Chapter 21 Performance Management and Evaluation
Organizational  Goals and the Balanced Scorecard <ul><li>Objective 1 </li></ul><ul><ul><li>Describe how the balanced score...
The Balanced Scorecard <ul><li>A framework that links the perspectives of an organization’s four basic stakeholder groups ...
<ul><li>Financial (investors) </li></ul><ul><li>Learning and growth (employees) </li></ul><ul><li>Internal business proces...
<ul><li>Provides a framework that enables managers to translate a vision into operations </li></ul>Planning Balanced Score...
<ul><li>Financial (investors) </li></ul><ul><ul><li>To achieve our organization’s vision, how should we appear to our shar...
<ul><li>Internal business processes </li></ul><ul><ul><li>To succeed, in which business processes must our organization ex...
<ul><li>Once the organization’s objectives are set, managers can select performance measures and set performance targets. ...
<ul><li>If Vail Resorts’ collective vision and strategy is customer satisfaction, its managers might establish the followi...
<ul><li>For ski lift manager: </li></ul><ul><ul><li>Financial </li></ul></ul><ul><ul><ul><li>Hourly lift cost </li></ul></...
<ul><ul><li>Learning and growth </li></ul></ul><ul><ul><ul><li>Number of cross-trained tasks per employee </li></ul></ul><...
Linked Objectives,  Performance Measures, and Targets
Performing <ul><li>Balance the needs of all stakeholder groups when making management decisions </li></ul><ul><ul><li>Use ...
Evaluating <ul><li>Evaluate performance by comparing financial and nonfinancial results with performance measurement targe...
Communicating <ul><ul><li>Financial performance reports </li></ul></ul><ul><ul><li>Customer PEAKS statements </li></ul></u...
Stop & Review <ul><li>With regard to evaluating the company vision from the perspective of the learning and growth (employ...
Performance Measurement <ul><li>Objective 2 </li></ul><ul><ul><li>Discuss performance measurement, and identify the issues...
Performance Management  and Evaluation System <ul><ul><li>Used to identify: </li></ul></ul><ul><ul><li>How well a company ...
Performance Measurement The use of quantitative tools to gauge an organization’s performance in relation to a specific goa...
Other Measurement Issues  <ul><ul><li>What performance measures can be used? </li></ul></ul><ul><ul><li>How can the level ...
Stop & Review <ul><li>What does a performance management and evaluation system identify? </li></ul>A.  How well a company ...
Responsibility Accounting <ul><li>Objective 3 </li></ul><ul><ul><li>Define  responsibility accounting , and describe the r...
Responsibility Accounting <ul><li>Assign resources to specific areas of responsibility </li></ul><ul><li>Track how the man...
Responsibility Accounting  (cont’d) <ul><li>Is an information system </li></ul><ul><li>Classifies data according to areas ...
Responsibility Center The activities of a responsibility center dictate the extent of a manager’s responsibility. An organ...
Types of Responsibility Centers <ul><li>Cost centers </li></ul><ul><li>Discretionary cost centers </li></ul><ul><li>Revenu...
Cost Center <ul><li>A responsibility center whose manager is accountable only for controllable costs that have well-define...
Cost Center Examples <ul><ul><li>Assembly plants in manufacturing organizations </li></ul></ul><ul><ul><ul><li>Relationshi...
Discretionary Cost Center <ul><ul><li>Cost-based measures cannot usually be used to evaluate performance </li></ul></ul>A ...
Discretionary  Cost Center Examples  <ul><ul><li>Administrative activities </li></ul></ul><ul><ul><ul><li>Accounting </li>...
Revenue Center A responsibility center whose manager is accountable primarily for revenue and whose success is based on it...
Profit Center <ul><li>Performance evaluated by comparing the figures from actual income statements with the figures in its...
Investment Center A responsibility center whose manager is accountable for profit generation and can also make significant...
Types of Responsibility Centers
Organizational Structure  and Performance Management <ul><li>Organization chart – visual representation of an organization...
Organizational Structure and Performance Management   (cont’d) <ul><li>Responsibility accounting systems establish communi...
Controllable Costs and Revenues <ul><li>The report for a responsibility center should contain only  controllable costs and...
Partial Organization Chart of  Café Cubano, a Restaurant Chain
Performance Reports <ul><li>Performance reports for each level of management are tailored to each manager’s individual nee...
Stop & Review <ul><li>What is the difference between a cost center and a discretionary cost center? </li></ul><ul><li>The ...
Performance Evaluation  of Cost Centers and Profit Centers <ul><li>Objective 4 </li></ul><ul><ul><li>Prepare performance r...
Performance Reports If a performance report includes items that the manager cannot control, the credibility of the entire ...
