Management Infomration Chapter08.a Performance Management

8/23/2019 Management Infomration Chapter08.a Performance Management

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Management Information

Performance Management


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Performance Evaluation


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Feedback Control

Information produced within the organization (ManagementControl Reports) with the purpose of helping managementand other employees with control decisions

o Step1: Plans and targets are set for future (e.g. Sales budget)

o Step 2: Plans are put into operations (e.g organize business recourses

to achieve the sales target)o Step 3: Actual results are recorded and analyzed (actual results are

reported back to management)

o Step 4: Information about actual results in feedback

o Step 5: The feedback is used by management to compare (managerscompare actual results against plan)

o Step 6: Compare plan with actual results and things can be done Take control action (work longer hours, spend on advertising, price discount)

Decide to do nothing

Alter plan or target


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Feedback Loop in the control Cycle

Plan, targetor budget Compare

actual resultswith plan

Control Action

MeasureOutput

OPERATIONS

INPUT

RESOURCES

OUTPUTS

(e.g. actual output,revenues, costs)

Feedback ofInformation


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Features of Effective Feedback

Reports should be clear and comprehensive

Exception principle should be applied so that significant differencebetween the target and actual results should be highlighted forinvestigation- areas conforming to plans should be given lessprominence in the management control report

The controllable costs and revenues should be separately identified Reports should be produced on a regular basis to ensure that the

continual control is exercised

Reports should be available to management in a timely fashion

Information should be sufficiently accurate for the purpose

intended Irrelevant details should be excluded from the report

Reports should be communicated to the managers who has theresponsibility and authority to act on the information


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Behavioral impact of performance

management

Performance measures lead to lack of goalcongruence- managers seek to improve theirperformance on the basis of the indicators used,even if this is not in the best interest of the

organization as a whole Example- production manager may be encouraged to

achieve and maintain high production level and to reducecosts, particularly if his bonus is linked to these factors-this may results in high level of slow moving inventory-

resulting in adverse effect on the companys cash flow Thus the managers behavior has been distorted by

the control system


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Behavioral impact of performance

management.. Hopwoods 3 distinct ways of

using budgetary informationStyle of evaluation CommentBudget constrained The managers performance is primarily evaluated upon the

basis of his ability to continually meet the budget on a short-term

basis.

This criterion of performance is stressed at the expense of other

valued and important criteria and the manager will receiveunfavorable feedback from his supervisor if, for instance, his

actual costs exceeds the budgeted costs regardless of other

considerations

Profit Conscious The managers performance is evaluated on the basis of hisability to increase the general effectiveness of his units operations

in relation to the long-term purposes of the organization

Non-accounting The budgetary information plays a relatively unimportant part inthe superiors evaluation of the managers performance


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A Summary of the effects of

evaluationBudget

Constrained

Profit

Conscious

Non

Accounting

Involvement with costs High High Low

Job-related tension High Medium Medium

Manipulation of accounting reports (bias) Extensive Little Little

Relations with the supervisor Poor Good Good

Relations with colleagues Poor Good Good

Research has shown no clear performance for one style over another


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Budget bias

Manipulation of budget is likely to occur if the manager isunder pressure to achieve short-term budget targets

In the process of preparing budgets, managers mightintroduce slack into their estimates- overestimate costs or

underestimate revenues In controlling actual operations managers might ensure that

their spending rises to meet their inflated budget, otherwisethey will be blamed for careless budgeting

After a mediocre results, managers might overstate revenuesand understate cost estimates, to make immediate favorableimpact by promising better performance in the future


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Responsibility Centers


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Divisionalisation

As companies grow and possibly also spreadgeographically, it is likely that they will considersome form of divisionalization

This involves splitting the company into divisions,e.g.

according to location or

according to the product or service provided

The division managers are given the authority tomake decisions concerning the activities of theirdivisions


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Decentralization

In general, a divisional structure will lead to

decentralization of the decision making

process

Division managers may have the freedom to

set selling prices, choose suppliers and make

output decisions and so on


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Factors effecting degree of

decentralization Management style: Authoritarian style is likely to mean that decision making is

centralized

Size of the organization: decentralization tends to increase as organization grows

Extent of activity diversification: greater diversification activities will lead to moredecentralization

Effectiveness of communication: decentralization can only operate if information

is communicated effectively both up and down the organization The ability of management: the more able the management team, the more

decentralization is likely results

The speed of technological advancement: Managers lower down the organizationare more likely to be familiar with changing technology, therefore decentralizationwould be more appropriate

The geography of location and the extent of local knowledge needed: if anorganization is spread over a wide range of locations then decentralization is likelyto be most effective. Local managers would make more effective decisions basedon their knowledge of local markets


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Decentralization in Organizations

Benefits ofDecentralization

Top managementfreed to concentrate

on strategy.

