2. Decentralization and Performance Evaluation
CHAPTER 12
Decentralization and Performance Evaluation

3. 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

4. Decentralized Organizations

5. 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

6. Disadvantages of Decentralization
Costly duplication of activities
Lack of goal congruence
Management pursues personal goals
Personal goals are incompatible with the company’s goals
To control goal congruence, companies evaluate the performance of subunit managers

7. Reasons for evaluating subunit managers:
Why Companies Evaluate the Performance of Subunits and Subunit Managers
A company evaluates subunits in order to decide if it should expand or contract them or change their operations
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

8. Responsibility Accounting and Performance Evaluation
Responsibility accounting is a technique that holds managers responsible only for costs and revenues that they can control
To implement responsibility accounting in a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled

9. Tracing Costs to Organizational Levels

10. Responsibility Centers
Cost Centers
Profit Centers
Investment Centers

11. Cost Centers
Subunit responsible for controlling costs but not responsible for generating revenue
Most service departments are cost centers (i.e., 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

12. Profit Centers
Subunit responsible for generating revenues and 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
A variety of methods are used to evaluate profitability
Current income compared to budgeted income
Current income compared to past income
Comparison with other profit centers, called relative performance evaluation

13. 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

14. Nordstrom

15. Study Break #1 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

16. Study Break #2 Cost centers are often evaluated using: Answer:
Variance analysis
Operating margin
Return on investment
Residual income
Answer:
a. Variance analysis

17. Study Break #3 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

18. Evaluating Investment Centers With ROI
ROI is a primary tool for evaluating the performance of investment centers
= Investment Center Income
Invested Capital
Focuses management’s attention on income and level of investment

19. ROI Components
ROI may be broken down into two components: profit margin and investment turnover.
ROI = Profit Margin x Investment Turnover
ROI = Income x ____Sales_____
Sales Invested Capital

20. 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
To calculate NOPAT, a company must add back nonoperating items to net income and adjust tax expense accordingly
See next slide for example

21. NOPAT Example

22. 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 noninterest-bearing current liabilities (method used in this textbook)

23. Invested Capital Example

24. ROI – France, Germany, and Japan

25. Example Exercise #1
Davenport Mills is a division of Iowa Woolen Products, Inc. For the most recent year, Davenport had net income of $16,000,000. Included in income was interest expense of $1,300,000. The operation’s tax rate is 40%. Total assets of Davenport Mills are $225,000,000, current liabilities are $45,000,000, and $30,000,000 of the current liabilities are noninterest-bearing.
Calculate NOPAT, invested capital, and ROI.

26. Example Exercise #1 Solution
NOPAT
= Net income + interest expense (1 - tax rate)
= $16,000,000 + $1,300,000 ( )
= $16,780,000
Invested Capital
= Total assets - noninterest-bearing current liabilities
= $225,000,000 - $30,000,000
= $195,000,000

27. Example Exercise #1 Solution
ROI
= NOPAT ÷ Invested capital
= $16,780,000 ÷ $195,000,000
= 86.05%

28. Problems with 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
Managers may put off purchase of new equipment
May lead to underinvestment

29. Problems of Overinvestment and Underinvestment
You get what you measure!
Evaluation using Profit can lead to overinvestment
Managers may be motivated to make investments that earn a return that is less than the cost of capital
Evaluation using ROI can lead to underinvestment
Managers may not take on projects that have a low ROI just to increase profit if they are evaluated in terms of the return they earn

30. Example Exercise #2
Using the same information as in Example Exercise #1, please calculate the residual income if the company’s cost of capital is 10%.

31. Example Exercise #2 Solution
Residual Income
= NOPAT – (Cost of Capital x Invested Capital)
= $16,780,000 – (10% x $195,000,000)
= ($2,720,000)

32. 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
We use total assets minus noninterest-bearing current liabilities as a measure of investment

33. Decision Making

34. 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
For example, under GAAP research and development costs are expensed, but the costs benefits future periods
Thus, under EVA research and development is capitalized and amortized over future periods

35. Residual Income

36. Study Break #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

37. Study Break #5 Investment centers are often evaluated using: Answer:
Standard cost variances
Return on investment
Residual income/EVA
Both b and c
Answer:
d. Both b and c

38. EVA

39. Using a Balanced Scorecard to Evaluate Performance
A problem in using financial measures like ROI and EVA is that they are “backward looking”

40. Balanced Scorecard
Set of performance measures constructed for four dimensions of performance
Financial
Critical measures even if they are backward looking
Customer
Examines the company’s 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

41. 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!

42. Balanced Scorecard

43. How Balance is Achieved in a Balanced Scorecard
Performance is assessed across a balanced set of dimensions
Balance quantitative measures with qualitative measures
There is a balance of backward-looking measures and forward-looking measures

44. You Get What You Measure

45. 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
Used to test the soundness of the strategy
Identifies how strategy is linked to measures on the scorecard
Communicates strategic objectives to employees

46. Strategy Map Example

47. 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
Responsibility
A particular employee must be given responsibility and held accountable for successfully implementing each initiative
Funding
Initiatives must be funded appropriately
Top Management Support
It is crucial to have the full support of top management

48. EVA

49. Transfer Pricing
The price that is used to value internal transfers of goods or services is referred to as transfer pricing
Subunits of a company sell goods or services to other subunits within the same company
Must determine the price that is used to value the value of internal transfers

50. Methods of Setting the Transfer Price
Primary alternatives:
Market Price
Variable Costs
Full Cost Plus Profit
Negotiated Prices
The most appropriate transfer price depends on the circumstances
Should lead subunit managers to make decisions that maximize firm value

51. Transfer Pricing
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

52. Lowering Transfer Price Below the Market Price

53. Copyright
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