Prepared by Debby Bloom-Hill CMA, CFM. Slide 12-2 CHAPTER 12 Decentralization and Performance...

Prepared by Debby Bloom-Hill CMA, CFM

2

CHAPTER 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 OrganizationsDecentralized Organizations

As firms increase in size and complexity, business segments or subunits are organized The managers of the segments are

granted decision making authority so that the firm will function efficiently and effectively Firms that grant substantial decision making authority to the managers of subunits are referred to as decentralized organizations


Slide 12-4


Most firms are neither totally centralized nor totally decentralized Typically, decentralization is a

matter of degree A firm is more decentralized if more

decision making authority is delegated to sub-unit managers Performance evaluation can be used to ensure that managers make decisions that are in the best interest of the entire firm


Slide 12-5



Slide 12-6

Advantages of DecentralizationAdvantages of Decentralization

A primary reason is that subunit managers have better information than top management and can respond quicker to changing circumstances

Other reasons include Some firms decentralize because they

believe that managers are more motivated and work harder

Decentralized organizations provide excellent training for future top-level executives


Slide 12-7

Disadvantages of DecentralizationDisadvantages of Decentralization

Decentralization can cause problems It may result in a costly duplication

of activities Managers may pursue personal goals

that are incompatible with the goals of the company as a whole This problem is called goal congruence

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 12-8 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 12-9

Evaluating SubunitsEvaluating Subunits

Evaluation of subunits is undertaken to identify successful operations and areas needing improvement

Top management may perform incremental analysis to determine: Whether a successful operation

should be expanded Whether an unsuccessful operation

should be eliminated or improved


Slide 12-10

Evaluating Subunit Managers

Evaluating 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

11

Responsibility Accounting and Performance Evaluation

Responsibility Accounting and Performance 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 used to evaluate managers Costs and revenues are traced to the organizational level where they can be controlled


12

Tracing Costs to Organizational Levels

Tracing Costs to Organizational Levels


Learning objective 3: Identify cost centers, profit centers, and investment centers

Slide 12-13

Responsibility CentersResponsibility Centers

Responsibility centers are organizational units responsible for the generation of revenue and/or the incurrence of costs

Responsibility centers typically are classified as being Cost centers Profit centers, or Investment centers


Slide 12-14

Cost CentersCost Centers A cost center is a subunit that has

responsibility for controlling costs but does not have responsibility for generating revenue Most service departments are

classified as cost centers The managers of these departments are responsible for making sure their services are provided at a reasonable cost to the company


Slide 12-15

Cost CentersCost Centers A common approach to controlling

cost centers is to compare their actual costs with standard or budgeted costs If variances from standard are

significant, an investigation into the activities of the cost center should be undertaken to determine whether costs are out of control

Other performance measures can be used as well

16

Profit CentersProfit Centers

A profit center is a subunit that has responsibility for generating revenues as well as for controlling costs Because both revenues and costs

are under the control of the profit center manager, the performance of the profit center can be evaluated in terms of profitability This motivates managers to focus their attention on ways of maximizing profit center profitabilityLearning objective 3: Identify cost centers, profit

centers, and investment centers

17

Profit CentersProfit Centers

Companies use a variety of methods to profit centers Income earned in the current year may

be compared with an income target Income earned may be compared with

income earned in the prior year Some firms use relative performance

evaluation, which involves evaluating the profitability of each profit center relative to the profitability of similar profit centers


18

Investment CentersInvestment Centers

An investment center is a subunit that is responsible for generating revenue, controlling costs, and investing in assets An investment center is changed

with earning income consistent with the amount of assets invested in the segment


19

Investment CentersInvestment Centers

If the manager can influence decisions affecting investment in divisional assets, the division should be considered an investment center Managers play a major role in the

determining the level of inventory, accounts receivable and equipment It seems reasonable to hold them responsible for earning a return on these assets


20

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


21

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 4: Calculate and interpret return on investment (ROI)

Slide 12-22

Evaluating Investment Centers With ROI

Evaluating Investment Centers With ROI

One of the primary tools for evaluating the performance of investment centers is return on investment, or ROI ROI is calculated as the ratio of

investment center income to invested capital

Focuses management’s attention on both income (numerator) and the level of investment (denominator)

23

ROI ComponentsROI Components

Some companies break ROI into two components Profit margin and Investment turnover


24

Measuring Income and Invested Capital for ROIMeasuring Income and Invested Capital for ROI

In calculating ROI, companies measure “income” in a variety of ways Net income, earnings before

interest and taxes, controllable profit, etc.