Evaluating Cost Center  Performance Using Flexible Budgeting <ul><li>The central kitchen is a cost center (well-defined re...
Central Kitchen’s Performance Report on Café Cubano’s House Dressing Note the difference in variance when actual costs are...
Evaluating Profit Center  Performance Using Variable Costing <ul><li>Profit center performance is usually evaluated by com...
Variable Costing <ul><li>Method of preparing profit center performance reports that classifies a manager’s controllable co...
Evaluating Profit Center  Performance Using Variable Costing <ul><li>When using variable costing to evaluate profit center...
Evaluating Profit Center Performance Using Variable Costing   (cont’d) <ul><li>When preparing a traditional income stateme...
<ul><li>Variable costing income statement </li></ul><ul><ul><li>Groups costs according to whether they are variable or fix...
Variable Costing Income Statement Versus Traditional Income Statement for a  Trenton Restaurant
<ul><li>Financial performance reports: </li></ul><ul><li>Vary in format depending on the type of responsibility center </l...
Stop & Review – E11, P2 <ul><li>How does a variable costing income statement arrive at profit center income? </li></ul>A. ...
Performance  Evaluation of Investment Centers <ul><li>Objective 5 </li></ul><ul><ul><li>Prepare performance reports for in...
Performance  Evaluation of Investment Centers <ul><li>Comparison of controllable revenues and costs with budgeted amounts ...
Return on Investment Assets invested  is the average of the beginning and ending asset balances for the period. Takes both...
Performance Report Based on Return on Investment for the Café Cubano  Restaurant Division
Return on Investment  (cont’d) <ul><li>The ROI computation is the aggregate measure of many interrelationships </li></ul><...
Return on Investment  (cont’d) <ul><li>Two important indicators of performance: </li></ul><ul><ul><li>Profit margin </li><...
<ul><li>Profit margin and asset turnover help to explain </li></ul><ul><ul><li>Changes in ROI for a single investment cent...
<ul><li>A single ROI number is a composite index of many cause-and-effect relationships and interdependent financial eleme...
Factors That Affect the  Return on Investment Calculation
<ul><li>ROI should be used cautiously in evaluating performance </li></ul><ul><ul><li>Affected by many factors </li></ul><...
Other Performance  Measures Used Along With ROI <ul><ul><li>Comparisons of revenues, costs, and operating income with budg...
Residual Income (RI) <ul><li>Developed because of pitfalls in using ROI as a performance measure </li></ul>The operating i...
Residual Income  (cont’d) <ul><li>Is not a ratio but a dollar amount </li></ul><ul><ul><li>Amount of profit left after sub...
Performance Report Based on Residual Income for the Café Cubano  Restaurant Division
Residual Income Analysis <ul><li>Comparisons with other RI figures will strengthen the analysis </li></ul><ul><li>To add c...
Residual Income Analysis <ul><li>When comparing a division’s RI with the RI of other investment centers of the company, ca...
Economic Value Added (EVA) <ul><li>Used as an indicator of performance </li></ul><ul><li>Is a registered trademark of the ...
Economic Value Added  (cont’d) <ul><li>Calculation can be complex </li></ul><ul><ul><li>Makes various cost of capital and ...
Performance Report Based on Economic Value Added for the Café Cubano Restaurant Division
Economic Value Added  (cont’d) <ul><li>Compare the current EVA with: </li></ul><ul><ul><li>EVAs from previous periods </li...
Factors Affecting the Computation  of Economic Value Added
Economic Value Added  (cont’d) <ul><li>The EVA number is a composite index drawn from many cause-and-effect relationships ...
The Importance of  Multiple Performance Measures <ul><li>To be effective, a performance management system must consider bo...
The Importance of Multiple  Performance Measures  (cont’d) <ul><li>Performance measures such as ROI, RI, and EVA  </li></u...
Stop & Review - E12, E13,  P3 , P7 <ul><li>What may happen if return on investment is overemphasized as a performance meas...
Performance Incentives and Goals <ul><li>Objective 6 </li></ul><ul><ul><li>Explain how properly linked performance incenti...
Performance Incentives and Goals <ul><li>Two key factors </li></ul><ul><ul><li>Logical linking of goals to measurable obje...
Linking Goals, Performance Objectives, Measures, and Performance Targets <ul><li>The causal links between an organization’...
Performance-Based Pay <ul><li>Increases likelihood that the goals of responsibility centers, managers, and the entire orga...
Common  Types of Incentive Compensation <ul><ul><li>Cash bonuses </li></ul></ul><ul><ul><ul><li>Usually awarded for short-...
Input From Employees  and Managers on Incentives <ul><li>When should the reward occur? </li></ul><ul><li>Whose performance...
