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Performance Evaluation

Performance Evaluation. Chapter 10. Objective 1. Understand decentralization and describe the different types of responsibility centers. Decentralization. Splitting operations into different operating segments Advantages Frees top management’s time Use of expert knowledge

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Performance Evaluation

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  1. Performance Evaluation Chapter 10

  2. Objective 1 Understand decentralization and describe the different types of responsibility centers

  3. Decentralization • Splitting operations into different operating segments • Advantages • Frees top management’s time • Use of expert knowledge • Improves customer relations • Provides training • Improves motivation and retention • Disadvantages • Duplication of costs • Potential problems achieving goal congruence

  4. Performance Evaluation Systems • Provide upper management with feedback • To be effective, should • Clearly communicate expectations • Provide benchmarks that promote goal congruence and coordination between segments • Motivate segment managers

  5. Responsibility Accounting • Responsibility Center - part of an organization whose manger is accountable for planning and controlling activities • Responsibility Accounting - system for evaluating performance of each responsibility center and its manger.

  6. Types of Responsibility Centers • Cost Center • Revenue Center • Profit Center • Investment Center

  7. Objective 2 Develop performance reports for different responsibility centers

  8. Responsibility Center Performance Reports • Performance Report – compares actual revenues and expenses to budgeted figures • Variance – difference between actual and budget • Favorable variance: causes operating income to be higher than budgeted • Unfavorable variance: causes operating income to be lower than budgeted • Management by exception

  9. Exhibit 10-3: Partial Performance Report for Revenue Center

  10. Segment Margin The operating income generated by a profit or investment center before subtracting common fixed costs that have been allocated to the center

  11. Exhibit 10-4: Performance Report Highlighting Segment Margin

  12. Organization-Wide Performance Reports • Performance reports for each level of management flow up • Controllable vs. uncontrollable variances

  13. Objective 3 Calculate ROI, Sales Margin, and Capital Turnover

  14. Evaluation of Investment Centers • Duties of Investment center manager similar to CEO • To assess performance • Return on Investment (ROI) • Residual Income (RI)

  15. Return on Investment (ROI) • Measures the amount of income an investment center earns relative to the size of its assets • ROI = Operating Income Total Assets

  16. Sales Margin and Capital Turnover • ROI = Operating Income x Sales___ SalesTotal Assets (ROI = Sales Margin x Capital Turnover)

  17. S10-6

  18. S10-6 • Functional Ingredients • Sales margin $5,445 / $21,780 = 25.0% • Capital turnover $21,780 / $12,100 = 1.8 • ROI 25.0% x 1.8 = 45.0% • Consumer Markets • Sales margin $2,075 / $20,750 = 10.0% • Capital turnover $20,750 / $8,300 = 2.5 • ROI 10.0% x 2.5 = 25.0% • Performance Markets • Sales margin $3,000 / $15,000 = 20.0% • Capital turnover $15,000 / $10,000 = 1.5 • ROI 20.0% x 1.5 = 30.0%

  19. Residual Income • Determines whether the division has created any excess (residual) income above management’s expectations • Incorporates Target Rate of Return RI = Operating Income – Minimal acceptable income RI = Operating Income – (Target rate of return x Total assets)

  20. S10-9

  21. S10-9 Snow Sports RI = $1,040,000 − ($4,000,000 × 16%) = $400,000 Non-Snow Sports RI = $1,680,000 − ($6,000,000 × 16%) = $720,000

  22. Goal Congruence Residual Income enhances goal congruence, whereas ROI may or may not

  23. Measurement Issues • Which balance sheet data should we use? • Should we include all assets? • Should we use gross book value or net book value of the assets? • Should we make other adjustments to income or assets?

  24. Limitations of Financial Performance Evaluation • Short-term focus • Potential Remedy: management can measure financial performance using a longer time horizon • Incentivizes segment managers to think long term rather than short term

  25. Transfer Pricing • The price charged for the internal sale between two different divisions of the same company • Encourage transfer only if the company would benefit by the exchange • Vertical Integration

  26. Exhibit 10-9: Strategies to Determine Transfer Price

  27. Global Considerations • Do the divisions operate under different taxing authorities such that income tax rates are higher for one division? • Would the amount paid to customs and duties be impacted by the transfer price used?

  28. Objective 4 Prepare and evaluate Flexible Budget Performance Reports

  29. Flexible Budget • A budget prepared for a different level of volume than that which was originally anticipated • Master Budget Variance – Difference between the actual revenues and expenses and the master budget • “Apples-to-oranges” comparison

  30. Exhibit 10-11 Creating a Flexible Budget Performance Report

  31. Volume Variance • The difference between the master budget and the flexible budget • Arises only because the actual volume differs from the volume originally anticipated in the master budget

  32. Exhibit 10-12 Volume Variances

  33. Flexible Budget Variance The difference between the flexible budget and the actual results

  34. Exhibit 10-13 Flexible Budget and Volume Variances

  35. Underlying Causes of the Variances • Management by exception • Use performance reports to see how operational decisions affected company’s finances

  36. Master Budget Variance: A Combination of Variances Flexible Budget Variance Volume Variance Master Budget Variance

  37. Objective 5 Describe the balanced scorecard and identify KPIs for each perspective

  38. Nonfinancial Performance Measurement • Lag indicators - reveal the results of past actions and decisions • Lead indicators - predict future performance

  39. The Balanced Scorecard • Management must consider both financial and operational performance measures • Major shift: financial indicators are no longer the sole measure of performance

  40. Four Perspectives of the Balanced Scorecard • Financial • Customer • Internal Business • Learning and Growth

  41. Key Performance Indicator (KPI) • Summary performance metric; assesses how well the company is achieving its goals • Continually measured • Reported on performance scorecard or performance dashboard

  42. Financial Perspective • “How do we look to shareholders?” • Must continually attempt to increase profits • Increase revenues • Control costs • Increase productivity

  43. Customer Perspective • “How do customers see us?” • Customers concerned with four product/service attributes: • Price • Quality • Sales service • Delivery time

  44. Internal Business Perspective • “At what business processes must we excel to satisfy customer and financial objectives?” • Three factors: • Innovation • Operations • Post-sales support

  45. Learning and Growth Perspective • “Can we continue to improve and create value?” • Three factors: • Employee capabilities • Information system capabilities • Company’s “climate for action”

  46. Sustainability and Performance Evaluation • Sustainability-related KPIs • Fifth perspective - “Sustainability” • Sixth perspective - “Community”

  47. End of Chapter 10

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