Performance Management and Evaluation

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Chapter 26

• Performance Management and Evaluation

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Organizational Goals and the Balanced Scorecard

• Objective 1 SKIP this L.O.
• Describe how the balanced scorecard aligns
  performance with organizational goals, and
  explain the role of the balanced scorecard in the
  management cycle

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Performance Measurement

• Objective 2 SKIP this L.O.
• Discuss performance measurement, and state the
  issues that affect managements ability to
  measure performance

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Responsibility Accounting

• Objective 3
• Define responsibility accounting, and describe
  the role that responsibility centers play in
  performance management and evaluation

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Responsibility Accounting

• As part of their performance management systems,
  many organizations
• Assign resources to specific areas of
  responsibility
• Track how the managers of those areas use those
  resources
• Evaluate managers at all levels in terms of their
  ability to manage their area of responsibility in
  keeping with organizational goals

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Responsibility Accounting (contd)

• Is an information system
• Classifies data according to areas of
  responsibility
• Reports each areas activities by including only
  the revenue, cost, and resource categories that
  the assigned manager can control

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Responsibility Accounting (contd)

• Responsibility center
• An organizational unit whose manager has been
  assigned the responsibility of managing a portion
  of the organizations resources
• The activity of the responsibility center
  dictates the extent of a managers responsibility

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Types of Responsibility Centers

• Cost centers
• Discretionary cost centers
• Revenue centers
• Profit centers
• Investment centers

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Cost Center

• A responsibility center whose manager is
  accountable only for controllable costs that have
  well-defined relationships between the centers
  resources and products or services
• Performance is usually evaluated by comparing an
  activitys actual cost with its budgeted cost and
  analyzing the resulting variances

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Cost Centers (contd)

• Examples
• Assembly plants in manufacturing organizations
• Relationship between the costs of resources and
  resulting products is well defined
• Food services in hospitals and nursing homes
• Clear relationship between costs of food and
  direct labor and the number of inpatient meals
  served

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Discretionary Cost Center

• A responsibility center whose manager is
  accountable for costs only and in which the
  relationship between resources and products or
  services produced is not well defined
• Cost-based measures cannot usually be used to
  evaluate performance

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Discretionary Cost Centers (contd)

• Examples
• Administrative activities
• Accounting
• Human resources
• Legal services
• Research and Development
• Might measure number of patents obtained and
  number of cost-saving innovations developed
• Service organizations
• United Way might measure administrative
  activities by how low their costs are as a
  percentage of total contributions

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Revenue Center

• A responsibility center whose manager is
  accountable primarily for revenue and whose
  success is based on its ability to generate
  revenue
• Performance is usually evaluated by comparing its
  actual revenue with its budgeted revenue and
  analyzing variances

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Revenue Centers (contd)

• Examples
• Car rental reservation center
• Clothing retailer e-commerce order department
• Performance measures for both manufacturing and
  service organizations may include
• Sales dollars
• Number of customer sales
• Sales revenue per minute

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Profit Center

• A responsibility center whose manager is
  accountable for both revenue and costs revenues
  expenses (i.e. costs) profits and for the
  resulting operating income
• Example
• Local store of a national chain such as Wal-Mart,
  Kinkos or Jiffy Lube
• Performance evaluated by comparing figures from
  actual income statements with figures in its
  master or flexible budget income statement

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Investment Center

• A responsibility center whose manager is
  accountable for profit generation and can also
  make significant decisions about the resources
  the center uses
• Performance of both manufacturing and service
  organizations is usually evaluated using measures
  such as
• Return on investment (ROI)
• Residual income (RI)
• Economic value added (EVA)

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Organizational Structure and Performance
Management

• A companys organizational structure formalizes
  its lines of managerial authority and control
• Organizational chart
• Visual representation of an organization's
  hierarchy of responsibility for purposes of
  management control
• Five types of responsibility centers are arranged
  by level of management authority and control

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Organizational Structure and Performance
Management (contd)

• Responsibility accounting system
• Establishes a communications network within an
  organization
• Ideal for gathering and reporting information
  about the operations of each area of
  responsibility
• Used to
• Prepare budgets by responsibility area
• Report the actual results of each responsibility
  area

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Organizational Structure and Performance
Management (contd)

