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Slide 12-2
CHAPTER 12CHAPTER 12CHAPTER 12CHAPTER 12
Decentralization
and
Performance Evaluation
Decentralization
and
Performance Evaluation
Learning objective 1: List and explain the advantages and disadvantages of decentralization
Slide 12-3
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
Learning objective 1: List and explain the advantages and disadvantages of decentralization
Slide 12-4
Decentralized Decentralized OrganizationsOrganizationsDecentralized Decentralized OrganizationsOrganizations
Learning objective 1: List and explain the advantages and disadvantages of decentralization
Slide 12-5
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
Learning objective 1: List and explain the advantages and disadvantages of decentralization
Slide 12-6
Disadvantages of Disadvantages of DecentralizationDecentralizationDisadvantages of Disadvantages of DecentralizationDecentralization
Costly duplication of activities Lack of goal congruence
- Management may pursue personal goalsthat are incompatible with the company’s goals
- To control goal congruence, companies evaluate the performance of subunit managers
All of the following are advantages of decentralization except:
a. Faster response to changing circumstances
b. Costly duplication of activitiesc. Increased motivation of managersd. Better information, leading to
superior decisions
Answer: bCostly duplication of activities
Slide 12-7 Learning objective 1: List and explain the advantages and disadvantages of decentralization
Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers
Slide 12-8
Evaluating SubunitsEvaluating SubunitsEvaluating SubunitsEvaluating Subunits
Evaluation of subunits is undertaken to identify successful operations and areas needing improvement
Top management perform incremental analysis to determine:- Whether a successful operation
should be expanded- Whether an unsuccessful operation
should be eliminated or improved
Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers
Slide 12-9
Evaluating Subunit ManagersEvaluating Subunit ManagersEvaluating Subunit ManagersEvaluating Subunit Managers
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
Slide 12-10
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
This idea should play a prominent role in the design of accounting systems- Costs and revenues are traced to the
organizational level where they can be controlled
Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers
Slide 12-11
Tracing Costs to Tracing Costs to Organizational LevelsOrganizational Levels
Tracing Costs to Tracing Costs to Organizational LevelsOrganizational Levels
Learning objective 2: Explain why companies evaluate the performance of subunits and subunit managers
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-12
Responsibility CentersResponsibility CentersResponsibility CentersResponsibility Centers
Responsibility centers are units responsible for the generation of revenue and/or the incurrence of costs
Three types of responsibility centers:- Cost centers- Profit centers- Investment centers
Slide 12-13
Cost CentersCost CentersCost CentersCost Centers
Subunit responsible for controlling costs but not responsible for generating revenue,e.g. 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
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-14
Profit CentersProfit CentersProfit CentersProfit Centers
Subunits responsible for generating revenues as well as 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
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-15
Profit CentersProfit CentersProfit CentersProfit Centers
Methods used to evaluate profitability
Current compared to budgeted income
Current compared to past income
Comparison with other profit centersi.e., relative performance evaluation
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-16
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
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-17
NordstromNordstromNordstromNordstrom
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-18
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
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-19
Cost centers are often evaluated using:
a. Variance analysisb. Operating marginc. Return on investmentd. Residual income
Answer:a. Variance analysis
Learning objective 3: Identify cost centers, profit centers, and investment centers
Slide 12-20
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
Learning objective 3: Identify cost centers, profit centers, and investment centers
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-21
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
Ratio of investment center income to invested capital
Focuses management’s attention on both income (numerator) and level of investment (denominator)
Slide 12-22
ROI ComponentsROI ComponentsROI ComponentsROI Components
ROI may be broken down into two components: Profit margin and Investment turnover
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-23
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
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-24
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
To calculate NOPAT, a company must make adjustments to net income:
Add back non-operating expense to net income, e.g. interest expense
Adjust tax expense accordingly
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-25
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 non-interest-bearing
current liabilities (method used in this textbook)
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-26
NOPAT ExampleNOPAT ExampleNOPAT ExampleNOPAT Example
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-27
ROI – France, Germany, and ROI – France, Germany, and JapanJapan
ROI – France, Germany, and ROI – France, Germany, and JapanJapan
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-28
Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which
$30,00,000 are non-interest bearing
Calculate NOPAT=Net income + interest expense (1 - tax
rate) =$16,000,000 + $1,300,000 (1 - .40) =$16,780,000
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-29
Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which
$30,00,000 are non-interest bearing
Calculate invested capital= Total assets – non-interest-bearing CL= $225,000,000 - $30,000,000 = $195,000,000
Learning objective 4: Calculate and interpret
return on investment (ROI)
Slide 12-30
Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which
$30,00,000 are non-interest bearing
Calculate ROI= NOPAT ÷ Invested capital= $16,780,000 ÷ $195,000,000 = 8.605%
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-31
Calculating ROICalculating ROICalculating ROICalculating ROI
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-32
Problems with Using ROIProblems with Using ROIProblems with Using ROIProblems with Using 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
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-33
Problems with Using ROIProblems with Using ROIProblems with Using ROIProblems with Using ROI
Managers may put off purchase of new equipment, i.e. may lead to under investment
Projects with positive net present value but low initial profitability might not be undertaken
