Performance
Evaluation
Chapter 10
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1
Objective 1
Understand decentralization and
describe the different types of
responsibility centers
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2
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
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3
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
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4
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.
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Types of Responsibility Centers
•
•
•
•
Cost Center
Revenue Center
Profit Center
Investment Center
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Objective 2
Develop performance reports for
different responsibility centers
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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
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Exhibit 10-3: Partial Performance
Report for Revenue Center
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9
Segment Margin
The operating income generated by a profit or
investment center before subtracting common
fixed costs that have been allocated to the
center
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Exhibit 10-4: Performance Report Highlighting Segment Margin
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Organization-Wide Performance
Reports
• Performance reports for each level of
management flow up
• Controllable vs. uncontrollable variances
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12
Objective 3
Calculate ROI, Sales Margin, and Capital
Turnover
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Evaluation of Investment Centers
• Duties of Investment center manager similar
to CEO
• To assess performance
– Return on Investment (ROI)
– Residual Income (RI)
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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
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Sales Margin and Capital Turnover
• ROI = Operating Income x
Sales___
Sales
Total Assets
(ROI = Sales Margin x Capital Turnover)
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16
S10-6
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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%
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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)
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S10-9
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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
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21
Goal Congruence
Residual Income enhances goal congruence,
whereas ROI may or may not
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22
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?
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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
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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
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Exhibit 10-9: Strategies to Determine Transfer
Price
Advantages
Disadvantages
Market Price
Usually viewed as fair
by both parties.
Can only be used if an The market price
outside market exists. 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.
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Considerations
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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?
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27
Objective 4
Prepare and evaluate Flexible Budget
Performance Reports
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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
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Exhibit 10-11 Creating a Flexible Budget Performance Report
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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
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Exhibit 10-12 Volume Variances
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Flexible Budget Variance
The difference between the flexible budget and
the actual results
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Exhibit 10-13 Flexible Budget and Volume Variances
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Underlying Causes of the Variances
• Management by exception
• Use performance reports to see how
operational decisions affected company’s
finances
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Master Budget Variance: A
Combination of Variances
Flexible Budget Variance
Volume Variance
Master Budget Variance
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Objective 5
Describe the balanced scorecard and
identify KPIs for each perspective
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Nonfinancial Performance
Measurement
• Lag indicators - reveal the results of past
actions and decisions
• Lead indicators - predict future performance
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The Balanced Scorecard
• Management must consider both financial and
operational performance measures
• Major shift: financial indicators are no longer
the sole measure of performance
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Four Perspectives of the Balanced
Scorecard
•
•
•
•
Financial
Customer
Internal Business
Learning and Growth
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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
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Financial Perspective
• “How do we look to shareholders?”
• Must continually attempt to increase profits
– Increase revenues
– Control costs
– Increase productivity
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42
Customer Perspective
• “How do customers see us?”
• Customers concerned with four
product/service attributes:
– Price
– Quality
– Sales service
– Delivery time
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43
Internal Business Perspective
• “At what business processes must we excel to
satisfy customer and financial objectives?”
• Three factors:
– Innovation
– Operations
– Post-sales support
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Learning and Growth Perspective
• “Can we continue to improve and create
value?”
• Three factors:
– Employee capabilities
– Information system capabilities
– Company’s “climate for action”
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Sustainability and Performance
Evaluation
• Sustainability-related KPIs
• Fifth perspective - “Sustainability”
• Sixth perspective - “Community”
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End of Chapter 10
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