1. business and industrial
2. publishing

Chapter 24
1
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Explain why and how companies decentralize
Explain why companies use performance
evaluation systems
Describe the balanced scorecard and identify
key performance indicators for each
perspective
Use performance reports to evaluate cost,
revenue, and profit centers
Use ROI, RI, and EVA to evaluate investment
centers
2
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1
Explain why and how companies decentralize
3
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CEO,
Top
Controller,
Sales Mngr.
Plant Mngr.
CFO,
Vice Pres.
Mid-Level
Supervisors
Front Line/Supervisory
Foremen
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Catch
Global Competition
Speed & efficiency
Flat vs. vertical hierarchy
Market centric management
Requires decentralization of
management
How do we measure the
performance of each segment?
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Advantages:
Frees top management time
Supports use of expert knowledge
Improves customer relations
Provides training
Improves motivation and retention
Disadvantages:
Duplication of costs
Problems achieving goal congruence
7
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A responsibility center is a part or subunit of an
organization whose manager is accountable for specific
activities (recall from Chapter 22)
8
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2
Explain why companies use performance
evaluation systems
9
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Provide a framework for performance based leadership
Everyone involved needs to know if they are meeting
company goals
Decentralized organizations need system to
communicate goals to subunit managers
Primary goals:
Promoting goal congruence and coordination
Communicating expectations
Benchmarking
Providing feedback
Motivating unit managers
10
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Traditional systems revolved almost entirely around
financial performance
Ultimate goal of a company is to generate profit
Financial measures follow performance, not create it
Just win baby leads to trouble
Better to measure what causes performance
Management needs lead indicators
Find out what causes success, and measure that
Strong indicators of future success, not just past success
Top management needs signals that assess and predict
performance over longer periods of time
11
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3
Describe the balanced scorecard and identify key
performance indicators for each perspective
13
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A major shift in corporate performance measurement
Recognizes that financial measures are only one type
of measure among many
Uses key performance indicators (KPI)
Management needs to consider other critical factors:
Customer satisfaction
Operational efficiency
Employee excellence
AND of course, financial performance
Measures should be linked with company goals and
strategies
14
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16
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How do we look to shareholders?
Ultimate goal is to generate income for owners
Strategy revolves around increasing the company’s
profits, for example:
Increasing revenue growth
Introducing new products, gaining new customers, and
increasing sales
Increasing productivity/profitability
Reducing costs and using the company’s assets more
efficiently
KPIs:
Sales revenue growth
Gross margin growth
Return on investment
17
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How do customers see us?
Top priority for long-term success
Customer satisfaction critical to achieving the company’s
financial goals
Typical customer concerns:
Product price
Product quality
Sales service quality
Product delivery time
KPIs:
Customer satisfaction
Market share and increasing number of customers
Repeat customers
Rate of on-time deliveries
18
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What business processes must we excel in to satisfy
customer and financial objectives?
Three factors critically affect customer satisfaction:
Innovation—must continually improve existing products
and develop new products
Operations—lean and effective internal operations,
product efficiency and product quality
Post-sales service—service customers after the sale
Sample KPIs:
The number of new products developed or
new-product development time
The number of units produced per hour and defect rate
The number of warranty claims received, average repair
time, and average wait time
19
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How can we continue to improve and create value?
Measures employee skills, knowledge, motivation, and
empowerment
Employee capabilities–skilled, positive culture ,and
up-to-date technology
System capabilities–must have accurate information on
customers, internal processes, and finances
Corporate culture–supports communication, change, and
growth
KPIs:
Hours of employee training, employee satisfaction and
turnover, and number of employee suggestions implemented
Percentage of employees with access to customer data and
percentage of processes with real-time feedback
Employee turnover rate
20
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Four Teams of victims:
Case 1
Case 2
Case 3
Case 4
List possible “Gaming” approaches by people trying to achieve
the new goal.
Create a balanced scorecard approach considering your
experience above & explain why it will align behavior with the
well being of all involved.
Financial Customer Internal processes Learning/Growing
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4
Use performance reports to evaluate cost,
revenue, and profit centers
25
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Capture the financial performance of cost,
revenue, and profit centers
Look for large variances in % and $$$
Cost center
Includes information on actual traceable costs versus
budgeted costs
Revenue center
Includes actual revenue versus budgeted revenue
Profit center
Includes actual and budgeted information on both
revenues and costs
26
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Control costs
27
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Generating sales revenue
28
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Producing profit through generating sales and
controlling costs
29
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Use management by exception to determine
which variances are worth investigating
Investigate material variances first
Don’t play the blame game
Focus on understanding underlying reasons for
performance and take corrective action
The numbers indicate where to start action
They are not an excuse to blame and torture
Recognize some variances are uncontrollable
30
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5
Use ROI, RI, and EVA to evaluate
investment centers
31
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Managers are responsible for:
Maximizing earnings
Minimizing assets utilized to minimize financing required
How can we measure to two counter goals?