Lower-level managersgain experience indecision-making. Decision-making

authority leads tojob satisfaction.

Lower-level decisionoften based onbetter information.

Lower-level managerscan respond quickly to

customers.


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Decentralization in Organizations

Disadvantages ofDecentralization

Lower-level managersmay make decisions

without seeing thebig picture.

May be a lack ofcoordination among

autonomousmanagers.

Lower-level managers

objectives may notbe those of theorganization. May be difficult to

spread innovative ideasin the organization.


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Responsibility Accounting

Responsibility accounting is the term used to describedecentralization of authority, with the performance of thedecentralization units or responsibility centers measured interms of accounting results.

There are four main type of responsibility centers

Cost Center

Revenue Center

Profit Center and

Investment Center

In the weakest form of decentralization, cost center orrevenue center might be used

As decentralization becomes stronger, responsibilityaccounting framework will be based around profit centers

Decentralization in its strongest form means that investment

centers are used


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Cost, Profit, Revenue and

Investments Centers

ResponsibilityCenter

CostCenter

RevenueCenter

InvestmentCenter

Cost, profit,Revenue and

investmentcenters are allknown asresponsibilitycenters.

ProfitCenter


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Cost CenterA segment whose

manager has controlover costs, but not

over revenues

or investment funds.

Cost, Profit, and Investments

Centers


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Profit CenterA segment whose

manager hascontrol over bothcosts andrevenues,

but no control overinvestment funds.

RevenuesSales

InterestOther

Costs

Mfg. costsCommissions

Salaries

Other


Centers


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Investment Center

A segment whosemanager has controlover costs, revenues,and investments in

operating assets.

Corporate Headquarters


Centers


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Salty Snacks

Product Manager

Bottling Plant

Manager

Warehouse

Manager

Distribution

Manager

Beverages

Product Manager

Confections

Product Manager

Operations

Vice President

Finance

Chief FInancial Officer

Legal

General Counsel

Personnel

Vice President

Superior Foods Corporation


President and CEO

Cost

Centers

InvestmentCenters

Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.


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Salty Snacks

Product Manager

Bottling Plant

Manager

Warehouse

Manager

Distribution

Manager

Beverages

Product Manager

Confections

Product Manager

Operations

Vice President

Finance


Legal

General Counsel

Personnel

Vice President



President and CEO

Profit

CentersSuperior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.


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Salty Snacks

Product Manager

Bottling Plant

Manager

Warehouse

Manager

Distribution

Manager

Beverages

Product Manager

Confections

Product Manager

Operations

Vice President

Finance


Legal

General Counsel

Personnel

Vice President



President and CEO

Cost

CentersSuperior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.


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Responsibility Accounting..

Type of

responsibility

Center

Manager has control over Principal

performance

measures

Cost Center Controllable Costs Variance Analysis

Efficiency measures

Revenue Center Revenues only Revenues

Profit Center Controllable Costs

Sales price (including transfer price)

Profit

Profit margin

Investment CenterControllable costs

Sales price (including transfer prices)

Output volume

Investment in non-current assets and

working capital

Return on investment

Residual income

Other financial ratios


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Decentralization and Segment

Reporting


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A segment is any part

or activity of an

organization about

which a managerseeks cost, revenue,

or profit data. A

segment can be . . .

A Sales Territory

A Service Center

An Individual StoreQuick Mart

Decentralization and Segment

Reporting


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Traceable and Common Fixed

Costs

In segment reports, traceablefixed costs should be distinguished

from common fixed costs.


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Traceable costs arise because of the existence of aparticular segment and would disappear over time if

the segment itself disappeared.

No computerdivision means . . .

No computerdivision manager.

Identifying Traceable Fixed Costs


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Common costs arise because of the overalloperation of the company and would not disappear

if any particular segment were eliminated.

No computerdivision but . . .

We still have acompany president.

Identifying Common Fixed Costs


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Performance Measures


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General requirements for effective

performance measures

Promote goal congruence- by providingincentives to promote the responsibilitycenters performance in line with overall

company objectives Incorporate factors over which centers

manager has control

Should encourage the pursuit of long termobjectives as well as short term, budgetconstraints objectives


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Potential problems with

inappropriate performance measures Managers may manipulate information in order to ensure

achievement of the KPIs

The measure might cause de-motivation and stress relatedconflictbetween a manager and the managers subordinate,superiors, or fellow managers

The measure might promote excessive concern for thecontrol of short term costs, possibly at the expense of longerterm profitability

They might lead to the assessment of a responsibility centeras an isolated unit, rather than as an integral part of thewhole organization


