Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 24 1

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Explain why and how companies decentralize Explain why companies use performance evaluation systems Describe the balanced scorecard and identify key performance indicators for each perspective Use performance reports to evaluate cost, revenue, and profit centers Use ROI, RI, and EVA to evaluate investment centers

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Explain why and how companies decentralize 1 1 3

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Top Mid-Level Front Line/Supervisory CEO, CFO, Vice Pres. Controller, Sales Mngr. Plant Mngr. SupervisorsForemen

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Global Competition Speed & efficiency Flat vs. vertical hierarchy Market centric management Requires decentralization of management How do we measure the performance of each segment? Catch

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Centralized operations All major planning and operating decisions are made by top management Decentralized operations Segmented into different divisions or operating units Unit managers make planning and operating decisions for their unit Companies decentralize as they grow Decentralization may be based on: Geographic area Product line Customer base Business function 6

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Advantages: Frees top management time Supports use of expert knowledge Improves customer relations Provides career path training Improves motivation and retention Disadvantages: Duplication of costs Problems achieving goal congruence 7

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A responsibility center is a part or subunit of an organization whose manager is accountable for specific activities (recall from Chapter 22) 8

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Explain why companies use performance evaluation systems 2 2 9

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Decentralized organizations need a system to communicate goals to segment managers Primary goals: Promoting goal congruence and coordination No one is apathetic except in the pursuit of somebody else’s goals Communicating expectations Visibility to management and workforce makes things clear Benchmarking These expectations provide objective, measureable, expectations Providing feedback Objective feedback promotes management to performance Motivate segment managers 10

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Traditional systems revolved almost entirely around financial performance Ultimate goal of a company is to generate profit Financial measures follow performance, don’t create it “Just win” mentality leads to trouble Measure causes of performance to build lasting success Management needs lead indicators Find out what causes success, and measure that Strong indicators of future success, not just past success Top management needs signals that assess and predict performance over longer periods of time 11

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Each of the following managers has been given certain decision-making authority: a. Manager of Holiday Inn’s Central Reservation Office b. Managers of various corporate-owned Holiday Inn locations c. Manager of the Holiday Inn Corporate Division d. Manager of the Housekeeping Department at a Holiday Inn e. Manager of the Holiday Inn Express Corporate Division f. Manager of the complimentary breakfast buffet at a Holiday Inn Express 1.Classify each of the managers according to the type of responsibility center they manage 12 Revenue center Profit center Investment center Cost center Investment center Cost center

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe the balanced scorecard and identify key performance indicators for each perspective

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A major shift in corporate performance measurement Recognizes that financial measures are only one type of measure among many Uses key performance indicators (KPI) Select ones that drive/cause/lead performance Well aligned with mission-centric management Management needs to consider other critical factors: Customer satisfaction Operational efficiency Employee excellence AND of course, financial performance 14

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 16

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How do we look to shareholders? Ultimate goal is to generate income for owners Strategy revolves around increasing the company’s profits, for example: Increasing revenue growth Introducing new products, gaining new customers, and increasing sales Increasing productivity/profitability Reducing costs and using the company’s assets more efficiently KPIs: Sales revenue growth Gross margin growth Return on investment 17

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How do customers see us? Top priority for long-term success Customer satisfaction critical to achieving the company’s financial goals Typical customer concerns: Product price Product quality Sales service quality Product delivery time KPIs: Customer satisfaction Market share and increasing number of customers Repeat customers Rate of on-time deliveries 18

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. What business processes must we excel in to satisfy customer and financial objectives? Three factors critically affect customer satisfaction: Innovation—must continually improve existing products and develop new products Operations—lean and effective internal operations, product efficiency and product quality Post-sales service—service customers after the sale Sample KPIs: The number of new products developed or new-product development time The number of units produced per hour and defect rate The number of warranty claims received, average repair time, and average wait time 19

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How can we continue to improve and create value? Measures employee skills, knowledge, motivation, and empowerment Employee capabilities–skilled, positive culture,and up-to-date technology System capabilities–insightful information systems, strong internal processes, and efficient finances Corporate culture–supports communication, change, and growth KPIs: Hours of employee training, employee satisfaction and turnover, and number of employee suggestions implemented Percentage of employees with access to customer data and percentage of processes with real-time feedback Employee turnover rate 20

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Four Teams of victims: Case 1 Case 2 Case 3 Case 4 List possible “Gaming” approaches by people trying to achieve the new goal. Create a balanced scorecard basket of measures considering your experience above & explain why it will align behavior with the well being of all involved. Financial Customer Internal processes Learning/Growing Subliminal thought #3: “I better volunteer right away so I can stop thinking about dinner.”

