Suggested Answers Chapters 1819

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-1

Performance evaluation can be thought of as the process by which managers at all levels in the
firm gain information about the performance of tasks within the firm and judge that performance
against pre-established criteria as set out in budgets, plans, and goals. In management
accounting there are two types of performance evaluation -- management control and operational
control.
Management control refers to the evaluation by upper-level managers of the
performance of mid-level managers. Operational control refers to the evaluation of operating
level employees by mid-level managers.

18-2
Strategic performance measurement is a management accounting system used by top

management for the evaluation of business unit managers. It is used when the conditions are
such that responsibility can be effectively delegated to business unit managers, and there are
adequate measures for evaluating the performance of the managers. It is important for effective
management because it helps the decentralized firm evaluate managers of decentralized
business units of the firm.
18-3
An effective performance evaluation system must consider both the individual and team aspects
of work and performance in the firm. In management accounting, we focus on the individual
aspects primarily in strategic performance measurement systems. However, strategy-focused
firms will also develop methods to evaluate teams using techniques such as bonuses based on
team performance and balanced scorecards based on performance measures that are commonly
controlled within the team.
18-4
The systems for management control are of two types -- formal and informal. Formal systems are
developed from explicit management guidance, while informal systems arise from the
unmanaged, and sometimes unintended, behavior of managers and employees. Informal
systems reflect the managers' and employees' reactions and feelings that arise from the positive
and negative aspects of the work environment, for example, the positive feelings of security and
acceptance of an employee in a company that has a successful product and generous employee
benefits. Formal and informal control systems can be implemented at both the level of the
individual manager or that of a team of managers or employees. Strategic performance
measurement is a type of formal control system at the individual level.
18-5
The two organizational designs are centralized and decentralized. A centralized firm reserves
much of the decision-making at the top management level. In contrast, a decentralized firm
delegates a significant amount of responsibility to lower level managers. Both the centralized and
decentralized firms are called hierarchical, because responsibility and reporting relationships
follow a top to bottom pattern. Responsibility flows top-down and reporting relationships flow
bottom-up.
18-6
A cost center is a production or support unit within a firm that is evaluated on the basis of cost.
A revenue center focuses on the selling function and is defined either by product line or by
geographical area.
A profit center generates both revenues and incurs the major portion of the cost
for producing these revenues.
An investment center evaluation includes assets employed by the center

as well as profits in the performance evaluation.
The goal of each type of is center as follows:
Cost center: produce a product or service of given quality at lowest cost.
19-1
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Education.

Revenue center: to meet sales goals within a given expense budget.
Profit center: achieve desired profit goals.
Investment center: achieve desired profit goals for a given amount of assets.
18-7
While net income determined using full costing is affected by changes in inventory levels, net
income using variable costing is not affected. This means that the proper interpretation of net
income under full costing, unlike variable costing, requires an adjustment for changing inventory
levels. This difference is important because users of financial statements prepared under full
costing can be misled about the actual performance of the firm if there are significant changes in
inventory level for the firm.
18-8
There are four behavioral/implementation issues for SBUs:

1. Cost shifting, wherein a department replaces its controllable costs with noncontrollable costs. For example, a manager might attempt to replace variable costs such as
manufacturing labor with fixed costs such as advanced equipment if the manager is evaluated on
the basis of contribution margin only (i.e., fixed costs are excluded).
2. Short term focus, where the concern is that strategic performance measurement, done
improperly, will motivate managers to focus on short-term profits and neglect long-term strategic
issues.
3. Budget slack which is often viewed negatively, can have a positive effect in
management control. Slack is sometimes viewed as a dysfunctional aspect of SBUs, a result of
managers attempting to make their performance goals easier, and therefore an indication of an
overall lower than appropriate level of performance. The positive view of slack is that it addresses
effectively the decision making and fairness objectives of performance evaluation. By limiting
managers' exposure to environmental uncertainty, it reduces the relative risk aversion of the
managers.
18-9
A pervasive issue when using cost centers is how the jointly incurred costs of service
departments -- such as data processing, engineering, human resources, or maintenance -- are to
be allocated to the departments using the service. The various cost allocation methods are
explained in Chapter 7. The choice of method will affect the amount of cost allocated to each
cost center, and therefore it is critical in effective cost center evaluation.
18-10
Strategic performance measurement can be used for both service and not-for-profit firms as well
as manufacturing firms. Cost centers are particularly appropriate across all organization types,
as the organization attempts to identify responsibility for costs and to develop a system for
recording, reporting and evaluating performance in managing costs. An example of an
application of strategic performance measurement in banking is presented in the chapter.
18-11
Cost centers are used when the firm wishes to focus the managers attention exclusively on
costs. This makes sense particularly when for example the manager is producing a product that
requires little coordination with marketing or design. There are therefore few times when the
manager will need to adjust the functionality of the product or adjust the production schedule to
suit the needs of a certain customer. The manager can then focus her or his attention primarily on
the cost of manufacture.
The revenue center is used for marketing and sales organizations where the principal
focus is sales volume.
The profit center is used when the manager has effective control over both revenues and
costs in the unit, and when there is a need for coordination between the marketing and production
areas, as for example, in handling special orders or rush orders. Evaluation on profit provides the
incentive for the departments to work together. Also, profit centers are used to set a desirable
competitive tone; all departments have the profit incentive to compete with other providers of the
good or service, inside or outside the firm.
18-12
(See also 18-5) Centralized firms have a strong hierarchical organization in which information
flows upward and management flows downward in the hierarchy. Centralized firms are effective
19-2
Education.