Coordination of Goals  <ul><li>The effectiveness of a performance management and evaluation system relies on the coordinat...
Stop & Review – E16 <ul><li>The successful coordination of goals between responsibility centers, managers, and the entire ...
Chapter Review <ul><li>Describe how the balanced scorecard aligns performance with organizational goals. </li></ul><ul><li...
Chapter Review  (cont’d) <ul><li>Define  responsibility accounting,  and describe the role that responsibility centers pla...
<ul><li>Prepare performance reports for investment centers using the traditional measures of return on investment and resi...
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Chapter 21

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Chapter 21

  1. 1. Chapter 21 Performance Management and Evaluation
  2. 2. Organizational Goals and the Balanced Scorecard <ul><li>Objective 1 </li></ul><ul><ul><li>Describe how the balanced scorecard aligns performance with organizational goals. </li></ul></ul>
  3. 3. The Balanced Scorecard <ul><li>A framework that links the perspectives of an organization’s four basic stakeholder groups with the organization’s mission and vision, performance measures, strategic and tactical plans, and resources </li></ul>Developed by Robert S. Kaplan and David P. Norton
  4. 4. <ul><li>Financial (investors) </li></ul><ul><li>Learning and growth (employees) </li></ul><ul><li>Internal business processes </li></ul><ul><li>Customers </li></ul>Stakeholder Groups To succeed, an organization must add value for all groups in both the short and the long term
  5. 5. <ul><li>Provides a framework that enables managers to translate a vision into operations </li></ul>Planning Balanced Scorecard
  6. 6. <ul><li>Financial (investors) </li></ul><ul><ul><li>To achieve our organization’s vision, how should we appear to our shareholders? </li></ul></ul><ul><li>Learning and growth (employees) </li></ul><ul><ul><li>To achieve our organization’s vision, how should we sustain our ability to improve and change? </li></ul></ul>Planning (cont’d)
  7. 7. <ul><li>Internal business processes </li></ul><ul><ul><li>To succeed, in which business processes must our organization excel? </li></ul></ul><ul><li>Customers </li></ul><ul><ul><li>To achieve our organization’s vision, how should we appeal to our customers? </li></ul></ul>Planning (cont’d)
  8. 8. <ul><li>Once the organization’s objectives are set, managers can select performance measures and set performance targets. </li></ul>Planning (cont’d) Managers translate objectives into an action plan
  9. 9. <ul><li>If Vail Resorts’ collective vision and strategy is customer satisfaction, its managers might establish the following overall objectives: </li></ul>Planning Illustrated Financial (investors) Increase guests’ spending at resorts Learning and growth Continually cross-train (employees) employees Internal business processes Leverage market position by introducing and improving innovations that benefit guests Customers Premium-price experiences and facilities for vacations in all seasons Perspective Objective
  10. 10. <ul><li>For ski lift manager: </li></ul><ul><ul><li>Financial </li></ul></ul><ul><ul><ul><li>Hourly lift cost </li></ul></ul></ul><ul><ul><ul><li>Lift ticket sales in dollars and in units </li></ul></ul></ul>Planning Illustrated (cont’d) Translate overall objectives into specific performance objectives and measures for managers at Vail
  11. 11. <ul><ul><li>Learning and growth </li></ul></ul><ul><ul><ul><li>Number of cross-trained tasks per employee </li></ul></ul></ul><ul><ul><ul><li>Employee turnover </li></ul></ul></ul><ul><ul><li>Internal business processes </li></ul></ul><ul><ul><ul><li>Number of accident-free days </li></ul></ul></ul><ul><ul><ul><li>Number and cost of mechanical breakdowns </li></ul></ul></ul><ul><ul><ul><li>Average lift cycle time </li></ul></ul></ul><ul><ul><li>Customers </li></ul></ul><ul><ul><ul><li>Average number of ski runs per daily lift ticket </li></ul></ul></ul><ul><ul><ul><li>Number of repeat customers </li></ul></ul></ul><ul><ul><ul><li>Number of PEAKS points redeemed </li></ul></ul></ul>Planning Illustrated (cont’d)
  12. 12. Linked Objectives, Performance Measures, and Targets
  13. 13. Performing <ul><li>Balance the needs of all stakeholder groups when making management decisions </li></ul><ul><ul><li>Use mutually agreed-on strategic and tactical objectives for the entire organization as the basis for decision making </li></ul></ul><ul><li>Improve performance by verifying and tracking causal relationships </li></ul>
  14. 14. Evaluating <ul><li>Evaluate performance by comparing financial and nonfinancial results with performance measurement targets </li></ul><ul><li>Analyze results and recommend changes </li></ul><ul><li>Determine… </li></ul><ul><ul><li>If the targets were met </li></ul></ul><ul><ul><li>What measures need to be changed </li></ul></ul><ul><ul><li>What strategies or objectives need revision </li></ul></ul>
  15. 15. Communicating <ul><ul><li>Financial performance reports </li></ul></ul><ul><ul><li>Customer PEAKS statements </li></ul></ul><ul><ul><li>Internal business processes reports for targeted performance measures and results </li></ul></ul><ul><ul><li>Performance appraisals of individual employees </li></ul></ul>Prepare reports of interest to stakeholder groups
  16. 16. Stop & Review <ul><li>With regard to evaluating the company vision from the perspective of the learning and growth (employee) stakeholder group, what key question would managers want to answer? </li></ul>A. To achieve our organization’s vision, how should we sustain our ability to improve and change?
