1. Prepared by Debby Bloom-Hill CMA, CFM

2. Performance Evaluation
CHAPTER 12
Decentralization
and
Performance Evaluation

3. Decentralized Organizations
As firms increase in size and complexity, business segments or subunits are organized
The managers of the segments are granted decision making authority so that the firm will function efficiently and effectively
Firms that grant substantial decision making authority to the managers of subunits are referred to as decentralized organizations
Learning objective 1: List and explain the advantages and disadvantages of decentralization

4. Decentralized Organizations
Most firms are neither totally centralized nor totally decentralized
Typically, decentralization is a matter of degree
A firm is more decentralized if more decision making authority is delegated to sub-unit managers
Performance evaluation can be used to ensure that managers make decisions that are in the best interest of the entire firm
Learning objective 1: List and explain the advantages and disadvantages of decentralization

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

6. Advantages of Decentralization
A primary reason is that subunit managers have better information than top management and can respond quicker to changing circumstances
Other reasons include
Some firms decentralize because they believe that managers are more motivated and work harder
Decentralized organizations provide excellent training for future top-level executives
Learning objective 1: List and explain the advantages and disadvantages of decentralization

7. Disadvantages of Decentralization
Decentralization can cause problems
It may result in a costly duplication of activities
Managers may pursue personal goals that are incompatible with the goals of the company as a whole
This problem is called goal congruence
To control goal congruence, companies evaluate the performance of subunit managers
Learning objective 1: List and explain the advantages and disadvantages of decentralization

8. Test Your Knowledge 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 12-8
Learning objective 1: List and explain the advantages and disadvantages of decentralization

9. Evaluating Subunits
Evaluation of subunits is undertaken to identify successful operations and areas needing improvement
Top management may perform incremental analysis to determine:
Whether a successful operation should be expanded
Whether an unsuccessful operation should be eliminated or improved
Slide 12-9
Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers

10. 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

11. 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 used to evaluate managers
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

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

13. Responsibility Centers
Responsibility centers are organizational units responsible for the generation of revenue and/or the incurrence of costs
Responsibility centers typically are classified as being
Cost centers
Profit centers, or
Investment centers
Learning objective 3: Identify cost centers, profit centers, and investment centers

14. Cost Centers
A cost center is a subunit that has responsibility for controlling costs but does not have responsibility for generating revenue
Most service departments are classified as cost centers
The managers of these departments are responsible for making sure their services are provided at a reasonable cost to the company
Learning objective 3: Identify cost centers, profit centers, and investment centers

15. Cost Centers
A common approach to controlling cost centers is to compare their actual costs with standard or budgeted costs
If variances from standard are significant, an investigation into the activities of the cost center should be undertaken to determine whether costs are out of control
Other performance measures can be used as well
Learning objective 3: Identify cost centers, profit centers, and investment centers

16. Profit Centers
A profit center is a subunit that has responsibility for generating revenues as well as for controlling costs
Because both revenues and costs are under the control of the profit center manager, the performance of the profit center can be evaluated in terms of profitability
This motivates managers to focus their attention on ways of maximizing profit center profitability
Learning objective 3: Identify cost centers, profit centers, and investment centers

17. Profit Centers Companies use a variety of methods to profit centers
Income earned in the current year may be compared with an income target
Income earned may be compared with income earned in the prior year
Some firms use relative performance evaluation, which involves evaluating the profitability of each profit center relative to the profitability of similar profit centers
Slide 12-17
Learning objective 3: Identify cost centers, profit centers, and investment centers

18. Investment Centers
An investment center is a subunit that is responsible for generating revenue, controlling costs, and investing in assets
An investment center is changed with earning income consistent with the amount of assets invested in the segment
Learning objective 3: Identify cost centers, profit centers, and investment centers

19. Investment Centers
If the manager can influence decisions affecting investment in divisional assets, the division should be considered an investment center
Managers play a major role in the determining the level of inventory, accounts receivable and equipment
It seems reasonable to hold them responsible for earning a return on these assets
Learning objective 3: Identify cost centers, profit centers, and investment centers

20. Test Your Knowledge 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

21. Test Your Knowledge 3 Profit centers are often evaluated using:
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

22. Evaluating Investment Centers With ROI
One of the primary tools for evaluating the performance of investment centers is return on investment, or ROI
ROI is calculated as the ratio of investment center income to invested capital
Focuses management’s attention on both income (numerator) and the level of investment (denominator)
Learning objective 4: Calculate and interpret return on investment (ROI)

23. ROI Components Some companies break ROI into two components
Profit margin and
Investment turnover
Learning objective 4: Calculate and interpret return on investment (ROI)

