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Performance Measurement in

Decentralized Organizations
Chapter 11

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
2

Decentralization in Organizations
Benefits of Top management
Decentralization freed to concentrate
on strategy.
Lower-level decisions
often based on
better information. Lower level managers
can respond quickly
to customers.
Lower-level managers
gain experience in
decision-making. Decision-making
authority leads to
job satisfaction.
3

Decentralization in Organizations
Lower-level managers
may make decisions
without seeing the
May be a lack of “big picture.”
coordination among
autonomous
managers. Disadvantages of
Decentralization
Lower-level manager’s
objectives may not
be those of the May be difficult to
organization. spread innovative ideas
in the organization.
4

Responsibility Accounting

Cost Profit Investment


Center Center Center

Cost, profit,
and investment
centers are all Responsibility
known as Center
responsibility
centers.
5

Cost Center
A segment whose manager has control over
costs, but not over revenues or investment
funds.
6

Profit Center

Revenues
A segment whose
Sales
manager has control Interest
over both costs and Other
revenues,
Costs
but no control over
Mfg. costs
investment funds.
Commissions
Salaries
Other
7

Investment Center

A segment whose
manager has control
over costs, revenues,
and investments in
operating assets.
8

Learning Objective 1

Compute return on
investment (ROI) and
show how changes in
sales, expenses, and
assets affect ROI.
9

Return on Investment (ROI) Formula


Income before interest
and taxes (EBIT)

Net operating income


ROI =
Average operating assets

Cash, accounts receivable, inventory,


plant and equipment, and other
productive assets.
10

Net Book Value versus Gross Cost


Most companies use the net book value of
depreciable assets to calculate average
operating assets.
11

Understanding ROI

Net operating income


Margin =
Sales
Sales
Turnover =
Average operating assets

ROI = Margin ´ Turnover


12

Increasing ROI – An Example


Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000

What is Regal Company’s ROI?


ROI = Margin ´ Turnover
ROI = Net operating income Sales
×Average operating
Sales assets
13

Increasing ROI – An Example

ROI = Margin ´ Turnover


Sales
ROI = Net operating income ×Average operating assets
Sales

ROI = $30,000 ×
$500,000
$500,000 $200,000

ROI = 6% ´ 2.5 = 15%


14

Investing in Operating Assets to Increase


Sales
Assume that Regal's manager invests in a $30,000
piece of equipment that increases sales by
$35,000, while increasing operating expenses by
$15,000.
Regal Company reports the following:
Net operating income $ 50,000
Average operating assets $ 230,000
Sales $ 535,000
Operating expenses $ 485,000

Let’s calculate the new ROI.


15

Investing in Operating Assets to Increase


Sales

ROI = Margin ´ Turnover


ROI = Net operating income Sales
×Average operating
Sales assets

ROI = $50,000 ×
$535,000
$535,000 $230,000

ROI =9.35% ´ 2.33 = 21.8%

ROI
ROI increased
increased from
from 15%
15% to
to 21.8%.
21.8%.
16

Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.

Managers often inherit many


committed costs over which
they have no control.

Managers evaluated on ROI


may reject profitable
investment opportunities.
17

Learning Objective 2

Compute residual
income and understand
its strengths and
weaknesses.
18

Residual Income - Another Measure of


Performance

Net operating income


above some minimum
return on operating
assets
19

Calculating Residual Income

( )
This computation differs from ROI.
ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.
20

Residual Income – An Example

•• The
The Retail
Retail Division
Division ofof Zephyr,
Zephyr, Inc.
Inc. has
has
average
average operating
operating assets
assets ofof $100,000
$100,000 andand is
is
required
required toto earn
earn aa return
return ofof 20%
20% onon these
these
assets.
assets.
•• In
In the
the current
current period,
period, thethe division
division earns
earns
$30,000.
$30,000.

Let’s calculate residual income.


21

Residual Income – An Example


22

Motivation and Residual Income

Residual income encourages managers to


make profitable investments that would
be rejected by managers using ROI.
23

Quick Check ✓
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
c. 15%
d. 20%
24

Quick Check ✓
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s ROI?
a. 25%
b. 5%
c. 15% ROI = NOI/Average operating assets
d. 20% = $60,000/$300,000 = 20%
25

Quick Check ✓
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000. If
the manager of the division is evaluated
based on ROI, will she want to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year?
a. Yes
b. No
26

Quick Check ✓
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000. If
the manager of the division is evaluated
based on ROI, will she want to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year? ROI = $78,000/$400,000 = 19.5%
a. Yes
This lowers the division’s ROI from
b. No
20.0% down to 19.5%.
27