  17. 17. Performance Measurement <ul><li>Objective 2 </li></ul><ul><ul><li>Discuss performance measurement, and identify the issues that affect management’s ability to measure performance. </li></ul></ul>
  18. 18. Performance Management and Evaluation System <ul><ul><li>Used to identify: </li></ul></ul><ul><ul><li>How well a company is doing </li></ul></ul><ul><ul><li>Where it is going </li></ul></ul><ul><ul><li>What improvements will make it more profitable </li></ul></ul>A set of procedures that account for and report on both financial and nonfinancial performance
  19. 19. Performance Measurement The use of quantitative tools to gauge an organization’s performance in relation to a specific goal or an expected outcome To succeed, managers must be able to distinguish between what is being measured and the actual measures used to monitor performance
  20. 20. Other Measurement Issues <ul><ul><li>What performance measures can be used? </li></ul></ul><ul><ul><li>How can the level of product or service quality to monitored? </li></ul></ul><ul><ul><li>How can areas that need improvement be identified? </li></ul></ul><ul><ul><li>How can customer satisfaction be measured? </li></ul></ul><ul><ul><li>How can financial performance be monitored? </li></ul></ul><ul><ul><li>Are there other stakeholders to whom a manager is accountable? </li></ul></ul><ul><ul><li>What performance measures do government entities impose on the company? </li></ul></ul><ul><ul><li>How can the company’s effect on the environment be measured? </li></ul></ul>Issues to consider other than what to measure and how to measure it
  21. 21. Stop & Review <ul><li>What does a performance management and evaluation system identify? </li></ul>A. How well a company is doing, where it is going, and what improvements will make it more profitable.
  22. 22. Responsibility Accounting <ul><li>Objective 3 </li></ul><ul><ul><li>Define responsibility accounting , and describe the role that responsibility centers play in performance management and evaluation. </li></ul></ul>
  23. 23. Responsibility Accounting <ul><li>Assign resources to specific areas of responsibility </li></ul><ul><li>Track how the managers of those areas use those resources </li></ul><ul><li>Evaluate managers at all levels in terms of their ability to manage their area of responsibility in keeping with organizational goals </li></ul>Performance management systems
  24. 24. Responsibility Accounting (cont’d) <ul><li>Is an information system </li></ul><ul><li>Classifies data according to areas of responsibility </li></ul><ul><li>Reports each area’s activities by including only the revenue, cost, and resource categories that the assigned manager can control </li></ul>
  25. 25. Responsibility Center The activities of a responsibility center dictate the extent of a manager’s responsibility. An organizational unit whose manager has been assigned the responsibility of managing a portion of the organization’s resources
  26. 26. Types of Responsibility Centers <ul><li>Cost centers </li></ul><ul><li>Discretionary cost centers </li></ul><ul><li>Revenue centers </li></ul><ul><li>Profit centers </li></ul><ul><li>Investment centers </li></ul>
  27. 27. Cost Center <ul><li>A responsibility center whose manager is accountable only for controllable costs that have well-defined relationships between the center’s resources and products or services </li></ul><ul><li>Performance evaluated by comparing an activity’s actual cost with its budgeted cost and analyzing the resulting variances </li></ul>Companies like Coach, Inc., Apple Computer, and Kraft use cost centers to manage assembly plants
  28. 28. Cost Center Examples <ul><ul><li>Assembly plants in manufacturing organizations </li></ul></ul><ul><ul><ul><li>Relationship between the costs of resources and resulting products is well defined </li></ul></ul></ul><ul><ul><li>Food services in hospitals and nursing homes </li></ul></ul><ul><ul><ul><li>Clear relationship between costs of food and direct labor and the number of inpatient meals served </li></ul></ul></ul>
  29. 29. Discretionary Cost Center <ul><ul><li>Cost-based measures cannot usually be used to evaluate performance </li></ul></ul>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
  30. 30. Discretionary Cost Center Examples <ul><ul><li>Administrative activities </li></ul></ul><ul><ul><ul><li>Accounting </li></ul></ul></ul><ul><ul><ul><li>Human resources </li></ul></ul></ul><ul><ul><ul><li>Legal services </li></ul></ul></ul><ul><ul><li>Research and Development </li></ul></ul><ul><ul><ul><li>Might measure number of patents obtained and number of cost-saving innovations developed </li></ul></ul></ul><ul><ul><li>Service organizations </li></ul></ul><ul><ul><ul><li>United Way might measure administrative activities by how low their costs are as a percentage of total contributions </li></ul></ul></ul>