in quickly implementing policy changes and in controlling operations according to the goals of top
management. Lower level managers are given limited autonomy, and have a limited range of
decision making. Their role is to provide information and to implement top management policies.
Decentralized firms grant a great deal of autonomy to local managers, on the belief that the local
managers will have the best knowledge to make appropriate decisions for the firm. The key
factor in decentralized firms is to develop management controls processes which provide the right
incentives to local managers -- so that they independently work hard for top management goals.
A key advantage of the centralized firm is that it has strong control over operations, while a key
disadvantage is that top management may lack the important day-to-day knowledge of local
managers which can make local managers more effective at day-to-day decisions. The key
advantage of the decentralized firm is that autonomy leads to strong success motivation for unit
managers and the firm can benefit when local managers are able to decide local issues. For this
reason, decentralization, with proper incentives, can more effectively achieve top managements
goals.
18-13
The marketing department can be viewed as both a revenue center and a cost center. The
marketing department is viewed as a revenue center because there is a revenue-generating
process. The marketing manager must therefore report revenues, typically by product line, and
sometimes also by sales area and salesperson. In addition, the marketing department is
commonly viewed as a cost center. In certain industries, such as pharmaceuticals, cosmetics,
software, games and toys, and specialized electrical equipment, the cost of advertising and
promotion is a significant portion of the total cost of producing and selling the product.
18-20 In the short run, Peppers will lose $100,000 in profits, shown by the
Controllable Margin for intake valves. However, in the long run,
Peppers will be able to save $150,000 in noncontrollable costs,
leading to a net increase in profits of $50,000 by dropping intake
valves from its production line.
18-23 For the Winter Outerwear division, the short-term effect would be a
loss of $500,000 in profits as shown by the Controllable Margin.
The long-term effect would be an increase of $250,000 in profits,
shown by the CPC. For the High-End Suits the short-term effect
would be a loss of $1,000,000 in profits and a long-term increase in
profits by $500,000. The decision would be based on whether the
company was more concerned with short-term or long-term. If
Manuel Inc. is more concerned about short-term effects from
dropping a division, it would most likely drop the Winter Outerwear
division due to a smaller loss in initial profits. However, if the
company was more concerned with long-term positioning, it would
drop the High-End Suits division due to a higher savings in the long
run.
19-3
Education.
18-26 Risk Aversion; Strategy (20 min)

Johns decision about scheduling the special order involves the
conflict of three key factors: the need for maintenance, the delay of
currently scheduled jobs, and the value of the new customer in terms
of current contribution to profits as well as the later contribution to
profits from future sales to the special order customer. Risk is an
important aspect of the problem because of the risk of the equipment
failure and its consequences, plus the uncertainty about the delay for
currently scheduled jobs, irrespective of whether the equipment fails.
Because of risk aversion (we expect John to be risk averse), John will
be motivated to reject the special order since it adds risk. However,
from the perspective of the entire firm, it is desirable to accept the
special order for its current and future contributions.
The best way to handle issues such as this is to address the
risk aversion issue directly. This can be done by making sure that
Johns performance evaluation includes a reward for accepting the
special order, and that any scheduling difficulties or additional costs
due to the special order will not be charged directly to him, but
against the contribution of the special order. In this way, Johns
interests are more in line with those of the entire firm.
19-4
Education.
18-27 Research and Development: Risk Aversion and Performance

Measurement (20 min)
1. Risk aversion, the tendency to avoid actions with uncertain outcomes
(even with good probability of success), is a common trait among
managers. This leads frequently to a choice of a short-term gain that
may conflict with a long-term benefit. In the case of R&D, when
economic times are hard, very often the risk aversion and the shortterm thinking take over and R&D is reduced.
A recent Business Week article (cited below) notes this trend among
Silicon Valley venture capitalists. The article notes that the solution
to risk aversion can be to rely on the least risk-averse entity around,
the federal government. The article notes that there are discussions
of federal tax breaks to encourage increased spending in R&D. Also,
the America Competes Act, passed by Congress in 2007 but not
funded, was intended to increase funding for research and
development at universities and in corporations, as well as
improvements in science education.
While managing risk aversion may mean relying in part on external
sources of funding, it can also be accomplished by a strong emphasis
on the importance of innovation and its role in future competitiveness.
Sometimes this means that champions of research within firms will
play an important role in increasing the funding of research. The
Business Week article notes that some Silicon Valley entrepreneurs
have taken money out of their own pockets to fund research.
Budgeting and controlling activities such as R&D is difficult. Nonetheless
some control must be exercised. The firm should attempt to track the costs
and progress of individual projects. Periodically the projects should be
evaluated by the personnel doing the research, by other scientists, and by
operating managers; the goals is to assess the progress and commercial
19-5
Education.
potential of the project. These evaluations should form the basis for setting
priorities on existing projects. For new projects the firm might use a
proposal system. Researchers would prepare a short proposal outlining
planned research and its expected benefits. A committee of scientists and
operating personnel could then set priorities for the various projects. For
control of overall spending, the company's approach of comparing its
19-6
Education.
18-27 (continued -1)

spending with the spending of competitors seems reasonable.
An alternative approach, used by Hewlett-Packards PC division is to
increase R&D spending for products that can most benefit. To
determine how to target R&D effort, H-P uses a measure called R&D
productivity, which is the ratio of R&D spending on a product line to
the gross margin of the product line. Using this approach, products
with higher gross margin are allocated a higher portion of R&D
expenditures. The idea is that products with higher gross margins,
such as high-end laptops, are more likely to compete on
differentiation, and investments in innovation will be rewarded by
increased customer demand. In contrast, products with low gross
margins, the cost leaders, require a focus on cost reduction rather
than innovation. (See also Exercise 18-36, Managing the Research
and Development Department)
Sources: Steve Hamm, Is Silicon Valley Losing Its Magic?: A Road Trip
Finds Risk Aversion, Short-term Thinking, and A Few Bold Ideas,
Business Week, January 12, 2009, pp. 29-33; Cliff Edwards, How HP Got
the Wow Back, Business Week, December 22, 2008, pp. 60-61.
19-7
Education.
18-39 Financial Reporting and SBU Performance (20 min)

1. The business unit information prepared for public (external) financial
reporting purposes may not be appropriate for the evaluation of
business unit management performance because:
an allocation of common costs incurred for the benefit of more
than one business unit must be included for public reporting
purposes,
in external financial reports, common costs are often allocated on
an arbitrary (non-causal) basis,
the business units identified for public reporting purposes may not
coincide with actual managerial responsibilities. A business unit
may have different operating responsibilities in practice than that
described in the financial report. For example, for simplicity the
annual report may group operations into geographical-based
categories (foreign versus domestic; western states versus
Midwest, etc. ), when instead unit managers are given
responsibility for product lines including all areas in which the
product is sold.
If business unit leaders performance is evaluated on the basis of
the information in the annual financial report, unit managers may
become frustrated and dissatisfied because they would be held
responsible for an earnings figure that includes the arbitrary
allocation of common costs and costs traceable to but not
controllable by them. This type of performance evaluation is unfair
to managers and does little to motivate them. As a result of this
dissatisfaction, the best managers may seek employment
elsewhere.
19-8
Education.

