PERFORMANCE MEASUREMENT SYSTEMS

Responsibility Budgeting & Accounting

The Rise of BureaucracyPerfected by Prussians during 19th

Century – detailed centralized materials requirements

and logistical planning (input budgets), – control by rules, standard operating

procedures, and the merit principle, – functional administrative design,

distinction between staff and line– decomposition of tasks to their simplest

components,– Sequential processing.

Bureaucracy• made large, complex organizations

possible; also made them inevitable• POSDCORB functions were all

treated as separate concerns, performed by staff specialists and coordinated by top mgmt.

• substantial staff resources needed to gather and process data for top mgmt. to coordinate activities and allocate resources

The MarketingInformation System

Marketingmanagers

Analysis

Planning

Implemen-tation

Control

Assessinginformation

needs

Distributinginformation

Internalrecords

Marketing decisions andMarketing decisions and communicationcommunication

Marketingenvironment

Testmarkets

Marketingchannels

Competitors

Publics

Macro-environment

forces

Marketing Information System

Developing information

Marketingintelligence

Marketingresearch

Marketingdecision supportanalysis

Managing at Arms Length• Multi-product, or M-form, organizational

structure – each major operating division serves a

distinct product market

• Decentralized control – by the numbers, using the DuPont system

of financial controls, return-on-assets target

• Coordination– short run via transfer prices– Long run via modern capital budgeting

system

Responsibility BudgetingThe most common decentralized control

system used by large-scale organizations (a) units and managers are evaluated relative to the targets they accept, (b) only financial measures are used to measure and reward accomplishment or punish failure, and (c) financial success or failure is attributed entirely to managerial decisions and/or employee performance.

Types of Responsibility CentersDiscretionary & Engineered

expense centersRevenue centers Cost centers

Standard cost centers

Quasi-profit centers

Profit centersInvestment Centers

EXPENSE CENTERSManagers are

responsible for executing the budget (Spending as planned)

Little discretion to acquire assets; no discretion to exceed authorized spending levels

OE & Program Budgets are Discretionary Expense Budgets(given recipe]

Performance Budgets are Engineered Expense Budgets[recipe varies with volume]

OE & Program Budgets are Discretionary Expense Budgets(given recipe]

Performance Budgets are Engineered Expense Budgets[recipe varies with volume]

Revenue centers• In some cases, expense center

managers are evaluated in terms of the number and type of activities performed by their center.

• Revenue centers are expense centers that earn revenue or are assigned notational revenue (transfer price) by the organization's controller as a direct result of the activities they perform.

Cost centers• Cost center managers are responsible for

producing a stated quantity and/or quality of output at the lowest feasible cost. Someone else within the organization usually determines the output of a cost center.

• Cost center managers are usually free to acquire short-term assets (those that are wholly consumed within a performance measurement cycle), to hire temporary or contract personnel, and to manage inventories.

Standard cost centers• In a standard cost center, output

levels are determined by requests from other responsibility centers

• The manager's budget for each performance measurement cycle is determined by multiplying actual output by standard cost per unit.

• Performance is measured against this figure -- the difference between actual costs and standard costs.

Quasi-profit centers• In a quasi-profit center, performance is

measured by the difference between the notational revenue earned and costs

• For example, – a VA hospital radiology department performs

500 chest X-rays and 200 skull X-rays.

– The notational revenue earned is $25 per chest

X-ray (500) = $12,500 and $50 per skull X-ray

(200) = $10,000, or $22,500 total.

– If the department’s costs are $18,000, it earns a

quasi-profit of $4,500 ($22,500 - $18,000).

Profit centers• In profit centers, managers are

responsible for both revenues and costs. Profit is the difference between revenue and cost (or expense).

• In addition to the authority to acquire short-term assets, to hire temporary or contract personnel, and to manage inventories, profit center managers are usually given the authority to make long-term hires, set salary and promotion schedules (subject to organization wide standards), organize their units, and acquire long-lived assets costing less than some specified amount.

Investment Centers• In investment centers, managers are

responsible for both profit and the assets used in generating the profit.

• Investment center managers are typically evaluated in terms of return on assets (ROA) -- the ratio of profit to assets employed.

• In recent years many have turned to economic value added (EVA), net operating "profit" less an appropriate capital charge.

