Keywords: performance measurement, decentralization, responsibility accounting, ROI, residual income, transfer pricing, service department cost allocation, managerial accounting
Introduction
In today’s complex business environment, organizations are increasingly adopting decentralization to boost responsiveness, empower employees, and drive innovation. However, decentralization also presents unique challenges for performance measurement and control. This article explores the core principles of performance measurement in decentralized organizations, including ROI, residual income, transfer pricing, and service department cost allocation—equipping you with the tools and understanding to drive effective decision-making and accountability at every level.
What Is Decentralization in Organizations?
Decentralization refers to distributing decision-making authority throughout an organization, empowering lower-level managers to make decisions for their specific units or departments. This approach contrasts with centralized management, where most decisions are made at the top.
Benefits of Decentralization
- Strategic Focus for Top Management: Senior leaders can concentrate on high-level strategy.
- Better Information at Lower Levels: Managers closer to operations often have superior knowledge for day-to-day decisions.
- Agility and Responsiveness: Lower-level managers can respond more quickly to customer needs and market changes.
- Development of Managerial Talent: Decentralization helps develop future leaders by giving managers valuable decision-making experience.
- Greater Job Satisfaction: Empowered managers often enjoy higher motivation and engagement.
Disadvantages of Decentralization
- Lack of Big Picture Perspective: Lower-level managers may not always align with company-wide goals.
- Coordination Challenges: Independent decisions can lead to duplication or inefficiency.
- Potential Conflicts of Interest: Managers may pursue their own objectives over those of the organization.
- Difficulties Sharing Innovation: Best practices may not spread quickly across decentralized units.
Responsibility Accounting: Defining Control and Accountability
Responsibility accounting is a system that holds managers accountable only for the items they can significantly control. The organization is divided into responsibility centers, each with its own manager.
Types of Responsibility Centers
- Cost Center: Manager controls only costs (e.g., a production department).
- Profit Center: Manager controls both revenues and costs (e.g., a product line).
- Investment Center: Manager controls revenues, costs, and investments in assets (e.g., a regional division).
This structure supports clear accountability and enables more precise performance evaluation.
Measuring Performance: Return on Investment (ROI)
What Is ROI?
Return on Investment (ROI) is a widely used performance metric in decentralized organizations. ROI measures how effectively a manager uses assets to generate operating income:
ROI = Net Operating Income / Average Operating Assets
- Net Operating Income typically excludes interest and taxes (focus on EBIT).
- Average Operating Assets include cash, receivables, inventory, and productive assets.
Example: Calculating ROI
Suppose Regal Company reports:
- Net operating income: $30,000
- Average operating assets: $200,000
ROI = $30,000 / $200,000 = 15%
Improving ROI
Managers can increase ROI by:
- Boosting sales
- Reducing expenses
- Using assets more efficiently
Investment Example
If Regal invests $30,000 in new equipment that increases sales and net income, and average assets rise to $230,000 with net income at $50,000, the new ROI is:
ROI = $50,000 / $230,000 = 21.8%
Criticisms of ROI
- ROI can discourage managers from making profitable investments that slightly reduce the division’s overall ROI.
- ROI can be distorted by costs outside a manager’s control.
- Without balanced scorecards or additional metrics, ROI may not encourage long-term strategic growth.
Residual Income: An Alternative Performance Measure
What Is Residual Income?
Residual Income (RI) is the net operating income earned above the required return on assets. It’s calculated as:
Residual Income = Net Operating Income – (Average Operating Assets × Required Rate of Return)
Example: Calculating Residual Income
A division with $100,000 in assets, earning $30,000, with a required return of 20%:
- Required return: 20% × $100,000 = $20,000
- Residual income: $30,000 – $20,000 = $10,000
Strengths of Residual Income
- Encourages managers to pursue investments that earn more than the company’s minimum required return—even if ROI decreases.
- Aligns manager and company goals more effectively than ROI alone.
Transfer Pricing: Managing Internal Transactions
Transfer pricing refers to the price one division charges another for goods or services transferred internally. Setting effective transfer prices is crucial for motivating managers to act in the best interest of the overall organization.
Three Primary Approaches to Transfer Pricing
- Negotiated Transfer Prices:
- Set by negotiation between buying and selling divisions.
- Pros: Preserves divisional autonomy and reflects real costs and benefits.
- Cons: May lead to conflict and inefficiency if divisions can’t agree.
- Cost-Based Transfer Prices:
- Based on the selling division’s variable or full cost.
- Pros: Simple and objective.
- Cons: May not provide incentive for cost control or profit motivation.
- Market-Based Transfer Prices:
- Set at the market price for the good or service.
- Pros: Objective and aligns internal transactions with external market realities.
- Cons: Not always applicable (e.g., if no market exists or there is idle capacity).
Example Scenario
If the selling division has idle capacity, the lowest acceptable transfer price is typically its variable cost. If there is no idle capacity, opportunity cost must be included, reflecting profits lost from not selling to external customers.
Allocating Service Department Costs
Organizations often have service departments (e.g., maintenance, IT) that support multiple operating departments.
Reasons to Allocate Service Department Costs
- Encourage responsible use of shared resources.
- Provide full cost information for decision-making.
- Motivate efficiency in service provision.
Methods of Allocation
- Variable Costs: Charged to departments based on actual usage (e.g., machine hours).
- Fixed Costs: Allocated based on long-term needs (e.g., peak-period demand), not fluctuating usage.
Example
A maintenance department’s variable costs are allocated by machine hours used, while fixed costs are distributed based on each department’s maximum required capacity.
Common Pitfalls in Performance Measurement and Cost Allocation
- Allocating fixed costs based on fluctuating bases (like sales) can create unfair incentives and departmental dissatisfaction.
- Managers may be penalized for growth or innovation if cost allocation methods are poorly designed.
- Overemphasizing financial measures like ROI can discourage valuable investments or continuous improvement.
Conclusion: Best Practices for Decentralized Performance Measurement
Performance measurement in decentralized organizations must balance autonomy, accountability, and strategic alignment. The most effective systems:
- Use a combination of financial metrics (ROI, residual income) and non-financial indicators.
- Set transfer prices that incentivize cooperation, efficiency, and company-wide benefit.
- Allocate service department costs transparently and rationally.
- Continuously review and refine measurement systems to reflect evolving business needs.
By understanding and applying these principles, organizations can unleash the full potential of decentralized management—empowering managers, improving performance, and achieving long-term success.
Tags: decentralization, performance measurement, ROI, residual income, transfer pricing, service department costs, responsibility accounting, management control, managerial accounting, business management
References:
Noreen, E., Brewer, P., & Garrison, R. (Managerial Accounting), Chapter 11: Performance Measurement in Decentralized Organizations