  31. 31. Revenue Center A responsibility center whose manager is accountable primarily for revenue and whose success is based on its ability to generate revenue <ul><li>Examples: </li></ul><ul><li>Car rental reservation center </li></ul><ul><li>Clothing retailer’s ecommerce order department </li></ul><ul><li>Performance measures: </li></ul><ul><li>Sales dollars </li></ul><ul><li>Sales revenue per minute </li></ul><ul><li>Number of sales </li></ul>
  32. 32. Profit Center <ul><li>Performance evaluated by comparing the figures from actual income statements with the figures in its master or flexible budget income statement </li></ul>A responsibility center whose manager is accountable for both revenue and costs and for the resulting operating income Local Jiffy Lube
  33. 33. Investment Center A responsibility center whose manager is accountable for profit generation and can also make significant decisions about the resources the center uses <ul><li>Performance of both manufacturing and service organizations usually evaluated using measures such as: </li></ul><ul><ul><li>Return on investment </li></ul></ul><ul><ul><li>Residual income </li></ul></ul><ul><ul><li>Economic value added </li></ul></ul>
  34. 34. Types of Responsibility Centers
  35. 35. Organizational Structure and Performance Management <ul><li>Organization chart – visual representation of an organization's hierarchy of responsibility for purposes of management control </li></ul>A company’s organizational structure formalizes its lines of managerial authority and control
  36. 36. Organizational Structure and Performance Management (cont’d) <ul><li>Responsibility accounting systems establish communications network within an organization </li></ul><ul><ul><li>Ideal for gathering and reporting information about the operations of each area of responsibility </li></ul></ul><ul><ul><li>Budgets can be prepared by responsibility area </li></ul></ul><ul><ul><li>Actual results reported by responsibility area </li></ul></ul>
  37. 37. Controllable Costs and Revenues <ul><li>The report for a responsibility center should contain only controllable costs and revenues </li></ul><ul><ul><li>The costs, revenues, and resources that the manager of a center can control </li></ul></ul>A responsibility accounting system assures managers will not be held responsible for items they cannot change
  38. 38. Partial Organization Chart of Café Cubano, a Restaurant Chain
  39. 39. Performance Reports <ul><li>Performance reports for each level of management are tailored to each manager’s individual needs for information </li></ul><ul><li>The same information may appear in various formats in several different reports </li></ul><ul><ul><li>Information from reports for lower-level managers is usually summarized and condensed when it appears in upper-level managers’ reports </li></ul></ul>
  40. 40. Stop & Review <ul><li>What is the difference between a cost center and a discretionary cost center? </li></ul><ul><li>The managers of cost centers are accountable for controllable costs that have well-defined relationships between the center’s 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. </li></ul>
  41. 41. Performance Evaluation of Cost Centers and Profit Centers <ul><li>Objective 4 </li></ul><ul><ul><li>Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing. </li></ul></ul>
  42. 42. Performance Reports If a performance report includes items that the manager cannot control, the credibility of the entire responsibility accounting system can be called into question. <ul><ul><li>Allow comparisons between actual performance and budget expectations </li></ul></ul><ul><ul><ul><li>Contain information about costs, revenues, and resources controllable by individual managers </li></ul></ul></ul><ul><ul><li>Allow evaluation of an individual’s performance with respect to responsibility center objectives and companywide objectives </li></ul></ul><ul><ul><li>Recommend changes </li></ul></ul>
  43. 43. Evaluating Cost Center Performance Using Flexible Budgeting <ul><li>The central kitchen is a cost center (well-defined relationships with resulting products) </li></ul><ul><li>Torres has decided to evaluate the performance of each food item produced </li></ul><ul><ul><ul><li>A separate report will be prepared for each product comparing actual costs with budgeted costs </li></ul></ul></ul>Orlena Torres, the VP of food products at Café Cubano, is responsible for the central kitchen, where the food products the restaurants sells are prepared.
  44. 44. Central Kitchen’s Performance Report on Café Cubano’s House Dressing Note the difference in variance when actual costs are compared to flexible budget amounts versus the master budget amounts.
