Decentralization and Performance Evaluation

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CHAPTER 12
Decentralization and Performance Evaluation
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Decentralized Organizations

• A decentralized organization is one that grants
  substantial decision making authority to the
  managers of subunits
• Most firms are neither totally centralized nor
  totally decentralized
• Typically, decentralization is a matter of degree

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Advantages of Decentralization

• Better information leading to superior decisions
• Managers can respond quicker to changing
  circumstances
• Increased motivation of managers
• Provides excellent training for future top-level
  executives

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Disadvantages of Decentralization

• Costly duplication of activities
• Lack of goal congruence
• Management pursues personal goals
• Personal goals are incompatible with the
  companys goals
• To control goal congruence, companies evaluate
  the performance of subunit managers

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Why Companies Evaluate the Performance of
Subunits and Subunit Managers

• 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 is a technique that
  holds 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
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Responsibility Centers

• Cost Centers
• Profit Centers
• Investment Centers

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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 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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Study Break 1

• An investment center is responsible for
• 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
• 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
• Investment turnover
• Income targets or profit budgets
• Return on investment
• Residual income
• Answer
• b. Income targets or profit budgets

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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 managements attention on income and
  level of investment

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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 x ____Sales_____
• Sales Invested Capital

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Measuring Income and Invested Capital for ROI

• In calculating ROI, companies measure income in
  a variety of ways
• Most common method is NOPAT
• Net Operating Profit After Taxes
• To calculate NOPAT, a company must add back
  nonoperating items to net income and adjust tax
  expense accordingly
• See next slide for example

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NOPAT Example
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Measuring Income and Invested Capital for ROI

• In calculating ROI, companies measure invested
  capital in a variety of ways
• Common approaches
• Total assets
• Total assets after adding back accumulated
  depreciation
• Total assets less current liabilities
• Total assets less noninterest-bearing current
  liabilities (method used in this textbook)

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Invested Capital Example
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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 operations 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

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Problems of Overinvestment and Underinvestment

• You get what you measure!
• 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, please calculate the residual income if the
  companys 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
  centers 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
• We use total assets minus noninterest-bearing
  current liabilities as a measure of investment

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Decision Making
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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
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Study Break 4

• Use of profit as a performance measure
• May lead to overinvestment in assets
• Is appropriate for an investment center
• Is appropriate as long as profit is calculated
  using GAAP
• 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
• Standard cost variances
• Return on investment
• Residual income/EVA
• Both b and c
• Answer
• d. Both b and c

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Using a Balanced Scorecard to Evaluate Performance

• A problem in using financial measures like ROI
  and EVA is that they are backward looking

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Balanced Scorecard

• Set of performance measures constructed for four
  dimensions of performance
• Financial
• Critical measures even if they are backward
  looking
• Customer
• Examines the companys success in meeting
  customer expectations
• Internal Processes
• Examines the companys success in improving
  critical business processes
• Learning and Growth
• Examines the companys success in improving its
  ability to adapt, innovate, and grow

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Balanced Scorecard

• Tying the Balanced Scorecard Measures to the
  Strategy for Success
• Company develops three to five performance
  measures for each dimension
• Measures should be tied to company strategy
• Balance among the dimensions is critical
• You get what you measure!

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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 backward-looking measures
  and forward-looking measures

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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

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Strategy Map Example
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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
• 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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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

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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

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Transfer Pricing

• Since there is no arms 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

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Lowering Transfer Price Below the Market Price