.

2. Profit Center: Segment Margin Analysis

NOTE:
Traceable FC is
relevant if you are
evaluating the
SEGMENT.

It will not be
relevant if you are
evaluating the
Segment Manager.

Illustration 2:
Evermore Company has the following information pertaining to its two divisions for 2023:
Common expenses are P 12,000 for 2023.

 What is the Segment Margin for Division A & B?

A=100K-55K-32.5K = 12,500, B=20,000

 What is the Net Income for the Evermore Company?

32,500-12,000=20,500

NOTES: Segment Reporting

 Segmented Income Statements present the results of operations for the whole company and for
each individual segment.
 Many accountants feel that organizations should not allocate common costs, or non-traceable
costs that benefit more than one segment (such as the CEO’s salary and headquarters’
depreciation).
 Allocations of common costs are often arbitrary, given that many different allocation methods
can be used. Such allocations can lead to misleading financial information and possible
erroneous decisions.
 If the segmented income statement is used to evaluate a manager’s performance, care is taken to
highlight costs that are controllable by the manager. Holding an individual responsible for costs
that he/she cannot change decreases the chance that the report will be a positive motivator.
 The contribution format shows the amount that each sub-unit is contributing to cover common
fixed costs and increase profits. It is also somewhat clear which costs would disappear if the
segment is discontinued—useful information for decision situations.

Problem 1:
MD Company produces and sells only two products that are referred to as MIX and MATCH.
Production is "for order" only, and no finished goods inventories are maintained; work in process
inventories are negligible. The following data have been extracted relating to last month:

An analysis has been made of the manufacturing overhead. Although the items listed above are
traceable to the products, P36,000 of the overhead assigned to MIX and P72,000 of that assigned to
MATCH is fixed. The balance of the overhead is variable.

Selling expenses consist entirely of commissions paid as a percentage of sales. Direct labor is
completely variable.
Administrative expenses in the data above are fixed and cannot be traced to the products but have
been arbitrarily allocated to the products.

Required:

Prepare a segmented income statement, in total and for the two products. Use the contribution
approach.

Answer:

3. Investment Center:
A. Return on Investment (ROI)
 This is a test of profitability by comparing a desired minimum required rate of return (ROR).
It measures the required investment to generate certain amount of profit. The investment
center is profitable as long as the ROI is equal or greater than the minimum ROR. It is
preferred that the company uses the Weighted Average Cost of Capital (WACC) as the
minimum ROR. As an alternative, the company may opt to use the financing cost specific to
the investment.

ROI = Operating Income / Average Investment or Assets

  ROI can be expanded to measure asset utilization and sales profitability analysis by
multiplying Rate of Return on Sales to Asset Turnover. The equation is expanded to:

ROI = Return on Sales x Asset Turnover

 Since ROI is stated in percentage, it allows the comparison of different investment

alternative of different sized. However, ROI has its own pitfalls. Managers easily manipulate
ROI most specially if it is used as a performance metric. The easiest way is to manipulate the
valuation of the investment base as stated in the above discussions. Managers can even defer
operating expenses in the current period to the next to increase current year profits. Managers
tend to become myopic and ignore the long-term effects of their actions.
 A major pitfall of ROI is managers tend to reject investments with lower ROI than his own
but would have increased the overall company ROI. This is an inherent disadvantage of
decentralization. Moreover, ROI is stated as a percentage. Percentage is a measurement of rate
and not an absolute value of money.

B. Residual Income (RI)

 measures the absolute peso return of an investment over the minimum ROR.
 It is almost the same with ROI but stated in money. The investment center is profitable as long
as RI is positive. The higher the RI, the better.
 Between ROI and RI, managers tend to rely more on RI because it measures absolute peso
return. It eliminates the weakness of ROI of rejecting investment that would increase overall
company ROI. Because of this, RI supports the principle of goal congruence. Meaning
investments are accepted because it will improve the profitability of the center as well as the
company as a whole.
 Unfortunately, RI does not allow the comparison of different investment alternative with
different sizes because it is stated in pesos.

