April 26, 2010

1. April 26, 2010 Decentralization, Profitability and ROI

2. Decentralization – what is it? Advantages and disadvantages Responsibility Centers Cost Centers Profit Centers Investment Centers Allocating costs equitably ROI & Residual Income Today’s Agenda

3. Decision making authority is spread throughout the organization Versus all decisions being made at the most senior level Large organizations need to decentralize decision making to at least to some extent Lower level employees are empowered What is Decentralization?

4. Decentralization in Organizations Benefits of Decentralization Top management freed to concentrate on strategy. Lower-level managers gain experience in decision-making. Decision-making authority leads to job satisfaction. Lower-level decision often based on better information. Lower-level managers can respond quickly to customers.

5. Decentralization in Organizations May be a lack of coordination among autonomous managers. Lower-level managers may make decisions without seeing the “big picture.” Disadvantages of Decentralization Lower-level manager’s objectives may not be those of the organization. May be difficult to spread innovative ideas in the organization.

6. In a Decentralized structure, organizations are divided into Responsibility Centers Allows tracking of performance of those who are making the decisions There are three types: Profit Center Measure on Profit & Loss, ROI Cost Center Measure on level of costs Investment Center Measure on ROI, for example Responsibility Centers

7. Investment Centers Cost Centers Responsibility Centers - Examples Profit Centers ?

8. Each Responsibility Center may be segmented into logical units; eg, Regions Retail Outlets Business Divisions This is done to track performance at different levels It isolates performance – good and bad Costs must be fairly allocated Challenging to allocate common costs Note: Increasingly GAAP requires segmented reporting in certain cases Segmented Reporting

9. Traceable Costs Costs that are directly traceable to the segment Eg, staff costs for the Western region These can be fixed or variable costs Common Costs Costs that are shared among all segments Eg, cost of centralized purchasing department These costs must be allocated in some manner acceptable to those whose performance is being measured Allocating Costs to Business Segments

10. Measuring Performance • Cost Centers • Measured on level of costs against budget • Profit Centers • Measured on Profit & Loss against budget • And possibly ROI • Investment Centers • Measured on ROI and Residual Income • ROI provides incentive to invest for increasing levels of profitability • Residual Income provides incentive to invest for increasing levels of income above a certain ROI threshold

11. Net operating income Average operating assets ROI = Return on Investment (ROI) Formula Income before interest and taxes (EBIT) Cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes.

12. Net operating income Average operating assets ROI = Improving ROI • Three ways to improve ROI: • 1. Reduce expenses • 2. Increase Revenue • 3. Reduce Operating Assets

13. ROI – an example • What is the Gross Margin? • & GM %? • What is Operating Income? • Operating Income %? • Calculate ROI

14. ROI – an example • ROI is 19% • Is that good? • How can it be improved?

15. Net operating income Average operating assets ROI = Net operating income Sales Margin = Sales Average operating assets Turnover = Margin  Turnover ROI = Return on Investment (ROI) Formula

16. Calculating Residual Income ( ) • ROI provides incentive to invest for increasing levels of profitability • Residual Income provides incentive to invest for increasing levels of income above a certain ROI threshold

17. Calculating Residual Income • Jack Company can invest Yuan 20 million in assets and expects it will generate Yuan 5 million per year in operating income • The ROI threshold is 20% • Should the company proceed with the investment?

18. Transfer Pricing • Transfer pricing is required when one part of an organization transfers goods or services to another part • A price needs to be determined in order to measure the performance of each group • Transfer Prices can be determined in a number of ways • Negotiated between the two departments • Cost • Fair Market Value • In any case, the Transfer Price must be fair in order to maintain motivation and appropriately measure and reward managers

19. Tutorial