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Chapter 12 Decentralization and Performance Evaluation

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Chapter 12 Decentralization and Performance Evaluation Powered By Docstoc
					Chapter Twelve

 Decentralization and Performance
             Evaluation
Introduction
   Decentralization means that decision
    making power concerning costs,
    revenues and/or investments is
    delegated to managers of subunits
    down the organizational chart.
Objectives
1. Discuss the advantages and
   disadvantages of decentralization.
2. Explain why companies evaluate the
   performance of subunit managers.
3. Three types of responsibility centers
   are cost centers, profit centers, and
   investment centers
4. Calculate and interpret return on
   investment (ROI).
Objectives       (Continued)




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
6. Calculate and interpret residual income
   (RI) and economic value added (EVA).
7. Explain the potential benefits of using a
   Balanced Scorecard to assess
   performance.
Advantages of Decentralization
1. Better information leading to superior
   decisions.
2. Faster response to changing
   circumstances.
3. Increased motivation of managers.
4. Excellent training for future top level
   executives.
Advantages of Decentralization
Disadvantages of
Decentralization
1. Costly duplication of activities.
2. Lack of goal congruence.
Why Companies Evaluate The
Performance of Subunits and
Subunit Managers
   Decentralization naturally implies
    evaluation of subunits and managers.
   Companies evaluate performance of
    subunits and managers for two reasons:
       To identify successful operations and areas
        needing improvement.
       To influences and motivate manager behavior.
Responsibility Accounting and
Performance Evaluation
1. Responsibility accounting holds
   managers responsible only for decisions
   about things they can control.
2. To implement responsibility accounting
   in a decentralized organization, costs
   revenues, and capital expenditures are
   traced to the organizational level where
   they can be controlled.
Responsibility Accounting and
Performance Evaluation
Cost Centers, Profit Centers,
and Investment Centers
   Subunits are organizational units or
    responsibility centers with identifiable
    collections of related resources and
    activities.

   They may be classified into
     Cost Centers
     Profit Centers
     Investment Centers
Cost Centers
1. Subunit that has responsibility for
   controlling costs but does not have
   responsibility for generating revenue.
2. Examples: Service and production
   departments.
3. Managerial goal: to provide services or
   make products at a reasonable cost to the
   company.
4. Evaluation: compare budgeted/standard
   costs with actual costs.
Profit Centers
1. Subunit that has responsibility for generating
   revenues as well as for controlling costs.
2. Examples: copier and camera divisions of
   an electronics firm.
3. Managerial goal: to generate profit
   (revenues – expenses) for the division.
4. Evaluation: profit from the current year may
   be compared with budget or previous years
   or compared with with other profit centers on
   a relative basis.
Investment Centers
1. Subunit that has responsibility for:
   a. Generating revenues
   b. Controlling costs
   c. Investing in assets
2. Managers of investment centers have
   control over inventory, receivables,
   equipment purchases, etc...
3. They are held responsible for generating
   some kind of return on them.
Investment Centers            (Continued)




4. Managerial goal: is to generate return on
   invested capital
5. Evaluation: rate of return (%) relative to a
   benchmark/budget rate of return or relative
   to other investment center rates of return.
6. Are the camera and copy divisions really
   profit centers or investment centers?
Evaluating Investment Centers
with Return On Investment (ROI)
1. ROI is one of the primary tools for evaluating
   performance of investment centers.
2. Calculated as follows: ROI = Income
                             Invested Capital
3. ROI focuses on income AND investment
4. Natural advantage over income (alone) as a
   measure of performance.
5. Removes the bias of larger investment over
   smaller investment.
Evaluating Investment Centers
with ROI    (Continued)




1. ROI can be analyzed into two components:

   a. Profit margin       =   Income
                              Sales

   b. Investment turnover =      Sales
                              Invested Capital
Measuring Income and
Invested Capital When
Calculating ROI
   For ROI calculations, companies measure
    “income” in a variety of ways:
     • Net income
     • Income before interest and taxes
     • Controllable profit…

   Our text uses uses Net Operating Profit
    After Taxes, NOPAT. This formula does not
    hold managers responsible for interest.
What is NOPAT?
Net Income                        $3,900,000
Add Back:
 Interest Expense                 1,000,000
 less tax deduction of interest    (350,000)
NOPAT                             $4,550,000
       Measuring Income and
       Invested Capital When
       Calculating ROI             (Continued)




   Invested capital is measured in a variety of ways.
   In the text, invested capital is measured as:
    Total Assets – Non-interest-bearing current liabilities
   Examples of non-interest-bearing current liabilities:
    • Accounts payable
    • Income taxes payable
    • Accrued liabilities (wages, utilities etc)
      Problems With Using ROI
   Major problem with ROI: the denominator,
    invested capital, is based on historical costs,
    net of depreciation.
   As those assets become fully depreciated, the
    invested capital denominator becomes
    extremely low and the ROI number quite high.
   Managers may therefore be compelled to put off
    purchases of new equipment necessary for
    long-term success. They “under-invest.”
Problems of Overinvestment and
Underinvestment: You Get What
You Measure
   Underinvestment results when Managers of
    investment centers with high ROI’s are
    unwilling to invest in good projects or assets
    that will dilute their current ROI.