• The report for a responsibility center should
  contain only controllable costs and revenues
• The costs, revenues, and resources that the
  manager of a center can control

A responsibility accounting system assures
managers will not be held responsible for items
they cannot change
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Partial Organizational Chart of Café Cubano, a
Restaurant Chain
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Organizational Structure and Performance
Management (contd)

• Performance reports for each level of management
  are tailored to each managers individual needs
  for information
• The same information may appear in various
  formats in several different reports
• Information from reports for lower-level managers
  is usually summarized and condensed when it
  appears in upper-level managers reports

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Discussion

• What is the difference between a cost center and
  a discretionary cost center?
• The managers of cost centers are accountable for
  controllable costs that have well-defined
  relationships between the centers resources and
  products or services
• The managers of discretionary cost centers are
  accountable for costs in which the relationship
  between resources and products or services
  produced is not well defined. Therefore,
  cost-based measures cannot usually be used to
  evaluate performance.

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Performance Evaluation of Cost Centers and Profit
Centers

• Objective 4
• Prepare performance reports for cost centers
  using flexible budgets and for profit centers
  using variable costing

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Performance Evaluation of Cost Centers and Profit
Centers

• Performance reports
• Allow comparisons between actual performance and
  budget expectations
• Contain information about costs, revenues, and
  resources that are controllable by individual
  managers
• Allow evaluation of an individuals performance
  with respect to responsibility center objectives
  and companywide objectives
• Recommend changes

If a performance report includes items that the
manager cannot control, the credibility of the
entire responsibility accounting system can be
called into question
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Evaluating Cost Center Performance Using Flexible
Budgeting
Orlena Torres, the VP of food products at Café
Cubano, is responsible for the central kitchen,
where basic preparation is done on the food
products the restaurants sell

• The central kitchen is a cost center
• Its costs have well-defined relationships with
  the resulting products
• To ensure the central kitchen is meeting its
  performance goals
• Torres has decided to evaluate the performance of
  each food item produced
• A separate report will be prepared for each
  product
• Will compare actual costs with the corresponding
  amounts from the flexible and master budgets

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Central Kitchens Performance Report on Café
Cubanos House Dressing
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Evaluating Profit Center Performance Using
Variable Costing

• Profit center performance is usually evaluated by
  comparing actual income statement results to the
  budgeted income statement

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Evaluating Profit Center Performance Using
Variable Costing (contd)

• Variable costing
• Method of preparing profit center performance
  reports that classifies a managers controllable
  costs as either variable or fixed
• Instead of a traditional income statement, a
  variable costing income statement is produced
• Also called full costing or absorption costing
  income statement
• Used for external reporting purposes
• Same as a contribution income statement
• Useful because it focuses on cost variability and
  the profit centers contribution to operating
  income

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Evaluating Profit Center Performance Using
Variable Costing (contd)

• When using variable costing to evaluate profit
  center performance
• Variable cost of goods sold and variable selling
  and administrative expenses are subtracted from
  sales to arrive at the contribution margin for
  the center
• All controllable fixed costs are subtracted from
  gross margin to determine the operating income
• Includes fixed manufacturing costs and fixed
  selling expenses

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Evaluating Profit Center Performance Using
Variable Costing (contd)

• When preparing a traditional income statement
• All manufacturing costs are assigned to cost of
  goods sold
• Cost of goods sold is subtracted from sales to
  arrive at the gross margin
• Variable and fixed selling expenses are
  subtracted from gross margin to determine
  operating income

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Evaluating Profit Center Performance Using
Variable Costing (contd)

• Variable costing income statement
• Groups costs according to whether they are
  variable or fixed
• Traditional income statement
• Groups cost according to whether they are costs
  of goods sold or manufactured or period costs

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Variable Costing Income Statement Versus
Traditional Income Statement for Trenton
Restaurant
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Evaluating Profit Center Performance Using
Variable Costing (contd)

• The manager of a profit center may also want to
  measure and evaluate nonfinancial information
• Performance reports
• Vary in format depending on the type of
  responsibility center
• Share common themes
• Compare a centers actual results to its budgeted
  figures
• Focus on the differences
• Only items managers can control are included

