1. Performance Measurement in Decentralized Organizations

2. Learning Objectives
Define decentralization and identify its advantages and disadvantages
Differentiate between cost centers, profit centers, and investment centers, and explain how performance is measured in each
Analyze segment profitability based on return on investment (ROI) and residual income (RI)
Understand the strength and weaknesses of ROI relative to RI
Understand balanced scorecard and its uses

3. Advantage of Decentralization
Benefits of decentralization, i.e., spreading decision making authority throughout the organization:
Top management can concentrate on strategy
Lower-level decisions often based on better information
Lower-level managers can respond quickly to customers
Lower-level managers gain experience in decision making
Decision making authority leads to job satisfaction

4. Disadvantage of Decentralization
Lower-level managers may make decisions without seeing the “big picture”
There may be a lack of coordination among autonomous managers
Lower-level manager’s objectives may not be those of the organization
May be difficult to spread innovative ideas in the organization

5. Responsibility Centers
Decentralized companies segment/divide their operations into:
Cost centers
Profit centers
Investment centers

6. Cost, Profit, and Investments Centers
Cost Center
A segment whose manager has control over costs,
but not over revenues or investments.
Cost
Cost
Cost

7. Cost, Profit, and Investments Centers
Revenues
Profit Center
A segment whose manager has control over both costs and revenues,
but no control over investments.
Sales
Interest
Other
Costs
Mfg. costs
Commissions
Salaries
Other

8. Cost, Profit, and Investments Centers
Investment Center
A segment whose manager has control over costs, revenues, and investments in operating assets.
Television Division

9. Cost, Profit, and Investments Centers
Cost, profit, and investment centers are all known as responsibility centers, meaning they have control over cost, profit, or investment.
Responsibility
Center

10. Measuring Management Performance
Cost centers are evaluated either in terms of meeting standards or measures of continuous improvement.
Profit centers are evaluated in terms of meeting sales and cost objectives.
Investment centers are evaluated in terms of rate of return on invested capital, or residual income.

11. Return on Investment (ROI)
Net operating income ROI = Average operating assets
Operating income is income before interest and taxes (EBIT).
Operating assets include cash, receivables, inventory, and other productive assets.
Most companies use book value (not cost) of assets.

12. Return on Investment (ROI)
Net operating income Sales
ROI = *
Sales Average operating assets
(Margin) * (Turnover)
Margin is a measure of the ability to control costs.
Turnover is a measure of the efficiency in the use of assets.
Margin by itself overlooks a crucial area of management’s responsibility: control of investment in operating assets.

13. Return on Investment (ROI) – Example
A division of Regal Company reports the following:
Net operating income $30,000
Sales ,000
Average operating assets 200,000
ROI = Margin * Turnover
$ 30, $500,000
= * = 6% * = 15%
$500, $200,000

14. Improving the ROI There are three ways to improve ROI:
Increase sales – particularly significant because it can affect the margin and the turnover
Reduce expenses – often the easy route is to cut the fat
Reduce operating assets – reduce receivables, inventory, etc.
For example, if Regal was able to increase advertising, increasing sales to $600,000 and increasing operating income to $42,000, then:
ROI = 7 % * = 21%

15. Let’s get to work on my ROI . . .

16. Criticism of ROI
Managers may reject profitable investment projects that reduce their segments’ ROI.
ROI tends to emphasize short-term rather than long-term profitability.
Managers may not replace old assets on a timely basis
ROI is not consistent with the cash flow models used for evaluating capital expenditures.
ROI may not be fully controllable by segment managers because of committed costs.

17. Residual Income – Another Measure of Performance
Residual income (RI) is the net operating income above some minimum return on operating assets.
Residual income is closely related to economic value added (EVA).
The objective under this approach is to maximize the residual income.