Managers with high ROI may consider the effect on ROI, rather than NPV
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-34
Information for Davenport Mills Net income $16,000,000 Interest expense $1,300,000 Tax rate 40% Total assets $225,000,000 Current liabilities $45,000,000 of which
$30,00,000 are non-interest bearing
Calculate residual income if cost of capital is 10%= NOPAT – (Cost of Capital x Invested Capital)= $16,780,000 – (10% x $195,000,000)= ($2,720,000)
Learning objective 4: Calculate and interpret return on investment (ROI)
Slide 12-35
Problems of Overinvestment Problems of Overinvestment and Underinvestmentand Underinvestment
Problems of Overinvestment Problems of Overinvestment and Underinvestmentand Underinvestment
Evaluation using profit can lead to overinvestment- Managers motivated to make investments
that earn a return less than cost of capital
Evaluation using ROI can lead to underinvestment- Managers may not take on projects with a
low ROI just to increase profit if they are evaluated in terms of the return they earn
Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment
Slide 12-36
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
Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment
Slide 12-37
Decision MakingDecision MakingDecision MakingDecision Making
Learning objective 5: Explain why using a measure of profit to evaluate performance can lead to overinvestment and why using a measure of return on investment (ROI) can lead to underinvestment
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)
Slide 12-38
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
Use total assets minus non-interest-bearing current liabilities as a measure of investment
Slide 12-39
Residual IncomeResidual IncomeResidual IncomeResidual Income
NIBCL = non-interest bearing current liabilities
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)
Slide 12-40
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 GAAPe.g., under GAAP research and development costs are expensed, but the costs benefit future periods
Thus, under EVA research and development is capitalized and amortized over future periods
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)
Slide 12-41
Economic Value Added Economic Value Added (EVA)(EVA)
Economic Value Added Economic Value Added (EVA)(EVA)
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)
Slide 12-42
Investment centers are often evaluated using:
a. Standard cost variancesb. Return on investmentc. Residual income/EVAd. Both b and c
Answer: dBoth b and c
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)
Slide 12-43
Economic Value Added Economic Value Added (EVA)(EVA)
Economic Value Added Economic Value Added (EVA)(EVA)
Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)
Learning objective 1: List and explain the advantages and disadvantages of decentralization
Slide 12-44
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”
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Slide 12-45
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard
Set of performance measures constructed for four dimensions of performance:
1. Financial2. Customer3. Internal processes4. Learning and growth
Slide 12-46
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard1. Financial
Is company meeting its financial goal?
2. Customer Examine company success in meeting customer
expectations?
3. Internal ProcessesExamines the company’s success in improving critical business processes
4. Learning and growth Examines the company’s success in improving
its ability to adapt, innovate, and grow
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Slide 12-47
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!
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Slide 12-48
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Slide 12-49
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
Quantitative measures are balanced with qualitative measures
There is a balance of backward-looking measures and forward-looking measures
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Slide 12-50
Balanced ScorecardBalanced ScorecardBalanced ScorecardBalanced Scorecard
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Slide 12-51
You Get What You MeasureYou Get What You MeasureYou Get What You MeasureYou Get What You Measure
Learning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance
Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard
Slide 12-52
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
Useful to test the soundness of the strategy
Identifies how strategy is linked to measures on the scorecard
Useful to communicates strategic objectives to employees
Slide 12-53
Strategy Map ExampleStrategy Map ExampleStrategy Map ExampleStrategy Map Example
Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard
Learning objective 9: Discuss the key items related to a successful balanced scorecard
Slide 12-54
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
Slide 12-55
Keys to a Successful Balanced Keys to a Successful Balanced ScorecardScorecard
Keys to a Successful Balanced Keys to a Successful Balanced ScorecardScorecard
Responsibility- A specific employee must be given
responsibility/accountability for the implementation of each initiative
Funding- Initiatives must be funded appropriately
Top Management Support- Crucial to have the full support of top
management
Learning objective 9: Discuss the key items related to a successful balanced scorecard
Slide 12-56
Keys to a Successful Balanced Keys to a Successful Balanced ScorecardScorecard
Keys to a Successful Balanced Keys to a Successful Balanced ScorecardScorecard
Learning objective 9: Discuss the key items related to a successful balanced scorecard
Slide 12-57
EvaluationEvaluationEvaluationEvaluation
Learning objective 9: Discuss the key items related to a successful balanced scorecard
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices
Slide 12-58
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
Transfer pricing - price used to value internal transfers of goods or services
Subunits of a company sell goods or services to other subunits within the same company
Must determine the price to use for internal transfers
Slide 12-59
Methods of Setting the Methods of Setting the Transfer PriceTransfer Price
Methods of Setting the Methods of Setting the Transfer PriceTransfer Price
Pricing alternatives:
Market price Variable costs Full cost plus profit Negotiated prices
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices
Slide 12-60
Methods of Setting the Methods of Setting the Transfer PriceTransfer Price
Methods of Setting the Methods of Setting the Transfer PriceTransfer Price
The most appropriate transfer price depends on the circumstances Should lead subunit managers to make
decisions that maximize firm value
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
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices
Slide 12-61
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
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices
Slide 12-62
Transfer PricingTransfer PricingTransfer PricingTransfer Pricing
Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices
Slide 12-63
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