slide 12-2 chapter 12 decentralization and performance evaluation decentralization and performance...

2

CHAPTER 12CHAPTER 12CHAPTER 12CHAPTER 12

Decentralization

and

Performance Evaluation

Decentralization

and

Performance Evaluation

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

Slide 12-3

Decentralized Decentralized OrganizationsOrganizationsDecentralized Decentralized OrganizationsOrganizations

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


Slide 12-4

Decentralized Decentralized OrganizationsOrganizationsDecentralized Decentralized OrganizationsOrganizations


Slide 12-5

Advantages of DecentralizationAdvantages of DecentralizationAdvantages of DecentralizationAdvantages 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


Slide 12-6

Disadvantages of Disadvantages of DecentralizationDecentralizationDisadvantages of Disadvantages of DecentralizationDecentralization

Costly duplication of activities Lack of goal congruence

- Management may pursue personal goalsthat are incompatible with the company’s goals

- To control goal congruence, companies evaluate the performance of subunit managers

All of the following are advantages of decentralization except:

a. Faster response to changing circumstances

b. Costly duplication of activitiesc. Increased motivation of managersd. Better information, leading to

superior decisions

Answer: bCostly duplication of activities

Slide 12-7 Learning objective 1: List and explain the advantages and disadvantages of decentralization

Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers

Slide 12-8

Evaluating SubunitsEvaluating SubunitsEvaluating SubunitsEvaluating 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 12-9

Evaluating Subunit ManagersEvaluating Subunit ManagersEvaluating Subunit ManagersEvaluating 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

10

Responsibility Accounting and Responsibility Accounting and Performance EvaluationPerformance Evaluation

Responsibility Accounting and Responsibility Accounting and Performance EvaluationPerformance 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


11

Tracing Costs to Tracing Costs to Organizational LevelsOrganizational Levels

Tracing Costs to Tracing Costs to Organizational LevelsOrganizational Levels


Learning objective 3: Identify cost centers, profit centers, and investment centers

Slide 12-12

Responsibility CentersResponsibility CentersResponsibility CentersResponsibility 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

13

Cost CentersCost CentersCost CentersCost 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


14

Profit CentersProfit CentersProfit CentersProfit 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


15

Profit CentersProfit CentersProfit CentersProfit Centers

Methods used to evaluate profitability

Current compared to budgeted income

Current compared to past income

Comparison with other profit centersi.e., relative performance evaluation


16

Investment CentersInvestment CentersInvestment CentersInvestment 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


17

NordstromNordstromNordstromNordstrom


18

An investment center is responsible for:

a. Investing in long term assetsb. Controlling costsc. Generating revenuesd. All of the above

Answer:d. All of the above


19

Cost centers are often evaluated using:

a. Variance analysisb. Operating marginc. Return on investmentd. Residual income

Answer:a. Variance analysis


20

Profit centers are often evaluated using:

a. Investment turnoverb. Income targets or profit budgetsc. Return on investmentd. Residual income

Answer:b. Income targets or profit budgets


Learning objective 4: Calculate and interpret return on investment (ROI)

Slide 12-21

Evaluating Investment Centers Evaluating Investment Centers With ROIWith ROI

Evaluating Investment Centers Evaluating Investment Centers With ROIWith 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)

22

ROI ComponentsROI ComponentsROI ComponentsROI Components

ROI may be broken down into two components: Profit margin and Investment turnover


23

Measuring Income and Measuring Income and Invested Capital for ROIInvested Capital for ROIMeasuring Income and Measuring Income and Invested Capital for ROIInvested Capital for ROI

In calculating ROI, companies measure “income” in a variety of ways

Most common method is NOPAT Net Operating Profit After Taxes


24


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


25


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)