RI = Operating Income - (minimum ROR x Average investment or Assets)

= Operating Income – Minimum Required Income

EXAMPLE 1:
Colors Corporation operates two (2) autonomous divisions, Red Company and Gold Company.
The divisions reported the following data with respect to their 2021 operations:
Compute for:

1. Return on investment (SI/I) 2. Residual income

Red= 20%, Gold= 18.75% Red= 2M, Gold=10.8M

Problem 1:
RTX is a division of a major corporation. The following data are for the latest year of operations:

Required:

a) What is the division's margin?

b) What is the division's turnover?
c) What is the division's return on investment (ROI)?
d) What is the division's residual income?

Solution:
RECALL: ROI = Return on Sales x Asset Turnover

C. Economic Value Added (EVA)

 is a measure of a company's financial performance based on the residual wealth calculated by

deducting its cost of capital from its Earnings Before Interest but After Tax (EBIAT) or Net
Operating Profit After Tax (NOPAT).
 can also be referred to as Economic Profit, as it attempts to capture the true economic profit of a
company.
 it is also a measure of return to the company's stakeholders because it tends to measure the
absolute peso return after recovering financing cost from Long-term Sources of Financing. It is
the only tool that considers tax effects, because interest on debt financing is tax deductible. A
 positive EVA shows a project is generating returns in excess of the required minimum return,
hence profitable. The higher the EVA, the better.

= EBIAT - (WACC% x Total Long-term EVA Sources of Financing)

= NOPAT - (Total Assets - Current Liabilities) x WACC

Problem 2:
Fedor Company has two sources of funds: long-term debt with market and book value of P10
million issued at an interest rate of 12%, and equity capital that has a market value of P8 million
(book value of P4 million). Fedor has profit centers in the following locations with the following
operating incomes, total assets, and total liabilities. The cost of equity capital is 12% while the tax
rate is 25%.

Required:

a. What is the EVA for Tarlac?

b. What is the EVA for Quezon?
c. What is the EVA for Manila?

Solution:
a) First compute for WACC to be used for Tarlac, Quezon, Manila

b) P 135,580*

c) P 414, 360*

* n.b. follow the same process to compute for Quezon and Manila

RECALL: INVESTMENT CENTER Performance measures

RECALL: INVESTMENT CENTER Performance Measures

1. ROI Model

Operating Income
ROI =
Ave . Investment
Du Pont Model:
 ROI = Return on sales x Asset turnover

Sales
ROI = ¿) x ( )
Investment
Note: Investment = “Operating Assets”

2. Residual Income (RI) Model

RI = Operating income – Minimum income*

*Minimum income = Investment x imputed rate

3. Economic Value Added (EVA) Model

EVA = Operating profit after tax – Minimum return on long-term equity**

** Minimum return on long-term equity = (Total assets – current liabilities) * WACC

TRANSFER PRICING
Rational and Need TRANSFER PRICING
Transfer Price - Supports the principle of preparing INTERNAL Reports

 is the price charged by one segment of an organization for a product or service that it supplies to
another segment of an organization. Transfer pricing is an accounting practice that represents
the price that one division in a company charges another division for goods and services
provided.
 Transfer pricing allows for the establishment of prices for the goods and services exchanged
between subsidiaries, affiliates, or commonly controlled companies that are part of the same
larger enterprise.
 Transfer prices are necessary to compute for the revenues and costs of the Cost, Profit,
Revenue, and Investment center.
 Simply stated, it is the selling/purchase price within the same company. Transfer prices are only
intended for performance evaluation. It will not affect the overall profit of an organization. A
transfer price is used to determine the cost to charge another division, subsidiary, or holding
company for services rendered. Typically, transfer prices are reflective of the going market price
for that good or service.
 Transfer pricing occurs when two or more affiliated companies transact with one another in an
arm’s length nature involving goods or services in the ordinary course of business operations. It
may be based on market-based pricing, cost-based pricing, negotiated pricing, arbitrary or dual
pricing.
 It is the price charged by one segment of an organization for a product or service that it supplies
to another segment of an organization
 Under responsibility accounting, the divisions are independent of each other. Even if one
division transfers or sells its product to another division within the same company it is viewed
as valid sales for that division for purposes of evaluation.