Responsibility budgets I

For expense centers the budget is a spending plan– For discretionary expense

centers, fixed spending targets

– For engineered expense centers, flexible spending targets (i.e., the budget has two components, a discretionary component and a component that varies directly with volume)

Responsibility budgets II For a cost or profit centers the

budget is a performance target or goal– For cost centers, the target is a

unit-cost standard

– For quasi-profit centers, the target is a quasi-profit measure: (Standard Cost [units delivered] – Actual Unit Cost [units delivered]).

Responsibility budgets III For profit centers, the budget is a

profit target [revenue – cost of goods sold.]

The budget of an investment center is also a target or goal – usually return on assets [ROA or ROI] or residual income [EVA or RI]

The main difference between investment centers and all other responsibility centers is that the former approve their own capital budgets

Capital budgeting I is concerned with changes that

have multi-period consequences for the responsibility center in question e.g. investment in new plant or

equipment, a new program, a major process enhancement, etc.

Where cost and profit centers are concerned, some higher authority must approve these kinds of projects. And, each time a project is approved, the targets for the current period should be adjusted accordingly, as should future year targets.

Capital budgeting IIIN CONTRAST, investment

center mangers make these kinds of decisions without the approval of a higher authority.

Their budgets are expressed in terms that reflect their skill in managing assets: ROA, EVA.

Formerly, individual production units were typically standard cost centers; staff units were typically discretionary expense centers. Mission centers were investment centers.

Mission centers in private sector organizations produce final products that are easily priced and that are expensed following generally accepted accounting practice.

In contrast, support centers produce intermediate products and these were, until recently, hard to cost, let alone price, with accuracy. Attempts to do so were often either excessively arbitrary or prohibitively costly.

Modern Control MethodsNew developments in

management control technique

Recognized that firms in Japan and Germany were producing higher quality goods and services at a lower cost:

JIT, Cycle-time analysis, Cost of Quality Analysis, Balanced Scorecards, and the Rules of BPR

The German Critique• Narrow rather than

comprehensive

• Uses wrong cost drivers

• Unwillingness to rely on statistical cost measures and estimates

• Poor averaging, especially temporal averaging

• Failure to distinguish between needs of financial reporting and management control

Investment Centers (Charging for Assets Used] IThe charge for invested capital =

[working capital + fixed capita] * discount rate

This approach contains three errors [assumed to be self-correcting]

HC is used rather than replacement cost;

A nominal rather than a real rate is used (not adjusted for inflation), and

An average rate is used rather than a marginal rate.

Investment Centers (Charging for Assets Used] IIThe proper way to measure the use

of invested capital would = the market rent that could be earned on each item

The rental rate per asset = interest foregone, plus depreciation, minus any price appreciation or decline

[Replacement Cost * (r+d-a)]

The Japanese Critique I• Importance of inventories

and overheads, insignificance of labor hours

• Quality– Solution: manage process

through product design and process value management so as to minimize the discrepancy between Process time and Cycle time [inefficiency = 1 – (PT/CT)]

Process value analysis (PVA)

•Chart the flow of activities needed to design, create, and deliver a service

•For each activity and step within the activity determine its associated cost and its cause

•Determine how the step adds value or, if it is non-value adding, identify ways to eliminate it and its associated cost;

•Determine the cycle time of each activity and calculate its cycle efficiency (value-added time/total time); and

•Seek ways to improve cycle efficiency and reduce associated costs due to delays, excesses, and unevenness in activities.

Business Process ReengineeringJobs should be designed around an objective or

outcome instead of a single function;

Functional specialization and sequential execution are inherently inimical to expeditious processing;

Those who use the output of activity should perform the activity and the people who produce information should process it, since they have the greatest need for information and the greatest interest in its accuracy;

Information should be captured once and at the source;

Parallel activities should be coordinated during their performance, not after they are completed;

The people who do the work should be responsible for decision making and control built into job designs

Reflects Assumptions of Flexible Production• Nobody but the front-line worker adds

value, • Front-line workers can perform most

functions better than specialists (lean manufacturing),

• Every step of the service delivery process should be done perfectly (TQM)

• This reduces the need for buffer stocks (JIT) and produces a higher quality end-product.

Modern IT: reduced economies of scale and scope– Multidisciplinary teams, members

work together from start of job to completion

– push exercise of judgment down to teams that do an organization's work

– more equal distribution of knowledge, authority, and responsibility

– average firm size falling for the last twenty years

The Balanced Scorecard

Four perspectives Four perspectives …………………………………. ………………………………….

• Financial• Customer• Internal Business Processes• Learning and Growth Perspective