Transcript Slide 1

Performance Evaluation
Performance of what?




Companies
Divisions
Products
managers
2
Centralization - Decentralization
 Total decentralization-minimum constraints
and maximum freedom for managers at the
lowest levels of an organization to make
decisions
 Total centralization - maximum constraints
and minimum freedom for managers at the
lowest levels of an organization to make
decisions
 A structure is chosen based on cost vs.
benefit analysis
3
Decentralized Organizations
 substantial decision making authority the managers of subunits
 managers at lower levels of the
organization free to make decisions
 Autonomy is the degree of freedom to
make decisions. The greater the
freedom, the greater the autonomy
 Usually some decentralized some
centralized
4
Advantages of Decentralization
 Provides better information to make decisions – at the
local and top management levels
 Leads to gains from faster decision making
 quicker responses to changing circumstances
 Creates greater responsiveness to local needs
Increases motivation of subunit managers
 Provides excellent training for future top-level
executives
 Sharpens the focus of subunit managers
5
Disadvantages of Decentralization
 Costly duplication of activities
 Lack of goal congruence
 Agency
 Management pursues personal goals
 Personal goals are incompatible with the
company’s goals
6
Why Evaluate
 A company evaluates subunits in order to decide if it
should expand or contract them or change their
operations
 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
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Responsibility Accounting and
Performance Evaluation
 Responsibility accounting - managers
responsible only for costs and revenues
that they can control
 To implement responsibility accounting in a
decentralized organization, costs and
revenues are traced to the organizational
level where they can be controlled
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Tracing Costs to Organizational
Levels
9
Types of responsibility centers
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
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Cost Center
Revenue Center
Profit Center
Investment Center
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Cost Centers
 Subunit responsible for controlling costs but
not responsible for generating revenue
 Most service departments are cost centers (i.e.,
janitorial, maintenance, computer services,
production)
 Must provide service to company at a
reasonable cost
 Evaluation based on comparison of
budgeted or standard costs with actual
costs
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Profit Centers
 Subunit responsible for generating revenues and
controlling costs
 Goal is to maximize profit for the division
 Performance can be evaluated in terms of profitability
 Motivates managers to focus their attention on ways of
maximizing profit
 A
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

variety of methods are used to evaluate profitability
Current income compared to budgeted income
Current income compared to past income
Comparison with other profit centers, called relative
performance evaluation
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Investment Centers
 Subunit responsible for generating revenue,
controlling costs, and investing in assets
 Goal is to maximize return on investment
 Evaluation based on comparison with a
benchmark, previous years, or other
investment centers
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Boyner Example
 A wide range of products varying from cosmetics to
sports, and from home appliances to kidswear are
presented at 24 Boyner Stores all over Turkey in
İstanbul, Ankara, Adana, Antalya, Bursa, İzmir,
Trabzon, Mersin, Diyarbakır, Denizli and Konya.
 Women, Men, Kids and Shoes at each of the Discount
Stores servicing the customers at 8 different locations
all over Turkey
 Outlet centers and stores could be profit or
investment centers
 Each store could be a revenue or profit center –
depending how autonomous they are
 Accounting department and maintenance-cost centers
14
Study Break #1
 An investment center is responsible
for:
a.
b.
c.
d.
Investing in long term assets
Controlling costs
Generating revenues
All of the above
Answer:
d. All of the above
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Study Break #2
 Cost centers are often evaluated
using:
a.
b.
c.
d.
Variance analysis
Operating margin
Return on investment
Residual income
Answer:
a. Variance analysis
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Study Break #3
 Profit centers are often evaluated
using:
a.
b.
c.
d.
Investment turnover
Income targets or profit budgets
Return on investment
Residual income
Answer:
b. Income targets or profit budgets
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Performance Measures



