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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