Copyright © by Houghton Miffin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson Multimedia Slides by: Harry Hooper Santa Fe Community College

Copyright © by Houghton Miffin Company. All rights reserved.2 Chapter 23 Performance Management and Evaluation

Copyright © by Houghton Miffin Company. All rights reserved.3 LEARNING OBJECTIVES 1.Describe how the balanced scorecard aligns performance with organizational goals and explain the balanced scorecard’s role in the management cycle. 2.Discuss performance measurement and state the issues that affect management’s ability to measure performance. 3.Define responsibility accounting and describe the role responsibility centers play in performance management and evaluation.

Copyright © by Houghton Miffin Company. All rights reserved.4 LEARNING OBJECTIVES 4.Prepare performance reports for the various types of responsibility centers, including reports based on the flexible budget for cost centers and variable costing for profit centers. 5.Use the traditional performance measures of return on investment and residual income to evaluate investment centers. 6.Use economic value added to evaluate investment centers. 7.Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.

Copyright © by Houghton Miffin Company. All rights reserved.5 Organizational Goals and the Balanced Scorecard OBJECTIVE 1 Describe how the balanced scorecard aligns performance with organizational goals and explain the balanced scorecard’s role in the management cycle.

Copyright © by Houghton Miffin Company. All rights reserved.6 The Balanced Scorecard u A framework that links the perspectives of an organization’s 4 stakeholder groups: 4 Financial (investors) 4 Learning and growth (employees) 4 Internal business processes (management) 4 Customers with the organization’s: 4 Mission and vision 4 Performance measures 4 Strategic plan 4 Resources

Copyright © by Houghton Miffin Company. All rights reserved.7 The Balanced Scorecard u To succeed, an organization must add value for all stakeholders. u Determine each group’s objectives. u Translate their objectives into performance measures that have specific, quantifiable performance targets.

Copyright © by Houghton Miffin Company. All rights reserved.8 The Balanced Scorecard and the Management Cycle u Planning Example: Strategy is to achieve customer satisfaction PerspectiveObjectivesPerformance Measures Financial (investors)Revenue growth% growth in sales dollars Learning and growth (employees) Trained employeesNumber of trained employees, employee turnover Internal business processes Reliable products, short delivery cycles Number and cost of breakdowns, repair costs, mean time between order and delivery CustomersCustomer loyaltyNumber of repeat customers, $ purchases per customer

Copyright © by Houghton Miffin Company. All rights reserved.9

10 The Balanced Scorecard and the Management Cycle Executing Use agreed-upon strategic objectives as a basis for decision-making. Reviewing Review financial and nonfinancial results frequently. Compare objectives with actual results. Determine if measures or objectives need revision. Reporting Prepare reports which show performance measures for each stakeholder group.

Copyright © by Houghton Miffin Company. All rights reserved.11

Copyright © by Houghton Miffin Company. All rights reserved.12Discussion Q. Q. Who are the stakeholders in an organization? 1. Investors 2. Employees 3. Management (Internal business processes) 4. CustomersA.

Copyright © by Houghton Miffin Company. All rights reserved.13 Performance Measurement OBJECTIVE 2 Discuss performance measurement and state the issues that affect management’s ability to measure performance.

Copyright © by Houghton Miffin Company. All rights reserved.14 What to Measure, How to Measure u Performance measurement is the use of quantitative tools to gauge an organization’s performance in relation to a specific goal or expected outcome. u Product or service quality is NOT a measure; it is what management wants to measure. Quantifiable measures must be developed to measure quality.

Copyright © by Houghton Miffin Company. All rights reserved.15 Other Measurement Issues u What performance measures can be used? u How can managers monitor the level of quality? u How can managers monitor processes to identify areas that need improvement? u How can managers measure customer satisfaction? u How can managers monitor financial performance? u Are there other stakeholders? u What performance measures do governments impose? u How can a manager measure the effect on the environment?

Copyright © by Houghton Miffin Company. All rights reserved.16Discussion Q. Q. How does a company measure the quality of its products and services? It develops quantitative measures which indicate whether quality objectives are being achieved.A.

Copyright © by Houghton Miffin Company. All rights reserved.17 Responsibility Accounting OBJECTIVE 3 Define responsibility accounting and describe the role responsibility centers play in performance management and evaluation.

Copyright © by Houghton Miffin Company. All rights reserved.18 Responsibility Accounting u Responsibility accounting classifies data by areas of responsibility and reports on only the revenues, costs and resources that the assigned manager can control. responsibility center u A responsibility center is an organizational unit whose manager is responsible for a portion of the organization’s resources and its activities.

Copyright © by Houghton Miffin Company. All rights reserved.19 Types of Responsibility Centers Cost Centers – the manager is accountable only for controllable costs. Discretionary Cost Centers – the manager is accountable only for costs; the relationship between resources and products or services produced is not well defined. Administrative or support functions are often discretionary cost centers. Revenue Centers – the manager is accountable primarily for controllable revenue generated.

Copyright © by Houghton Miffin Company. All rights reserved.20 Types of Responsibility Centers (continued…) Profit Centers – the manager is accountable for revenues, costs and the resulting operating income. Investment Centers – the manager is accountable for profit generation and can make decisions about resources used.

Copyright © by Houghton Miffin Company. All rights reserved.21 Organizational Structure and Performance Management u An organization chart shows the hierarchy of responsibility for the purpose of management control. u Performance reporting by responsibility level traces the source of a cost, revenue or resource to the manager who controls it enabling his or her performance to be evaluated.