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Return on Investment
Residual Income
Economic Value Added
Return on Sales
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Evaluating Investment Centers With
ROI
 ROI is a primary tool for evaluating the performance
of investment centers
= Investment Center Income
Invested Capital
Focuses management’s attention on income and level of
investment
 Most popular metric for two reasons:
 Blends all the ingredients of profitability (revenues,
costs, and investment) into a single percentage
 May be compared to other ROIs both inside and
outside the firm
 Also called the Accounting Rate of Return (ARR) or the
Accrual Accounting Rate of Return (AARR)
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ROI Components
 ROI may be broken down into two components:
profit margin and investment turnover.
 ROI = Profit Margin x Investment Turnover
ROI =
Income
Sales
x ____Sales_____
Invested Capital
 ROI = Return on Sales X Investment Turnover
 This is known as the DuPont Method of
Profitability Analysis
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Which investment?
 Four possible alternative definitions of
investment:
1. Total Assets Available- all assets
2. Total Assets Employed-total assets
available less any idle assets or assets
purchased for expansion in the future
3. Total Assets Employed minus Current
Liabilities
4. Stockholders’ Equity
 Gross or net?
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Measuring Income
 In calculating ROI, companies measure
“income” in a variety of ways
 net income after tax
 Operating income
 Income before tax
 Most common method is NOPAT
 Net Operating Profit After Taxes
 To calculate NOPAT, a company must add back
non-operating items to net income and adjust tax
expense accordingly
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NOPAT Example
Tax rate 35%
23
Measuring Income and Invested
Capital for ROI
 In calculating ROI, companies
measure “invested capital” in a
variety of ways
 Approach used here:
Total assets less non-interest-bearing
current liabilities
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Invested Capital Example
25
ROI – France, Germany, and Japan
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Most common financial measures
Country
Financial Measures
USA
Budgeted-Actual Income (49%)ROI (29%) EVA
(14%) ROSales(3%)
Australia
ROI, Budgeted-Actual Income
Germany
Revenue, Contribution Margin(per unit)
India
ROI, Budgeted-Actual Income
Japan
ROS(82%) ROI (37%)
Netherlands
ROI, cash flows, income
Singapore
ROI
Horngren et al, 2006,p.799
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Example Exercise #1
 Davenport Mills is a division of Iowa Woolen
Products, Inc. For the most recent year,
Davenport had net income of $16,000,000.
Included in income was interest expense of
$1,300,000. The operation’s tax rate is
40%. Total assets of Davenport Mills are
$225,000,000, current liabilities are
$45,000,000, and $30,000,000 of the
current liabilities are noninterest-bearing.
 Calculate NOPAT, invested capital, and ROI.
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Example Exercise #1 Solution
 NOPAT
= Net income + interest expense (1 - tax rate)
= $16,000,000 + $1,300,000 (1 - .40)
= $16,780,000
 Invested Capital
= Total assets - noninterest-bearing current
liabilities
= $225,000,000 - $30,000,000
= $195,000,000
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Example Exercise #1 Solution
 ROI
= NOPAT ÷ Invested capital
= $16,780,000 ÷ $195,000,000
= 86.05%
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Problems with ROI
 Invested capital is typically based on historical costs
 Fully depreciated assets lead to a low invested capital
number resulting in high ROI
 Makes comparison of investment centers using ROI
difficult
 Managers may put off purchase of new equipment
 May lead to underinvestment
 Possible alternative definitions of cost:
1. Current Cost
2. Gross Value of Fixed Assets
3. Net Book Value of Fixed Assets
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Problems of Overinvestment and
Underinvestment
 Evaluation using Profit can lead to