24. Measuring Income and Invested Capital for ROI
In calculating ROI, companies measure “income” in a variety of ways
Net income, earnings before interest and taxes, controllable profit, etc.
Most common method is NOPAT
Net operating profit after taxes
NOPAT excludes interest expense, which is a nonoperating expense
Therefore, add interest expense back to net income and adjust tax expense accordingly
Slide 12-24
Learning objective 4: Calculate and interpret return on investment (ROI)

25. Measuring Income and Invested Capital for ROI
In calculating ROI, companies measure “invested capital” in a variety of ways
Common approaches include
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)

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

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

28. Test Your Knowledge 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 NOPAT
= Net income + interest expense (1 - tax rate)
= $16,000,000 + $1,300,000 ( )
= $16,780,000
Learning objective 4: Calculate and interpret return on investment (ROI)

29. Test Your Knowledge 5 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 current liabilities = $225,000,000 - $30,000,000
= $195,000,000
Learning objective 4: Calculate and interpret return on investment (ROI)

30. Test Your Knowledge 6 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)

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

32. 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
This makes comparison of investment centers using ROI difficult
Learning objective 4: Calculate and interpret return on investment (ROI)

33. Problems with Using ROI
Managers may put off purchase of new equipment, which 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)

34. Problems of Overinvestment and Underinvestment
We would like managers to invest in assets that earn a return in excess of the cost of capital
If we evaluate managers in terms of growth in profit, they may be motivated to make investments that earn a return that is less than the cost of capital
This is called 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

35. Problems of Overinvestment and Underinvestment
An obvious solution is to evaluate managers in terms of ROI
Managers won’t be motivated to take on projects with a low return just to increase profits
ROI can lead managers to underinvest, that is they may pass up projects that earn a return that is greater than the cost of capital
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

36. Test Your Knowledge 7 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

37. 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

38. Evaluation Using Economic Value Added (EVA)
An approach to solving overinvestment and underinvestment problems involves the use of a performance measure known as economic value added (EVA)
Firms that use EVA typically tie bonus compensation to the measure
Thus, managers become very focused on achieving high levels of EVA
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

39. Residual Income (RI)
Residual income (RI) is the net operating profit after taxes of an investment center in excess of its required profit
The 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
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

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

41. Economic Value Added (EVA)
Economic value added, better known as EVA, is simply residual income adjusted for “accounting distortions” that arise from following GAAP
GAAP required R&D to be expensed in the period incurred, but with EVA it is capitalized as an asset and amortized over future periods of benefit
𝐄𝐕𝐀= 𝐍𝐎𝐏𝐀𝐓 𝐚𝐝𝐣𝐮𝐬𝐭𝐞𝐝 −(𝐂𝐨𝐬𝐭 𝐨𝐟 𝐂𝐚𝐩𝐢𝐭𝐚𝐥∗ 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐚𝐝𝐣𝐮𝐬𝐭𝐞𝐝 )
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

42. Test Your Knowledge 8 Investment centers are often evaluated using:
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)

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

44. 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

45. Using a Balanced Scorecard to Evaluate Performance
A problem with assessing performance with measures like profit, ROI and EVA is that these measures are all backward looking
The balanced scorecard is an approach to performance measurement that also focuses on what managers are doing today to create future shareholder value
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

46. Balanced Scorecard
The balanced scorecard is constructed for four dimensions of performance
Financial
Having financial measures is critical even if they are backward looking
Customer
Examines the company’s success in meeting customer expectations
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

47. Balanced Scorecard
The balanced scorecard is constructed for four dimensions of performance
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

48. Tying the Balanced Scorecard Measures to the Strategy for Success
Typically, a company will develop three to five performance measures for each dimension
Where possible, measures should be tied to the company’s strategy for success
Balance among the dimensions is critical
You get what you measure!
Companies need measures that drive desirable behaviors
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

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

50. 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

51. Balanced Scorecard Slide 12-51
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

52. Balanced Scorecard Slide 12-52
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

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

54. 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 of the balanced scorecard
It is useful to test the soundness of the strategy and how the strategy is linked to measures on the scorecard
It is 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

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

56. 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

57. 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
It is crucial to have the full support of top management
Learning objective 9: Discuss the key items related to a successful balanced scorecard

58. Keys to a Successful Balanced Scorecard
Slide 12-58
Learning objective 9: Discuss the key items related to a successful balanced scorecard

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

60. Appendix - Transfer Pricing
The transfer price is the price that is used to value internal transfers of goods or services
For external financial reporting purposes, a company cannot recognize revenue on the sale of goods between responsibility centers within the firm
The revenue has not been realized
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

61. Methods of Setting the Transfer Price
In practice, a number of different approaches are taken to setting transfer prices
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

62. 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

63. 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

64. Transfer Pricing Slide 12-64
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

65. Copyright
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