  45. 45. Evaluating Profit Center Performance Using Variable Costing <ul><li>Profit center performance is usually evaluated by comparing actual income statement results to the budgeted income statement </li></ul>
  46. 46. Variable Costing <ul><li>Method of preparing profit center performance reports that classifies a manager’s controllable costs as either variable or fixed </li></ul><ul><li>Instead of a traditional income statement, a variable costing income statement is produced </li></ul><ul><ul><li>Same as a contribution income statement </li></ul></ul><ul><ul><li>Useful because it focuses on cost variability and the profit center’s contribution to operating income </li></ul></ul>
  47. 47. Evaluating Profit Center Performance Using Variable Costing <ul><li>When using variable costing to evaluate profit center performance </li></ul><ul><ul><li>Variable cost of goods sold and variable selling and administrative expenses are subtracted from sales to arrive at the contribution margin for the center </li></ul></ul><ul><ul><li>All controllable fixed costs are subtracted from gross margin to determine the operating income </li></ul></ul><ul><ul><ul><li>Includes fixed manufacturing costs and fixed selling and administrative expenses </li></ul></ul></ul>
  48. 48. Evaluating Profit Center Performance Using Variable Costing (cont’d) <ul><li>When preparing a traditional income statement </li></ul><ul><ul><li>All manufacturing costs are assigned to cost of goods sold </li></ul></ul><ul><ul><li>Cost of goods sold is subtracted from sales to arrive at the gross margin </li></ul></ul><ul><ul><li>Variable and fixed selling expenses are subtracted from gross margin to determine operating income </li></ul></ul>
  49. 49. <ul><li>Variable costing income statement </li></ul><ul><ul><li>Groups costs according to whether they are variable or fixed </li></ul></ul><ul><li>Traditional income statement </li></ul><ul><ul><li>Groups cost according to whether they are costs of goods sold or period costs </li></ul></ul>Evaluating Profit Center Performance Using Variable Costing (cont’d)
  50. 50. Variable Costing Income Statement Versus Traditional Income Statement for a Trenton Restaurant
  51. 51. <ul><li>Financial performance reports: </li></ul><ul><li>Vary in format depending on the type of responsibility center </li></ul><ul><li>Share common themes </li></ul><ul><ul><li>Compare a center’s actual results to its budgeted figures </li></ul></ul><ul><ul><li>Focus on the differences </li></ul></ul><ul><ul><li>Only items managers can control are included </li></ul></ul>Evaluating Profit Center Performance Using Variable Costing (cont’d) The manager of a profit center may also want to measure and evaluate nonfinancial information
  52. 52. Stop & Review – E11, P2 <ul><li>How does a variable costing income statement arrive at profit center income? </li></ul>A. Variable cost of goods sold and variable selling and administrative expenses are subtracted from sales to determine the contribution margin. All fixed manufacturing costs and fixed selling and administrative expenses are subtracted from the contribution margin to arrive at profit center income.
  53. 53. Performance Evaluation of Investment Centers <ul><li>Objective 5 </li></ul><ul><ul><li>Prepare performance reports for investment centers using the traditional measures of return on investment and residual income and the newer measure of economic value added. </li></ul></ul>
  54. 54. Performance Evaluation of Investment Centers <ul><li>Comparison of controllable revenues and costs with budgeted amounts </li></ul><ul><li>Performance measures for capital investments that mangers control </li></ul>Performance evaluation of an investment center should include:
  55. 55. Return on Investment Assets invested is the average of the beginning and ending asset balances for the period. Takes both operating income and assets invested to earn that income into account
  56. 56. Performance Report Based on Return on Investment for the Café Cubano Restaurant Division
  57. 57. Return on Investment (cont’d) <ul><li>The ROI computation is the aggregate measure of many interrelationships </li></ul><ul><ul><li>The basic ROI equation can be rewritten to show the many elements a manager can influence </li></ul></ul>
  58. 58. Return on Investment (cont’d) <ul><li>Two important indicators of performance: </li></ul><ul><ul><li>Profit margin </li></ul></ul><ul><ul><ul><li>Ratio of operating income to sales </li></ul></ul></ul><ul><ul><ul><li>Represents the percentage of each sales dollar the results in profit </li></ul></ul></ul><ul><ul><li>Asset turnover </li></ul></ul><ul><ul><ul><li>Ratio of sales to average assets invested </li></ul></ul></ul><ul><ul><ul><li>Indicates the productivity of assets </li></ul></ul></ul><ul><ul><ul><ul><li>Number of sales dollars generated by each dollar invested in assets </li></ul></ul></ul></ul>