Quick Check ✓
The company’s required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year?
a. Yes
b. No
28

Quick Check ✓
The company’s required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year?
ROI = $18,000/$100,000 = 18%
a. Yes
b. No The return on the investment
exceeds the minimum required rate
of return.
29

Quick Check ✓
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000
d. $ 51,000
30

Quick Check ✓
Redmond Awnings, a division of Wrap-up Corp.,
has a net operating income of $60,000 and
average operating assets of $300,000. The
required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000
b. $ 45,000
c. $ 15,000 Net operating income $60,000
Required return (15% of $300,000) (45,000)
d. $ 51,000 Residual income $15,000
31

Quick Check ✓
If the manager of the Redmond Awnings
division is evaluated based on residual
income, will she want to make an investment
of $100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No
32

Quick Check ✓
If the manager of the Redmond Awnings
division is evaluated based on residual
income, will she want to make an investment
of $100,000 that would generate additional net
operating income of $18,000 per year?
a. Yes
b. No Net operating income $78,000
Required return (15% of $400,000) (60,000)
Residual income $18,000

Yields an increase of $3,000 in the residual income.


33

Divisional Comparisons and Residual


Income
The residual income
approach has one
major disadvantage.

It cannot be used to
compare the
performance of
divisions of
different sizes.
34

Zephyr, Inc. - Continued


Recall the following Assume the following
information for the Retail information for the Wholesale
Division of Zephyr, Inc. Division of Zephyr, Inc.
35

Zephyr, Inc. - Continued


The residual income numbers suggest that the Wholesale Division outperformed
the Retail Division because its residual income is $10,000 higher. However, the
Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale
Division. The Wholesale Division’s residual income is larger than the Retail
Division simply because it is a bigger division.
36

Learning Objective 3

Compute delivery cycle


time, throughput time,
and manufacturing cycle
efficiency (MCE).
37

Delivery Performance Measures


Order Production Goods
Received Started Shipped

Process Time + Inspection Time


Wait Time + Move Time + Queue Time

Throughput Time

Delivery Cycle Time

Process time is the only value-added time.


38

Delivery Performance Measures


Order Production Goods
Received Started Shipped

Process Time + Inspection Time


Wait Time + Move Time + Queue Time

Throughput Time

Delivery Cycle Time


Manufacturing Value-added time
Cycle = Manufacturing cycle time
Efficiency
39

Quick Check ✓
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp has
has recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.2
0.2 days
days
What
What is
is the
the throughput
throughput time?
time?
a.
a. 10.4
10.4 days.
days.
b.
b. 0.2
0.2 days.
days.
c.
c. 4.1
4.1 days.
days.
d.
d. 13.4
13.4 days.
days.
40

Quick Check ✓
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp has
has recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.2
0.2 days
days
What
What is
is the
the throughput
throughput time?
time?
a.
a. 10.4
10.4 days.
days.
b.
b. 0.2
0.2 days.
days.
Throughput
c. time = Process + Inspection + Move + Queue
c. 4.1
4.1 days.
days.
= 0.2 days + 0.4 days + 0.5 days + 9.3 days
d.
d. 13.4
13.4 days.
days.= 10.4 days
41

Quick Check ✓
A TQM team at Narton Corp has recorded the
following average times for production:
Wait 3.0 days Move 0.5 days
Inspection 0.4 days Queue 9.3 days
Process 0.2 days
What is the Manufacturing Cycle Efficiency
(MCE)?
a. 50.0%.
b. 1.9%.
c. 52.0%.
d. 5.1%.
42

Quick Check ✓
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp has
has recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.2
0.2 days
days
What
What is
is the
the Manufacturing
Manufacturing Cycle
Cycle Efficiency
Efficiency
(MCE)?
(MCE)? MCE = Value-added time ÷ Throughput time
a.
a. 50.0%.
50.0%. = Process time ÷ Throughput time
b.
b. 1.9%.
1.9%. = 0.2 days ÷ 10.4 days
c.
c. 52.0%.
52.0%. = 1.9%
d.
d. 5.1%.
5.1%.
43

Quick Check ✓
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp has
has recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.2
0.2 days
days
What
What is
is the
the delivery
delivery cycle
cycle time
time (DCT)?
(DCT)?
a.
a. 0.5
0.5 days.
days.
b.
b. 0.7
0.7 days.
days.
c.
c. 13.4
13.4 days.
days.
d.
d. 10.4
10.4 days.
days.
44