2. The company should consider establishing profit centers for its
business units. The contribution income statement should be used to
evaluate Samentech Inc.s business unit managers. The contribution
income statement is the best measure of performance because it
distinguishes both:
a) traceable and nontraceable costs, and
b) controllable and uncontrollable costs (some costs might be
traceable to a unit, but not controllable in the short term, as for example
the cost of facilities.)
The determination of whether noncontrollable costs should be charged to
division is a complex issue. For example, the managers in this case are
choosing a higher cost insurance coverage in order to maintain some
local flexibility. If insurance costs are not charged to the unit managers,
there is no incentive for them to choose a cost-saving insurance plan. In
this case, the desired incentive might be achieved by allocating the cost
of insurance (for example, on the basis of headcount, number of claims,
or some measure that is related to the use of insurance), thereby
providing the incentive for the managers to get together and choose a
cost-saving join policy.
Many times it can be advantageous to compare the managers
performance to a budget, where the budget is determined with an explicit
consideration of conditions in the industry for that unit. This way
managers are not rewarded or penalized for favorable or unfavorable
conditions within the market place that are beyond their control.
Also, the company should consider using the balanced scorecard, in
order to include in the performance measurement all of the critical
success factors that managers should attend to in order to align their
performance with the companys strategic goals.
3. Using the BSC and the contribution income statement should help
Samentech Inc. bring its managers decision making more in line with
overall corporate strategy. It will specifically help control the lack of
motivation and cooperation that is commonplace in Samentech Inc.s
current operations.
19-9
Education.
18-54 Centralization vs Decentralization; Banking (30 min)

1. The following advantages are attributed to a decentralized
organizational structure:
The manager making the decisions is closer to the situation and
can make better and faster decisions.
Top management has more time for strategic decisions and longrange planning because operational decisions are made at lower
levels.
Greater freedom and responsibility provide greater opportunity for
individual development, innovation, and creative decisions.
Excellent training in decision-making is provided for lower level
managers resulting in a pool of trained managerial talent.
2. The following disadvantages of a decentralized structure and their
effect on RNB are as follows.
There is an increased risk of loss of control. RNB does not have
sufficient control over its individual banks as evidenced by the
unique packaged accounts, inter-bank competition, and
conflicting advertising.
19-10
Education.

There is less information flow to top levels. The individual banks
sometimes failed to notify the executive office of their plans and
programs.
Duplication of effort may result. This is the case at RNB as
evidenced by advertising campaigns for the state-wide group and
for the individual banks.
An important advantage of centralized structures is the opportunity
to more effectively employ internal accounting controls systems to
prevent and detect errors and fraud. These types of systems are
especially important in financial service companies where the
assets are so liquid.
3. The change appears to be risky. RNB has built a successful
business on the basis of local bank autonomy, allowing the local bank
executives to develop products and services that fit the needs of their
local customers. Local managers should be in the best position to
determine how to improve customer satisfaction. The reduction of
local autonomy will also likely have a negative impact on the
motivation of the local managers and on the effectiveness of RNBs
management incentive plans.
The concerns about duplication of effort and loss of control are valid
concerns, and it may be that for the bank to successfully implement new
strategic initiatives, more top level control will be necessary. For
example, if the firm wants to appeal to the type of customer that needs
higher-level services of the type that would require coordination from a
centralized office, or if the customers are large businesses that will need
to deal with many of RNBs local banks in a coordinated manner, then a
greater emphasis on centralization would be advisable.
19-11
Education.
18-55 Balanced Scorecard; Strategic Business Units; Ethics

(40 min)
1. The new CEO made the correct decision because the increased
contribution of sales from lighting fixtures upscale and electronic
timing devices more than made up for the increased selling costs and
the lost sales in the mid-range unit. This is due largely to the fact that
the mid-range units had relatively low margins in comparison to those
in the upscale unit and the timing devices unit.
2.
a. The benefits that an organization realizes from business unit
reporting include the following:
Improved evaluation of profit contributions of divisions, plants,
product lines, and sales territories because of the separation of
traceable and nontraceable costs and the separation of
controllable and non-controllable costs.
Better consideration of decisions such as eliminating
unprofitable business units, providing special attention to
problem business units, and allocating capital to the most
promising business units.
b. Business unit reporting on a variable cost basis not only focuses
on costs that vary with production and sales but also requires the
segregation of fixed costs between traceable fixed costs (i.e., those
directly assignable to the business unit) and common fixed costs.
Traceable fixed costs can also be further distinguished as controllable
or not. Controllable fixed costs could be discontinued if the business
unit were to be discontinued. Thus, variable costing allows
management to focus on the profit contribution of decisions or
actions. Under full costing the allocation of fixed manufacturing costs
to inventory and cost of goods sold can introduce a bias into the
calculation of profit, since profit under full costing is affected by
changes in inventory levels.
19-12
Education.