Most common method is NOPAT Net operating profit after taxes

NOPAT excludes interest expense, which is a nonoperating expense

Therefore, add interest expense back to net income and adjust tax expense accordingly Learning objective 4: Calculate and interpret

return on investment (ROI)

25

Measuring Income and Invested Capital for ROIMeasuring Income and Invested Capital for ROI

In calculating ROI, companies measure “invested capital” in a variety of ways Common approaches include

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)


26

NOPAT ExampleNOPAT Example


27

ROI – France, Germany, and Japan

ROI – France, Germany, and Japan


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


29



Calculate invested capital= Total assets – non-interest-bearing

current liabilities = $225,000,000 - $30,000,000

= $195,000,000 Learning objective 4: Calculate and interpret

return on investment (ROI)

30



Calculate ROI= NOPAT ÷ Invested capital= $16,780,000 ÷ $195,000,000 = 8.605%


31

Calculating ROICalculating ROI


32

Problems 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

This makes comparison of investment centers using ROI difficult


33

Problems with Using ROIProblems with Using ROI

Managers may put off purchase of new equipment, which 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


34

Problems of Overinvestment and Underinvestment


We would like managers to invest in assets that earn a return in excess of the cost of capital If we evaluate managers in terms of

growth in profit, they may be motivated to make investments that earn a return that is less than the cost of capital This is called 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

35



An obvious solution is to evaluate managers in terms of ROI Managers won’t be motivated to

take on projects with a low return just to increase profits ROI can lead managers to underinvest, that is they may pass up projects that earn a return that is greater than the cost of capital


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


37

Decision MakingDecision Making


Learning objective 6: Calculate and interpret residual income (RI) and economic value added (EVA)

Slide 12-38

Evaluation Using Economic Value Added (EVA)

Evaluation Using Economic Value Added (EVA)

An approach to solving overinvestment and underinvestment problems involves the use of a performance measure known as economic value added (EVA) Firms that use EVA typically tie

bonus compensation to the measure Thus, managers become very focused on achieving high levels of EVA


Slide 12-39

Residual Income (RI)Residual Income (RI)

Residual income (RI) is the net operating profit after taxes of an investment center in excess of its required profit The 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

40

Residual IncomeResidual Income

NIBCL = non-interest bearing current liabilities


41

Economic Value Added (EVA)



Economic value added, better known as EVA, is simply residual income adjusted for “accounting distortions” that arise from following GAAP GAAP required R&D to be expensed

in the period incurred, but with EVA it is capitalized as an asset and amortized over future periods of benefit

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


43





Slide 12-44

Using a Balanced Scorecard to Evaluate 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



A problem with assessing performance with measures like profit, ROI and EVA is that these measures are all backward looking The balanced scorecard is an

approach to performance measurement that also focuses on what managers are doing today to create future shareholder value

46

Balanced ScorecardBalanced Scorecard The balanced scorecard is

constructed for four dimensions of performance1. Financial

Having financial measures is critical even if they are backward looking

2. CustomerExamines the company’s success in meeting customer expectations


47

Balanced ScorecardBalanced Scorecard The balanced scorecard is

constructed for four dimensions of performance

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


48

Tying the Balanced Scorecard Measures to the Strategy for

Success

Tying the Balanced Scorecard Measures to the Strategy for

Success Typically, a company will develop

three to five performance measures for each dimension Where possible, measures should be

tied to the company’s strategy for success

Balance among the dimensions is critical

You get what you measure! Companies need measures that drive

desirable behaviorsLearning objective 7: Explain the potential benefits of using a balanced scorecard to assess performance

49

Balanced ScorecardBalanced Scorecard


50

How Balance is Achieved in a Balanced Scorecard

How Balance is Achieved in a Balanced Scorecard

1. Performance is assessed across a balanced set of dimensions

2. Quantitative measures are balanced with qualitative measures

3. There is a balance of backward-looking measures and forward-looking measures


51



52



53

You Get What You MeasureYou Get What You Measure


Learning objective 8: Discuss how a strategy map can be used to communicate the measures in a balanced scorecard

Slide 12-54

Developing a Strategy Map for a Balanced Scorecard

Developing a Strategy Map for a Balanced Scorecard

A strategy map is a diagram of the relationships of the strategic objectives across the four dimensions of the balanced scorecard It is useful to test the soundness of

the strategy and how the strategy is linked to measures on the scorecard

It is useful to communicates strategic objectives to employees

55

Strategy 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 12-56

Keys to a Successful Balanced Scorecard


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

57



Responsibility A specific employee must be given

responsibility/accountability for the implementation of each initiative

Funding Initiatives must be funded

appropriately Top Management Support

It is crucial to have the full support of top management


58




59

EvaluationEvaluation


Learning objective A1: Discuss the use of market price, variable cost, full cost plus profit, and negotiation in setting transfer prices

Slide 12-60

Appendix - Transfer PricingAppendix - Transfer Pricing

The transfer price is the price that is used to value internal transfers of goods or services For external financial reporting

purposes, a company cannot recognize revenue on the sale of goods between responsibility centers within the firm

The revenue has not been realized

61

Methods of Setting the Transfer Price


In practice, a number of different approaches are taken to setting transfer prices Market price Variable costs Full cost plus profit Negotiated prices


62



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 companyLearning objective A1: Discuss the use of market price, variable

cost, full cost plus profit, and negotiation in setting transfer prices

63

Lowering Transfer Price Below the Market Price

Lowering Transfer Price Below the Market Price


64

Transfer PricingTransfer Pricing


65

CopyrightCopyright© 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Prepared by Debby Bloom-Hill CMA, CFM. Slide 12-2 CHAPTER 12 Decentralization and Performance...

Documents

Transcript of Prepared by Debby Bloom-Hill CMA, CFM. Slide 12-2 CHAPTER 12 Decentralization and Performance...