  59. 59. <ul><li>Profit margin and asset turnover help to explain </li></ul><ul><ul><li>Changes in ROI for a single investment center </li></ul></ul><ul><ul><li>Differences in ROI among investment centers </li></ul></ul><ul><li>ROI formula is useful for analyzing and interpreting the elements that make up a business’s overall return on investment </li></ul>Return on Investment (cont’d)
  60. 60. <ul><li>A single ROI number is a composite index of many cause-and-effect relationships and interdependent financial elements </li></ul><ul><li>Managers can improve ROI by </li></ul><ul><ul><li>Increasing sales </li></ul></ul><ul><ul><li>Decreasing costs </li></ul></ul><ul><ul><li>Decreasing assets </li></ul></ul>Return on Investment (cont’d)
  61. 61. Factors That Affect the Return on Investment Calculation
  62. 62. <ul><li>ROI should be used cautiously in evaluating performance </li></ul><ul><ul><li>Affected by many factors </li></ul></ul><ul><li>If overemphasized </li></ul><ul><ul><li>Investment center managers may make business decisions that favor their personal ROI </li></ul></ul><ul><ul><ul><li>At the expense of companywide profits or long-term success of other investment centers </li></ul></ul></ul><ul><ul><li>To avoid this problem, always use other performance measures in conjunction with ROI </li></ul></ul>Return on Investment (cont’d)
  63. 63. Other Performance Measures Used Along With ROI <ul><ul><li>Comparisons of revenues, costs, and operating income with budgeted amounts or past trends </li></ul></ul><ul><ul><li>Sales growth percentages </li></ul></ul><ul><ul><li>Market share percentages </li></ul></ul><ul><ul><li>Other key variables in the organization's activity </li></ul></ul><ul><ul><li>Ratio of ROI to budgeted goals and past ROI trends </li></ul></ul><ul><ul><ul><li>Changes in this ratio over time can be more revealing than any single number </li></ul></ul></ul>
  64. 64. Residual Income (RI) <ul><li>Developed because of pitfalls in using ROI as a performance measure </li></ul>The operating income that an investment center earns above a minimum desired return on invested assets The desired RI will vary among investment centers depending on the type of business and level of risk assumed
  65. 65. Residual Income (cont’d) <ul><li>Is not a ratio but a dollar amount </li></ul><ul><ul><li>Amount of profit left after subtracting a predetermined desired income target for an investment center </li></ul></ul>As with ROI computations, assets invested is the average of the center’s beginning and ending asset balances for the period
  66. 66. Performance Report Based on Residual Income for the Café Cubano Restaurant Division
  67. 67. Residual Income Analysis <ul><li>Comparisons with other RI figures will strengthen the analysis </li></ul><ul><li>To add context to the analysis, the following questions should be answered </li></ul><ul><ul><li>How does the division’s RI for this year compare with previous years? </li></ul></ul><ul><ul><li>Did actual RI exceed budgeted RI? </li></ul></ul><ul><ul><li>How does this division’s RI compare with the RI of other investment centers of the company? </li></ul></ul>
  68. 68. Residual Income Analysis <ul><li>When comparing a division’s RI with the RI of other investment centers of the company, caution should be used </li></ul><ul><ul><li>For RI figures to be comparable, all investment centers must have </li></ul></ul><ul><ul><ul><li>Equal access to resources </li></ul></ul></ul><ul><ul><ul><li>Similar asset investment bases </li></ul></ul></ul><ul><ul><li>Managers may be able to produce a larger RI simply because their investment centers are larger </li></ul></ul><ul><ul><ul><li>May not reflect better performance </li></ul></ul></ul>
  69. 69. Economic Value Added (EVA) <ul><li>Used as an indicator of performance </li></ul><ul><li>Is a registered trademark of the consulting firm Stern Stewart & Company </li></ul>The shareholder wealth created by an investment center
  70. 70. Economic Value Added (cont’d) <ul><li>Calculation can be complex </li></ul><ul><ul><li>Makes various cost of capital and accounting principles adjustments </li></ul></ul><ul><li>EVA is expressed as a dollar amount </li></ul>Cost of capital is the minimum desired rate of return on an investment, such as assets invested in an investment center or
  71. 71. Performance Report Based on Economic Value Added for the Café Cubano Restaurant Division
  72. 72. Economic Value Added (cont’d) <ul><li>Compare the current EVA with: </li></ul><ul><ul><li>EVAs from previous periods </li></ul></ul><ul><ul><li>Target EVAs </li></ul></ul><ul><ul><li>EVAs from other investment centers </li></ul></ul>Caution Use care when evaluating performance using EVA. Many factors affect the economic value of an investment center. <ul><li>Pricing </li></ul><ul><li>Sales Volume </li></ul><ul><li>Taxes </li></ul><ul><li>Cost of capital </li></ul>
  73. 73. Factors Affecting the Computation of Economic Value Added
