Performance Management and Evaluation

Performance Management and Evaluation
Chapter 7 Performance Management and Evaluation Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objectives Describe how the balanced scorecard aligns performance with organizational goals, and explain the role of the balanced scorecard in the management cycle. Discuss performance measurement, and state the issues that affect management’s ability to measure performance. Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives (cont’d)
Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation. Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing. Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives (cont’d)
Prepare performance reports for investment centers using traditional measures of return on investment and residual income and the newer measure of economic value added. Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation. Copyright © Houghton Mifflin Company. All rights reserved.

Organizational Goals and the Balanced Scorecard
Objective 1 Describe how the balanced scorecard aligns performance with organizational goals, and explain the role of the balanced scorecard in the management cycle Copyright © Houghton Mifflin Company. All rights reserved.

The Balanced Scorecard
… is a framework that links the perspectives of an organization’s four basic stakeholder groups with the organization’s mission and vision, performance measures, strategic plan, and resources Developed by Robert S. Kaplan and David P. Norton Copyright © Houghton Mifflin Company. All rights reserved.

The Balanced Scorecard (cont’d)
Four basic stakeholder groups of an organization Financial (investors) Learning and growth (employees) Internal business processes Customers Copyright © Houghton Mifflin Company. All rights reserved.

The Balanced Scorecard (cont’d)
To succeed, an organization must add value for all groups in both the short and long terms Must determine each group’s objectives Translate objectives into performance measures that have specific, quantifiable performance targets Copyright © Houghton Mifflin Company. All rights reserved.

Planning Managers must evaluate the company vision from the perspective of each stakeholder group Seek to answer one key question for each group These key questions align the organization’s strategy from all perspectives Copyright © Houghton Mifflin Company. All rights reserved.

Planning (cont’d) Financial (investors)
To achieve our organization’s vision, how should we appear to our shareholders? Learning and growth (employees) To achieve our organization’s vision, how should we sustain our ability to improve and change? Internal business processes To succeed, at what business processes must our organization excel? Customers To achieve our organization’s vision, how should we appear to our customers? Copyright © Houghton Mifflin Company. All rights reserved.

Planning (cont’d) Once the organization’s objectives are set, managers can select performance measures and set performance targets Translates objectives into an action plan Copyright © Houghton Mifflin Company. All rights reserved.

Planning (cont’d) If Vail Resorts’ collective vision and strategy is customer satisfaction, its managers might establish the following overall objectives Copyright © Houghton Mifflin Company. All rights reserved.

Planning (cont’d) These overall objectives are then translated into specific performance objectives and measures for managers Examples of how performance measures might be measured for a ski lift manager include Financial Hourly lift cost Lift ticket sales in dollars and in units Copyright © Houghton Mifflin Company. All rights reserved.

Planning (cont’d) Learning and growth Internal business processes
Number of cross-trained tasks per employee Employee turnover Internal business processes Number of accident-free days Number and cost of mechanical breakdowns Average lift cycle time Customers Average number of ski runs per daily lift ticket Number of repeat customers Number of PEAKS points redeemed Copyright © Houghton Mifflin Company. All rights reserved.

Sample Balanced Scorecard of Linked Objectives, Performance Measures, and Targets
Copyright © Houghton Mifflin Company. All rights reserved.

Executing Balance the needs of all stakeholder groups when making management decisions Use mutually agreed-on strategic objectives for the entire organization as the basis for decision making Improve performance by verifying and tracking causal relationships Copyright © Houghton Mifflin Company. All rights reserved.

Reviewing Evaluate performance by comparing financial and nonfinancial results with performance measurement targets Analyze results and recommend changes Determine If the targets were met What measures need to be changed What strategies or objectives need revision Copyright © Houghton Mifflin Company. All rights reserved.

Reporting Prepare reports of interest to stakeholder groups
Financial performance reports Customer PEAKS statements Internal business processes reports for targeted performance measures and results Performance appraisals of individual employees Such reports enable managers to monitor and evaluate performance measures that add value for stakeholder groups Copyright © Houghton Mifflin Company. All rights reserved.

The Balanced Scorecard and the Management Cycle

Discussion With regard to evaluating the company vision from the perspective of the learning and growth (employee) stakeholder group, what key question would managers want to answer? To achieve our organization’s vision, how should we sustain our ability to improve and change? Copyright © Houghton Mifflin Company. All rights reserved.

Performance Measurement
Objective 2 Discuss performance measurement, and state the issues that affect management’s ability to measure performance Copyright © Houghton Mifflin Company. All rights reserved.