3. The current approach of allocating common fixed expenses on the
basis of units produced is unfavorable to the Electronic Timing
Devices unit. The effect of the deletion of the unit in the Lighting
division and the increased production and sales in the electronics unit
has had the effect of increasing the amount of common fixed
expenses allocated to the Electronic Timing Devices unit. The
allocated amount is projected to be $195 relative to a budget of $120.
PWC should either keep the budgeted allocation or exclude the
allocation of common costs in the evaluation of unit managers.
4.The actions contemplated by the Lighting Fixtures Division
controller (i.e., deferring some revenues into the next year and
accruing, in the current year, expenditures that are applicable for the
next year, because of better than expected performance in the
current year) are considered unethical as they would be in conflict
with the specific standards from Institute of Management Accountants
"Standards of Ethical Conduct for Management Accountants
(relevant portions shown below). These actions are in conflict with
the controllers responsibility to appropriately report net income under
generally accepted accounting principles. The reporting obligations
are governed by the American Institute of CPAs as well as the
Institute of Management Accountants.
Institute of Management Accountants Standards of Ethical Conduct:
I. COMPETENCE
Each member has a responsibility to:
1. Maintain an appropriate level of professional expertise by
continually developing knowledge and skills.
2. Perform professional duties in accordance with relevant laws,
regulations, and technical standards.
3. Provide decision support information and recommendations that
are accurate, clear, concise, and timely.
19-13
Education.

4. Recognize and communicate professional limitations or other
constraints that would preclude responsible judgment or successful
performance of an activity.
II. CONFIDENTIALITY
1. Keep information confidential except when disclosure is
authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential
information. Monitor subordinates activities to ensure compliance.
3. Refrain from using confidential information for unethical or illegal
advantage.
III. INTEGRITY
1. Mitigate actual conflicts of interest. Regularly communicate with
business associates to avoid apparent conflicts of interest. Advise all
parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice
carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might
discredit the profession.
19-14
Education.
IV. CREDIBILITY
1. Communicate information fairly and objectively.
2. Disclose all relevant information that could reasonably be
expected to influence an intended users understanding of the
reports, analyses, or recommendations.
3. Disclose delays or deficiencies in information, timeliness,
processing, or internal controls in conformance with organization
policy and/or applicable law.
5. The balanced scorecard for PWC
A variety of answers are possible. The important point is that the
balanced scorecard allows the firm to measure performance in a way that
is aligned with the firms strategy. For example, since customer service is a
key strategic factor, it should be included in performance evaluation, though
it does not appear to be included currently. Therefore, a good answer
should take into account PWCs business strategy. The firm focuses on
downstream rather than upstream activities in the value chain. It has a
strong record in customer service, and has chosen to be a follower in
product innovation. Also, the firm once felt that a broad diversification in
the lighting division was necessary to attract customers, but the new CEO
has decided to concentrate on the upscale line. Can this be achieved with
a continued emphasis on customer service, without additional efforts in
product innovation?
19-15
Education.

Since customer service is critical, the balanced scorecard should begin with
the customer perspective. The learning and innovation perspective might
be left for last or omitted because of the firms approach in this area, while
the financial and operations perspectives should get a second and third
ranking of importance. Some suggested measures in each perspectives
follow. Each measure should be determined for each business unit, and
when practical, for each product line and sales region.
Customer Perspective
Number of new customers this period
Number of customers lost this period
Number of complaints
Customer satisfaction, as measured by reports from sales reps
and by direct report from customers
Average lead time
Advertising expenditures
Financial Perspective
Contribution margin
Controllable margin
Contribution by CPC
Sales growth
Change in stock price
Selected financial ratios: the current ratio, gross margin
percentage, etc.
Operations Perspective
Cycle time
Level of work-in-process inventory
Plant efficiency, by work unit
Delivery time
18-59 Performance Measurement; Balanced Scorecard; Hospital (20

min)
1. The number of perspectives was likely reduced to further refine the
focus of the scorecard and the performance measurement system. Too
many perspectives and critical success factors could reduce the desired
19-16
Education.
emphasis on key measures. The two perspectives, quality and process

improvement, were combined in 2001, for this reason. Both of these
perspectives were related to performance in meeting patients expectations
through improved operations, and the combination of the two provide
greater focus on operational improvement. The remaining four
perspectives could be related to the conventional balanced scorecard in the
following way:
Perspectives in the BHHS and Conventional Balanced Scorecard:
BHHS Scorecard (2001)
Balanced Scorecard
Organizational Health
Learning and Innovation
Process and Quality Improvement
Operational Performance
Volume and Market Share Growth
Customer
Financial Health
Financial
19-17
Education.

1. The CSFs used by BHHS in the 2000 BSC include the following:
Organizational
percentage of employee development plans in
Health
place, number of employee survey action plans,
job vacancy rates, turnover rates
Process
Improvement
operating room turnaround time, number of

physicians using online hospital clinical information
systems
Quality Improvement
patient satisfaction survey scores, patient safety

measures, score on Connecticut quality award,
measurable progress to implementing a minimally
invasive surgery program
Volume and Market

Share Growth
medical volume, surgical volume, urgent care visits,

primary care visits, home care visits
Financial Health
measured growth in group purchasing, measured

growth in funding, managed care price increases,
cost per discharge
3. The scorecard perspectives appear to be correctly aligned with the

mission statement which has goals for improvement in terms of patient
care, physician satisfaction, and overall staff satisfaction. The
perspectives of process and quality improvement should support the
satisfaction of patients, while the focus on the organizational health
perspective should help support physician and staff satisfaction. However,
it appears that the critical success factor measures are not as clearly
targeted. For example, none of the critical success factors noted in the
article directly address physician satisfaction. Physician satisfaction could
be directly measured by survey or indirectly, by tenure, turnover, salary and
benefits, and related measures.
19-18
Education.
19-19
Education.