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Discussion

• How does a variable costing income statement
  arrive at profit center income?
• Variable cost of goods sold and variable selling
  expenses are subtracted from sales to determine
  the contribution margin. All fixed manufacturing
  costs and fixed selling expenses are subtracted
  from the contribution margin to arrive at profit
  center income

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Performance Evaluation of Investment Centers

• Objective 5
• Prepare performance reports for investment
  centers using traditional measures of return on
  investment and residual income and the newer
  measure of economic value added

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Performance Evaluation of Investment Centers

• Performance evaluation of an investment center
  must include
• Comparison of controllable revenues and costs
  with budgeted amounts
• Performance measures for capital investments that
  mangers control

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Return on Investment (ROI)

• Takes into account both operating income and the
  assets invested to earn that income
• Common measure

Assets invested is the average of the beginning
and ending asset balances for the period
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Return on Investment (contd)

• Income and assets specifically controlled by a
  manager must be properly measured
• Critical to the quality of ROI
• ROI may be used to evaluate the manager of any
  investment center
• An entire company
• A unit within the company
• Subsidiary, division, or other segment

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Performance Report Based on Return on Investment
for the Café Cubano Restaurant Division
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Return on Investment (contd)

• The ROI computation is the aggregate measure of
  many interrelationships
• The basic ROI equation can be rewritten to show
  the many elements a manager can influence

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Return on Investment (contd)

• Two important indicators of performance
• Profit margin
• Ratio of operating income to sales
• Represents the percentage of each sales dollar
  the results in profit
• Asset turnover
• Ratio of sales to average assets invested
• Indicates the productivity of assets
• Number of sales dollars generated by each dollar
  invested in assets

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Return on Investment (contd)

• Profit margin and asset turnover help to explain
• Changes in ROI for a single investment center
• Differences of ROI among investment centers
• ROI formula is useful for analyzing and
  interpreting the elements that make up a
  businesss overall return on investment

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Return on Investment (contd)

• A single ROI number is a composite index of many
  cause-and-effect relationships and interdependent
  financial elements
• Managers can improve ROI by
• Increasing sales
• Decreasing costs
• Decreasing assets

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Factors That Affect the Return on Investment
Calculation
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Return on Investment (contd)

• ROI should be used cautiously in evaluating
  performance
• Affected by many factors
• If overemphasized
• Investment center managers may make business
  decisions that favor their personal ROI
• At the expense of companywide profits or
  long-term success of other investment centers
• To avoid this problem, always use other
  performance measures in conjunction with ROI

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Return on Investment (contd)

• Other performance measures to use in conjunction
  with ROI
• Comparisons of revenues, costs, and operating
  income with budgeted amounts or past trends
• Sales growth percentages
• Market share percentages
• Other key variables in the organization's
  activity
• Ratio of ROI to budgeted goals and past ROI
  trends
• Changes in this ratio over time can be more
  revealing than any single number

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Residual Income (RI)

• is the operating income that an investment
  center earns above a minimum desired return on
  invested assets
• Developed because of pitfalls in using ROI as a
  performance measure

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Residual Income (contd)

• Is not a ratio but a dollar amount
• Amount of profit left after subtracting a
  predetermined desired income target for an
  investment center

As with ROI computations, assets invested is the
average of the centers beginning and ending
asset balances for the period
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Residual Income (contd)

• The desired RI will vary among investment centers
  depending on the
• Type of business
• Level of risk assumed

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Performance Report Based on Residual Income for
the Café Cubano Restaurant Division
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Residual Income (contd)

• Comparisons with other RI figures will strengthen
  the analysis
• To add context to the analysis, the following
  questions should be answered
• How does the divisions RI for this year compare
  with previous years?
• Did actual RI exceed budgeted RI?
• How does this divisions RI compare with the RI
  of other investment centers of the company?

