Copyright © 2008 Prentice Hall All rights reserved 12-1 Performance Evaluation and the Balanced Scorecard Chapter 12

Copyright © 2008 Prentice Hall All rights reserved 12-2 Objective 1 Explain why and how companies decentralize

Copyright © 2008 Prentice Hall All rights reserved 12-3 Decentralized Operations Operations are split into divisions Advantages:  Frees top management time  Supports use of expert knowledge  Improves customer relations  Provides training  Improves motivation and retention

Copyright © 2008 Prentice Hall All rights reserved 12-4 Decentralized Operations Disadvantages:  Duplication of costs  Problems achieving goal congruence

Copyright © 2008 Prentice Hall All rights reserved 12-5 Responsibility Centers Responsibility Center Manager is responsible for… Examples Cost CenterControlling CostsProduction line at Dell computer Revenue CenterGenerating Sales Revenue Midwest sales region at Pace Foods Profit CenterProducing profit through generating sales and controlling costs Product line at Anheuser-Busch Investment CenterProducing profit and managing the division’s invested capital Company divisions such as Walt Disney World Resorts

Copyright © 2008 Prentice Hall All rights reserved 12-6 Objective 2 Explain why companies use performance evaluation systems

Copyright © 2008 Prentice Hall All rights reserved 12-7 Goals of Performance Evaluation Systems Promoting goal congruence and coordination Communicating expectations Motivating Unit Managers Providing feedback Benchmarking

Copyright © 2008 Prentice Hall All rights reserved 12-8 Limitations of Financial Performance Measures Management needs both:  Lag indicators  Lead indicators Tendency to focus on short-term achievements

Copyright © 2008 Prentice Hall All rights reserved 12-9 Objective 3 Describe the balanced scorecard and identify key performance indicators for each perspective

Copyright © 2008 Prentice Hall All rights reserved Balanced Scorecard Measure company’s activities in terms of its vision and strategies Financial and operational performance measures are considered Link company goals to key performance indicators

Copyright © 2008 Prentice Hall All rights reserved COMPANY GOALS CRITICAL FACTORS (customer satisfaction, operational efficiency, employee excellence, financial profitability) CRITICAL FACTORS (customer satisfaction, operational efficiency, employee excellence, financial profitability) KEY PERFORMANCE INDICATORS (KPIs) (market share, yield rate, employee training hours, revenue growth) KEY PERFORMANCE INDICATORS (KPIs) (market share, yield rate, employee training hours, revenue growth)

Copyright © 2008 Prentice Hall All rights reserved Four Perspectives Financial perspective Customer perspective Internal business perspective Learning and growth perspective

Copyright © 2008 Prentice Hall All rights reserved Financial Perspective How do we look to shareholders? Strategy to increase company profits  Increase revenue growth  Increase productivity

Copyright © 2008 Prentice Hall All rights reserved Customer Perspective How do customers see us? Strategy for customer satisfaction  Product price  Product quality  Sales service quality  Product delivery time

Copyright © 2008 Prentice Hall All rights reserved Internal Business Perspective At what business processes must we excel to satisfy customer and financial objectives? Three factors:  Innovation  Operations  Post-sales service

Copyright © 2008 Prentice Hall All rights reserved Learning and Growth Perspective Can we continue to improve and create value? Three factors:  Employee capabilities  System capabilities  Company’s climate for action

Copyright © 2008 Prentice Hall All rights reserved E12-17 Sketch the Balanced Score Card 1. Financial Perspective: “How do we look to shareholders?” 3. Internal Business Perspective: “At what business processes must we excel?” 4. Learning and Growth Perspective: “Can we continue to improve and create value?” 2. Customer Perspective: “How do customers see us?”

Copyright © 2008 Prentice Hall All rights reserved Financial Perspective 3. Internal Business Perspective 4. Learning and Growth Perspective 2. Customer Perspective RevenueProductivity Price Quality Sales service Delivery time InnovationOperationsPostsales service Employee Capabilities System Capabilities Climate for Action

Copyright © 2008 Prentice Hall All rights reserved E12-19: Classify KPI’s by Balanced Scorecard Perspective a.Customer perspective b.Learning and growth perspective c.Financial perspective d.Internal business perspective e.Learning and growth perspective f.Internal business perspective g.Customer perspective h.Internal business perspective

Copyright © 2008 Prentice Hall All rights reserved E12-19: Continued i.Customer perspective j.Financial perspective k.Internal business perspective l.Learning and growth perspective m.Internal business perspective n.Financial perspective o.Internal business perspective p.Customer perspective

Copyright © 2008 Prentice Hall All rights reserved E12-19: Continued q.Learning and growth perspective r.Financial perspective s.Customer perspective t.Internal business perspective u.Internal business perspective v.Learning and growth perspective w.Internal business perspective

