Performance Evaluation

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Performance Evaluation
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Performance of what?

• Companies
• Divisions
• Products
• managers

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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

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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

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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

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Disadvantages of Decentralization

• Costly duplication of activities
• Lack of goal congruence
• Agency
• Management pursues personal goals
• Personal goals are incompatible with the
  companys goals

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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
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Types of responsibility centers

• 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 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 Istanbul, Ankara, Adana, Antalya, Bursa,
  Izmir, Trabzon, Mersin, Diyarbakir, 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

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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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Performance Measures

• 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 managements 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 x ____Sales_____
• 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
• Total Assets Available- all assets
• Total Assets Employed-total assets available less
  any idle assets or assets purchased for expansion
  in the future
• Total Assets Employed minus Current Liabilities
• 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
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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
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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 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
• Possible alternative definitions of cost
• Current Cost
• Gross Value of Fixed Assets
• 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
  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

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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
NIBCL Net Income Before Current
Liabilities(excluding debt)
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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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EVA
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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 Ck
• 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 NOPAT- Operating 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 RD and AP expenses are removed from
  the income determination
• RD and AP 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 NOPAT- Goodwill

• 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

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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

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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
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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
Tax rate 30
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EVA example
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EVA example
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Example - comparison
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Discussion of financial measures

• Growth- may lead to over investment- investing 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

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Cash flow ROI-CFROI

• represents companys 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 companys assets
  can be used to estimate the companys 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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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

• 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 backward-looking measures
  and forward-looking 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 companys 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
• Innovation
• Operations
• 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
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Balanced Scorecard Implementation

• Must have commitment and leadership from top
  management
• Must be communicated to all employees

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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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Features of a Good Balanced Scorecard

• Tells the story of a firms 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

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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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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

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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

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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

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Preferred Performance Measures

• Preferred Performance Measures are those that are
  sensitive to or change significantly with the
  managers performance
• They do not change much with changes in factors
  that are beyond the managers control
• They motivate the manager as well as limit the
  managers exposure to risk, reducing the cost of
  providing incentives
• May include Benchmarking

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Performance Measures at the Individual Activity
Level

• Two issues when evaluating performance at the
  individual activity level
• Designing performance measures for activities
  that require multiple tasks
• Designing performance measures for activities
  done in teams

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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

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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

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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 firms goals

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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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THANK YOU