2. 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
Learning objective 1: List and explain the advantages and disadvantages of decentralization

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

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

6. 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

7. 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

8. 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

9. 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

10. 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

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

12. 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

13. 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

14. 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

15. 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

16. 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

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

18. 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

19. 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

20. 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

21. 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)

22. 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)

23. 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)

24. 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)

25. 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)

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. 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 ( )
= $16,780,000
Learning objective 4: Calculate and interpret return on investment (ROI)

29. 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)

30. 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)

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
- 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, 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)

34. 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)

35. 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

36. 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

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. 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)

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

40. 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)

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

42. 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)

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. 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

46. 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

47. 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

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

49. 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

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

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

52. 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

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

54. 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

55. 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

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

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

58. 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

59. 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

60. 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

61. 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

62. 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

63. Copyright
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