chapter 12 decentralization and performance evaluation decentralization and performance evaluation
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CHAPTER 12CHAPTER 12CHAPTER 12CHAPTER 12
Decentralization and Decentralization and Performance EvaluationPerformance Evaluation
Decentralization and Decentralization and Performance EvaluationPerformance Evaluation
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
Decentralized Decentralized OrganizationsOrganizationsDecentralized Decentralized OrganizationsOrganizations
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
Disadvantages of Disadvantages of DecentralizationDecentralizationDisadvantages of Disadvantages of DecentralizationDecentralization
Costly duplication of activities
Lack of goal congruence Management pursues personal
goals Personal goals are incompatible
with the company’s goals To control goal congruence,
companies evaluate the performance of subunit managers
Why Companies Evaluate the Why Companies Evaluate the Performance of Subunits and Subunit Performance of Subunits and Subunit
ManagersManagers
Why Companies Evaluate the Why Companies Evaluate the Performance of Subunits and Subunit Performance of Subunits and Subunit
ManagersManagers A company evaluates subunits in order
to decide if it should expand or contract them or change their operations
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
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
To implement responsibility accounting in a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled
Tracing Costs to Tracing Costs to Organizational LevelsOrganizational Levels
Tracing Costs to Tracing Costs to Organizational LevelsOrganizational Levels
Responsibility CentersResponsibility CentersResponsibility CentersResponsibility Centers
Cost Centers
Profit Centers
Investment Centers
Cost CentersCost CentersCost CentersCost Centers Subunit responsible for controlling
costs but not responsible for generating revenue Most service departments are cost centers
(i.e., 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
Profit CentersProfit CentersProfit CentersProfit Centers Subunit responsible for generating revenues
and 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
A variety of methods are used to evaluate profitability Current income compared to budgeted income Current income compared to past income Comparison with other profit centers, called
relative performance evaluation
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
NordstromNordstromNordstromNordstrom
Study Break #1Study Break #1Study Break #1Study Break #1
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
Study Break #2Study Break #2Study Break #2Study Break #2
Cost centers are often evaluated using:
a. Variance analysisb. Operating marginc. Return on investmentd. Residual income
Answer:a. Variance analysis
Study Break #3Study Break #3Study Break #3Study Break #3
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
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
= Investment Center Income Invested Capital
Focuses management’s attention on income and level of investment
ROI ComponentsROI ComponentsROI ComponentsROI Components
ROI may be broken down into two components: profit margin and investment turnover.
ROI = Profit Margin x Investment Turnover
ROI = Income x ____Sales_____ Sales Invested Capital
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 To calculate NOPAT, a company
must add back nonoperating items to net income and adjust tax expense accordingly
See next slide for example
NOPAT ExampleNOPAT ExampleNOPAT ExampleNOPAT Example
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 “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 noninterest-bearing
current liabilities (method used in this textbook)
Invested Capital ExampleInvested Capital ExampleInvested Capital ExampleInvested Capital Example
ROI – France, Germany, and ROI – France, Germany, and JapanJapan
ROI – France, Germany, and ROI – France, Germany, and JapanJapan
Example Exercise #1Example Exercise #1Example Exercise #1Example Exercise #1 Davenport Mills is a division of Iowa
Woolen Products, Inc. For the most recent year, Davenport had net income of $16,000,000. Included in income was interest expense of $1,300,000. The operation’s tax rate is 40%. Total assets of Davenport Mills are $225,000,000, current liabilities are $45,000,000, and $30,000,000 of the current liabilities are noninterest-bearing.
Calculate NOPAT, invested capital, and ROI.
Example Exercise #1 Example Exercise #1 SolutionSolution
Example Exercise #1 Example Exercise #1 SolutionSolution
NOPAT=Net income + interest expense (1 - tax
rate) =$16,000,000 + $1,300,000 (1 - .40) =$16,780,000
Invested Capital= Total assets - noninterest-bearing current
liabilities= $225,000,000 - $30,000,000 = $195,000,000
Example Exercise #1 Example Exercise #1 SolutionSolution
Example Exercise #1 Example Exercise #1 SolutionSolution
ROI= NOPAT ÷ Invested capital= $16,780,000 ÷ $195,000,000 = 86.05%
Problems with ROIProblems with ROIProblems with ROIProblems with 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
Managers may put off purchase of new equipment May lead to underinvestment
Problems of Overinvestment Problems of Overinvestment and Underinvestmentand Underinvestment
Problems of Overinvestment Problems of Overinvestment and Underinvestmentand Underinvestment
You get what you measure!
Evaluation using Profit can lead to overinvestment Managers may be motivated to make
investments that earn a return that is less than the cost of capital
Evaluation using ROI can lead to underinvestment Managers may not take on projects that
have a low ROI just to increase profit if they are evaluated in terms of the return they earn
Example Exercise #2Example Exercise #2Example Exercise #2Example Exercise #2
Using the same information as in Example Exercise #1, please calculate the residual income if the company’s cost of capital is 10%.
Example Exercise #2 Example Exercise #2 SolutionSolution
Example Exercise #2 Example Exercise #2 SolutionSolution
Residual Income
= NOPAT – (Cost of Capital x Invested Capital)
= $16,780,000 – (10% x $195,000,000)= ($2,720,000)
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
We use total assets minus noninterest-bearing current liabilities as a measure of investment
Decision MakingDecision MakingDecision MakingDecision Making
Economic Value Added Economic Value Added (EVA)(EVA)
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 GAAP
For example, under GAAP research and development costs are expensed, but the costs benefits future periods Thus, under EVA research and development is
capitalized and amortized over future periods
Residual IncomeResidual IncomeResidual IncomeResidual Income
Study Break #4Study Break #4Study Break #4Study Break #4
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
Study Break #5Study Break #5Study Break #5Study Break #5
Investment centers are often evaluated using:
a. Standard cost variancesb. Return on investmentc. Residual income/EVAd. Both b and c
Answer:d. Both b and c
EVAEVAEVAEVA
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”
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced ScorecardSet of performance measures constructed for four dimensions of performance Financial
Critical measures even if they are backward looking
Customer Examines the company’s success in meeting
customer expectations
Internal Processes Examines the company’s success in improving
critical business processes
Learning and Growth Examines the company’s success in improving its
ability to adapt, innovate, and grow
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard
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!
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard
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
Balance quantitative measures with qualitative measures
There is a balance of backward-looking measures and forward-looking measures
You Get What You MeasureYou Get What You MeasureYou Get What You MeasureYou Get What You Measure
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
Used to test the soundness of the strategy
Identifies how strategy is linked to measures on the scorecard
Communicates strategic objectives to employees
Strategy Map ExampleStrategy Map ExampleStrategy Map ExampleStrategy Map Example
Keys to a Successful Balanced Keys to a Successful Balanced ScorecardScorecard
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
Responsibility A particular employee must be given responsibility
and held accountable for successfully implementing each initiative
Funding Initiatives must be funded appropriately
Top Management Support It is crucial to have the full support of top
management
EVAEVAEVAEVA
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
The price that is used to value internal transfers of goods or services is referred to as transfer pricing
Subunits of a company sell goods or services to other subunits within the same company
Must determine the price that is used to value the value of internal transfers
Methods of Setting the Methods of Setting the Transfer PriceTransfer Price
Methods of Setting the Methods of Setting the Transfer PriceTransfer Price
Primary alternatives: Market Price Variable Costs Full Cost Plus Profit Negotiated Prices
The most appropriate transfer price depends on the circumstances Should lead subunit managers to make
decisions that maximize firm value
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
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
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
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