Copyright © by Houghton Miffin Company. All rights reserved.22

Copyright © by Houghton Miffin Company. All rights reserved.23Discussion Q. Q. Name the types of responsibility centers? 1.Cost Centers 2.Discretionary Cost Centers 3.Revenue Centers 4.Profit Centers 5.Investment CentersA.

Copyright © by Houghton Miffin Company. All rights reserved.24 Performance Evaluation OBJECTIVE 4 Prepare performance reports for the various types of responsibility centers, including reports based on the flexible budget for cost centers and variable costing for profit centers.

Copyright © by Houghton Miffin Company. All rights reserved.25 Evaluating Cost Center Performance Use flexible budgets to identify variances between actual and expected costs. Evaluating Profit Center Performance Compare actual results to budgeted income statement. Use variable costing (contribution method) income statements to focus on cost variability and the profit center’s contribution to operating income. Only show controllable costs. Show other, nonfinancial performance measures.

Copyright © by Houghton Miffin Company. All rights reserved.26Discussion Q. Q. What type of Income Statement should be used to evaluate profit centers? Variable Costing Income StatementA.

Copyright © by Houghton Miffin Company. All rights reserved.27 Evaluating Investment Center Performance OBJECTIVE 5 Use the traditional performance measures of return on investment and residual income to evaluate investment centers.

Copyright © by Houghton Miffin Company. All rights reserved.28 Return on Investment (ROI) Traditionally the most common performance measure ROI = Operating Income Average Assets Invested = Operating Income x Sales Sales Average Assets Invested = Profit Margin xAsset Turnover

Copyright © by Houghton Miffin Company. All rights reserved.29

Copyright © by Houghton Miffin Company. All rights reserved.30 Other Measures used in conjunction with ROI include: 4 Revenues 4 Costs 4 Operating Income 4 Revenue growth 4 Market share 4 % changes in ROI

Copyright © by Houghton Miffin Company. All rights reserved.31 Residual Income u The operating income earned above a minimum desired return on invested assets. Residual Income = Operating Income – (Desired ROI x Average Assets Invested) u Residual income eliminates the possibility of missed income opportunities that exist if ROI is used as a performance measure. BUT residual income does not provide a meaningful comparison between investment centers of a different size because residual income shows absolute dollars not a percentage.

Copyright © by Houghton Miffin Company. All rights reserved.32Discussion Q. Q. What measure of investment center performance is best used to compare managers of different size investment centers? ROI, because it provides a ratio. Residual income provides an absolute dollar amount.A.

Copyright © by Houghton Miffin Company. All rights reserved.33 Economic Value Added (EVA) OBJECTIVE 6 Use economic value added to evaluate investment centers.

Copyright © by Houghton Miffin Company. All rights reserved.34 Economic Value Added – the shareholder wealth created by an investment center. Cost of Capital – the minimum desired rate of return on an investment. EVA = After Tax Operating Income – [Cost of Capital x (Total Assets – Current Liabilities)]

Copyright © by Houghton Miffin Company. All rights reserved.35 Economic Value Added u Compare EVAs from previous periods, target EVAs, and EVAs from other investment centers. u Affected by decisions on pricing, sales volume, taxes, cost of capital, etc.

Copyright © by Houghton Miffin Company. All rights reserved.36

Copyright © by Houghton Miffin Company. All rights reserved.37Discussion Q. Q. Why should multiple performance measures be used to evaluate investment center performance? Because any one performance measure tends to emphasize only one particular aspect of performance.A.

Copyright © by Houghton Miffin Company. All rights reserved.38 Performance Incentives OBJECTIVE 7 Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.

Copyright © by Houghton Miffin Company. All rights reserved.39 Linking Goals, Objectives, Measures and Performance Targets The links should be causal : Goal  Objective  Measure  Performance Target To be a friend of the environment To reduce the company’s environmental risk Number of products recycled To recycle at least 10% of products sold

Copyright © by Houghton Miffin Company. All rights reserved.40 Performance-Based Pay u Responsibility center managers are more likely to achieve their performance targets if their pay depends on it. u Cash bonuses, awards, profit-sharing and stock options are forms of incentive compensation.

Copyright © by Houghton Miffin Company. All rights reserved.41 The Coordination of Goals u Incentive plans to coordinate goals must consider: 4 When to give rewards? 4 Who shall be rewarded? 4 How should the reward be computed? 4 Does the incentive plan address the interest of all stakeholders? u Performance Management and Evaluation systems should balance and benefit all stakeholders.

Copyright © by Houghton Miffin Company. All rights reserved.42Discussion Q. Q. What does “an organization will get what it measures” mean? If performance measures (and incentives) are based on specific objectives, managers will be motivated to achieve the objectives that are being measured.A.

Copyright © by Houghton Miffin Company. All rights reserved.43 OK, LET’S REVIEW... 1.Describe how the balanced scorecard aligns performance with organizational goals and explain the balanced scorecard’s role in the management cycle. 2.Discuss performance measurement and state the issues that affect management’s ability to measure performance. 3.Define responsibility accounting and describe the role responsibility centers play in performance management and evaluation.

Copyright © by Houghton Miffin Company. All rights reserved.44 CONTINUING OUR REVIEW... 4.Prepare performance reports for the various types of responsibility centers, including reports based on the flexible budget for cost centers and variable costing for profit centers. 5.Use the traditional performance measures of return on investment and residual income to evaluate investment centers.

Copyright © by Houghton Miffin Company. All rights reserved.45 AND FINALLY... 6.Use economic value added to evaluate investment centers. 7.Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.