Performance Management and Evaluation System
… is a set of procedures that account for and report on both financial and nonfinancial performance Used to identify How well a company is doing Where it is going What improvements will make it more profitable Copyright © Houghton Mifflin Company. All rights reserved.

What to Measure, How to Measure
Performance measurement The use of quantitative tools to gauge an organization’s performance in relation to a specific goal or an expected outcome To succeed, managers must be able to distinguish between what is being measured and the actual measures used to monitor performance Copyright © Houghton Mifflin Company. All rights reserved.

Other Measurement Issues
A unique set of performance measures must be developed that are appropriate to each organization’s situation Copyright © Houghton Mifflin Company. All rights reserved.

Other Measurement Issues (cont’d)
Issues to consider other than what to measure and how to measure it What performance measures can be used? How can managers Monitor the level of product or service quality? Monitor production and other business processes to identify areas that need improvement? Measure customer satisfaction? Monitor financial performance? Copyright © Houghton Mifflin Company. All rights reserved.

Other Measurement Issues (cont’d)
Are there other stakeholders to whom a manager is accountable? What performance measures do government entities impose on the company? How can a manager measure the company’s effect on the environment? Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What does a performance management and evaluation system identify? How well a company is doing, where it is going, and what improvements will make it more profitable Copyright © Houghton Mifflin Company. All rights reserved.

Responsibility Accounting
Objective 3 Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation Copyright © Houghton Mifflin Company. All rights reserved.

Responsibility Accounting
As part of their performance management systems, many organizations Assign resources to specific areas of responsibility Track how the managers of those areas use those resources Evaluate managers at all levels in terms of their ability to manage their area of responsibility in keeping with organizational goals Copyright © Houghton Mifflin Company. All rights reserved.

Responsibility Accounting (cont’d)
Is an information system Classifies data according to areas of responsibility Reports each area’s activities by including only the revenue, cost, and resource categories that the assigned manager can control Copyright © Houghton Mifflin Company. All rights reserved.

Responsibility Accounting (cont’d)
Responsibility center An organizational unit whose manager has been assigned the responsibility of managing a portion of the organization’s resources The activity of the responsibility center dictates the extent of a manager’s responsibility Copyright © Houghton Mifflin Company. All rights reserved.

Types of Responsibility Centers
Cost centers Discretionary cost centers Revenue centers Profit centers Investment centers Copyright © Houghton Mifflin Company. All rights reserved.

Cost Center A responsibility center whose manager is accountable only for controllable costs that have well-defined relationships between the center’s resources and products or services Performance is usually evaluated by comparing an activity’s actual cost with its budgeted cost and analyzing the resulting variances Copyright © Houghton Mifflin Company. All rights reserved.

Cost Centers (cont’d) Examples
Assembly plants in manufacturing organizations Relationship between the costs of resources and resulting products is well defined Food services in hospitals and nursing homes Clear relationship between costs of food and direct labor and the number of inpatient meals served Copyright © Houghton Mifflin Company. All rights reserved.

Discretionary Cost Center
A responsibility center whose manager is accountable for costs only and in which the relationship between resources and products or services produced is not well defined Cost-based measures cannot usually be used to evaluate performance Copyright © Houghton Mifflin Company. All rights reserved.

Discretionary Cost Centers (cont’d)
Examples Administrative activities Accounting Human resources Legal services Research and Development Might measure number of patents obtained and number of cost-saving innovations developed Service organizations United Way might measure administrative activities by how low their costs are as a percentage of total contributions Copyright © Houghton Mifflin Company. All rights reserved.

Revenue Center A responsibility center whose manager is accountable primarily for revenue and whose success is based on its ability to generate revenue Performance is usually evaluated by comparing its actual revenue with its budgeted revenue and analyzing variances Copyright © Houghton Mifflin Company. All rights reserved.

Revenue Centers (cont’d)
Examples Car rental reservation center Clothing retailer ecommerce order department Performance measures for both manufacturing and service organizations may include Sales dollars Number of customer sales Sales revenue per minute Copyright © Houghton Mifflin Company. All rights reserved.

Profit Center A responsibility center whose manager is accountable for both revenue and costs and for the resulting operating income Example Local store of a national chain such as Wal-Mart, Kinko’s or Jiffy Lube Performance evaluated by comparing figures from actual income statements with figures in its master or flexible budget income statement Copyright © Houghton Mifflin Company. All rights reserved.

Investment Center A responsibility center whose manager is accountable for profit generation and can also make significant decisions about the resources the center uses Performance of both manufacturing and service organizations usually evaluated using measures such as Return on investment Residual income Economic value added Copyright © Houghton Mifflin Company. All rights reserved.

