Chapter 10 – Performance Evaluation

1. How Does Decentralization Affect Performance Evaluation?
   1. Advantages and Disadvantages of Decentralization

i.      Small companies can use centralized decision making because of the smaller scope of their operations.

ii.      Companies that decentralize split their operations into different operating segments.

iii.      Top management delegates decision making responsibility to the segment managers.

1. May be based on: geographic area, product line, distribution channel, customer base, business function or some other business characteristic.

iv.      Advantages: Frees top management’s time, encourages use of expert knowledge, improves customer relations, provides training, improves motivation and retention

v.      Disadvantages: potential duplication of costs, potential problems achieving goal congruence (goal congruence occurs when the goals of the segment managers align with the goals of top management).

1. Performance Evaluation Systems

i.      Performance evaluation systems provide upper management with feedback needed to maintain control over the entire organization, even though it had delegated responsibility and decision making authority to segment managers.

ii.      Effective performance evaluation systems should:

1. Clearly communicate expectations
2. Provide benchmarks that promote goal congruence and coordination between segments
3. Motivate segment managers (possibly through paying bonus incentives to managers who achieve performance targets)
4. What is Responsibility Accounting?
   1. Types of Responsibility Centers

i.      A responsibility center is a part of an organization whose manager is accountable for planning and controlling certain activities.

ii.      Responsibility accounting is a system for evaluating the performance of each responsibility center and its manager. Responsibility accounting performance reports compare plans (budgets) with actual results for each center.

iii.      Cost center: In a cost center, managers are accountable for costs only.

iv.      Revenue center: In a revenue center, managers are accountable primarily for revenues. May also be responsible for the costs of their own sales operations.

v.      Profit center: In a profit center, managers are accountable for both revenues and costs, and therefore profits.

vi.      Investment center: In an investment center, managers are responsible for generating revenues, controlling costs, and efficiently managing the division’ assets.

vii.      Organization Chart

1. At the top level, the CEO oversees each of the four divisions (investment centers)
2. The manager of each division overseas all of the product lines (profit centers) in that division.
3. The manager of each product line is responsible for evaluating lower-level managers of cost centers and revenue centers.
4. Responsibility Center Performance Reports

i.      A performance report compares actual revenues and expenses against budgeted figures. The difference between the actual and budget is known as a variance.

ii.      The specific figures included on each performance report will depend on the type of responsibility center being evaluated.

1. The performance reports of cost centers will only include costs incurred within the center.
2. The performance reports of revenue centers will only include revenues generated by the center.

iii.      Variances are typically presented as either favorable or unfavorable.

1. A favorable variance is one that causes operating income to be higher than budgeted.
2. An unfavorable variance is one that causes operating income to be lower than budgeted.

iv.      Managers use a technique called management by exception when analyzing performance reports. Management by exception means that managers will only investigate budget variances that are relatively large.

v.      Segment margin

1. The performance reports of profit and investment centers include both revenues and expenses. Performance reports are often presented in the contribution margin format rather than the traditional income statement format. These reports often include a line called segment margin. A segment marginis the operating income generated by a profit or investment center before subtracting common fixed costs that have been allocated to the center.
   1. Direct fixed expenses include those fixed expenses that can be traced to the profit center.
   2. Common fixed expenses include those fixed expenses that cannot be traced to the profit center. Rather, these are fixed expenses incurred by the overarching investment center that have been allocated among the different profit centers in the division.
   3. Evaluation of Investment Centers

i.      To adequately evaluate an investment center’s financial performance, top manager assess each division’s operating income in relationship to its assets.

ii.      Return on Investment (ROI)

1. Return on Investment measures the amount of income an investment center earns relative to the size of its assets.
2. ROI = Operating Income/Total Assets
3. ROI = Operating Income/Sales x Sales/Total Assets = Operation Income. Total Assets
4. Sales margin focuses on profitability by showing how much operating income the division earns on every  $1 of sales revenue
   1. Sales margin = Operating Income /Sales
   2. Capital turnover focuses on how efficiently the division uses its assets to generate sales revenue.
      1. Capital turnover = sales/Total Assets

iii.      Residual income (RI) determines whether the division has created any excess (residual) income above and beyond management’s expectations.

1. RI = Operating income – minimum acceptable income
2. RI = Operating income – (target rate of return x Total assets)
3. How do Manager Use Flexible Budgets to Evaluate Performance?
   1. Creating a Flexible Budget Performance Report

i.      To create a flexible budget managers simply use the actual volume achieved and the original budget assumptions.

ii.      The volume variance is the difference between the master budget and the flexible budget.

iii.      The flexible budget variance is the difference between the flexible budget and actual results.

1. Underlying Causes of the Variances
2. How do Companies Incorporate Nonfinancial Performance Measurement?
   1. The Balanced Scorecard

i.      Current financial performance tends to reveal the result of past decisions and actions; financial performance measures are known as lag indicators. Management also needs lead indicators which are performance measures that predict future performance.

ii.      The balanced scorecard recognizes that management must consider both financial performance measures and operational performance measures when judging the performance of a company and its segments.

iii.      Four Perspectives of the Balanced Scorecard

1. Financial perspective
2. Customer perspective
3. Internal business perspective
4. Learning and growth perspective

iv.      Key performance indicators (KPIs) are summary performance metrics to assess how well a company is achieving its goals.

v.      KPIsare continually measured, and are reported on a performance scorecard, a report that allows managers to visually monitor and focus on managing the company’s key activities and strategies as well as business risks.

1. Financial Perspective
   1. Increasing revenue: introducing new products, gaining new customers, expanding into new markets
   2. Controlling costs: seeking to minimize costs without jeopardizing quality of long-run success, eliminating costs associated with wasteful activities
   3. Increasing productivity: using existing assets as efficiently as possible.
   4. Customer Perspective
      1. Price: the lower the better
      2. Quality: the higher the better
      3. Sales service: importance of knowledgeable and helpful salespeople
      4. Delivery time: the shorter the better
      5. Internal Business Perspective
         1. Innovation: developing new products
         2. Operation: using lean operating techniques to increase efficiency
         3. Post-sales support: providing excellent customer service after the sale
      6. Learning and Growth Perspective
         1. Employee capabilities: critical and creative thinkers, skilled, knowledgeable, motivated
         2. Information system capabilities: a system that provides timely and accurate data
         3. The company’s climate for action: corporate culture supports communication, teamwork, change, and employee growth.