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider the key performance indicators listed below. Classify each of the key performance indicators according to the balanced scorecard perspective it addresses. Choose from financial perspective, customer perspective, internal business perspective, or learning and growth perspective. a. Number of employee suggestions implemented b. Revenue growth c. Number of on-time deliveries d. Percentage of sales force with access to real-time inventory levels 23 Learning and growth perspective Financial perspective Customer, Internal business perspective Learning and growth perspective

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. e. Customer satisfaction ratings f. Number of defects found during manufacturing g. Number of warranty claims h. ROI i. Variable cost per unit j. Percentage of market share 24 Customer perspective Internal business perspective Financial perspective Customer perspective

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. k. Number of hours of employee training l. Number of new products developed m. Yield rate (number of units produced per hour) n.Average repair time o. Employee satisfaction p. Number of repeat customers 25 Learning and Growth perspective Internal business perspective Learning and Growth perspective Customer perspective

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use performance reports to evaluate cost, revenue, and profit centers

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Capture the financial performance of cost, revenue, and profit centers Look for large variances in % and $$$ Cost center Includes information on actual traceable costs versus budgeted costs Revenue center Includes actual revenue versus budgeted revenue Profit center Includes actual and budgeted information on both revenues and costs 27

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Control costs 28

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Generating sales revenue 29

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Producing profit through generating sales and controlling costs 30

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use management by exception to determine which variances are worth investigating Investigate material variances first Don’t play the blame game Focus on understanding underlying reasons for performance and take corrective action The numbers indicate where to start action They are not an excuse to blame and torture Recognize some variances are uncontrollable 31

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use ROI, RI, and EVA to evaluate investment centers

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Managers are responsible for: Maximizing earnings Minimizing assets utilized to minimize financing required How can we measure to two counter goals? Basic: Use a ratio to compare the two items ROI = Return ÷ Investment Complex: Use residuals to assess earnings Performance measures: How much operating income the division is generating How efficiently the division is using its assets KPIs 33

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. ROI compares Profits to Investment required, thereby helping maximize earnings per dollar invested ROI is size-independent, easily comparing small to large divisions. ROI carries an odd side effect that sometimes leads managers to decline profitable projects.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. ROI = Operating income Average total assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. (L+OE) Cash, accounts receivable, inventory, plant and equipment, and other productive assets. (L+OE) Income earned by the segment

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Royal Division reports the following: Operating income $ 30,000 Average total assets $ 200,000 Sales $ 500,000 $30,000 $200,000 = 15% ROI =

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Three ways to improve ROI...  Increase Sales  Reduce Expenses  Reduce Assets ROI = Operating income Average total assets

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. This expanded equation allows a quick view of two determinates of Return on Investment: Profit Margin: Does a healthy portion of sales make it to the bottom line? Expense control. Pricing power. Asset Turnover: Are our assets used efficiently to generate sales volume? Lean assets. Strong sales. ROI = Profit margin  Asset turnover

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 40 Royal division reports the following: Operating income $ 30,000 Average total assets $ 200,000 Sales $ 500,000 ROI = Profit margin  Asset turnover $30,000 $500,000 15% = ROI = x $500,000 $200,000 6%250% x Royal division Boosts operating income to $50,000 by cutting expenses. New ROI? $50,000 $500,000 25% = ROI = x $500,000 $200,000 10%250% x

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 41 Royal division reports the following: Operating income $ 30,000 Average total assets $ 200,000 Sales $ 500,000 $30,000 $500,000 15% = ROI = x $500,000 $200,000 6%250% x Royal division Boosts operating income to $50,000 by Raising Sales $333,333. New ROI? $50,000 $833,333 25% = ROI = x $833,333 $200,000 6%417% x ROI = Profit margin  Asset turnover

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 42 Royal division reports the following: Operating income $ 30,000 Average total assets $ 200,000 Sales $ 500,000 $30,000 $500,000 15% = ROI = x $500,000 $200,000 6%250% x Royal division Boosts ROI to 25% by eliminating non-productive assets $30,000 $500,000 25% = ROI = x $500,000 $120,000 6%417% x ? #1 ? #2 ROI = Profit margin  Asset turnover