18. Residual Income – Another Measure of Performance
For example, a division of Regal Company reports the following:
Average operating assets $100,000
Operating income ,000
Required rate of return %
Computation of residual income:
Actual return $ 30,000
Required return ($100,000 * 20%) 20,000
Residual income $ 10,000

19. Advantages and Disadvantages of Residual Income
Residual income approach overcomes the main (first) objection to ROI approach.
RI for segments, however, cannot be compared.

20. Quick Check
Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%

21. Quick Check
Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%
ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%

22. Quick Check
Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
a. Yes
b. No

23. This lowers the division’s ROI from 20.0% down to 19.5%.
Quick Check
Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
a. Yes
b. No
ROI = $78,000/$400,000 = 19.5%
This lowers the division’s ROI from 20.0% down to 19.5%.

24. Quick Check
The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
a. Yes
b. No

25. Quick Check
The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
a. Yes
b. No
ROI = $18,000/$100,000 = 18%
The return on the investment exceeds the minimum required rate of return.

26. Quick Check
Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000

27. Quick Check
Redmond Awnings, a division of Wrap-up Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
Net operating income $60,000
Required return (15% of $300,000) (45,000)
Residual income $15,000

28. Quick Check
If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
a. Yes
b. No

29. Quick Check
If the manager of the Redmond Awnings division is evaluated based on residual income, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year?
a. Yes
b. No
Net operating income $78,000
Required return (15% of $400,000) (60,000)
Residual income $18,000
Yields an increase of $3,000 in the residual income.

30. The Balanced Scorecard
Management translates its strategy into performance measures that employees understand and accept.
Financial
Customers
Learning and growth
Internal business processes
Performance measures

31. The Balanced Scorecard
How do we look to the owners?
In which internal business processes must we excel?
How can we continually learn, grow, and improve?
How do we look to customers?

32. The Balanced Scorecard
Learning improves business processes.
Improved business processes improve customer satisfaction.
Improving customer satisfaction improves financial results.

33. The Balanced Scorecard: From Strategy to Performance Measures
Financial
Has our financial performance improved?
What are our financial goals?
What customers do we want to serve and how are we going to win and retain them?
Vision and Strategy
Customer
Do customers recognize that we are delivering more value?
Internal Business Processes
Have we improved key business processes so that we can deliver more value to customers?
What internal busi- ness processes are critical to providing value to customers?
Learning and Growth
Are we maintaining our ability to change and improve?

34. The Balanced Scorecard
A balanced scorecard should have measures that are linked together on a cause-and-effect basis.
If we improve one performance measure . . .
Another desired performance measure will improve.
Then
The balanced scorecard lays out concrete actions to attain desired outcomes.

35. The Balanced Scorecard and Compensation
Incentive compensation should be linked to balanced scorecard performance measures.

36. The Balanced Scorecard Example
Profit
Financial
Contribution per car
Number of cars sold
Customer
Customer satisfaction with options
Internal Business Processes
Number of options available
Time to install option
Learning and Growth
Employee skills in installing options

37. The Balanced Scorecard Example
Profit
Contribution per car
Number of cars sold
Results
Customer satisfaction with options
Satisfaction Increases
Strategies
Increase Options
Number of options available
Time to install option
Time Decreases
Increase Skills
Employee skills in installing options

38. The Balanced Scorecard Example
Profit
Contribution per car
Results
Cars sold Increase
Number of cars sold
Customer satisfaction with options
Satisfaction Increases
Number of options available
Time to install option
Employee skills in installing options

39. The Balanced Scorecard Example
Profit
Results
Contribution per car
Contribution Increases
Number of cars sold
Customer satisfaction with options
Satisfaction Increases
Number of options available
Time to install option
Time Decreases
Employee skills in installing options

40. The Balanced Scorecard Example
Results
Profit
Profits Increase
If number of cars sold and contribution per car increase, profits increase.
Contribution per car
Contribution Increases
Number of cars sold
Cars Sold Increases
Customer satisfaction with options
Number of options available
Time to install option
Employee skills in installing options