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Decentralization and Performance Evaluation

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Title: Decentralization and Performance Evaluation


1
CHAPTER 12
Decentralization and Performance Evaluation
2
Decentralized Organizations
  • 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

3
Advantages 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

4
Disadvantages of Decentralization
  • Costly duplication of activities
  • Lack of goal congruence
  • Management pursues personal goals
  • Personal goals are incompatible with the
    companys goals
  • To control goal congruence, companies evaluate
    the performance of subunit managers

5
Why Companies Evaluate the Performance of
Subunits and Subunit Managers
  • 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

6
Responsibility Accounting and Performance
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

7
Tracing Costs to Organizational Levels
8
Responsibility Centers
  • Cost Centers
  • Profit Centers
  • Investment Centers

9
Cost 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

10
Profit 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

11
Investment 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

12
Study Break 1
  • An investment center is responsible for
  • Investing in long term assets
  • Controlling costs
  • Generating revenues
  • All of the above
  • Answer
  • d. All of the above

13
Study Break 2
  • Cost centers are often evaluated using
  • Variance analysis
  • Operating margin
  • Return on investment
  • Residual income
  • Answer
  • a. Variance analysis

14
Study Break 3
  • Profit centers are often evaluated using
  • Investment turnover
  • Income targets or profit budgets
  • Return on investment
  • Residual income
  • Answer
  • b. Income targets or profit budgets

15
Evaluating Investment Centers With ROI
  • ROI is a primary tool for evaluating the
    performance of investment centers
  • Investment Center Income
  • Invested Capital
  • Focuses managements attention on income and
    level of investment

16
ROI 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

17
Measuring Income and Invested 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

18
NOPAT Example
19
Measuring Income and Invested 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)

20
Invested Capital Example
21
Example 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 operations 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.

22
Example Exercise 1 Solution
  • 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

23
Example Exercise 1 Solution
  • ROI
  • NOPAT Invested capital
  • 16,780,000 195,000,000
  • 86.05

24
Problems 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

25
Problems of Overinvestment and 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

26
Example Exercise 2
  • Using the same information as in Example Exercise
    1, please calculate the residual income if the
    companys cost of capital is 10.

27
Example Exercise 2 Solution
  • Residual Income
  • NOPAT (Cost of Capital x Invested Capital)
  • 16,780,000 (10 x 195,000,000)
  • (2,720,000)

28
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
    centers 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

29
Decision Making
30
Economic Value Added (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

31
Residual Income
32
Study Break 4
  • Use of profit as a performance measure
  • May lead to overinvestment in assets
  • Is appropriate for an investment center
  • Is appropriate as long as profit is calculated
    using GAAP
  • Encourages managers to finance operations with
    debt rather than equity
  • Answer
  • a. May lead to overinvestment in assets

33
Study Break 5
  • Investment centers are often evaluated using
  • Standard cost variances
  • Return on investment
  • Residual income/EVA
  • Both b and c
  • Answer
  • d. Both b and c

34
Using a Balanced Scorecard to Evaluate Performance
  • A problem in using financial measures like ROI
    and EVA is that they are backward looking

35
Balanced Scorecard
  • Set of performance measures constructed for four
    dimensions of performance
  • Financial
  • Critical measures even if they are backward
    looking
  • Customer
  • Examines the companys success in meeting
    customer expectations
  • Internal Processes
  • Examines the companys success in improving
    critical business processes
  • Learning and Growth
  • Examines the companys success in improving its
    ability to adapt, innovate, and grow

36
Balanced 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!

37
Balanced Scorecard
38
How Balance is Achieved in a Balanced 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

39
Developing a Strategy Map for a 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

40
Strategy Map Example
41
Keys to a Successful Balanced Scorecard
  • 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

42
Transfer 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

43
Methods of Setting the Transfer 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

44
Transfer Pricing
  • Since there is no arms 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

45
Lowering Transfer Price Below the Market Price
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