   Conversely, evaluation in terms of profit can
    lead to “overinvestment.”
Residual Income (RI)
   Residual Income (RI): net operating profit
    after taxes of an investment center in
    excess of the profit required for the level of
    investment.
   RI = NOPAT - Cost of Capital x Investment
   Using RI may avoid overinvestment and
    underinvestment tendencies because it will
    reward managers who invest in projects
    returning above the firms cost of capital
     Residual Income (RI):
     Examples
   The Camera Division Earned $180,000 and had
    invested capital of $1,000,000.

   Suppose the cost of capital is 10%, and the
    division has the chance to earn $60,000 a year
    more on additional investment of $500,000.

   If performance is based on ROI manager may
    reject, but RI yields a better decision.
Economic Value Added (EVA)
   A refined version of RI, which has gained
    wide acceptance is called Economic Value
    Added
   Developed by the consulting firm Stern
    Stewart to adjust RI for “accounting
    distortions.”
   The principal distortion is related to
    research and development (R&D).
      Economic Value Added (EVA)
      (Continued)




   Under GAAP, R&D is expensed immediately while
   Under EVA, R&D is capitalized and amortized
   over a number of future accounting periods.

                    adjusted
EVA = NOPAT       minus
                                        adjusted
          (Cost of Capital x Investment         )
        Using A Balanced Scorecard
        To Evaluate Performance
   ROI RI and EVA are criticized because they do little
    more than summarized the past “backward looking.”

   Balanced Scorecard is a framework of performance
    measures which incorporate forward looking and
    qualitative information:
    • Financial perspective
    • Customer perspective
    • Internal process perspective
    • Learning and growth
      Using A Balanced Scorecard
      To Evaluate Performance                (Continued)



   Balanced Scorecard uses performance
    measures that are tied to the company’s strategy
    for success.
   Progress towards current financial goals is only
    one component of success in the longer run.
    Other factors may be more important for success
    in the future
   Consider the balanced scorecard measured
    shown in illustration 12-10
    How Balance is Achieved in A
    Balanced Scorecard
  Balance between qualitative and
  quantitative, forward and backward
  measures, and balanced company
  dimensions!
 Performance is assessed across a balanced
  set of dimensions.
 Quantitative measures are balanced with
  qualitative measures.
 There is a balance of backward-looking and
  forward-looking measures.
How Balance is Achieved in A
Balanced Scorecard
Quick Review Question #1

1. A profit center is responsible for all of
   the following except:
    a. Investing in long term assets.
    b. Controlling costs.
    c. Generating revenues.
    d. It is responsible for all of the
       above, no exception.
Quick Review Question #1

1. A profit center is responsible for all of
   the following except:
    a. Investing in long term assets.
    b. Controlling costs.
    c. Generating revenues.
    d. It is responsible for all of the
       above, no exception
Quick Review Question #2

2. What is the difference between RI and
   EVA?
   a. RI is a new concept.
   b. EVA makes adjustments for “accounting
      distortions.”
   c. RI excludes research and development
      as an expense.
   d. EVA includes a capital charge.
Quick Review Question #2

2. What is the difference between RI and
   EVA?
   a. RI is a new concept.
   b. EVA makes adjustments for “accounting
      distortions.”
   c. RI excludes research and development
      as an expense.
   d. EVA includes a capital charge.
Quick Review Question #3

3. Return on Investment (ROI) is calculated
   as:
   a. Sales / Total assets.
   b. Gross margin / Invested capital.
   c. Investment center income / Invested
       capital.
   d. Income / Sales.
Quick Review Question #3

3. Return on Investment (ROI) is calculated
   as:
   a. Sales / Total assets.
   b. Gross margin / Invested capital.
   c. Investment center income / Invested
       capital.
   d. Income / Sales.
Quick Review Question #4

4. Investment center income is $864,000.
   Investment turnover is 2. ROI is 24%.
   Sales is?
    a. $8,000,000
    b. $7,200,000
    c. $6,000,000
    d. $3,600,000
Quick Review Question #4

4. Investment center income is $864,000.
   Investment turnover is 2. ROI is 24%.
   Sales is?
    a. $8,000,000
    b. $7,200,000
    c. $6,000,000
    d. $3,600,000

				
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