overinvestment
 Managers may be motivated to make
investments that earn a return that is less than
the cost of capital
 Evaluation using ROI can lead to
underinvestment
 Managers may not take on projects that have a
low ROI just to increase profit if they are
evaluated in terms of the return they earn
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Example Exercise #2
 Using the same information as in
Example Exercise #1, calculate the
residual income if the company’s cost
of capital is 10%.
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Example Exercise #2 Solution
 Residual Income
= NOPAT – (Cost of Capital x Invested Capital)
= $16,780,000 – (10% x $195,000,000)
= ($2,720,000)
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Residual Income (RI)
 Net operating profit after taxes of an
investment center in excess of its required
profit
 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
 Required rate of return is generally the cost
of capital for the investment center
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Decision Making
36
Economic Value Added (EVA)
 EVA is residual income adjusted for accounting
distortions that arise from GAAP
 A performance measure approach to solving
overinvestment and underinvestment problems
 Advantage is that managers are less tempted to cut
those costs that distort income under GAAP
 For example, under GAAP research and
development costs are expensed, but the
costs benefits future periods
 Thus, under EVA research and development is
capitalized and amortized over future periods
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Residual Income
NIBCL = Net Income Before
Current Liabilities(excluding debt)
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Study Break #4
 Use of profit as a performance measure:
a. May lead to overinvestment in assets
b. Is appropriate for an investment center
c. Is appropriate as long as profit is calculated
using GAAP
d. Encourages managers to finance operations
with debt rather than equity
Answer:
a. May lead to overinvestment in assets
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Study Break #5
 Investment centers are often
evaluated using:
a.
b.
c.
d.
Standard cost variances
Return on investment
Residual income/EVA
Both b and c
Answer:
d. Both b and c
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EVA
41
Economic Profit – Economic
Value Added – EVA*
 yardstick to measure if the business is
earning above its cost of capital of
resources it employs
 developed by Stern Stewart and Co.
EVA= NOPAT – C*k
NOPAT = operating profit after tax (adjusted)
C = capital base employed net of depreciation
k = weighted average cost of capital
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EVA Adjustments to NOPATOperating leases
 operating lease expenses: in a sense the assets
under operating lease should be part of the capital
employed – thru off balance sheet financing
 operating lease (net of tax) is added back to
operating profit
 therefore future payments of the operating lease is
discounted and added to assets and a related liability
is also established
 then the present value of the operating lease is
amortized over an appropriate period such as the
contract period, and this derived amortization amount
is deducted from net income
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EVA Adjustments to NOPAT- Research
and Development and Advertising and
Promotional Expenses
 the benefits extend into the future
 therefore R&D and A&P expenses are
removed from the income determination
 R&D and A&P expenses are capitalized
and amortized over a reasonable period
 the amortized amount is then deducted in
the income determination
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EVA Adjustments to NOPAT- Inventory
Value Adjustment (LIFO)and Deferred
tax
 when companies use LIFO as their inventory cost flow,
then the value of the inventories on the balance sheet
will be different from its current value because the
amount that appears on the balance sheet is based on
“old” cost figures
 recent additions to inventory become part of COGS
 thus inventories are restated to current higher (the