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Performance measures for a

cost center

Cost variance, which are the difference

between the budgeted or standard costs and

the actual costs

Cost per unit

Cost per employee

Other non-financial measures such as the rate

of labor turnover or staff absenteeism


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Performance measures for a

revenue center

Revenue variance, which are the difference

between the budgeted or standard revenue

and the actual revenue achieved

Revenue earned per employee

Percentage market share achieved

Growth in revenue


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Performance measure for a

profit center

Gross profit margin, which is the difference

between the selling price and the direct costs

incurred, often expressed as a percentage of

the selling price

Operating profit margin, which is the gross

profit less indirect costs incurred such as

administrative salaries, often expressed as apercentage of the selling price


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Performance measures for an

Investment Center

Working Capital Ratios

Liquidity measures such as current ratio and thequick (liquidity) ratios

Rate of inventory turnover Receivable and payable periods

Return achieved in the division in relation tolevel of investment

Return on Investment (ROI)

Residual Income (RI)


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Rate of inventory turnover

The rate of inventory turnover monitors how many timesinventory turns over during the trading period

In general the rate of turnover should be as high as possible-since this means inventory is lower, reducing costs such asspace costs, insurance costs, obsolescence write-off and thecost of capital being tied up

However, potential sales might be forgone if inventory is solow that customers needs cannot be met

Cost of Sales

Average Inventory

Rate of inventory turnover =


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Receivable collection period

This KPI monitors how long on average it takes to collect debts

The collection period can also be measured in months, in which case theratio calculation would be multiplied by 12 instead of 365

The lower this period, the lower the capital cost of money invested inreceivable balances and the lower the risk of bad debts

However, customers may go elsewhere if the credit period offered is toolow

Receivable collection period (in days) =Average receivables

Average sales revenueX 365


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Payables payment period

This KPI monitors how long on average the company waitsbefore paying its suppliers

The payment period can also be measured in months, inwhich case the ratio calculation would be multiplied by 12instead of 365

In general this period should be as high as possible.

However supplier goodwill may be lost if the period of credittaken is too long.

Continuity of supply could also be disrupted if suppliers placeoverdue accounts on stop

Payables payment period =Average payables

X 365Annual purchase


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ROI is often used as a measure to monitor the performance of investmentcenter.

It shows how much profit has been earned in relations to the amount ofcapital invested in the center

The main reason for widespread use of ROI is that it ties in directly withthe accounting system and is identifiable from the income statement and

balance sheet

ROI facilitates comparisons but ranking is difficult as the measure is arelative percentage.

ROI = Controllable divisional profit X 100%Divisional capital employed


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ROI = Net operating incomeAverage operating assets

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Income before interestand taxes (EBIT)


Formula



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ROI = Net operating incomeAverage operating assets

Margin =Net operating income

Sales

ROI = Margin Turnover


Formula

Turnover =

Sales

Average operating assets


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There are three ways to increase ROI . . .

Increase

Sales

ReduceExpenses

Reduce

Assets

Increasing ROI


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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. The

required rate of return for the company is 15%.What is the divisions ROI?

a. 25%

b. 5%

c. 15%d. 20%

Quick Check


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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. Therequired rate of return for the company is 15%.What is the divisions ROI?

a. 25%

b. 5%

c. 15%d. 20%

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%

Quick Check


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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. If themanager of the division is evaluated based onROI, will she want to make an investment of$100,000 that would generate additional netoperating income of $18,000 per year?

a. Yesb. No

Quick Check


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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. If themanager of the division is evaluated based onROI, will she want to make an investment of$100,000 that would generate additional netoperating income of $18,000 per year?

a. Yesb. No ROI = $78,000/$400,000 = 19.5%

This lowers the divisions ROI from

20.0% down to 19.5%.

Quick Check


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The companys required rate of return is 15%.

Would the company want the manager of the

Redmond Awnings division to make an

investment of $100,000 that would generateadditional net operating income of $18,000 per

year?

a. Yes

b. No

Quick Check


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The companys required rate of return is 15%.

Would the company want the manager of the

Redmond Awnings division to make an

investment of $100,000 that would generateadditional net operating income of $18,000 per

year?

a. Yes

b. No ROI = $18,000/$100,000 = 18%

The return on the investment exceedsthe minimum required rate of return.

Quick Check


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Capital employed

Decision needs to be taken which assets to include in capitalemployed.

Leased assets, shared assets, idle assets and goodwill need tobe given careful considerations.