4.
The strategy map is likely to follow the sequence of perspectives
provided in the article.
Organization Health, as the foundation of the
strategy map, supports
Process Improvement, which in turn supports
Quality Improvement, which in turn supports
Volume and Market Share Growth, which finally
supports
Financial Results
5.
It is unlikely that a profit center approach alone would be able to
capture the breadth of goals that BHHS has. In this case, because of the
breadth of its mission and goals, BHHS has chosen the use of multiple
measures, in the form of a balanced scorecard.
Source: Journey to Destination 2005, by Andra Gumbus, Bridget Lyons,

and Dorothy E. Bellhouse, Strategic Finance, August 2002, pp. 46-50.
19-20
Education.
19-1 Investment centers are commonly used when there are a number of business units
to be compared, and/or when top management intends to evaluate the economic
performance of the business unit relative to alternative investments. By definition,
managers of these business units exercise control over revenues, costs, and the
level of investment in the business unit. The profit per dollar invested (usually
called the return) can be compared to the rate of return for alternative
investments other types of business units or other investment possibilities.
Commonly, the rate of return is determined by taking the ratio of the amount of
profit divided by the amount invested in the business unit.
19-2 Return on investment (ROI) is the ratio of some measure of profit to some
measure of invested capital for the business unit.
19-3 The primary measurement issues for ROI are:
1. The effect of accounting policies, which affect the determination of income.
2. Other measurement issues for income, which include the handling of nonrecurring items in the income statement, differences in the effect of income
taxes across units, differential effect of foreign currency exchange, and the
effect of cost allocation when two or more units share a facility or cost.
3. Measuring investment: which assets to include?
4. Measuring investment: whether and how to allocate the cost of shared assets.
19-4 The primary advantages of using return on investment (ROI) as a performance
indicator are:
1. It is intuitive and easily understood.
2. It provides a useful basis for comparison among SBUs.
3. It is widely used.
The primary limitations of return on investment (ROI) as a performance indicator
are:
1. It has an excessive short-term focus.
2. Investment planning uses discounted cash flow (DCF) analysis (Chapter 12),
while managers are evaluated on ROI.
3. It contains a disincentive for new investment by the most profitable units.
19-5 We can enhance the ROI measures usefulness by making it the product of two
ratios:
ROI = (Profit Sales) (Sales Assets)
19-21
Education.
ROI = Return on Sales Asset Turnover

ROI = ROS AT
Return on sales (ROS) is the firms profit per sales dollar and it measures the unit
managers ability to control expenses and increase revenues to improve
profitability. For divisions (investment centers), profit is usually interpreted as
operating profit. For the company as a whole, profit can be defined as net
income.
Asset turnover, the amount of sales achieved per dollar of investment, measures
the managers ability to manage both sales and assets, that is, to produce
increased sales from a given level of investment in assets. Together, the two
components of ROI tell a more complete story of the managers performance and
enhance top managements ability to evaluate and compare the different units.
19-6 The key advantage of residual income (RI) is that it deals effectively with the
limitation of ROI: ROI has a disincentive for the managers of the most profitable
units to make new investments. With residual income, no matter how profitable
the unit, there is still an incentive for new profitable investment. In contrast, a key
limitation is that since RI is not a percentage, it suffers the same problem of using
the amount of investment-center profit in that it is not useful for comparing units
of significantly different sizes. It favors larger units that would be expected to
have larger residual incomes, even with relatively poor performance. Moreover,
relatively small changes in the desired minimum rate of return can dramatically
affect RI for different-sized units. And, in contrast to ROI, some managers do not
find RI to be as intuitive and as easily understood.
19-7 Economic value added (EVA) is a profitability measure that approximates the
economic earnings of an investment center. Operationally, we define EVA as
business units income after-tax cash earnings and after deducting an imputed
charge of the level of invested capital in the business unit. On the surface, RI and
EVA look confusingly similar. There is a major difference, however. Residual
income (RI) is calculated entirely using reported accounting data, for income and
for assets (level of invested capital). As such, the resulting measure of
profitability suffers from all of the limitations associated with historical-based
accounting statements. By contrast, EVA attempts to approximate economic,
rather than accounting, earnings and level of invested capital.
Thus, RI and EVA are similar in form but are strikingly different in terms of
measurement. Thus, the overall objective of EVA is to provide an estimate of
the value added to (or destroyed by) each strategic investment unit during a
given period. As such, EVA is one approach to what we call Value-Based
Management.
19-22
Education.
19-8 The three most widely accepted methods are: (1) the comparable uncontrolled
price method, (2) the resale price method, and (3) the cost-plus method. The
comparable controlled price method establishes an arms length price by using
the sales prices of similar products made by unrelated firms. The resale price
method is based on determining an appropriate markup, where the markup is
based on gross profits of unrelated firms selling similar products. The cost-plus
method determines the transfer price based on the sellers costs, plus a gross
profit percentage determined from comparison of sales of the seller to unrelated
parties, or sales of unrelated parties to other unrelated parties.
19-9 The arms-length standard says that transfer prices should be set so they reflect
the price that would have been set by unrelated parties acting independently. It is
used to set transfer prices on global business such that the countries affected will
accept the cost and revenue information for tax and customs purposes.
19-10 Expropriation happens when a foreign government takes ownership and control
of assets the domestic investor has invested in that country. When there is a
significant risk of expropriation, the domestic firm can take appropriate actions
such as limiting new investment, developing improved relationships with the
foreign government, and setting the transfer price such that funds are removed
from the foreign country as quickly as possible.
19-41 Return on Investment (ROI); Residual Income (RI) (45 minutes)

1. The calculation of the unit contribution margin for Reigis Steel Division,
assuming 1,500,000 units were produced and sold during the year
ended November 30, 2016 is presented below.
Reigis Steel Division
Operating Statement
For the Year Ended November 30, 2016
($000 omitted)
Sales Revenue
Less Variable Costs
Cost of Goods Sold
Selling Expenses ($2,700 (1/3))
Contribution Margin
$36,000
$18,675
900
19,575
$16,425
Contribution margin per unit = $16,425 1,500 = $10.95