26

NOPAT ExampleNOPAT ExampleNOPAT ExampleNOPAT Example


27

ROI – France, Germany, and ROI – France, Germany, and JapanJapan

ROI – France, Germany, and ROI – France, Germany, and JapanJapan


28

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 (1 - .40) =$16,780,000


29



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



Calculate ROI= NOPAT ÷ Invested capital= $16,780,000 ÷ $195,000,000 = 8.605%


31

Calculating ROICalculating ROICalculating ROICalculating ROI


32

Problems with Using ROIProblems with Using ROIProblems with Using ROIProblems 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


33

Problems with Using ROIProblems with Using ROIProblems with Using ROIProblems 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


34



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)


35

Problems of Overinvestment Problems of Overinvestment and Underinvestmentand Underinvestment

Problems of Overinvestment Problems of Overinvestment and Underinvestmentand 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

Use of profit as a performance measure:a. May lead to overinvestment in assetsb. Is appropriate for an investment centerc. Is appropriate as long as profit is

calculated using GAAPd. Encourages managers to finance

operations with debt rather than equity

Answer:a. May lead to overinvestment in assets


37

Decision MakingDecision MakingDecision MakingDecision Making


Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Slide 12-38

Residual Income (RI)Residual Income (RI)Residual Income (RI)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

39

Residual IncomeResidual IncomeResidual IncomeResidual Income

NIBCL = non-interest bearing current liabilities


40

Economic Value Added Economic Value Added (EVA)(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 GAAPe.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


41




42

Investment centers are often evaluated using:

a. Standard cost variancesb. Return on investmentc. Residual income/EVAd. Both b and c

Answer: dBoth b and c


43





Slide 12-44

Using a Balanced Scorecard to Using a Balanced Scorecard to Evaluate PerformanceEvaluate Performance

Using a Balanced Scorecard to Using a Balanced Scorecard to Evaluate PerformanceEvaluate Performance

A problem in using financial measures like ROI and EVA is that they are “backward looking”

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

Slide 12-45

Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard

Set of performance measures constructed for four dimensions of performance:

1. Financial2. Customer3. Internal processes4. Learning and growth

46

Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard1. Financial

Is company meeting its financial goal?

2. Customer Examine company success in meeting customer

expectations?

3. Internal ProcessesExamines the company’s success in improving critical business processes

4. Learning and growth Examines the company’s success in improving

its ability to adapt, innovate, and grow


47


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!


48



49

How Balance is Achieved in a How Balance is Achieved in a Balanced ScorecardBalanced Scorecard

How Balance is Achieved in a How Balance is Achieved in a Balanced ScorecardBalanced 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


50



51

You Get What You MeasureYou Get What You MeasureYou Get What You MeasureYou Get What You Measure


Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard

Slide 12-52

Developing a Strategy Map for Developing a Strategy Map for a Balanced Scorecarda Balanced Scorecard

Developing a Strategy Map for Developing a Strategy Map for a Balanced Scorecarda 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

53

Strategy Map ExampleStrategy Map ExampleStrategy Map ExampleStrategy Map Example

Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard

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

Slide 12-54

Keys to a Successful Balanced Keys to a Successful Balanced ScorecardScorecard


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

55



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


56




57

EvaluationEvaluationEvaluationEvaluation


Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

Slide 12-58

Transfer PricingTransfer PricingTransfer PricingTransfer 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

59

Methods of Setting the Methods of Setting the Transfer PriceTransfer Price


Pricing alternatives:

Market price Variable costs Full cost plus profit Negotiated prices


60



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


61

Lowering Transfer Price Below Lowering Transfer Price Below the Market Pricethe Market Price

Lowering Transfer Price Below Lowering Transfer Price Below the Market Pricethe Market Price


62

Transfer PricingTransfer PricingTransfer PricingTransfer Pricing


63

CopyrightCopyrightCopyrightCopyright© 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

slide 12-2 chapter 12 decentralization and performance evaluation decentralization and performance...

Documents

improvedlearning objective

performance of subunits

subunit managersa company

successful operations

managers of subunitsmost

goal congruence management

subunitsevaluation of

improvementtop management