PERFORMANCE EVALUATION AND THE BALANCED SCORECARD CHAPTER 10
PERFORMANCE EVALUATION AND THE BALANCED SCORECARD CHAPTER 10 Professor Garvin, JD; CPA – ACG 2071
2 Centralized and Decentralized Operations Centralized Decision making and planning Application base Advantages Disadvantages Decentralized Owner/Manager Delegated to unit managers Small scope of operations Business characteristic - Geographic area, product line, customer base, business function, other. • Avoids duplication of costs • Simplifies goal congruence • Frees management time • Uses experts knowledge • Improves Customer Relations • Vast training and experience • Increases managers’ motivation and retention • Limits management time • Managers knowledge limited • Customer Relations strained • Costly Training for one • Duplicates certain costs or assets • Problems with Goal Congruence
3 Performance Evaluation Systems Provide management with feedback To be effective, should � Clearly communicate expectations to all employees � Provide benchmarks that promote goal congruence & coordination between operating segments (divisions/departments) � Motivate segment managers � Provide feedback
Responsibility Accounting 4 Responsibility Center � Part of an organization whose manager is accountable for planning & controlling activities Responsibility Accounting � System for evaluating performance of each responsibility center and its manager
Responsibility Centers 5 Responsibility Center Manager is responsible for… Examples Cost Center Controlling Costs Production line at Dell computer Revenue Center Generating Sales Revenue Midwest sales region at Pepsi Beverage Div. Profit Center Producing profit through generating sales and controlling costs Gainesville Macy’s Manager Investment Center Producing profit and managing the Company divisions such as Walt division’s invested capital Disney World Resorts
6 Responsibility Center Performance Reports Performance Report � Compares actual revenues & expenses to budget Variance � Difference between actual and budget Favorable variance: difference causes operating income to be higher than budgeted Unfavorable variance: difference causes operating income to be lower than budgeted
7 Responsibility Center Performance Reports Management by exception � Only investigate budget variances that are material � Focuses management attention where needed � Should not be used to blame but explain
8 Responsibility Accounting Performance Reports MANAGER—Pace Mexican Sauces QUARTERLY PERFORMANCE REPORT (in millions of dollars) Revenue and Expenses Actual Variance Favorable/ (Unfavorable) Budget Variance %* Sales revenue $84 $80 $ 4 5% F Cost of goods sold (30) (36) 6 16. 7% F Gross profit 54 44 10 22. 7% F Marketing expenses (9) (12) 3 25% F Research & development exp (3) (2) (1) 50% U Other expenses (4) (5) 1 20% F $38 $25 13 52% F Operating Income *Calculated as variance divided by budgeted amount
VP: U. S. SAUCES & BEVERAGES; Quarterly Performance Report Operating Income of Product Lines 9 Prego Pasta Sauces Actual Variance Fav. /(Unf. ) Budget Variance % $18 $20 $ (2) 10% U Pace Mexican Sauces 38 25 13 52% F V 8 Vegetable Juices 15 10 5 50% F Campbell's Soups 13 15 (2) 13. 3% U Operating Income $84 $70 14 20% F CEO’S QUARTERLY PERFORMANCE REPORT Operating Income of Divisions and Corporate Headquarters Expense North American Foodservice Actual Budget Variance Fav. /(Unfav. ) Variance % $209 $218 $ (9) 4. 1% U U. S. Soups, Sauces and Beverages 84 70 14 20% F Baking and Snacking 87 79 8 10% F International Soups, Sauces & Beverages 34 35 (1) 2. 9% U (29) (33) 4 12. 1% U $385 $369 16 4. 3% F Corporate Headquarters Expense Operating Income
10 Identify Types of Responsibility Centers a. The Bakery Department of a Publix supermarket reports income for the current year. b. Pace Foods is a subsidiary of Campbell Soup Company. c. The Personnel Department of State Farm Insurance Companies prepares its budget and subsequent performance report on the basis of its expected expenses for the year. d. The Shopping site Burpee. com reports both revenues and expenses.