2. Calculations of selected performance measures for 2016 for Reigis Steel
Division are presented below
19-23
Education.
a. The pretax return on average investment in operating assets

employed is 13.16%, calculated as follows:
ROI = Income from operations before taxes average operating
assets
= $10,625,000 $80,750,000 = 13.16%
b. The calculation of residual income (RI) on the basis of average
operating assets employed is as follows:
RI = income from operations before taxes minimum
required return on average assets
= $10,625,000 ($80,750,000 0.09)
= $10,625,000 $7,267,500
= $3,357,500
19-24
Education.
19-41 (continued)
3. The management of Reigis Steel would be more likely to accept the
contemplated capital acquisition if residual income (RI) were used as the
performance measure because the investment would increase both the
divisions residual income and management bonuses. Using residual
income (RI), management would accept all investments with a return
higher than 9% as these investments would all increase the dollar value
of RI. When using ROI as a performance measure, Regis management
is likely to reject any investment that would lower the current overall ROI
(13.16% for 2016), even though the return is higher than the required
minimum, as this would lower bonus rewards.
4. Reigis must be able to control all items related to profits and investment
if it is to be evaluated fairly as an investment center using either ROI or
residual income (RI) as a performance measure. Reigis must control all
elements of the business except the cost of invested capital, that being
controlled by Consolidated Industries.
19-25
Education.
19-42 Calculating Return on Investment (ROI) and Residual Income (RI);

Comparing Results (25 minutes)
1. a. ROI = Operating Income Average Assets
= $2,440,000 {[$16,000,000 + ($16,000,000 1.06)] 2}
= $2,440,000 (($16,000,000 + $15,094,340) 2)
= $2,440,000 $15,547,170 = 15.69%
b. RI = Operating Income (Avg. Assets Min. pre-tax rate of return)
= $2,440,000 ($15,547,170 0.10)
= $2,440,000 $1,554,717
= $885,283
2. In this case residual income (RI) provides the desired incentive for local
managers to make investments desired by top management. Delta
management would have accepted the opportunity if RI were the
performance measure.
3. Like many organizations, Blackwood Industries should benefit from a
management control system which gives explicit attention to strategic
factors. The balanced scorecard (BSC) would be a useful approach to
accomplish this objective. The BSC considers not only financial factors,
but also non-financial factors such as progress with customer relations,
improvements in operations, and improvements in capabilities of
employees. The balanced scorecard would thus be a useful
supplement to financial-performance indicators such as ROI or residual
income (RI). In evaluating an investment center, performance should
be measured by only those factors over which management has
control. These include not only the revenues, costs, and assets used in
the calculation of ROI and RI, but also the critical success factors,
which are likely to include both financial and non-financial types of
information in the balanced scorecard.
19-26
Education.
19-47 General Transfer-Pricing Rule; Goal Congruence (30-40 Minutes)

1. Using the general guideline presented in the chapter, the minimum price
at which the Transmission Division (i.e., the producer) would sell
standard transmissions to the Auto Division (i.e., the buyer) is $1,350 per
unit, the incremental costs. The Transmission Division currently has idle
capacity (it is currently working at 75% of capacity). Therefore, its
opportunity cost for an internal sale is zerothe Transmission Division
does not forgo any external sales and, as a result, does not forgo any
contribution margin from making internal transfers. Transferring standard
transmissions at incremental cost achieves goal congruence in the
sense that it induces the correct decision from the standpoint of the
company as a whole.
2. Transferring products internally at incremental cost has the following
properties:
a. Achieves goal congruence? Yes, as described in requirement 1
above.
b. Useful for evaluating division performance? No, because this transfer
price does not cover or exceed full costs. By transferring at
incremental costs and not covering fixed costs, the Transmission
Division will show a loss. This loss, the result of the incremental costbased transfer price, is not a good measure of the economic
performance of the subunit.
c. Motivating management effort? Yes, if based on budgeted costs
(actual costs can then be compared to budgeted costs). If, however,
transfers are based on actual costs, the management of the
Transmission Division has little incentive to control costs.
d. Preserves division autonomy? No. Because it is rule-based, the
Transmission Division has no say in the setting of the transfer price.
3. If the two divisions were to negotiate a transfer price, the range of
possible transfer prices will be between $1,350 and $1,875 per unit. The
Transmission Division has excess capacity that it can use to supply
transmissions to the Auto Division. The Transmission Division will be
willing to supply the transmissions only if the transfer price equals or
exceeds $1,350, its incremental cost of manufacturing each standard
19-27
Education.
19-47 (Continued)
transmission. The Auto Division will be willing to buy units from the
Transmission Division only if the price does not exceed the external
market price of $1,875 per unit. Within the price range of $1,350$1,875,
each division will be willing to transact with the other and maximize
overall income of American Motors. The exact transfer price between
$1,350 and $1,875 will depend on the bargaining strengths of the two
divisions. The negotiated transfer price has the following properties.
a. Achieves goal congruence? Yes, as described above.
b. Useful for evaluating division performance? Yes, because the transfer
price is the result of direct negotiations between the two divisions. Of
course, the transfer prices will be affected by the bargaining strengths
of the two divisions.
c. Motivating management effort? Yes, because once negotiated, the
transfer price is independent of actual costs of the producing division.
Thus, management of this division has every incentive to manage
efficiently to improve profits.
d. Preserves subunit autonomy? Yes, because the transfer price is
based on direct negotiations between the two divisions and is not
specified by headquarters on the basis of some rule (such as the
producing divisions incremental costs).
4. Neither method is perfect, but negotiated transfer pricing (requirement 3)
has more favorable properties than the cost-based transfer pricing
(requirement 2). Both transfer-pricing methods achieve goal
congruence, but negotiated transfer pricing facilitates the evaluation of
divisional performance, motivates management effort, and preserves
division autonomy, whereas the transfer price based on incremental cost
does not achieve these objectives.
19-28
Education.
19-48 Transfer-Pricing Methods (50 minutes)

