C11 -accounting

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CHAPTER 11

Performance Evaluation and the Balanced Scorecard

Copyright © 2015 Pearson Canada Inc.

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OBJECTIVE 1Explain why and how companies decentralize.


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Centralized and Decentralized OperationsCentralized Decentralized

Decision making and planning Owner/Manager Delegated to unit managers

Applicationbase Small scope of operations

Business characteristic - Geographic area, product line, customer base, business function, other.

Advantages • Avoids duplication of costs• Simplifies goal congruence

• Frees management time• Uses experts knowledge• Improves Customer Relations • Vast training and experience • Increases managers’ motivation and

retention

Disadvantages

• Limits management time• Managers knowledge limited• Customer Relations strained • Costly Training for one• Decreases managers’ motivation

and retention

• Duplicates certain costs or assets• Problems with Goal Congruence


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Responsibility Centers

Responsibility Center Manager is responsible for…

Examples

Cost Center Controlling Costs Production line at Dell computer

Revenue Center Generating Sales Revenue Midwest sales region at Pace Foods

Profit Center Producing profit through generating sales and controlling costs

Product line at Anheuser-Busch

Investment Center Producing profit and managing the division’s invested capital

Company divisions such as Walt Disney World Resorts


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OBJECTIVE 2

Explain why companies use performance evaluation systems.


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Goals of Performance Evaluation Systems

• Promoting goal congruence and coordination• Communicating expectations• Motivating unit managers• Providing feedback• Benchmarking


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Limitations of Financial Performance Measures

• Management needs both:– Lag indicators– Lead indicators

• Tendency to focus on short-term achievements


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OBJECTIVE 3

Describe the balanced scorecard and identify key performance indicators for each perspective.


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Balanced Scorecard

• Measure company’s activities in terms of its vision and strategies

• Financial and operational performance measures are considered

• Link company goals to key performance indicators


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COMPANY GOALS

CRITICAL FACTORS(customer satisfaction, operational efficiency, employee excellence, financial profitability)

KEY PERFORMANCE INDICATORS (KPIs)(market share, yield rate, employee training

hours, revenue growth)

Linking Goals to Key Performance Indicators (See examples at Exhibit 11-2)


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Four Perspectives• Financial perspective

– How do we look to shareholders?• Customer perspective

– How do customers see us?• Internal business perspective

– At what business processes must we excel to satisfy customer and financial objectives?

• Learning and growth perspective– Can we continue to improve and create value?


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OBJECTIVE 4

Use performance reports to evaluate cost, revenue, and profit centers.


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Performance Reports

• Report financial performance of responsibility centers– Cost center: focus on flexible budget variance– Revenue center: focus on flexible budget variance and

sales volume variance– Profit center: focus on flexible budget variance• Includes allocated charges from service departments


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Cost Center Performance Reports: Exhibit 11-4

HOUSE AND GARDEN DEPOT—QUEBEC

REGIONActual Flexible

budgetFlexible budget

variance%

Variance

Salary & wages $18,500 $18,000 $500 U 2.8% U

Payroll benefits 6,100 5,000 1,100 U 22.0% U

Equipment depreciation 3,000 3,000 3,000 0%

Supplies 1,850 2,000 150 F 7.5% FOther 1,900 2,000 100 F 5.0% F

Total $31,350 $30,000 $1,350 U 4.5% U


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Revenue Center Performance Reports: Exhibit 11-5

Sales Revenue

Actual Sales

Flexible budget

varianceFlexible budget

Sales Volume Variance

Static(Master)Budget

Benjamin Moore – Flat:

Volume (gallons) 2,480 -0- 2,480 155 F 2,325

Revenue $40,920 $3,720 U $44,640 2,790 F $41,850


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Profit Center Performance Reports: Exhibit 11-6

Subunit X Actual Flexible budget

Flexible budget

variance%

Variance

Sales Revenue $5,243,600 $5,000,000 $243,600 F 4.9% F

Operating expenses 4,183,500 4,000,000 183,500 U 4.6% U

Income from operations before service department charges

1,060,100 1,000,000 60,100 F 6.0% F

Service department charges (allocated) 84,300 75,000 9,300 U 12.4% U

Total $975,800 $925,000 $50,800 F 5.5% FCopyright © 2015 Pearson Canada Inc.

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Centralized Services Decision TreeTop Management Decision:Provide centralized service

departments?

Charge subunits fortheir use of centralizedservice departments?

Centralized servicedepartment costs are

allocated between subunits

Centralized servicesare provided

“free of charge”

Subunits must provideor outsource their

own services

YES NO

YES NO


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OBJECTIVE 5

Use return on investment (ROI), residual income (RI), and economic value added (EVA) to evaluate investment centers.


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Investment Centers

• Financial evaluation must measure– Income generated– Effective use of center’s assets

• Performance measures– Return on investment (ROI)– Residual income (RI)– Economic value added (EVA)


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Summary Performance Measures

Summary Performance Measures for Investment CentersThese three measures take into consideration:1. The division’s operating income2. The division’s assets

Residual Income (RI)

Return on Investment (ROI)

Economic Value Added (EVA)


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Return On Investment (ROI)

Operating incomeTotal assets

Or

Operating incomeSales

SalesTotal assetsX

Sales margin Capital turnover


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ROIAdvantages:• Expanded equation provides additional

information• Can be used to compare across divisions and with

other companies• Useful for resource allocationDrawback:• Provides an incentive to select projects that are

expected to increase ROI


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Residual Income

• Compares division’s operating income with minimum operating income expected, given the size of the division’s assets

Positive – income exceeds target rate of return Negative – income does not meet target rate of

return

RI = Operating income − Minimum acceptable income

RI = Operating income − (Target rate of return x Total assets)


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Economic Value Added

Looks at a division’s RI through the eyes of the company’s primary stakeholders: its investors and long-term creditors

EVA = After-tax operating income − [(Total assets − Current liabilities) WACC%]


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RI vs EVA• Both calculate whether the division created any

income above and beyond expectationsDifferences:• The EVA calculation uses after-tax operating

income• Total assets is reduced by current liabilities• The WACC replaces management’s target rate of

return


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Limitations of Financial Performance Measures

• Measurement issues– Total Assets beginning or end of year– All Assets or exclude nonproductive assets– Use Gross Book Value vs Net Book Value

• Short-term focus– Time frame of one year or less


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Summary Performance MeasuresSummary Performance Measures for Investment Centers

These three measures take into consideration:1. The division’s operating income2. The division’s assets

Residual Income (RI)

RI = Operating income − Minimum acceptable

income

Return on Investment (ROI)

ROI = Operating incomeTotal assets

Economic Value Added (EVA)

EVA = After-tax operating income − [(Total assets − Current liabilities) WACC

%]


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