11 Identify Types of Responsibility Centers e. Burpee. com’s investor relations Web site provides operating and financial information to investors and other interested parties. f. The manager of a BP service station is evaluated based on the station’s revenues and expenses. g. A charter airline records revenues and expenses for each airplane each month. Each airplane’s performance report shows its ratio of operating income to average book value. h. The manager of the Southwest sales territory is evaluated based on a comparison of current period sales against budgeted sales.
Using Flexible Budgets to Evaluate Performance 12 Static budget – (Master Budget) prepared for one level of sales volume, not adjusted for actual level of production/sales Flexible budgets - prepared for different levels of volume. Variance - difference between actual results and the budget
Static Budget 13 Co. installs in-ground pools. Master Budget below based on installing 8 pools next year. Actual Results Output units Sales Revenue Expenses Operating Income 10 $ 121, 000 (105, 000) $16, 000 Static (Master) Results 8 $ 96, 000 (84, 000) $12, 000 Static Budget Variance 2 $ 25, 000 F (21, 000) U $ 4, 000 F
14 Flexible Budget Performance Report Units Produced Actual Flexible Budget Variance 10 10 -0 - Variable Costs $ 83, 000 $ 80, 000 $ 3, 000 U Fixed Costs 22, 000 20, 000 2, 000 U Total Costs $105, 000 $ 100, 000 5, 000 U
Flexible Budget 15 Summarized budgets prepared for different levels of volume Flexible budgets can help managers answer such questions as Why did the unfavorable expense variance occur? � Were materials wasted? � Did the cost of materials suddenly increase? � How much of the additional expense and revenues arose because of a change in a business decision? �
Flexible Budgets for Planning 16 Kool-Time Pools Flexible Budget, Month Ended June 30, 2012 Flexible Budget per output unit 5 8 11 Sales Revenue $12, 000 $60, 000 $96, 000 $132, 000 Variable Expenses $8, 000 40, 000 64, 000 88, 000 Fixed Expenses 20, 000 Total Expenses 60, 000 84, 000 108, 000 Operating Income $ $12, 000 $24, 000 0 Flexible budget total cost = (number of output units * V. C. /unit) + F. C.
Using Flexible Budgets for Evaluating Performance 17 Use flexible budgets at the end of the period to evaluate the company’s financial performance and help control costs Compare the actual results against the flexible budget for the actual volume of output that occurred during the period
Static Budget Variances 18 Actual Results Flexible Budget based on actual number of outputs Flexible Budget Variance Static Budget based on expected number of outputs Sales Volume Variance Static Budget Variance Sales Volume Variance Flexible Budget (for # units actually sold) minus to be sold) Flexible Budget Variance Actual Results Static Budget (for # units expected Flexible Budget minus (for # units actually sold)
Kool-Time Pools Income Statement Performance Report (in thousands), For Month Ending June 30 1 2 (1 -3) 3 4 (3 -5) 5 Act. Results Flex Bud-Act # Sales Volume Master at Act Prices Variance Units Variance Static Budget 19 Output units Sales rev. 10 -0 - 10 2 F 8 $121, 000 $1, 000 F $120, 000 $24, 000 F $96, 000 Variable exp. 83, 000 U 80, 000 16, 000 U 64, 000 Fixed exp. 22, 000 U 20, 000 -0 - 20, 000 Total exp. 105, 000 U 100, 000 16, 000 U 84, 000 Op. income $16, 000 $4, 000 U $20, 000 $8, 000 F $12, 000 Col. 5 – Static Master Budget-based on producing 8 pools: Rev(VC)(FC)=Operating Inc (prepared before month starts) – Static Budget Col. 1 – Actual results: Rev (VC)(FC)= Operating income (prepared after month end) Col. 3 – Developed at end of month, flexible budget #s based on actual prod. -10 pools (prepared using Total Cost Equation)
Interpreting the Variances 20 Favorable variances, favorable because they increase operating income. � Higher sales price, higher sales volume than budgeted � Lower expenses than budgeted Unfavorable variances, unfavorable because they decrease operating income. � Lower sales price or volume than budgeted � Higher expenses than budgeted
