Performance Evaluation
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Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. 1
Performance Evaluation
Chapter 10
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Objective 1Understand decentralization and
describe the different types of responsibility centers
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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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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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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 2Develop 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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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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Objective 3Calculate 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 IncomeTotal 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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S10-6
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S10-6Functional 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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Goal Congruence
Residual Income enhances goal congruence, whereas ROI may or may not
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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 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.
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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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Objective 4Prepare 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 5Describe 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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Customer Perspective
• “How do customers see us?”• Customers concerned with four
product/service attributes:– Price– Quality– Sales service– Delivery time
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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