Basic: Use a ratio to compare the two items
ROI = Return ÷ Investment
Complex: Use residuals to assess earnings
Performance measures:
How much operating income the division is generating
How efficiently the division is using its assets
KPIs
32
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33
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Both methods are useful in
evaluating the performance of
investment centers.
ROI is size-independent, easily comparing
small to large divisions.
Residual income removes a curious
side effect of ROI which leads
managers to sometimes decline
profitable projects.
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Income earned by the segment
ROI =
Operating income
Average total assets
Cash, accounts receivable, inventory,
plant and equipment, and other
productive assets. (L+OE)
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Royal Division reports the following:
Operating income
Average total assets
Sales
ROI =
$ 30,000
$ 200,000
$ 500,000
$30,000
$200,000
= 15%
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Three ways to improve ROI . . .
 Increase
Sales
ROI =
Reduce
Expenses
 Reduce
Assets
Operating income
Average total assets
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ROI = Profit margin  Asset turnover
=
Operating income
Sales
x
Sales
Average total assets
=
Operating income
Average total assets
This expanded equation allows a quick view of two
determinates of Return on Investment:
Profit Margin: Does a healthy portion of sales make it to
the bottom line? Expense control. Pricing power.
Asset Turnover: Are our assets used efficiently to generate
sales volume? Lean assets. Strong sales.
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Royal division reports the following:
Operating income
$ 30,000
Average total assets
$ 200,000
Sales
$ 500,000
ROI
=
ROI
=
ROI =
15% =
Profit margin
Operating income
Sales
$30,000
$500,000
6%

Asset turnover
x
Sales
Average total assets
x
$500,000
$200,000
x
250%
Royal division Boosts operating income to $50,000 by cutting expenses
ROI =
$50,000
$500,000
x
25% =
10%
x
39
$500,000
$200,000
250%
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Royal division reports the following:
Operating income
$ 30,000
Average total assets
$ 200,000
Sales
$ 500,000
ROI
=
ROI
=
ROI =
15% =
Profit margin
Operating income
Sales
$30,000
$500,000
6%

Asset turnover
x
Sales
Average total assets
x
$500,000
$200,000
x
250%
Royal division Boosts operating income to $50,000 by Raising Sales $333,333
ROI =
25% =
40
$50,000
$833,333
6%
x
x
$833,333
$200,000
417%
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Royal division reports the following:
Operating income
$ 30,000
Average total assets
$ 200,000
Sales
$ 500,000
ROI
=
ROI
=
ROI =
15% =
Profit margin
Operating income
Sales
$30,000
$500,000
6%

Asset turnover
x
Sales
Average total assets
x
$500,000
$200,000
x
250%
Royal division Boosts ROI to 25% by eliminating non-productive assets
ROI =
25% =
41
$30,000
$500,000
6%
x
x
$500,000
$120,000
? #2
? #1
417%
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Royal division reports the following:
Operating income
$ 30,000
Average total assets
$ 200,000
Sales
$ 500,000
ROI
=
ROI
=
ROI =
15% =
Profit margin
Operating income
Sales
$30,000
$500,000
6%

Asset turnover
x
Sales
Average total assets
x
$500,000
$200,000
x
250%
Benchmarking Royal Division’s performance against company standards
25% =
ROI =
42
8%
$44,000
$550,000
x
313%
x
$550,000
$175,718
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Extreme Sports Company has two divisions based on the climate
required for the sporting goods they sell: Snow sports and Nonsnow sports. The following divisional information is available for
the past year:
Sales
Snow sports
Non-snow sports
Operating Average Total Current
Income
Assets
Liabilities
ROI
$ 5,500,000
$ 935,000
$ 4,500,000
$ 420,000 20.8%
8,400,000
1,428,000
6,700,000
695,000 21.3%
1. Calculate their ROI using the DuPont method.
Compare the profitability of both segments
Compare the asset turnover of both segments
Compare and interpret the two segments’ overall ROI performance
43
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Extreme’s management has specified a 16% target rate of return.
The company’s weighted average cost of capital (WACC) is 10%
and its effective tax rate is 38%.
1. Calculate each division’s profit margin. Interpret your results.
Profit Margin = Operating Income ÷ Sales
Operating income
÷ Sales
Profit margin
Snow Sports Non-snow Sports
935,000
1,428,000
÷5,500,000
÷8,400,000
17%
17%
Interpret:
Both divisions had 17% sales margins. This means that both
divisions were able to earn $0.17 of income on each dollar of sales.
