Transcript Performance Evaluation and the Balanced Scorecard

Chapter 24
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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
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Explain why and how companies decentralize
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Centralized operations
All major planning and operating decisions are made by top
management
Decentralized operations
Segmented into different divisions or operating units
Unit managers make planning and operating decisions for
their unit
Companies decentralize as they grow
Decentralization may be based on:
Geographic area
Product line
Customer base
Business function
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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
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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)
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Explain why companies use performance
evaluation systems
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Provide top management with a framework for
maintaining control
Top management needs to know if the decisions at the
subunit level are effectively meeting company goals
Decentralized organizations need system to
communicate goals to subunit managers
Primary goals:
Promoting goal congruence and coordination
Communicating expectations
Motivating unit managers
Providing feedback
Benchmarking
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Outdated systems revolved almost entirely around
financial performance
Ultimate goal of a company is to generate profit
Focuses on past actions, not future performance
Financial measures tend to be lag indicators, after the fact
Focus on the company’s short-term achievements
Management also needs lead indicators, before the fact
Needs to know the results of past decisions
Needs to know how current decisions may affect the future
Top management needs signals that assess and predict
performance over longer periods of time
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Each of the following managers has been given certain
decision-making authority:
a. Manager of Holiday Inn’s
Revenue center
Central Reservation Office
b. Managers of various corporate-owned
Profit center
Holiday Inn locations
c. Manager of the Holiday Inn
Investment center
Corporate Division
d. Manager of the Housekeeping
Cost center
Department at a Holiday Inn
e. Manager of the Holiday Inn
Investment center
Express Corporate Division
f. Manager of the complimentary
Cost center
breakfast buffet at a Holiday Inn Express
1. Classify each of the managers according to the
type
of responsibility center they manage
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Describe the balanced scorecard and identify key
performance indicators for each perspective
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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
Measures should be linked with company goals and
strategies
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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
Increasing revenue growth
Introducing new products, gaining new customers, and
increasing sales
Increasing productivity
Reducing costs and using the company’s assets more
efficiently
KPIs:
Sales revenue growth
Gross margin growth
Return on investment
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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
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
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What business processes must we excel 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
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
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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
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Consider the key performance indicators listed below.
Classify each of the key performance indicators according
to the balanced scorecard perspective it addresses. Choose
from financial perspective, customer perspective, internal
business perspective, or learning and growth perspective.
a. Number of employee suggestions implemented
Learning and growth perspective
b. Revenue growth
Financial perspective
c. Number of on-time deliveries
Customer, Internal business perspective
d. Percentage of sales force with access to real-time
inventory levels
Learning and growth perspective
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e. Customer satisfaction ratings
Customer perspective
f. Number of defects found during manufacturing
Internal business perspective
g. Number of warranty claims
Internal business perspective
h. ROI
Financial perspective
i. Variable cost per unit
Financial perspective
j. Percentage of market share
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Customer perspective
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k. Number of hours of employee training
Learning and Growth perspective
l. Number of new products developed
Internal business perspective
m. Yield rate (number of units produced per hour)
Internal business perspective
n. Average repair time
Internal business perspective
o. Employee satisfaction
Learning and Growth perspective
p. Number of repeat customers
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Customer perspective
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Use performance reports to evaluate cost,
revenue, and profit centers
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Capture the financial performance of cost,
revenue, and profit centers
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
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Control costs
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Generating sales revenue
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Producing profit through generating sales and
controlling costs
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Use management by exception to determine
which variances are worth investigating
Investigate material variances only, for now
Smaller variances do not require immediate
attention
Focus on information, not blame
Focus on understanding underlying reasons for
performance and take corrective action
Recognize some variances are uncontrollable
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Use ROI, RI, and EVA to evaluate
investment centers
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Unit managers are responsible for:
Maximizing income in relation to the company’s invested
capital
Using company assets efficiently by making the best use of
the investment center’s assets
How?
Manager has decision-making responsibility over all of the
division’s assets
Cannot evaluate investment centers in the same manner as
profit centers
Performance measures:
How much operating income the division is generating
How efficiently the division is using its assets
KPIs
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Amount of income an investment center earns
relative to the amount of its assets
Defined as
A division with a higher ROI is more likely to
receive extra funds because it is providing a
higher return
Compared across divisions and time
Can be used as a benchmark to compare against the
industry and competitors
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Management often restates the ROI equation to
determine what drives a division’s ROI
Expanded shows two components:
Profit margin
How much operating income the division earns on every
$1.00 of sales
Asset turnover
How efficiently a division uses its average total assets to
generate sales
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If management is not satisfied with the:
Profit margin
Unit must increase the operating income earned on every
dollar of sales
How?
Cut product costs or selling and administrative costs
Asset turnover
Eliminate nonproductive assets
How?
Be more aggressive in collecting accounts receivables or by
decreasing inventory levels.
Change retail-store layout to increase sales
Drawback
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Management tempted to choose only projects that meet or
exceed current ROIs
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Another commonly used KPI for evaluating an
investment center
Considers both the division’s operating income and its
average total assets
Measures the division’s profitability and the efficiency
with which the division uses its average total assets
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
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RI equation:
Minimum acceptable operating income changed to:
Target rate of return:
Minimum acceptable rate of return that management expects
a division to earn with its average total assets
Positive–exceeded expectations
Negative–did not use assets effectively
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Benefits:
Promotes goal congruence better than ROI
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
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Special type of RI calculation
Looks at a division’s residual income through the eyes
of the company’s primary stakeholders
Investors (Owners)
Creditors (Bondholders)
Stakeholders want to evaluate how efficiently a division
is using its assets
Considerations:
After-tax income available to stakeholders
Assets used to generate after-tax operating income for
stakeholders
Minimum rate of return required by stakeholders
Referred to as weighted-average cost of capital (WACC)
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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)
WACC replaces management’s target rate of return
(rate of return expected by stakeholders)
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Management must decide:
Components of the total asset figure
Simple average or weighted average assets
All assets or productive assets only
Assets gross book value or net book value
Depreciation may artificially inflate measures
over time
Short-term focus:
Division managers have incentives to create
immediate increase which may not be in the best
interest of the division in the long-term
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Extreme Sports Company makes snowboards, downhill skis, crosscountry skis, skateboards, surfboards, and in-line skates. The
company has found it beneficial to split operations into 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 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.
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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%
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.
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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)
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.
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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
Sales 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.
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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.
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Refer to the information in S24-7.
1. Compute each division’s EVA. Interpret your results.
(After-tax operating income)
− [(Total assets − Current liabilities) × WACC%]
= EVA
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.
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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.
47
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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.
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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.
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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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