method is usually used under inflationary conditions)
values with an offsetting increase to earnings- add
back the change in LIFO reserves to income
 add the changes in deferred taxes to NOPAT
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EVA Adjustments to NOPATGoodwill
 any amortization of goodwill is added back
to operating profit before tax
 assumption : total amount of goodwill
should be reflected in the balance sheet
because this asset is a permanent part of
the capital base
 so adjust NOPAT by the amount of
amortization and balance sheet to reflect
the total amount of goodwill
 If the company applies IFRS there is no
need – as of this time Capital Markets
Board still requires goodwill amortization
46
EVA Adjustments to Capital
Base
 Non-operating assets: such assets
should be excluded from the capital
base because they are not used in
generation of earnings
47
How to compute EVA*
Step 1 - Calculate the capital base
Current assets (excluding cash)
+
Net Fixed Assets
+
+
+/=
Capitalization of Operating Leases
Other Long-term Assets
Equity Equivalents
Current Liabilities (excluding debt)
Long term liabilities (excluding debt)
Capital Employed ( Capital Base)
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How to compute EVA*
Step 2 - Calculate net operating profit after
tax
EBIT
+/Change in equity equivalents
+
operating lease payments
Cash tax
=
NOPAT
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How to compute EVA*
Step 3 - Calculate Capital Charge =
Cost of Capital * Capital base (opening)
Step 4 - Calculate EVA *= NOPAT - Capital Charge
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EVA* example
Inventory method
Inventory end
Operating leases
R&D
Net PPE (book value)
NOPAT
Cost of capital
Goodwill- unamortized
Amortization of goodwill
Current Assets
Cash
Interest Expense
Tax rate 30%
Company A
Uses FIFO
50,000 annual for 3 years
Company B
Uses LIFO
100.000 60000 (change in LIFO reserve 9,000)
40,000 annual for 4 years
45.000
40.000
250.000
300.000
70.000
80.000
10%
15%
40.000
50.000
1000
1250
150000
175000
15000
15000
9000
1250
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EVA* example
Capital Base:
Current Assets
Net PPe
Goodwill
Operating lease
R&D (amortize over 3 yrs)
Inventory increase
135,000
250,000
40,000
124,343
45,000
0
594,343
160,000
300,000
50,000
114,199
40,000
9,000
673,199
52
EVA* example
NOPAT adjusted:
NOPAT
Amortization of goodwill
LIFO adjustment
Oper.Leases Amort. PV/period
Operating lease Expense net of tax
Research and Development
70,000
1,000
0
-41,448
35,000
15,000
79,552
80,000
1,250
9,000
-38,066
28,000
13,333
93,517
Capital employed x cost of cap
59,434
100,980
EVA:
20,118
-7,463
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Example - comparison
EVA:
Total Assets
NI
ROA:
Residual Income Calculation
Required Return*Tot Assets
NI- Req.Ret*TA
20.118
-7.463
385.000
61.000
15,84%
460.000
78.750
17,12%
38.500
22.500
69.000
9.750
54
Discussion of financial measures
 Growth- may lead to over investmentinvesting in projects with lower returns
 ROI – may lead to under investment –
lower capital base produces higher returns
 Residual Income – affected by the
accounting standards
 EVA* - motivates good investment
decisions because EVA increases as good
investment decisions are made – effects of
accounting standards are eliminated
 However, they are all backward looking –
based on historical performance
55
Cash flow ROI-CFROI
 represents company’s economic performance
 developed by Holt Value Associates
 based on transforming financial results to current
dollar cash flow return on investment
 many adjustments
 when applied to future cash flows and combined
with projected growth in the company’s assets –
can be used to estimate the company’s market
value
 culminates the concept of Cash Value Added –
CVA- finding the economic value created by
successful business strategies and investments
over and above earning the cost of capital on a
discounted cash flow basis
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57
Balanced Scorecard
Set of performance measures constructed for four dimensions
of performance