Organizational Structure and Performance Management
A company’s organizational structure formalizes its lines of managerial authority and control Organizational chart Visual representation of an organization's hierarchy of responsibility for purposes of management control Five types of responsibility centers are arranged by level of management authority and control Copyright © Houghton Mifflin Company. All rights reserved.

Organizational Structure and Performance Management (cont’d)
Responsibility accounting system Establishes a communications network within an organization Ideal for gathering and reporting information about the operations of each area of responsibility Used to Prepare budgets by responsibility area Report the actual results of each responsibility area Copyright © Houghton Mifflin Company. All rights reserved.

The report for a responsibility center should contain only controllable costs and revenues The costs, revenues, and resources that the manager of a center can control A responsibility accounting system assures managers will not be held responsible for items they cannot change Copyright © Houghton Mifflin Company. All rights reserved.

Partial Organizational Chart of Café Cubano, a Restaurant Chain

Performance reports for each level of management are tailored to each manager’s individual needs for information The same information may appear in various formats in several different reports Information from reports for lower-level managers is usually summarized and condensed when it appears in upper-level managers’ reports Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What is the difference between a cost center and a discretionary cost center? The managers of cost centers are accountable for controllable costs that have well-defined relationships between the center’s resources and products or services The managers of discretionary cost centers are accountable for costs in which the relationship between resources and products or services produced is not well defined. Therefore, cost-based measures cannot usually be used to evaluate performance Copyright © Houghton Mifflin Company. All rights reserved.

Performance Evaluation of Cost Centers and Profit Centers
Objective 4 Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing Copyright © Houghton Mifflin Company. All rights reserved.

Performance Evaluation of Cost Centers and Profit Centers
Performance reports Allow comparisons between actual performance and budget expectations Contain information about costs, revenues, and resources that are controllable by individual managers Allow evaluation of an individual’s performance with respect to responsibility center objectives and companywide objectives Recommend changes If a performance report includes items that the manager cannot control, the credibility of the entire responsibility accounting system can be called into question Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Cost Center Performance Using Flexible Budgeting
Orlena Torres, the VP of food products at Café Cubano, is responsible for the central kitchen, where basic preparation is done on the food products the restaurants sell The central kitchen is a cost center Its costs have well-defined relationships with the resulting products To ensure the central kitchen is meeting its performance goals Torres has decided to evaluate the performance of each food item produced A separate report will be prepared for each product Will compare actual costs with the corresponding amounts from the flexible and master budgets Copyright © Houghton Mifflin Company. All rights reserved.

Central Kitchen’s Performance Report on Café Cubano’s House Dressing

Evaluating Profit Center Performance Using Variable Costing
Profit center performance is usually evaluated by comparing actual income statement results to the budgeted income statement Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Profit Center Performance Using Variable Costing (cont’d)
Method of preparing profit center performance reports that classifies a manager’s controllable costs as either variable or fixed Instead of a traditional income statement, a variable costing income statement is produced Also called full costing or absorption costing income statement Used for external reporting purposes Same as a contribution income statement Useful because it focuses on cost variability and the profit center’s contribution to operating income Copyright © Houghton Mifflin Company. All rights reserved.

When using variable costing to evaluate profit center performance Variable cost of goods sold and variable selling and administrative expenses are subtracted from sales to arrive at the contribution margin for the center All controllable fixed costs are subtracted from gross margin to determine the operating income Includes fixed manufacturing costs and fixed selling expenses Copyright © Houghton Mifflin Company. All rights reserved.

When preparing a traditional income statement All manufacturing costs are assigned to cost of goods sold Cost of goods sold is subtracted from sales to arrive at the gross margin Variable and fixed selling expenses are subtracted from gross margin to determine operating income Copyright © Houghton Mifflin Company. All rights reserved.

Variable costing income statement Groups costs according to whether they are variable or fixed Traditional income statement Groups cost according to whether they are costs of goods sold or manufactured or period costs Copyright © Houghton Mifflin Company. All rights reserved.

Variable Costing Income Statement Versus Traditional Income Statement for Trenton Restaurant

The manager of a profit center may also want to measure and evaluate nonfinancial information Performance reports Vary in format depending on the type of responsibility center Share common themes Compare a center’s actual results to its budgeted figures Focus on the differences Only items managers can control are included Copyright © Houghton Mifflin Company. All rights reserved.

Discussion How does a variable costing income statement arrive at profit center income? Variable cost of goods sold and variable selling expenses are subtracted from sales to determine the contribution margin. All fixed manufacturing costs and fixed selling expenses are subtracted from the contribution margin to arrive at profit center income Copyright © Houghton Mifflin Company. All rights reserved.