In other words, they were both equally profitable on sales.
44
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Refer to the information in S24-7.
1. Compute each division’s asset turnover (round to two decimal
places). Interpret your results.
Asset Turnover = Sales ÷ Total Assets
Sales
÷ Total assets
Asset turnover
Snow Sports
Non-snow Sports
5,500,000
8,400,000
÷4,500,000
÷6,700,000
1.22 (rounded)
1.25 (rounded)
Interpret:
The Non-snow Sports Division had a higher asset turnover (1.25) than the
Snow Sports Division (1.22). This means that the Non-snow Sports
Division was able to generate $1.25 of sales for every dollar of assets
invested in the division, whereas the Snow Sports Division was able to
generate $1.22 for every dollar of assets invested. The Non-snow Sports
Division was able to use its assets more efficiently to generate sales
revenue. The higher asset turnover accounts for its higher ROI.
45
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Refer to the information in S24-7.
2. Use your answers to Requirement 1, along with the profit margin,
to recalculate ROI using the expanded formula. Do your answers
agree with the basic ROI in S24-7?
ROI = Sales Margin × Asset Turnover
Profit margin (from S 23-7)
× Asset turnover (from part 1)
ROI
Snow Sports
17%
×1.22 (rounded)
20.7%
Non-snow Sports
17%
×1.25 (rounded)
21.3%
The results of the expanded ROI formula agree, with slight
rounding variance, to those found using the simple ROI
formula.
46
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A division with a higher ROI is performing
better
more likely to receive extra funds, putting more
assets under the control of the more successful
managers
Lower ROE divisions may be under more
operational scrutiny, or divestment pressure
Drawback to using ROI
Tempts management to choose only projects that meet or
exceed current ROIs
Rejecting profitable projects may be harmful to the company
47
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As division manager your pay includes a bonus based on
your division’s ROI -- the higher your ROI, the bigger
your bonus.
The company wide ROI stands at 15% -- your division has
a much higher ROI.
You rather like your enormous bonus checks.
You have an opportunity to add a new product line in your
division that will produce an ROI greater than 15%, but
lower than your division’s ROI.
What is this new product line going to do to
your division’s ROI?
To your bonus?
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This KPI better aligns incentives with business goals
Compares segment profits with profits at the required
rate of return
Positive–income exceeds target rate of return
Negative–income does not meet target rate of return
General formula:
Applicable formula:
51
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CM Income Statement
Sales
Variable expenses
Contribution Margin
Fixed expenses
Net operating income
Assets
ROI (NOI ÷ Assets)
Drink It In Corp. Coffee segment
Cofee segment
Coffee segment
Proposal
with proposed
status Quo
ONLY
changes
10,000,000
6,000,000
4,000,000
3,200,000
800,000
2,000,000
1,200,000
800,000
640,000
160,000
12,000,000
7,200,000
4,800,000
3,840,000
960,000
4,000,000
1,000,000
5,000,000
20%
16%
19%
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Gee . . .
I thought we were
supposed to do what
was best for the
company!
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!
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RI Measures operating
income above the minimum
acceptable operating
income as established by
the target ROI
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CM Income Statement
Sales
Variable expenses
Contribution Margin
Fixed expenses
Net operating income
Drink It In Corp. Coffee Segment
Coffee Segment
Coffee Segment
Proposal
with proposed
Status Quo
ONLY
changes
10,000,000
6,000,000
4,000,000
3,200,000
800,000
2,000,000
1,200,000
800,000
640,000
160,000
12,000,000
7,200,000
4,800,000
3,840,000
960,000
4,000,000
1,000,000
5,000,000
Require NOI at 12% minimum (12%*assets)
480,000
120,000
600,000
Residual income (Actual earning - Mimimum earnings)
320,000
40,000
360,000
Assets
VS ROI
20%
16%
19%
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Benefits:
Promotes goal congruence better than ROI,
minimizes gaming
Incorporates management’s minimum required rate
of return
Advantages:
Divisions will be motivated to take the action that
top management desires
Can use different target rates of return for divisions
with different levels of risk
Disadvantages:
Complex, we fear change
57
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Extreme Sports Company has two divisions based on the climate
required for the sport: Snow sports and Non-snow sports. The
following divisional information is available for the past year:
Sales
Snow sports
Non-snow sports
Operating Average Total Current
Income
Assets
Liabilities
ROI
$ 5,500,000
$ 935,000
$ 4,500,000
$ 420,000 20.8%
8,400,000
1,428,000
6,700,000
695,000 21.3%
Extreme’s management has specified a 16% target ROI.