Financial


Customer


Examines the company’s success in meeting customer
expectations
Internal Processes


Critical measures even if they are backward looking
Examines the company’s success in improving critical business
processes
Learning and Growth

Examines the company’s success in improving its ability to adapt,
innovate, and grow
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Balanced Scorecard
 Company develops three to five
performance measures for each
dimension
 Measures should be tied to company
strategy
 Balance among the dimensions is critical
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Balanced Scorecard
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How Balance is Achieved in a
Balanced Scorecard
 Performance is assessed across a
balanced set of dimensions
 Balance quantitative measures with
qualitative measures
 There is a balance of backwardlooking measures and forwardlooking measures
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The Financial Perspective
 Evaluates the profitability of the
strategy
 Uses the most objective measures in
the scorecard
 The other three perspectives
eventually feed back into this
dimension
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The Customer Perspective
 Identifies targeted customer and
market segments and measures the
company’s success in these segments
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The Internal Business Prospective
 Focuses on internal operations that
create value for customers that, in
turn, furthers the financial
perspective by increasing
shareholder value
 Includes three subprocesses:
1. Innovation
2. Operations
3. Post-sales service
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The Learning and Growth
Perspective
 Identifies the capabilities the
organization must excel at to achieve
superior internal processes that
create value for customers and
shareholders
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The Balanced Scorecard Flowchart
Financial
Customer
Internal
Business
Process
Learning
&
Growth
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Balanced Scorecard
Implementation
 Must have commitment and
leadership from top management
 Must be communicated to all
employees
67
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
 Used to test the soundness of the strategy
 Identifies how strategy is linked to
measures on the scorecard
 Communicates strategic objectives to
employees
68
Strategy Map Example
69
Features of a Good
Balanced Scorecard
 Tells the story of a firm’s strategy,
articulating a sequence of cause-and-effect
relationships: the links among the various
perspectives that describe how strategy will
be implemented
 Helps communicate the strategy to all
members of the organization by translating
the strategy into a coherent and linked set
of understandable and measurable
operational targets
70
Keys to a Successful Balanced
Scorecard

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


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
Responsibility
 A particular employee must be given responsibility and held
accountable for successfully implementing each initiative
Funding
 Initiatives must be funded appropriately
Top Management Support
 It is crucial to have the full support of top management
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Features of a Good
Balanced Scorecard
 Must motivate managers to take actions
that eventually result in improvements in
financial performance
 Predominately applies to for-profit entities, but
has some application to not-for-profit entities as
well
 Limits the number of measures, identifying
only the most critical ones
 Highlights less-than-optimal tradeoffs that
managers may make when they fail to
consider operational and financial measures
together
72
Balanced Scorecard
Implementation Pitfalls
 Managers should not assume the
cause-and-effect linkages are precise:
they are merely hypotheses
 Managers should not seek
improvements across all of the
measures all of the time
 Managers should not use only
objective measures: subjective
measures are important as well
73
Balanced Scorecard
Implementation Pitfalls
 Managers must include both costs
and benefits of initiatives placed in
the balanced scorecard: costs are
often overlooked
 Managers should not ignore
nonfinancial measures when
evaluating employees
 Managers should not use too many
measures
74
Preferred Performance Measures
 Preferred Performance Measures are those
that are sensitive to or change significantly
with the manager’s performance
 They do not change much with changes in
factors that are beyond the manager’s
control
 They motivate the manager as well as limit
the manager’s exposure to risk, reducing
the cost of providing incentives
 May include Benchmarking
75
Performance Measures at the
Individual Activity Level
 Two issues when evaluating
performance at the individual activity
level:
1. Designing performance measures for
activities that require multiple tasks
2. Designing performance measures for
activities done in teams
76
Compensation for Multiple Tasks
 If the employer wants an employee to
focus on multiple tasks of a job, then
the employer must measure and
compensate performance on each of
those tasks
77
Team-Based Compensation
 Companies use teams extensively for
problem solving
 Teams achieve better results than
individual employees acting alone
 Companies must reward individuals
on a team based on team
performance
78
Executive Compensation Plans
 Based on both financial and nonfinancial
performance measures, and include a mix
of:
 Base Salary
 Annual Incentives, such as cash bonuses
 Long-Run Incentives, such as stock options
 Well-designed plans use a compensation
mix that balances risk (the effect of
uncontrollable factors on the performance
measure, and hence compensation) with
short-run and long-run incentives to
achieve the firm’s goals
79
Transfer Pricing
 The price that is used to value internal
transfers of goods or services is referred to
as transfer pricing
 Subunits of a company sell goods or
services to other subunits within the same
company
 Must determine the price that is used to
value the value of internal transfers
80
Methods of Setting the Transfer
Price
 Primary alternatives:




Market Price
Variable Costs
Full Cost Plus Profit
Negotiated Prices
 The most appropriate transfer price
depends on the circumstances
 Should lead subunit managers to make
decisions that maximize firm value
81
Transfer Pricing
 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 company
82
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