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 43 Royal division reports the following: Operating income $ 30,000 Average total assets $ 200,000 Sales $ 500,000 $30,000 $500,000 15% = ROI = x $500,000 $200,000 6%250% x Benchmarking Royal Division’s performance against company standards 25% = 8% 313% x $44,000 $550,000 ROI = x $550,000 $175,718 ROI = Profit margin  Asset turnover

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Complete JUST THE ROI questions, 1, 2, and the typo-filled 3 for problem 24-21A on page We will do the other sections of this problem as we work through it. 44

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Extreme Sports Company has two divisions based on the climate required for the sporting goods they sell: Snow sports and Non- snow sports. The following divisional information is available for the past year: 1.Analyze their ROI using the DuPont method. Compare the profitability ratios of both segments Compare the asset turnover ratios of both segments Compare and interpret the two segments’ overall ROI performance Suggest what each segment may learn from the other. 45 Sales Operating Income Average Total Assets ROI Snow sports$ 3,700,000$ 924,660$ 5,757,000? Non-snow sports7,125,0001,425,0008,904,000?

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Extreme Sports Company has two divisions based on the climate required for the sporting goods they sell: Snow sports and Non- snow sports. The following divisional information is available for the past year: 46 Sales Operating Income Average Total Assets ROI Snow sports$ 3,700,000$ 924,660$ 5,757,000? Non-snow sports7,125,0001,425,0008,904,000?

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A division with a higher ROI is performing better more likely to receive extra funds, putting more assets under the control of the more successful managers Lower ROE divisions may be under more operational scrutiny, or divestment pressure Drawback to using ROI Tempts management to choose only projects that meet or exceed current ROIs Rejecting profitable projects may be harmful to the company 47

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Management often restates the ROI equation to determine what drives a division’s ROI Expanded shows two components: Profit margin How much operating income the division earns on every $1.00 of sales Asset turnover How efficiently a division uses its assets to generate sales 48

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If management is not satisfied with the: Profit margin Unit must increase the operating income earned on every dollar of sales How? Cut product costs or selling and administrative costs Asset turnover Eliminate nonproductive assets How? Be more aggressive in collecting accounts receivables or by decreasing inventory levels. Change retail-store layout to increase sales Drawback Management tempted to choose only projects that meet or exceed current ROIs 49

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. As division manager your pay includes a bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company wide ROI stands at 15% -- your division has a much higher ROI at 20%. You rather like your enormous bonus checks. You have an opportunity to add a new product line in your division that will produce an ROI greater than 15%, but lower than your division’s ROI. What is this new product line going to do to your division’s ROI? To your bonus?

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. This KPI better aligns incentives with business goals Compares segment profits with profits at the required rate of return Positive–income exceeds target rate of return Negative–income does not meet target rate of return General formula: Applicable formula: 51

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Gee... I thought we were supposed to do what was best for the company! As division manager, I wouldn’t invest in that project because it would lower my pay!

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. RI Measures operating income above the minimum acceptable operating income as established by the target ROI

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Benefits: Promotes goal congruence better than ROI, minimizes gaming Incorporates management’s minimum required rate of return Advantages: Divisions will be motivated to take the action that top management desires Can use different target rates of return for divisions with different levels of risk Disadvantages: Complex, we fear change 57

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Extreme Sports Company has two divisions based on the climate required for the sport: Snow sports and Non-snow sports. The following divisional information is available for the past year: Extreme’s management has specified a 16% target ROI. Calculate Extreme’s Residual Income for each segment and compare. 58 Sales Operating Income Average Total Assets Current Liabilities ROI Snow sports$ 5,500,000$ 935,000$ 4,500,000$ 420, % Non-snow sports8,400,0001,428,0006,700,000695, %

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the information in S Compute each division’s RI. Interpret your results. Are your results consistent with each division’s ROI? 59 RI = Operating income − Minimum acceptable income = Operating income − (Target rate of return × Total assets) Snow Sports RI= $935,000 – ($4,500,000 × 16%) = $935,000 – $720,000 = $215,000 Non-snow Sports RI = $1,428,000 – ($6,700,000 × 16%) = $1,428,000 - $1,072,000 = $356,000 Both divisions have positive residual income. Positive residual income means that the divisions are earning income at a rate that exceeds management’s minimum expectations. This result is consistent with the ROI calculations.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Special type of Residual income calculation Looks at residual income through the eyes of the company’s primary stakeholders Investors (Owners) Creditors (Bondholders ) Uses a weighted-average cost of capital, instead of Non-investor perspective basis for calculating minimum ROI Considerations: After-tax income available to stakeholders Very appropriate for whole company analysis Omit assets committed to paying current liabilities 60