Transfer Pricing Schemes:

 Market-based price - that which is closely aligned with the current market prices of similar
products.
 Cost-based price - equals the cost-plus lump-sum or mark-up percentage.
  Negotiated transfer prices - may occur when segments are free to determine the prices at
which they buy and sell internally.
 Arbitrary transfer price - one that is set by the management in the corporate headquarters.
 Dual price - is used when the divisions, selling and buying, use different prices in recording
their intercompany transfers.

Goals of Transfer Pricing

When the overall goal of the organization prevails over that of the divisional goals, it is
called goal congruence or optimization. When the individual goal of the managers prevails over that
of the overall organization’s goals, it is called sub-optimization.

Transfer Price Range

DILLEMA:

The division that is selling the good or service would prefer a high transfer price because it
will be evaluated based on the revenue/profit it generates.

However, the division that is buying would prefer a low transfer price because it will be
evaluated based on its cost.

The acceptable transfer price is between the highest transfer price of the buying division
and the lowest acceptable transfer price of the selling division.

The highest/maximum transfer The lowest/minimum acceptable

price of the buying division. The highest transfer price for the selling division. The
price the buying division would be willing to selling division would like for the transfer
pay is the external price it pays from an price to be as high as possible, but the lowest
outside supplier. price he is willing to accept is the variable
cost per unit of his division. The variable cost
The external price is net of trade
is the lowest price provided there is no
discount if any. The buying division would be
opportunity cost and fixed costs remain
willing to agree on a transfer price that is
unaffected.
lower than the external price.

This situation will be fully discussed

under Make or Buy analysis of Relevant
Costing.

LOWEST/ MINIMUM TRANSFER HIGHEST/ MAXIMUM TRANSFER

PRICE PRICE

(Selling Division is willing to sell) (Buying Division is willing to pay)

= Check the capacity: = Market Price, NET of trade discount

 Computing Transfer Prices:
Two general rules when computing a transfer price:

1. The maximum price should be no higher than the market price at which the buying
segment can acquire the good or service externally.
(MAXIMUM TRANSFER PRICE ≤ OUTSIDE SELLING PRICE)

2. The minimum price should be no less than the sum of the selling segment’s incremental
costs associated with the goods or services plus the opportunity cost of the facilities used.
(MINIMUM TRANSFER PRICE ≥ INCREMENTAL COST + LOST CM*)

Minimum Transfer Price

Model for Computing Transfer Prices

 Minimum transfer price = Variable costs + Lost contribution margin (at maximum
capacity)
 Maximum transfer price = Market price (if available)

A good should be transferred internally whenever the minimum transfer price (set by the
selling division) is less than the maximum transfer price (set by the buying division). By using this
rule, total profits of the firm are not decreased by an internal transfer.

EXAMPLE 1:
Legend Corp. produces various products used in the construction industry. The Plumbing
Division produces and sells 100,000 copper fittings each month. Relevant information for last
month follows:

Top-level managers are trying to determine how a transfer price can be set on a transfer of
10,000 of the copper fittings from the Plumbing Division to the Bathroom Products Division.

REQUIRED:

 A transfer price based on variable cost. = .95 = .5 +.3 + .15

 A transfer price based on full production cost. = .75 = .50+.25
 A transfer price based on market price. = 2.5 = 250,000/100,000
 If the Plumbing Division is operated as an autonomous investment center and its capacity is
100,000 fittings per month, the per-unit transfer price is not likely to be below:

Min. transfer price = VC+ lost CM = .95 + 1.55 = 2.5