Performance Evaluation of Investment Centers
Objective 5 Prepare performance reports for investment centers using traditional measures of return on investment and residual income and the newer measure of economic value added Copyright © Houghton Mifflin Company. All rights reserved.

Performance Evaluation of Investment Centers
Performance evaluation of an investment center must include Comparison of controllable revenues and costs with budgeted amounts Performance measures for capital investments that mangers control Copyright © Houghton Mifflin Company. All rights reserved.

Return on Investment Takes into account both operating income and the assets invested to earn that income Common measure Assets invested is the average of the beginning and ending asset balances for the period Copyright © Houghton Mifflin Company. All rights reserved.

Return on Investment (cont’d)
Income and assets specifically controlled by a manager must be properly measured Critical to the quality of ROI ROI may be used to evaluate the manager of any investment center An entire company A unit within the company Subsidiary, division, or other segment Copyright © Houghton Mifflin Company. All rights reserved.

Performance Report Based on Return on Investment for the Café Cubano Restaurant Division

The ROI computation is the aggregate measure of many interrelationships The basic ROI equation can be rewritten to show the many elements a manager can influence Copyright © Houghton Mifflin Company. All rights reserved.

Two important indicators of performance Profit margin Ratio of operating income to sales Represents the percentage of each sales dollar the results in profit Asset turnover Ratio of sales to average assets invested Indicates the productivity of assets Number of sales dollars generated by each dollar invested in assets Copyright © Houghton Mifflin Company. All rights reserved.

Profit margin and asset turnover help to explain Changes in ROI for a single investment center Differences of ROI among investment centers ROI formula is useful for analyzing and interpreting the elements that make up a business’s overall return on investment Copyright © Houghton Mifflin Company. All rights reserved.

A single ROI number is a composite index of many cause-and-effect relationships and interdependent financial elements Managers can improve ROI by Increasing sales Decreasing costs Decreasing assets Copyright © Houghton Mifflin Company. All rights reserved.

Factors That Affect the Return on Investment Calculation

ROI should be used cautiously in evaluating performance Affected by many factors If overemphasized Investment center managers may make business decisions that favor their personal ROI At the expense of companywide profits or long-term success of other investment centers To avoid this problem, always use other performance measures in conjunction with ROI Copyright © Houghton Mifflin Company. All rights reserved.

Other performance measures to use in conjunction with ROI Comparisons of revenues, costs, and operating income with budgeted amounts or past trends Sales growth percentages Market share percentages Other key variables in the organization's activity Ratio of ROI to budgeted goals and past ROI trends Changes in this ratio over time can be more revealing than any single number Copyright © Houghton Mifflin Company. All rights reserved.

Residual Income … (RI) is the operating income that an investment center earns above a minimum desired return on invested assets Developed because of pitfalls in using ROI as a performance measure Copyright © Houghton Mifflin Company. All rights reserved.

Residual Income (cont’d)
Is not a ratio but a dollar amount Amount of profit left after subtracting a predetermined desired income target for an investment center As with ROI computations, assets invested is the average of the center’s beginning and ending asset balances for the period Copyright © Houghton Mifflin Company. All rights reserved.

Performance Report Based on Residual Income for the Café Cubano Restaurant Division

Comparisons with other RI figures will strengthen the analysis To add context to the analysis, the following questions should be answered How does the division’s RI for this year compare with previous years? Did actual RI exceed budgeted RI? How does this division’s RI compare with the RI of other investment centers of the company? Copyright © Houghton Mifflin Company. All rights reserved.

When comparing a division’s RI with the RI of other investment centers of the company, caution should be used For RI figures to be comparable, all investment centers must have Equal access to resources Similar asset investment bases Managers may be able to produce a larger RI simply because their investment centers are larger May not reflect better performance Copyright © Houghton Mifflin Company. All rights reserved.

… (EVA) is the shareholder wealth created by an investment center
Economic Value Added … (EVA) is the shareholder wealth created by an investment center Used as an indicator of performance Is a registered trademark of the consulting firm Stern Stewart & Company Copyright © Houghton Mifflin Company. All rights reserved.

Economic Value Added (cont’d)
Calculation can be complex Makes various cost of capital and accounting principles adjustments EVA is expressed as a dollar amount or Cost of capital is the minimum desired rate of return on an investment, such as assets invested in an investment center Copyright © Houghton Mifflin Company. All rights reserved.