Centrally controlled assets are excluded because theinvestment center manager cannot exercise control over theiruse

Usually opening capital employed or an average of openingand closing capital is used, on the grounds that this has been

generating the years profit The use of historical cost/carrying amount may lead to

problems

E l Eff t f h i th


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Example: Effect of changing the

capital employed base

An asset costs TK 100,000 has a life of four years, and itsscrap value is nil. The asset generates annual cash flows ofTK 34,000 and straight line depreciation is used

Requirements:(a) Calculate annual ROI using opening carrying amount (i.e.

depreciation is deducted from the asset values)

(b) Calculate annual ROI using historical cost (i.e. nodepreciation is deducted from the asset value)

(c) Comment on any problems identified by these calculations


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Solution

ROI using opening carrying amountYear 1: (34-25) 100 = 9% (cash flow-Depreciation)

Year 2: (34-25) 75 = 12%

Year 3: (34-25) 50 = 18%

Year 4: (34-25) 25 = 36%

ROI improves despite constant annual profits. Consequently divisionalmanagers may hold assets for too long.

ROI using historical costs

Year 1-4: (34-25) 100 = 9%

ROI using historical costs overcomes the increasing return problem of usingthe carrying amount. However, it is not perfect

Li it ti f i hi t i l


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Limitations of using historical

cost/carrying in ROI calculations

Using historical cost/carrying amounts may bemisleading, particularly when comparing divisions. If

Assets have been bought at different points in timeand prices have changed due to inflation

Assets of one division are older than those ofanother and have been written down a lower value

Different depreciation policies are applied by

different divisionsTo resolve this, one solution would be to use a

replacement cost valuation


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Profit

Usually profit figure taken as the numerator in theROI calculation is after depreciation, but this maylead to distortion (as discussed)

It is common for divisions and managers to beassessed on pre-tax profit, since the companysultimate tax charge is likely to be significantlyaffected by central decisions and it therefore notcontrollable by divisional managers

It is important that managers are made aware of thetax implications of their operational decisions

Residual Income Another


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Net operating incomeabove some minimum

return on operatingassets

Residual Income Another

Measure of Performance


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Calculating Residual Income

Residual

income=

Net

operating

income

-

Average

operating

assets

Minimum

required rate of

return( )

This computation differs from ROI.

ROI measures net operating income earned relativeto the investment in average operating assets.

Residual income measures net operatingincome earned less the minimum required

return on average operating assets.


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Residual income encourages managers tomake profitable investments that would

be rejected by managers using ROI.

Motivation and Residual Income


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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. Therequired rate of return for the company is 15%.What is the divisions residual income?

a. $240,000

b. $ 45,000

c. $ 15,000d. $ 51,000

Quick Check


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Redmond Awnings, a division of Wrapup Corp.,has a net operating income of $60,000 andaverage operating assets of $300,000. Therequired rate of return for the company is 15%.What is the divisions residual income?

a. $240,000

b. $ 45,000

c. $ 15,000d. $ 51,000

Net operating income $60,000Required return (15% of $300,000) $45,000Residual income $15,000

Quick Check

Divisional Comparisons


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Divisional Comparisons

and Residual Income

The residualincome approach

has one major

disadvantage.

It cannot be usedto compare

performance ofdivisions ofdifferent sizes.


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Zepher, Inc. - Continued

Retail Wholesale

Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%

Minimum required return 20,000$ 200,000$

Retail WholesaleActual income 30,000$ 220,000$

Minimum required return (20,000) (200,000)

Residual income 10,000$ 20,000$

Recall the followinginformation for the RetailDivision of Zepher, Inc.

Assume the followinginformation for the Wholesale

Division of Zepher, Inc.


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Zepher, Inc. - Continued

Retail Wholesale

Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%

Minimum required return 20,000$ 200,000$

Retail WholesaleActual income 30,000$ 220,000$

Minimum required return (20,000) (200,000)

Residual income 10,000$ 20,000$

The residual income numbers suggest that the Wholesale Division outperformed

the Retail Division because its residual income is $10,000 higher. However, theRetail Division earned an ROI of 30% compared to an ROI of 22% for the

Wholesale Division. The Wholesale Divisions residual income is larger than the

Retail Division simply because it is a bigger division.

Advantages and disadvantages of


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Advantages and disadvantages of

using RI compared with ROI

Residual income will increase when investmentsearning above the cost of capital are undertaken andinvestments earning below the cost of capital areeliminated

Residual income are more flexible since a differentcost of capital can be applied to investments withdifferent risk characteristics

The disadvantage of RI are that it does not facilitatecomparisons between investments centers nor doesit relate the size of a centers income to the size ofthe investment

RI verses ROI: marginally profitable


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RI verses ROI: marginally profitable

investments

Residual income will increase if a new investment isundertaken which earns a profit excess of the imputedinterest charge on the value of the asset acquired

Residual income will go up even if the profit from the

investment only just exceeds the imputed interest charges,and this means that marginally profitable investments arelikely to be undertaken by the investment center managers

In contrast, when a manager is judged by ROI, a marginally

profitable investment would be less likely to be undertakenbecause it would reduce the average ROI earned by thecenter as a whole

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Management Infomration Chapter08.a Performance Management

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