Calculate Extreme’s Residual Income for each segment and
compare.
58
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Refer to the information in S24-7.
1. Compute each division’s RI. Interpret your results. Are your
results consistent with each division’s ROI?
RI = Operating income − Minimum acceptable income
= Operating income − (Target rate of return × Total assets)
Snow Sports RI = $935,000 – ($4,500,000 × 16%)
= $935,000 – $720,000
= $215,000
Non-snow Sports RI = $1,428,000 – ($6,700,000 × 16%)
= $1,428,000 - $1,072,000
= $356,000
Both divisions have positive residual income. Positive residual income
means that the divisions are earning income at a rate that exceeds
management’s minimum expectations. This result is consistent with the
ROI calculations.
59
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Special type of Residual income calculation
Looks at a division’s residual income through the eyes
of the company’s primary stakeholders
Investors (Owners)
Creditors (Bondholders)
Uses a weighted-average cost of capital, instead of
Non-investor perspective basis for calculating
minimum ROI
Calculating WACC
Considerations:
After-tax income available to stakeholders
Very appropriate for whole company analysis
Omit assets committed to paying current liabilities
60
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Compare the EVA equation with the RI equation
Both calculate whether any operating income was
above and beyond expectations
Differences:
EVA uses after-tax operating income (income
available to stakeholders)
EVA reduces average total assets by current
liabilities (funds not available for generating
income)
Replace management’s target rate of return with
WACC (rate of return expected by stakeholders)
61
Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.
Extreme Sports Company has two divisions based on the climate
required for the sport: Snow sports and Non-snow sports. The
following divisional information is available for the past year:
Sales
Snow sports
Non-snow sports
Operating Average Total Current
Income
Assets
Liabilities
ROI
$ 5,500,000
$ 935,000
$ 4,500,000
$ 420,000 20.8%
8,400,000
1,428,000
6,700,000
695,000 21.3%
The company’s weighted average cost of capital (WACC) is 10%
and its effective tax rate is 38%.
1. Calculate each segment’s Economic Value Added.
64
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Refer to the information in S24-7.
1. Compute each division’s EVA. Interpret your results.
Snow EVA =
=
=
=
Non-snow EVA =
=
=
=
($935,000× 62%) − [($4,500,000 − $420,000) × 10%]
$579,700 − ($4,080,000 × 10%)
$579,700 − $408,000
$171,700
($1,428,000 × 62%) − [($6,700,000 − $695,000) × 10%]
$885,360 − ($6,005,000 × 10%)
$885,360 − $600,500
$284,860
Both divisions have positive economic value added (EVA). This means that the
divisions are generating income for investors and long-term creditors at a rate
that exceeds the expectations of these two groups of stakeholders.
65
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As companies grow, they often decentralize by
geographic area, product line, customer base,
business function, or some other characteristic.
Decentralization frees top management’s time by
delegating decision making, supports the use of
expert knowledge, improves customer relations,
provides training for managers, and improves
employee motivation and retention. Disadvantages of
decentralization include possible cost duplications
and difficulty achieving goal congruence among
decentralized divisions.
67
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Performance evaluation systems provide top
management with a framework for maintaining
control over the entire organization once it is
decentralized. Such systems should help
management promote goal congruence, provide a
tool for communications, motivate unit managers,
provide feedback, and allow for benchmarking.
These measures should not revolve around just
financial performance measures, however.
68
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The balanced scorecard focuses performance
measurement on progress toward the company’s
goals in each of the four perspectives. In designing
the scorecard, managers start with the company’s
goals and its strategy for achieving those goals and
then identify the most important measures of
performance that will predict long-term success.
Some of these measures are lead indicators, while
others are lag indicators. Managers must consider the
linkages between strategy and operations and how
those operations will affect finances now and in the
future.
69
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Responsibility accounting performance reports
capture the financial performance of cost, revenue,
and profit centers. They compare actual amounts to
budgeted amounts to determine variances. Then,
management investigates to identify if the cause of
the variance was controllable or uncontrollable.
Management can then make decisions to take
corrective actions for controllable variances.
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To evaluate an investment center’s financial
performance, companies need summary
performance measures—or KPIs—that include both
the division’s operating income and its assets.
Commonly used KPIs for evaluating an investment
center’s financial performance are return on
investment (ROI), residual income (RI), and
economic value added (EVA). Each of these
financial KPIs must be considered in conjunction
with KPIs that come from all four of the balanced
scorecard perspectives.
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Copyright
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Printed in the United States of America.
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