Performance Report Based on Economic Value Added for the Café Cubano Restaurant Division

Caution should be used when evaluating performance using EVA Many factors affect the economic value of an investment center Compare the current EVA with EVAs from previous periods Target EVAs EVAs from other investment centers Copyright © Houghton Mifflin Company. All rights reserved.

Factors Affecting the Computation of Economic Value Added

An investment center’s EVA is affected by a manager’s decisions on Pricing Product sales volume Taxes Cost of capital Capital investments Other financial decisions Copyright © Houghton Mifflin Company. All rights reserved.

The EVA number is a composite index drawn from many cause-and-effect relationships and interdependent financial elements Managers can improve the EVA of an investment center by Increasing sales Decreasing costs Decreasing assets Lowering the cost of capital Copyright © Houghton Mifflin Company. All rights reserved.

The Importance of Multiple Performance Measures
To be effective, a performance management system must consider both operating results and multiple performance measures, such as ROI, RI, and EVA Comparing actual results to budgeted figures adds meaning to the evaluation Copyright © Houghton Mifflin Company. All rights reserved.

The Importance of Multiple Performance Measures (cont’d)
Performance measures such as ROI, RI, and EVA Indicate whether an investment center is effective in coordinating its goals with companywide goals Take into account both operating income and the assets used to produce that income Are limited by their focus on short-term financial performance Management should break these measures down into their components, analyze information over time, and compare current results to targeted amounts Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What may happen if return on investment is overemphasized as a performance measure? Investment center managers may make business decisions that favor their personal ROI at the expense of companywide profits or long-term success of other investment centers To avoid this problem, always use other performance measures in conjunction with ROI Copyright © Houghton Mifflin Company. All rights reserved.

Performance Incentives and Goals
Objective 6 Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation Copyright © Houghton Mifflin Company. All rights reserved.

Performance Incentives and Goals
The effectiveness of a performance management and evaluation system depends on successful coordination of goals between Responsibility centers Managers Entire company Two key factors Logical linking of goals to measurable objects and targets Performance-based pay Copyright © Houghton Mifflin Company. All rights reserved.

Linking Goals, Performance Objectives, Measures, and Performance Targets
The causal links between an organization’s goals, performance objectives, measures, and targets must be apparent Recall that the balanced scorecard also links objectives, measures, and targets Copyright © Houghton Mifflin Company. All rights reserved.

Performance-Based Pay
… is the linking of employee compensation to the achievement of measurable business targets Increases likelihood that the goals of responsibility centers, managers, and the entire organization will be well coordinated Copyright © Houghton Mifflin Company. All rights reserved.

Performance-Based Pay (cont’d)
Common types of incentive compensation Cash bonuses Usually awarded for short-term performance Awards May be a trip or some other form of recognition Profit-sharing plans Reward employees with a share of the company’s profits Stock option programs Used to motivate employees to achieve financial targets that increase the company’s stock price Copyright © Houghton Mifflin Company. All rights reserved.

The Coordination of Goals
Incentive plans must be developed with input from all employees to be effective Employees and managers must answer the following questions to determine the right performance incentives for their organization When should the reward occur? Whose performance should be rewarded? How should the reward be computed? On what should the reward be based? What performance criteria should be used? Does the performance incentive plan address the interests of all stakeholders? Copyright © Houghton Mifflin Company. All rights reserved.

The Coordination of Goals (cont’d)
The effectiveness of a performance management and evaluation system relies on the coordination of responsibility center, managerial, and company goals Can be optimized by Linking goals to measurable objectives and targets Tying appropriate compensation incentives to the achievement of the targets Copyright © Houghton Mifflin Company. All rights reserved.

The Coordination of Goals (cont’d)
Each organization’s unique circumstances will determine its correct mix of measures and compensation incentives If management values the perspectives of all its stakeholder groups, its performance and evaluation system will balance and benefit all interests Copyright © Houghton Mifflin Company. All rights reserved.

Discussion The successful coordination of goals between responsibility centers, managers, and the entire company is dependent upon what two key factors? The logical linking of goals to measurable objects and targets and performance-based pay Copyright © Houghton Mifflin Company. All rights reserved.

Time for Review Describe how the balanced scorecard aligns performance with organizational goals, and explain the role of the balanced scorecard in the management cycle Discuss performance measurement, and state the issues that affect management’s ability to measure performance Copyright © Houghton Mifflin Company. All rights reserved.

More Review Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing Copyright © Houghton Mifflin Company. All rights reserved.

And Finally… Prepare performance reports for investment centers using traditional measures of return on investment and residual income and the newer measure of economic value added Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation Copyright © Houghton Mifflin Company. All rights reserved.

Performance Management and Evaluation

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