Performance Evaluation CHAPTER 12 Decentralization and Performance Evaluation

Decentralized Organizations A decentralized organization is one that grants substantial decision making authority to the managers of subunits Most firms are neither totally centralized nor totally decentralized Typically, decentralization is a matter of degree Learning objective 1: List and explain the advantages and disadvantages of decentralization

Decentralized Organizations Learning objective 1: List and explain the advantages and disadvantages of decentralization

Advantages of Decentralization Better information leading to superior decisions Managers can respond quicker to changing circumstances Increased motivation of managers Provides excellent training for future top-level executives Learning objective 1: List and explain the advantages and disadvantages of decentralization

Disadvantages of Decentralization Costly duplication of activities Lack of goal congruence - Management may pursue personal goals that are incompatible with the company’s goals - To control goal congruence, companies evaluate the performance of subunit managers Learning objective 1: List and explain the advantages and disadvantages of decentralization

Review 1 All of the following are advantages of decentralization except: Faster response to changing circumstances Costly duplication of activities Increased motivation of managers Better information, leading to superior decisions Answer: b Slide 12-7 Learning objective 1: List and explain the advantages and disadvantages of decentralization

Evaluating Subunits Evaluation of subunits is undertaken to identify successful operations and areas needing improvement Top management perform incremental analysis to determine: Whether a successful operation should be expanded Whether an unsuccessful operation should be eliminated or improved Slide 12-8 Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers

Evaluating Subunit Managers A company evaluates subunit managers in order to motivate them to take actions that maximize the value of the firm Reasons for evaluating subunit managers: - Identifies successful operations and areas needing improvement - Influences the behavior of managers Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers

Responsibility Accounting and Performance Evaluation Responsibility accounting is a technique that holds managers responsible only for costs and revenues that they can control This idea should play a prominent role in the design of accounting systems - Costs and revenues are traced to the organizational level where they can be controlled Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers

Tracing Costs to Organizational Levels Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers

Responsibility Centers Responsibility centers are units responsible for the generation of revenue and/or the incurrence of costs Three types of responsibility centers: - Cost centers - Profit centers - Investment centers Learning objective 3: Identify cost centers, profit centers, and investment centers

Cost Centers Subunit responsible for controlling costs but not responsible for generating revenue,e.g. janitorial, maintenance, computer services, production Must provide service to company at a reasonable cost Evaluation based on comparison of budgeted or standard costs with actual costs Learning objective 3: Identify cost centers, profit centers, and investment centers

Profit Centers Subunits responsible for generating revenues as well as controlling costs Goal is to maximize profit for the division - Performance can be evaluated in terms of profitability - Motivates managers to focus their attention on ways of maximizing profit Learning objective 3: Identify cost centers, profit centers, and investment centers

Profit Centers Methods used to evaluate profitability Current compared to budgeted income Current compared to past income Comparison with other profit centers i.e., relative performance evaluation Slide 12-15 Learning objective 3: Identify cost centers, profit centers, and investment centers

Investment Centers Subunit responsible for generating revenue, controlling costs, and investing in assets Goal is to maximize return on investment Evaluation based on comparison with a benchmark, previous years, or other investment centers Learning objective 3: Identify cost centers, profit centers, and investment centers

Nordstrom Learning objective 3: Identify cost centers, profit centers, and investment centers

Review 2 An investment center is responsible for: Answer: Investing in long term assets Controlling costs Generating revenues All of the above Answer: d. All of the above Learning objective 3: Identify cost centers, profit centers, and investment centers

Review 3 Cost centers are often evaluated using: Answer: Variance analysis Operating margin Return on investment Residual income Answer: a. Variance analysis Learning objective 3: Identify cost centers, profit centers, and investment centers

Review 4 Profit centers are often evaluated using: Answer: Investment turnover Income targets or profit budgets Return on investment Residual income Answer: b. Income targets or profit budgets Learning objective 3: Identify cost centers, profit centers, and investment centers

Evaluating Investment Centers With ROI ROI is a primary tool for evaluating the performance of investment centers Ratio of investment center income to invested capital Focuses management’s attention on both income (numerator) and level of investment (denominator) Learning objective 4: Calculate and interpret return on investment (ROI)

ROI Components ROI may be broken down into two components: Profit margin and Investment turnover Learning objective 4: Calculate and interpret return on investment (ROI)

Measuring Income and Invested Capital for ROI In calculating ROI, companies measure “income” in a variety of ways Most common method is NOPAT Net Operating Profit After Taxes Slide 12-23 Learning objective 4: Calculate and interpret return on investment (ROI)

Measuring Income and Invested Capital for ROI To calculate NOPAT, a company must make adjustments to net income: Add back non-operating expense to net income, e.g. interest expense Adjust tax expense accordingly Learning objective 4: Calculate and interpret return on investment (ROI)

Measuring Income and Invested Capital for ROI In calculating ROI, companies measure “invested capital” in a variety of ways Common approaches: - Total assets - Total assets after adding back accumulated depreciation - Total assets less current liabilities - Total assets less non-interest-bearing current liabilities (method used in this textbook) Learning objective 4: Calculate and interpret return on investment (ROI)

NOPAT Example Learning objective 4: Calculate and interpret return on investment (ROI)

ROI – France, Germany, and Japan Learning objective 4: Calculate and interpret return on investment (ROI)

Exercise 1 Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which $30,00,000 are non-interest bearing Calculate NOPAT = Net income + interest expense (1 - tax rate) = $16,000,000 + $1,300,000 (1 - .40) = $16,780,000 Learning objective 4: Calculate and interpret return on investment (ROI)