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Compare the EVA equation with the RI equation Both calculate whether any operating income was above and beyond expectations Differences: EVA uses after-tax operating income (income available to stakeholders) EVA reduces average total assets by current liabilities (funds not available for generating income) Replace management’s target rate of return with WACC (rate of return expected by stakeholders) 61

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Management must decide: Components of the total asset figure Simple average or weighted average assets All assets or productive assets only Assets gross book value or net book value Depreciation may artificially inflate measures over time Short-term focus: Division managers have incentives to create immediate increase which may not be in the best interest of the division in the long-term 63

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Work this entire problem from the homework in class right now with help available. 64

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Extreme Sports Company has two divisions based on the climate required for the sport: Snow sports and Non-snow sports. The following divisional information is available for the past year: The company’s weighted average cost of capital (WACC) is 10% and its effective tax rate is 38%. 1. Calculate each segment’s Economic Value Added. 65 Sales Operating Income Average Total Assets Current Liabilities ROI Snow sports$ 5,500,000$ 935,000$ 4,500,000$ 420, % Non-snow sports8,400,0001,428,0006,700,000695, %

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Refer to the information in S Compute each division’s EVA. Interpret your results. 66 (After-tax operating income) − [(Total assets − Current liabilities) × WACC%] = EVA Snow EVA=($935,000× 62%) − [($4,500,000 − $420,000) × 10%] =$579,700 − ($4,080,000 × 10%) =$579,700 − $408,000 =$171,700 Non-snow EVA=($1,428,000 × 62%) − [($6,700,000 − $695,000) × 10%] =$885,360 − ($6,005,000 × 10%) =$885,360 − $600,500 =$284,860 Both divisions have positive economic value added (EVA). This means that the divisions are generating income for investors and long-term creditors at a rate that exceeds the expectations of these two groups of stakeholders.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 68 The following are focus areas of the final exam. This is not an exhaustive list of every single questions, but a targeting of where 80% of your studying time should be spent to master core concepts: Relevant cost decision making: apply concepts E20-10 Capital investment NPV focus, P21-28A Budgeting Focus on operating expense and cash budget Responsibility centers E22-21 Flex budgeting E23-15 Variance Analysis DM/DL focus, E23-19 Performance evaluation P24-21A

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. As companies grow, they often decentralize by geographic area, product line, customer base, business function, or some other characteristic. Decentralization frees top management’s time by delegating decision making, supports the use of expert knowledge, improves customer relations, provides training for managers, and improves employee motivation and retention. Disadvantages of decentralization include possible cost duplications and difficulty achieving goal congruence among decentralized divisions. 69

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Performance evaluation systems provide top management with a framework for maintaining control over the entire organization once it is decentralized. Such systems should help management promote goal congruence, provide a tool for communications, motivate unit managers, provide feedback, and allow for benchmarking. These measures should not revolve around just financial performance measures, however. 70

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The balanced scorecard focuses performance measurement on progress toward the company’s goals in each of the four perspectives. In designing the scorecard, managers start with the company’s goals and its strategy for achieving those goals and then identify the most important measures of performance that will predict long-term success. Some of these measures are lead indicators, while others are lag indicators. Managers must consider the linkages between strategy and operations and how those operations will affect finances now and in the future. 71

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Responsibility accounting performance reports capture the financial performance of cost, revenue, and profit centers. They compare actual amounts to budgeted amounts to determine variances. Then, management investigates to identify if the cause of the variance was controllable or uncontrollable. Management can then make decisions to take corrective actions for controllable variances. 72

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. To evaluate an investment center’s financial performance, companies need summary performance measures—or KPIs—that include both the division’s operating income and its assets. Commonly used KPIs for evaluating an investment center’s financial performance are return on investment (ROI), residual income (RI), and economic value added (EVA). Each of these financial KPIs must be considered in conjunction with KPIs that come from all four of the balanced scorecard perspectives. 73

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 75 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.