1. a. The positive and negative motivational implications arising from
employing a negotiated transfer price system for goods exchanged
between divisions include the following:
Positive:
Both the buying and selling divisions have participated in the
negotiations and are likely to believe they have agreed on the best
deal possible.
Negotiating and determining transfer prices will enhance the
autonomy/independence of the divisions.
Negative:
The result of a negotiated transfer price between divisions may not
be optimal for the firm as a whole and therefore will not be goal
congruent.
The negotiating process may cause harsh feelings and conflicts
between divisions. (The process is viewed as a zero-sum game.)
The negotiating process itself may be costly and time-consuming.
b. The motivational problems that can arise from using actual full
(absorption) manufacturing cost as a transfer price include the
following.
Full-cost transfer pricing is not suitable for a decentralized
structure where the autonomous divisions are measured on
profitability as the selling unit is unable to realize a profit.
This method can lead to decisions that are not goal congruent if
the buying unit decides to buy outside at a price less than the full
cost of the selling unit. If the selling unit is not operating at full
capacity, it should reduce the transfer price to the market price if
this would allow the recovery of variable costs plus a portion of the
fixed costs. This price reduction would optimize overall company
performance.
19-29
Education.
19-48 (continued-1)
2. The motivational problems that could arise if Mylar Corporation decides
to change its transfer pricing policy to one that would apply uniformly to
all divisions include the following:
A change in policy may be interpreted by the divisional managers as
an attempt to decrease their freedom to make decisions and reduce
their autonomy. This perception could lead to reduced motivation.
If managers lose control of transfer prices and thus, some control
over profitability, they will be unwilling to accept the change to uniform
prices.
Selling divisions will be motivated to sell outside if the transfer price is
lower than market as this behavior is likely to increase profitability
and bonuses.
3. The likely behavior of both buying and selling divisional managers, for
each of the following transfer pricing methods being considered by Mylar
Corporation, include the following:
a. Standard full manufacturing cost plus a markup.
The selling divisions will be motivated to control costs because any
costs over standard cannot be passed on to the buying division and
will reduce the profit of the selling division.
The buying divisions may be pleased with this transfer price.
However, if the market price is lower and the buying divisions are
forced to take the transfer price, the managers of the buying
divisions will be unhappy.
b. Market selling price of the product being transferred.
Creates a fair and equal chance for the buying and selling divisions
to make the most profit they can and should promote cost control,
motivate divisional management, and optimize overall company
performance. Since both parties are aware of the market price,
there will be no distrust between the parties, and both should be
willing to enter into the transaction.
19-30
Education.
19-48 (continued-2)
c. Outlay (out-of-pocket) costs incurred to the point of transfer plus
opportunity cost per unit.
This method is the same as market price when there is an
established market price and the seller is at full capacity. At any
level below full capacity, the transfer price is the outlay cost only
(as there is no opportunity cost) which would approximate the
variable costs of the good being transferred.
Both buyers and sellers should be willing to transfer under this
method because the price is the best either party should be able to
realize for the product under the circumstances. This method
should promote overall goal congruence between managers and
the firm, should motivate managers, and should optimize overall
company profits.
19-31
Education.
19-49 Transfer Pricing; Decision Making (30-45 minutes)

1. Division B has capacity to produce 62,500 units (50,000 0.80).
Division A will require 25,000 units, which will limit Bs outside sales to
37,500 units, a loss in outside sales of 12,500 units (50,000
37,500).
The contribution for each type of sale by Division B is:
To Division A
Selling Price
$ 75
Less: Variable Costs per unit 60
Less: Variable Marketing Costs
0
Contribution Margin
$ 15
Outside
$130
70
8
$ 52
Determining the Best Decision (assuming Division A requires all

25,000 units):
The best decision in the interest of Division B is to not sell all 25,000
units to Division A:
Contribution for selling 25,000 units to Division A:
$15 25,000 = $375,000
Forgone contribution of not selling to outside consumers:
$52 12,500 = $650,000
Net operating loss to Division B for sales to Division A:
$650,000 $375,000 = $275,000
The Division B manager should reject the proposal because it
reduces Division Bs operating income by $275,000.
Also, the decision of Division B to not sell inside is in the best interest
of the firm as a whole. The savings to the firm of Division A buying
inside would be $500,000 (savings of $80 $60 25,000 units),
while the opportunity cost of lost sales is $650,000 [($130 $78)
12,500] for a net loss to the firm of $150,000 ($650,000 $500,000).
19-32
Education.
19-49 (continued)
If Partial Sales to Division A are OK:
Division B should sell as many units as possible (in this case 50,000
of total demand) to outside consumers. The remaining capacity (20%,
or 12,500 units) should be used to provide Division A with equipment.
2. Assuming that Division B limits its sales to Division A to the excess
capacity of 12,500 units, the best transfer price should fall in the range
of $60 (Division Bs variable cost) and $80 (the outside purchase cost
to Division A). The two divisions should negotiate to determine the
desired price in this range. A price of $60 would allocate all the profit
on the manufacture of the equipment to Division A, while a price of $80
would allocate all the profit to Division B. Any price less than $60 would
be unacceptable to Division B, and any price greater than $80 would
be unacceptable to Division A. It appears that a fair price of
approximately $70 should be determined for these internal sales. The
important point from the firms view is that these 12,500 parts should
be purchased internally, since the internal cost of $60 is less than the
external cost of $80. It is up to the two divisions to determine the right
price, but to fail to transfer the units would not be acceptable from the
overall firms view.
P=$80
O/S
P=$75 (what division A wants)

V=$60
O/S
B
Bs Capacity = 62,500
P=$130
V=$78
19-33
Education.
19-50 Transfer Pricing; Strategy (45 minutes)

1. There are three options for the commercial division: buy from the
internal supplier (the industrial division), buy from Admiral Electric, or
buy from Advanced Micro. The analysis follows, from the perspective of
FMI:
Buy inside from the industrial division:
Cost to FMI (assuming the Industrial Division is at full capacity):
Ind. Div.s variable cost: $155 5,000
$775,000
Plus: lost contribution on Industrial Division
sales: ($205 $155) 5,000
250,000
$1,025,000
$1,025,000 5,000 = $205 per unit
Buy from Admiral Electric: Cost to FMI is $210. The contribution on
sales to Admiral by the industrial division is ignored because these
sales are not contingent on the commercial divisions decision.
Buy from Advanced Micro: Cost to FMI: $200
Best decision for FMI: have the commercial division buy from
Advanced Micro, presuming the parts sold by Advanced Micro and
Admiral Electric are of equivalent quality and service. The cost is the
lowest, at $200.
The best transfer price, which would cause the buying division to
autonomously make the correct decision, would be to use the selling
divisions market price of $205.
2.
If the sales to Admiral Electric by the industrial division were