Copyright © 2008 Prentice Hall All rights reserved Objective 4 Use performance reports to evaluate cost, revenue, and profit centers

Copyright © 2008 Prentice Hall All rights reserved Performance Reports Report financial performance of responsibility centers  Cost center: focus on flexible budget variance  Revenue center: focus on flexible budget variance and sales volume variance  Profit center: focus on flexible budget variance Includes allocated charges from service departments

Copyright © 2008 Prentice Hall All rights reserved E12-21: Complete and Analyze a Performance Report Racer-Subunit X Actual Flexible budget Flexible budget variance % Variance Direct materials$28,100$26,000 Direct labor13,50014,000 Indirect labor26,00023,000 Utilities12,00011,000 Depreciation25,000 Repair & Maint4,3005,000 Total$108,900$104,000 $2,100 U8.08% U 500 F3.57% F 3,000 U13.04% U 1,000 U9.09% U F14.00% F 4,900 U4.71% U

Copyright © 2008 Prentice Hall All rights reserved Objective 5 Use ROI, RI, and EVA to evaluate investment centers

Copyright © 2008 Prentice Hall All rights reserved Investment Centers Financial evaluation must measure:  Income generated  Effective use of center’s assets Performance measures:  Return on investment (ROI)  Residual income (RI)  Economic value added (EVA)

Copyright © 2008 Prentice Hall All rights reserved Return On Investment (ROI) Operating income ÷ Total assets Or Operating income Sales Total assets X

Copyright © 2008 Prentice Hall All rights reserved ROI Operating income Sales Total assets X Sales margin = Operating income Sales Capital turnover = Sales Total assets

Copyright © 2008 Prentice Hall All rights reserved ROI Advantages: Expanded equation provides additional information Can be used to compare across divisions and with other companies Useful for resource allocation

Copyright © 2008 Prentice Hall All rights reserved E12-23: Compute Each Division’s ROI Professional: $173,000 ÷ $420,000 = 41.19% Residential: $62,000 ÷ $188,000 = 32.98% ROI = Operating Income ÷ Total Assets

Copyright © 2008 Prentice Hall All rights reserved E12-23: Compute Each Division’s Sales Margin and Interpret Results Professional: $173,000 ÷ $1,030, % Residential: $62,000 ÷ $555, % Sales Margin = Operating income ÷ Sales

Copyright © 2008 Prentice Hall All rights reserved E12-23: Calculate Each Division’s Capital Turnover Professional: $1,030,000 ÷ $420, Residential: $555,000 ÷ $188, Capital Turnover = Sales ÷ Total Assets

Copyright © 2008 Prentice Hall All rights reserved E12-23: Expanded ROI Formula Professional: 16.80% x % Residential: 11.17% x % ROI = Sales margin x Capital turnover

Copyright © 2008 Prentice Hall All rights reserved Residual Income Compares division’s operating income with minimum operating income expected, given the size of the division’s assets  Positive – income exceeds target rate of return  Negative – income does not meet target rate of return

Copyright © 2008 Prentice Hall All rights reserved RI Operating income – minimum acceptable income Minimum acceptable income = target rate of return x Total assets

Copyright © 2008 Prentice Hall All rights reserved RI Advantages: Promotes goal congruence better than ROI Incorporates management’s minimum required rate of return Can use different target rates of return for divisions with different levels of risk

Copyright © 2008 Prentice Hall All rights reserved E12-24: Calculate Each Division’s RI Professional: $173,000 - ($420,000 x 25%) = $68,000 Residential $62,000 - ($188,000 x 25%) = $15,000 Residual Income = Operating income – Minimum acceptable income Are the divisions meeting or exceeding management’s minimum required rate of return? If yes, what does this mean?

Copyright © 2008 Prentice Hall All rights reserved Economic Value Added After-tax operating income – [(Total assets – Current liabilities) x WACC%] WACC% – weighted average cost of capital

Copyright © 2008 Prentice Hall All rights reserved E12-24: Calculate Each Division’s EVA Professional: ($173,000 x 70%) – [($420,000 - $150,000) x 15%] $80,600 Residential ($62,000 x 70%) – [($188,000 - $68,000) x 15%] $25,400 EVA = (After-tax operating income) – [(total assets – current liabilities) x WACC%] Have the divisions created wealth for their stockholders and long term creditors? How can you use EVA to answer this question?

Copyright © 2008 Prentice Hall All rights reserved EVA Advantages: Considers wealth created just for investors and long-term creditors Promotes goal congruence

Copyright © 2008 Prentice Hall All rights reserved Limitations of Financial Performance Measures Measurement issues – how to define “total assets” Short-term focus

Copyright © 2008 Prentice Hall All rights reserved End of Chapter 12