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Residual Income (contd)

• When comparing a divisions RI with the RI of
  other investment centers of the company, caution
  should be used
• For RI figures to be comparable, all investment
  centers must have
• Equal access to resources
• Similar asset investment bases
• Managers may be able to produce a larger RI
  simply because their investment centers are
  larger
• May not reflect better performance

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Economic Value Added (EVA)

• is the shareholder wealth created by an
  investment center
• Used as an indicator of performance
• Is a registered trademark of the consulting firm
  Stern Stewart Company

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Economic Value Added (contd)

• Calculation can be complex
• Makes various cost of capital and accounting
  principles adjustments
• EVA is expressed as a dollar amount
• or

Cost of capital is the minimum desired rate of
return on an investment, such as assets invested
in an investment center
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Performance Report Based on Economic Value Added
for the Café Cubano Restaurant Division
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Economic Value Added (contd)

• Caution should be used when evaluating
  performance using EVA
• Many factors affect the economic value of an
  investment center
• Compare the current EVA with
• EVAs from previous periods
• Target EVAs
• EVAs from other investment centers

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Factors Affecting the Computation of Economic
Value Added
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Economic Value Added (contd)

• An investment centers EVA is affected by a
  managers decisions on
• Pricing
• Product sales volume
• Taxes
• Cost of capital
• Capital investments
• Other financial decisions

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Economic Value Added (contd)

• The EVA number is a composite index drawn from
  many cause-and-effect relationships and
  interdependent financial elements
• Managers can improve the EVA of an investment
  center by
• Increasing sales
• Decreasing costs
• Decreasing assets
• Lowering the cost of capital

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The Importance of Multiple Performance Measures

• To be effective, a performance management system
  must consider both operating results and multiple
  performance measures, such as ROI, RI, and EVA
• Comparing actual results to budgeted figures adds
  meaning to the evaluation

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The Importance of Multiple Performance Measures
(contd)

• Performance measures such as ROI, RI, and EVA
• Indicate whether an investment center is
  effective in coordinating its goals with
  companywide goals
• Take into account both operating income and the
  assets used to produce that income
• Are limited by their focus on short-term
  financial performance
• Management should break these measures down into
  their components, analyze information over time,
  and compare current results to targeted amounts

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Discussion

• What may happen if return on investment is
  overemphasized as a performance measure?
• Investment center managers may make business
  decisions that favor their personal ROI at the
  expense of companywide profits or long-term
  success of other investment centers
• To avoid this problem, always use other
  performance measures in conjunction with ROI

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Performance Incentives and Goals

• Objective 6
• Explain how properly linked performance
  incentives and measures add value for all
  stakeholders in performance management and
  evaluation

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Performance Incentives and Goals

• The effectiveness of a performance management and
  evaluation system depends on successful
  coordination of goals between
• Responsibility centers
• Managers
• Entire company
• Two key factors
• Logical linking of goals to measurable objects
  and targets
• Performance-based pay

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Linking Goals, Performance Objectives, Measures,
and Performance Targets

• The causal links between an organizations goals,
  performance objectives, measures, and targets
  must be apparent

Recall that the balanced scorecard also links
objectives, measures, and targets
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Performance-Based Pay

• is the linking of employee compensation to the
  achievement of measurable business targets
• Increases likelihood that the goals of
  responsibility centers, managers, and the entire
  organization will be well coordinated

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Performance-Based Pay (contd)

• Common types of incentive compensation
• Cash bonuses
• Usually awarded for short-term performance
• Awards
• May be a trip or some other form of recognition
• Profit-sharing plans
• Reward employees with a share of the companys
  profits
• Stock option programs
• Used to motivate employees to achieve financial
  targets that increase the companys stock price

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The Coordination of Goals

• Incentive plans must be developed with input from
  all employees to be effective
• Employees and managers must answer the following
  questions to determine the right performance
  incentives for their organization
• When should the reward occur?
• Whose performance should be rewarded?
• How should the reward be computed?
• On what should the reward be based?
• What performance criteria should be used?
• Does the performance incentive plan address the
  interests of all stakeholders?

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The Coordination of Goals (contd)

• The effectiveness of a performance management and
  evaluation system relies on the coordination of
  responsibility center, managerial, and company
  goals
• Can be optimized by
• Linking goals to measurable objectives and
  targets
• Tying appropriate compensation incentives to the
  achievement of the targets

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The Coordination of Goals (contd)

• Each organizations unique circumstances will
  determine its correct mix of measures and
  compensation incentives
• If management values the perspectives of all its
  stakeholder groups, its performance and
  evaluation system will balance and benefit all
  interests

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Discussion

• The successful coordination of goals between
  responsibility centers, managers, and the entire
  company is dependent upon what two key factors?
• The logical linking of goals to measurable
  objects and targets and performance-based pay