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Performance Evaluation

Chapter 10

Objective 1

Understand decentralization and describe the different types of responsibility centers

Decentralization

Splitting operations into different operating segments

Advantages

Frees top management’s time

Use of expert knowledge

Improves customer relations

Provides training

Improves motivation and retention

Disadvantages

Duplication of costs

Potential problems achieving goal congruence

Performance Evaluation Systems

Provide upper management with feedback

To be effective, should

Clearly communicate expectations

Provide benchmarks that promote goal congruence and coordination between segments

Motivate segment managers

Responsibility Accounting

Responsibility Center - part of an organization whose manger is accountable for planning and controlling activities

Responsibility Accounting - system for evaluating performance of each responsibility center and its manger.

Types of Responsibility Centers

Cost Center

Revenue Center

Profit Center

Investment Center

Objective 2

Develop performance reports for different responsibility centers

Responsibility Center Performance Reports

Performance Report – compares actual revenues and expenses to budgeted figures

Variance – difference between actual and budget

Favorable variance: causes operating income to be higher than budgeted

Unfavorable variance: causes operating income to be lower than budgeted

Management by exception

Exhibit 10-3: Partial Performance Report for Revenue Center

Segment Margin

The operating income generated by a profit or investment center before subtracting common fixed costs that have been allocated to the center

Exhibit 10-4: Performance Report Highlighting Segment Margin

Organization-Wide Performance Reports

Performance reports for each level of management flow up

Controllable vs. uncontrollable variances

Objective 3

Calculate ROI, Sales Margin, and Capital Turnover

Evaluation of Investment Centers

Duties of Investment center manager similar to CEO

To assess performance

Return on Investment (ROI)

Residual Income (RI)

Return on Investment (ROI)

Measures the amount of income an investment center earns relative to the size of its assets

ROI = Operating Income

Total Assets

Sales Margin and Capital Turnover

ROI = Operating Income x Sales___

Sales Total Assets

(ROI = Sales Margin x Capital Turnover)

S10-6

Functional Ingredients

Sales margin $5,445 / $21,780 = 25.0%

Capital turnover $21,780 / $12,100 = 1.8

ROI 25.0% x 1.8 = 45.0%

Consumer Markets

Sales margin $2,075 / $20,750 = 10.0%

Capital turnover $20,750 / $8,300 = 2.5

ROI 10.0% x 2.5 = 25.0%

Performance Markets

Sales margin $3,000 / $15,000 = 20.0%

Capital turnover $15,000 / $10,000 = 1.5

ROI 20.0% x 1.5 = 30.0%

Residual Income

Determines whether the division has created any excess (residual) income above management’s expectations

Incorporates Target Rate of Return

RI = Operating Income – Minimal acceptable income

RI = Operating Income – (Target rate of return x Total assets)

S10-9

Snow Sports RI = $1,040,000 − ($4,000,000 × 16%) = $400,000

Non-Snow Sports RI = $1,680,000 − ($6,000,000 × 16%) = $720,000

Goal Congruence

Residual Income enhances goal congruence, whereas ROI may or may not

Measurement Issues

Which balance sheet data should we use?

Should we include all assets?

Should we use gross book value or net book value of the assets?

Should we make other adjustments to income or assets?

Limitations of Financial Performance Evaluation

Short-term focus

Potential Remedy: management can measure financial performance using a longer time horizon

Incentivizes segment managers to think long term rather than short term

Transfer Pricing

The price charged for the internal sale between two different divisions of the same company

Encourage transfer only if the company would benefit by the exchange

Vertical Integration

Exhibit 10-9: Strategies to Determine Transfer Price

	Advantages	Disadvantages	Considerations
Market Price	Usually viewed as fair by both parties.	Can only be used if an outside market exists.	The market price could be reduced by any cost savings occurring from the internal sale..
Negotiated	Allows division managers to act autonomously rather than being dictated a transfer price by top management.	Takes time and effort. May lead to friction (or better understanding) between division managers.	Negotiated transfer price will generally fall in the range between variable cost (low end) and market price( high end).
Cost or Cost-plus a markup	Useful if a market price is not available.	Selling division has no incentive to control costs. A “fair” markup may be difficult to determine.	Several definition of cost could be used, ranging from variable cost to full absorption cost.

Global Considerations

Do the divisions operate under different taxing authorities such that income tax rates are higher for one division?

Would the amount paid to customs and duties be impacted by the transfer price used?

Objective 4

Prepare and evaluate Flexible Budget Performance Reports

Flexible Budget

A budget prepared for a different level of volume than that which was originally anticipated

Master Budget Variance – Difference between the actual revenues and expenses and the master budget

“Apples-to-oranges” comparison

Exhibit 10-11 Creating a Flexible Budget Performance Report

Volume Variance

The difference between the master budget and the flexible budget

Arises only because the actual volume differs from the volume originally anticipated in the master budget

Exhibit 10-12 Volume Variances

Flexible Budget Variance

The difference between the flexible budget and the actual results

Exhibit 10-13 Flexible Budget and Volume Variances

Underlying Causes of the Variances

Management by exception

Use performance reports to see how operational decisions affected company’s finances

Master Budget Variance: A Combination of Variances

Flexible Budget Variance

Volume Variance

Master Budget Variance

Objective 5

Describe the balanced scorecard and identify KPIs for each perspective

Nonfinancial Performance Measurement

Lag indicators - reveal the results of past actions and decisions

Lead indicators - predict future performance

The Balanced Scorecard

Management must consider both financial and operational performance measures

Major shift: financial indicators are no longer the sole measure of performance

Four Perspectives of the Balanced Scorecard

Financial

Customer

Internal Business

Learning and Growth

Key Performance Indicator (KPI)

Summary performance metric; assesses how well the company is achieving its goals

Continually measured

Reported on performance scorecard or performance dashboard

Financial Perspective

“How do we look to shareholders?”

Must continually attempt to increase profits

Increase revenues

Control costs

Increase productivity

Customer Perspective

“How do customers see us?”

Customers concerned with four product/service attributes:

Price

Quality

Sales service

Delivery time

Internal Business Perspective

“At what business processes must we excel to satisfy customer and financial objectives?”

Three factors:

Innovation

Operations

Post-sales support

Learning and Growth Perspective

“Can we continue to improve and create value?”

Three factors:

Employee capabilities

Information system capabilities

Company’s “climate for action”

Sustainability and Performance Evaluation

Sustainability-related KPIs

Fifth perspective - “Sustainability”

Sixth perspective - “Community”

End of Chapter 10