  74. 74. Economic Value Added (cont’d) <ul><li>The EVA number is a composite index drawn from many cause-and-effect relationships and interdependent financial elements </li></ul><ul><li>Managers can improve the EVA of an investment center by </li></ul><ul><ul><li>Increasing sales </li></ul></ul><ul><ul><li>Decreasing costs </li></ul></ul><ul><ul><li>Decreasing assets </li></ul></ul><ul><ul><li>Lowering the cost of capital </li></ul></ul>
  75. 75. The Importance of Multiple Performance Measures <ul><li>To be effective, a performance management system must consider both operating results and multiple performance measures, such as ROI, RI, and EVA </li></ul><ul><ul><li>Comparing actual results to budgeted figures adds meaning to the evaluation </li></ul></ul>
  76. 76. The Importance of Multiple Performance Measures (cont’d) <ul><li>Performance measures such as ROI, RI, and EVA </li></ul><ul><ul><li>Indicate whether an investment center is effective in coordinating its goals with companywide goals </li></ul></ul><ul><ul><ul><li>Take into account both operating income and the assets used to produce that income </li></ul></ul></ul><ul><ul><li>Are limited by their focus on short-term financial performance </li></ul></ul><ul><ul><ul><li>Management should break these measures down into their components, analyze information over time, and compare current results to targeted amounts </li></ul></ul></ul>
  77. 77. Stop & Review - E12, E13, P3 , P7 <ul><li>What may happen if return on investment is overemphasized as a performance measure? </li></ul>A. 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.
  78. 78. Performance Incentives and Goals <ul><li>Objective 6 </li></ul><ul><ul><li>Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation. </li></ul></ul>
  79. 79. Performance Incentives and Goals <ul><li>Two key factors </li></ul><ul><ul><li>Logical linking of goals to measurable objectives and targets </li></ul></ul><ul><ul><li>Performance-based pay </li></ul></ul>The effectiveness of a performance management and evaluation system depends on successful coordination of goals between… Managers Responsibility centers Entire company
  80. 80. Linking Goals, Performance Objectives, Measures, and Performance Targets <ul><li>The causal links between an organization’s goals, performance objectives, measures, and targets must be apparent </li></ul>Recall that the balanced scorecard also links objectives, measures, and targets
  81. 81. Performance-Based Pay <ul><li>Increases likelihood that the goals of responsibility centers, managers, and the entire organization will be well coordinated </li></ul>Linking of employee compensation to the achievement of measurable business targets
  82. 82. Common Types of Incentive Compensation <ul><ul><li>Cash bonuses </li></ul></ul><ul><ul><ul><li>Usually awarded for short-term performance </li></ul></ul></ul><ul><ul><li>Awards </li></ul></ul><ul><ul><ul><li>May be a trip or some other form of recognition </li></ul></ul></ul><ul><ul><li>Profit-sharing plans </li></ul></ul><ul><ul><ul><li>Reward employees with a share of the company’s profits </li></ul></ul></ul><ul><ul><li>Stock programs </li></ul></ul><ul><ul><ul><li>Used to motivate employees to achieve financial targets that increase the company’s stock price </li></ul></ul></ul>
  83. 83. Input From Employees and Managers on Incentives <ul><li>When should the reward occur? </li></ul><ul><li>Whose performance should be rewarded? </li></ul><ul><li>How should the reward be computed? </li></ul><ul><li>On what should the reward be based? </li></ul><ul><li>What performance criteria should be used? </li></ul><ul><li>Does the performance incentive plan address the interests of all stakeholders? </li></ul>
  84. 84. Coordination of Goals <ul><li>The effectiveness of a performance management and evaluation system relies on the coordination of responsibility center, managerial, and company goals </li></ul><ul><ul><li>Can be optimized by </li></ul></ul><ul><ul><ul><li>Linking goals to measurable objectives and targets </li></ul></ul></ul><ul><ul><ul><li>Tying appropriate compensation incentives to the achievement of the targets </li></ul></ul></ul>
  85. 85. Stop & Review – E16 <ul><li>The successful coordination of goals between responsibility centers, managers, and the entire company is dependent upon what two key factors? </li></ul>A. The logical linking of goals to measurable objectives and targets and performance-based pay.
  86. 86. Chapter Review <ul><li>Describe how the balanced scorecard aligns performance with organizational goals. </li></ul><ul><li>Discuss performance measurement, and identify the issues that affect management’s ability to measure performance. </li></ul>
  87. 87. Chapter Review (cont’d) <ul><li>Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation. </li></ul><ul><li>Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing. </li></ul>
  88. 88. <ul><li>Prepare performance reports for investment centers using the traditional measures of return on investment and residual income and the newer measure of economic value added. </li></ul><ul><li>Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation. </li></ul>Chapter Review (cont’d)

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