Title: Decentralization and Performance Evaluation
1CHAPTER 12
Decentralization and Performance Evaluation
2Decentralized 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
3Advantages 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
4Disadvantages 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
5Why 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
6Responsibility 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
7Tracing Costs to Organizational Levels
8Responsibility Centers
- Cost Centers
- Profit Centers
- Investment Centers
9Cost 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
10Profit 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
11Investment 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
12Study 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
13Study Break 2
- Cost centers are often evaluated using
- Variance analysis
- Operating margin
- Return on investment
- Residual income
- Answer
- a. Variance analysis
14Study 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
15Evaluating 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
16ROI 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
-
17Measuring 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
18NOPAT Example
19Measuring 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)
20Invested Capital Example
21Example 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.
22Example 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
23Example Exercise 1 Solution
- ROI
- NOPAT Invested capital
- 16,780,000 195,000,000
- 86.05
24Problems 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
25Problems 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
26Example Exercise 2
- Using the same information as in Example Exercise
1, please calculate the residual income if the
companys cost of capital is 10.
27Example Exercise 2 Solution
- Residual Income
- NOPAT (Cost of Capital x Invested Capital)
- 16,780,000 (10 x 195,000,000)
- (2,720,000)
28Residual 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
29Decision Making
30Economic 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
31Residual Income
32Study 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
33Study 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
34Using a Balanced Scorecard to Evaluate Performance
- A problem in using financial measures like ROI
and EVA is that they are backward looking
35Balanced 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
36Balanced 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!
37Balanced Scorecard
38How 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
39Developing 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
40Strategy Map Example
41Keys 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
42Transfer 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
43Methods 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
44Transfer 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
45Lowering Transfer Price Below the Market Price