Exercise 2 Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which $30,00,000 are non-interest bearing Calculate invested capital = Total assets – non-interest-bearing CL = $225,000,000 - $30,000,000 = $195,000,000 Learning objective 4: Calculate and interpret return on investment (ROI)

Exercise 3 Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which $30,00,000 are non-interest bearing Calculate ROI = NOPAT ÷ Invested capital = $16,780,000 ÷ $195,000,000 = 8.605% Learning objective 4: Calculate and interpret return on investment (ROI)

Calculating ROI Slide 12-31 Learning objective 4: Calculate and interpret return on investment (ROI)

Problems with Using ROI Invested capital is typically based on historical costs - Fully depreciated assets lead to a low invested capital number resulting in high ROI - Makes comparison of investment centers using ROI difficult Learning objective 4: Calculate and interpret return on investment (ROI)

Problems with Using ROI Managers may put off purchase of new equipment, i.e. may lead to under investment Projects with positive net present value but low initial profitability might not be undertaken Managers with high ROI may consider the effect on ROI, rather than NPV Slide 12-33 Learning objective 4: Calculate and interpret return on investment (ROI)

Exercise 4 Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which $30,00,000 are non-interest bearing Calculate residual income if cost of capital is 10% = NOPAT – (Cost of Capital x Invested Capital) = $16,780,000 – (10% x $195,000,000) = ($2,720,000) Learning objective 4: Calculate and interpret return on investment (ROI)

Problems of Overinvestment and Underinvestment Evaluation using profit can lead to overinvestment Managers motivated to make investments that earn a return less than cost of capital Evaluation using ROI can lead to underinvestment Managers may not take on projects with a low ROI just to increase profit if they are evaluated in terms of the return they earn Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment

Review 4 Use of profit as a performance measure: Answer: May lead to overinvestment in assets Is appropriate for an investment center Is appropriate as long as profit is calculated using GAAP Encourages managers to finance operations with debt rather than equity Answer: a. May lead to overinvestment in assets Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment

Decision Making Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment

Residual Income (RI) Net operating profit after taxes of an investment center in excess of its required profit Required profit is equal to the investment center’s required rate of return times the level of investment in the center - RI = NOPAT – Required Profit - Required rate of return is generally the cost of capital for the investment center Use total assets minus non-interest-bearing current liabilities as a measure of investment Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Residual Income NIBCL = non-interest bearing current liabilities Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Economic Value Added (EVA) EVA is residual income adjusted for accounting distortions that arise from GAAP: A performance measure approach to solving overinvestment and underinvestment problems Advantage is that managers are less tempted to cut those costs that distort income under GAAP e.g., under GAAP research and development costs are expensed, but the costs benefit future periods Thus, under EVA research and development is capitalized and amortized over future periods Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Economic Value Added (EVA) Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Review 5 Investment centers are often evaluated using: Answer: d Standard cost variances Return on investment Residual income/EVA Both b and c Answer: d Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Economic Value Added (EVA) Slide 12-43 Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Using a Balanced Scorecard to Evaluate Performance A problem in using financial measures like ROI and EVA is that they are “backward looking” Learning objective 1: List and explain the advantages and disadvantages of decentralization

Balanced Scorecard Set of performance measures constructed for four dimensions of performance: Financial Customer Internal processes Learning and growth Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

Balanced Scorecard Financial Customer Internal Processes Is company meeting its financial goal? Customer Examine company success in meeting customer expectations? Internal Processes Examines the company’s success in improving critical business processes Learning and growth Examines the company’s success in improving its ability to adapt, innovate, and grow Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

Balanced Scorecard Tying the balanced scorecard measures to the strategy for success - Company develops three to five performance measures for each dimension - Measures should be tied to company strategy Balance among the dimensions is critical You get what you measure! Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

Balanced Scorecard Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

How Balance is Achieved in a Balanced Scorecard Performance is assessed across a balanced set of dimensions Quantitative measures are balanced with qualitative measures There is a balance of backward-looking measures and forward-looking measures Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

Balanced Scorecard Slide 12-50 Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

You Get What You Measure Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

Developing a Strategy Map for a Balanced Scorecard A strategy map is a diagram of the relationships of the strategic objectives across the four dimensions Useful to test the soundness of the strategy Identifies how strategy is linked to measures on the scorecard Useful to communicates strategic objectives to employees Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard

Strategy Map Example Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard

Keys to a Successful Balanced Scorecard Targets For each measure, there should be a target so managers know what they are expected to achieve Initiatives - For each measure, the company must identify actions that will be taken to achieve the target Learning objective 9: Discuss the key items related to a successful balanced scorecard

Keys to a Successful Balanced Scorecard Responsibility A specific employee must be given responsibility/accountability for the implementation of each initiative Funding Initiatives must be funded appropriately Top Management Support - Crucial to have the full support of top management Learning objective 9: Discuss the key items related to a successful balanced scorecard

Keys to a Successful Balanced Scorecard Slide 12-56 Learning objective 9: Discuss the key items related to a successful balanced scorecard

Evaluation Learning objective 9: Discuss the key items related to a successful balanced scorecard

Transfer Pricing Transfer pricing - price used to value internal transfers of goods or services Subunits of a company sell goods or services to other subunits within the same company Must determine the price to use for internal transfers Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

Methods of Setting the Transfer Price Pricing alternatives: Market price Variable costs Full cost plus profit Negotiated prices Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

Methods of Setting the Transfer Price The most appropriate transfer price depends on the circumstances Should lead subunit managers to make decisions that maximize firm value Since there is no arm’s length transaction, revenue is not recognized for financial reporting purposes Motivation of best decision is measured by opportunity cost of producing an item and transferring it inside the company Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

Lowering Transfer Price Below the Market Price Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

Transfer Pricing Slide 12-62 Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

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