Quick Check ✓
AA TQM
TQM team
team at
at Narton
Narton Corp
Corp has
has recorded
recorded the
the
following
following average
average times
times for
for production:
production:
Wait
Wait 3.0
3.0 days
days Move
Move 0.5
0.5 days
days
Inspection
Inspection 0.4
0.4 days
days Queue
Queue 9.3
9.3 days
days
Process
Process 0.2
0.2 days
days
What
What is
is the
the delivery
delivery cycle
cycle time
time (DCT)?
(DCT)?
a.
a. 0.5
0.5 days.
days.
b.
b. 0.7
0.7 days.
days. DCT = Wait time + Throughput time
c.
c. 13.4
13.4 days.
days. = 3.0 days + 10.4 days
d.
d. 10.4
10.4 days.
days. = 13.4 days
45

Learning Objective 4

Understand how to
construct and use a
balanced scorecard.
46

The Balanced Scorecard


Management
Management translates
translates its
its strategy
strategy into
into
performance
performance measures
measures that
that employees
employees
understand
understand and
and influence.
influence.

Financial Customer

Performance
measures
Internal Learning
business and growth
processes
47

The Balanced Scorecard: From


Strategy to Performance Measures
Performance Measures
Financial
Has our financial What are our
performance improved? financial goals?

Customer What customers do Vision


Do customers recognize that we want to serve and and
we are delivering more value? how are we going to
win and retain them? Strategy

Internal Business Processes What internal busi-


Have we improved key business ness processes are
processes so that we can deliver critical to providing
more value to customers? value to customers?

Learning and Growth


Are we maintaining our ability
to change and improve?
48

The Balanced Scorecard:


Non-financial Measures
The balanced scorecard relies on non-financial measures
in addition to financial measures for two reasons:


❶ Financial
Financial measures
measures are are lag
lag indicators
indicators that
that summarize
summarize
the
the results
results of
of past
past actions.
actions. Non-financial
Non-financial measures
measures are
are
leading
leading indicators
indicators of
of future
future financial
financial performance.
performance.


❷ Top
Top managers
managers are
are ordinarily
ordinarily responsible
responsible forfor financial
financial
performance
performance measures
measures –– not
not lower
lower level
level managers.
managers.
Non-financial
Non-financial measures
measures are
are more
more likely
likely to
to be
be
understood
understood and
and controlled
controlled by
by lower
lower level
level managers.
managers.
49

The Balanced Scorecard for Individuals

The entire organization Each individual should


should have an overall have a personal
balanced scorecard. balanced scorecard.

AApersonal
personal scorecard
scorecard should
should contain
contain measures
measures that
that can
can be
be
influenced
influenced by
by the
the individual
individual being
being evaluated
evaluated and
and that
that
support
support the
the measures
measures in in the
the overall
overall balanced
balanced scorecard.
scorecard.
50

The Balanced Scorecard


A balanced scorecard should have measures
that are linked together on a cause-and-effect basis.

If we improve Another desired


Then
one performance performance measure
measure . . . will improve.

The balanced scorecard lays out concrete


actions to attain desired outcomes.
51

The Balanced Scorecard and


Compensation
Incentive compensation should be linked to
balanced scorecard performance
measures.
52

The Balanced Scorecard ─ Jaguar


Example
Profit
Financial
Contribution per car

Number of cars sold


Customer
Customer satisfaction
with options

Internal
Number of Time to
Business options available install option
Processes

Learning Employee skills in


and Growth installing options
53

The Balanced Scorecard ─ Jaguar


Example
Profit

Contribution per car

Number of cars sold

Customer satisfaction
Results
with options Satisfaction
Increases
Strategies
Increase Number of Time to
Options options available install option Time
Decreases

Increase Employee skills in


Skills installing options
54

The Balanced Scorecard ─ Jaguar


Example
Profit

Contribution per car


Results
Number of cars sold Cars sold
Increase

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option

Employee skills in
installing options
55

The Balanced Scorecard ─ Jaguar


Example
Profit
Results
Contribution per car Contribution
Increases

Number of cars sold

Customer satisfaction
with options Satisfaction
Increases

Number of Time to
options available install option Time
Decreases

Employee skills in
installing options
56

The Balanced Scorecard ─ Jaguar


Example Results
Profit Profits
Increase
If number
Contribution per car Contribution
of cars sold
Increases
and contribution
per car increase, Number of cars sold Cars Sold
Increases
profit should
increase. Customer satisfaction
with options

Number of Time to
options available install option

Employee skills in
installing options
57

End of Chapter 11