contingent on the commercial divisions decision, the relevant cost to
FMI would be the price of $210 5,000 units (amount needed over
the capacity of the industrial division). The net cost would then be the
cost of $210 5,000 = $1,050,000 less the contribution from the
sales to Admiral Electric, 650 ($95 $65) = $19,500, or $1,030,500,
or $206.10 per unit. The correct transfer price would not change but
would still be $205, as in part 1.
19-34
Education.
19-50 (continued)
3. The decision to have the commercial division buy outside to reduce
overall costs is also consistent with a strategy of decreasing the
reliance of the commercial division on products from the industrial
division. If top management is unsure about the growth potential of the
industrial division and has declined any new investments there,
perhaps the future holds capacity reduction or divestment of the
industrial division. On the other hand, it appears that the outside sales
of the industrial division are currently quite strong. There is a good
margin of $50 on its sales of part 23-6711 outside the company.
Moreover, it appears that Admiral Electric intends to continue to buy
part 88-461 from the industrial division, irrespective of the commercial
divisions decision. This is a positive statement about the quality of the
industrial divisions product and the quality of its relationship with
Admiral. Perhaps top management should rethink its long-term
strategy for the industrial division.
19-35
Education.
19-51 Strategy; Strategic Performance Measurement; Transfer Pricing

(50 minutes)
1. Transfer prices based on cost are not appropriate as a divisional
performance measure, and among the reasons are because they:
provide little incentive for the selling division to control manufacturing
costs as all costs incurred will be recovered
often lead to suboptimal decisions for the company as a whole
2. Using the market price as the transfer price the contribution margin for
both the Mining Division and the Metals Division for the year ended May
31, 2016 is as calculated below.
Ajax Consolidated Calculation of
Divisional Contribution Margin
For the Year Ended May 31, 2016
Selling Price
Less: Variable costs
Direct materials
Direct labor
Manufacturing overhead (1)
Transfer price
Unit contribution margin
Volume
Total contribution margin
Mining Division
$90
12
16
24
0
$38
400,000
$15,200,000
Metals Division
$150
6
20
10
90
24
400,000
$9,600,000
Notes:
(1) Variable overhead = $32 75% = $24 for mining division;
Variable overhead = $25 40% = $10 for metals division
(2) The $5 variable selling cost that the Mining Division would incur for
sales on the open market should not be included as this is an
internal transfer.
19-36
Education.
19-37
Education.
19-51 (continued)
3. If the use of a negotiated transfer price was instituted by Ajax
Consolidated, which also permitted the divisions to buy and sell on the
open market, the price range for toldine that would be acceptable to both
divisions would be determined as follows.
The Mining Division would prefer to sell to the Metals Division for the
same price it can obtain on the outside market, $90 per unit. However,
Mining would be willing to sell the toldine for $85 per unit as the $5
variable selling cost would be avoided.
The Metals Division would prefer to continue paying the bargain price of $66 per unit. However, if Mining does
not sell to Metals, Metals would be forced to pay $90 on the open market. Therefore, Metals would be satisfied
to receive a price concession from Mining equal to the costs that Mining would avoid by selling internally.
Thus, a negotiated transfer price for toldine between $85 and $90 would benefit both divisions and the
company as a whole.
4. A negotiated transfer price is the most likely to elicit desirable

management behavior as it will:
Encourage the management of the Mining Division to be more
conscious of cost control
Benefit the Metals Division by providing toldine at less cost than its
competitors
Provide a more realistic measure of divisional performance.
19-38
Education.

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Chapter 19 - Strategic Performance MeasurementInvestment Centers

Strategic performance measurement is a management accounting system used by top

An investment center evaluation includes assets employed by the center

Chapter 19 - Strategic Performance MeasurementInvestment Centers

There are four behavioral/implementation issues for SBUs:

Chapter 19 - Strategic Performance MeasurementInvestment Centers

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-26 Risk Aversion; Strategy (20 min)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-27 Research and Development: Risk Aversion and Performance

Chapter 19 - Strategic Performance MeasurementInvestment Centers

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-27 (continued -1)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-39 Financial Reporting and SBU Performance (20 min)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-39 (continued -1)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-54 Centralization vs Decentralization; Banking (30 min)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-54 (continued -1)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-55 Balanced Scorecard; Strategic Business Units; Ethics

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-55 (continued -1)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-55 (continued -2)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-55 (continued -3)

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-55 (continued -4)

18-59 Performance Measurement; Balanced Scorecard; Hospital (20

Chapter 19 - Strategic Performance MeasurementInvestment Centers

emphasis on key measures. The two perspectives, quality and process

BHHS Scorecard (2001)

Learning and Innovation

Process and Quality Improvement

Volume and Market Share Growth

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-59 (continued -1)

operating room turnaround time, number of

patient satisfaction survey scores, patient safety

Volume and Market

medical volume, surgical volume, urgent care visits,

measured growth in group purchasing, measured

3. The scorecard perspectives appear to be correctly aligned with the

Chapter 19 - Strategic Performance MeasurementInvestment Centers

Chapter 19 - Strategic Performance MeasurementInvestment Centers

18-59 (continued -2)

Source: Journey to Destination 2005, by Andra Gumbus, Bridget Lyons,

Chapter 19 - Strategic Performance MeasurementInvestment Centers

Chapter 19 - Strategic Performance MeasurementInvestment Centers

ROI = Return on Sales Asset Turnover

Chapter 19 - Strategic Performance MeasurementInvestment Centers

19-41 Return on Investment (ROI); Residual Income (RI) (45 minutes)

Contribution margin per unit = $16,425 1,500 = $10.95

Chapter 19 - Strategic Performance MeasurementInvestment Centers

a. The pretax return on average investment in operating assets

Chapter 19 - Strategic Performance MeasurementInvestment Centers

Chapter 19 - Strategic Performance MeasurementInvestment Centers