21 Co. budgeted sales of 145, 000 units at $8/unit. Actual sales were 140, 000 units at $9. 50/unit. Variable exp. were budgeted at $2. 20/unit & actual var. exp. were $2. 30/unit. Actual fixed exp. of $420, 000 exceeded budgeted F. C. by $20, 000. Prepare and analyze Income Statement Performance Report Manion Industries: Income Statement Performance Report (in thousands) Act. Results at Act Prices 140 Output units -0 - Flex Bud-Act Sales Volume # Units Variance Static Budget 140 5 U 145 $210 F $1, 120 b $40 U 308 400 e 11 F 319 420 14 U 20 U -0 - 400 Fixed exp. 742 34 U 708 11 F 719 Total exp. $ 588 $176 F $412 $29 U $441 Sales rev. Variable exp. $1, 330 Flex Bud Variance 322 a d $1, 160 c f Op. income a. 140, 000 x $9. 50, b. 140, 000 x $8, c. 145, 000 x $8, d. 140, 000 x $2. 30, e. 140, 000 x $2. 20, f. 145, 000 x $2. 20
Compute Sales Volume and Flexible Budget Variances 22 Manion Industries Income Statement Performance Report (in thousands) Actual Results at Actual Prices Op. income $588 Flexible Budget Variance $176 F Flex Bud. Actual # Units $412 Sales Volume Variance $29 U Static Budget $441 Static (Master)Budget Variance $147, 000 F Static Budget Variance: Combination of Flexible Budget Variance & Sales Volume
Investment Centers 23 Financial evaluation must measure � Income generated & � Effective use of center’s assets Performance measures � Return on investment (ROI) � Residual income (RI) � Economic value added (EVA)
24 Evaluating Investment Centers with ROI Gator Sporting Goods, Inc. Segmente d Income Statement s For Year Ending 12/31 Fall Sports Div. Spring Sports Div. Camping Div. Sales Revenue $20, 000 $34, 000 $29, 000 COGS 6, 000 11, 000 10, 000 Gross Margin $14, 000 $23, 000 $19, 000 Allocated O/H 1, 205 2, 048 1, 747 S, G & A expenses 9, 500 16, 000 15, 000 Operating Income $ 3, 295 $ 4, 952 $ 2, 253 Income Tax Expense 989 1, 486 676 Net Income $ 2, 306 $ 3, 466 $ 1, 577 Sales Margin Ratio 16. 5% 14. 6% 7. 8%
25 Evaluating Investment Centers With ROI is one of primary tools for evaluating the performance of investment centers � ROI is ratio of income to invested capital ROI = Investment Center Income (Operating Income) Invested Capital (Total Assets) Ex: Div. 1 & 2 both have operating income of $100, 000. Div. 1 investment in assets of $1 m Div. 2 investment in assets of $500, 000 Div 1 ROI = $100, 000 ÷ $1 m = 10% Div 2 ROI = $100, 000 ÷$500, 000 = 20%
Return On Investment (ROI) 26 Operating income Total assets Or Operating income Sales X Sales Total assets Sales margin ratio X Capital turnover ratio
Evaluating Divisions with ROI 27 Advantages: Expanded equation provides additional information � Evaluate divisional profit relative to level of inv in that Division How efficient did divisional mgr. use assets already invested? Can be used to compare across divisions & w/other Co. 's Useful for future resource allocation
Evaluating Divisions with ROI 28 Drawbacks: Invested capital (total assets) based on historical costs & NBV (Cost < Accumulated Depreciation) As assets become fully depreciated, measure of asset (NBV) becomes lower, resulting in higher ROI � This can make comparisons of different divisions difficult (depends on whether Division’s assets are newer or older) � Divisional Mgrs. may put off purchase of new equipment, leading to underinvestment � Using only ROI provides incentive to select only projects that are expected to increase Division’s ROI
Decision Making with ROI 29 Manager of Division evaluated based on ROI. L/Y Div. ROI was 15%. Would Manager take on Project that would probably have ROI of 12% & provide increased profitability and increased S/H value to Company, if cost of capital to Co. is 10%? Cost of Capital = Average of cost of debt & equity
30 Compute Each Division’s ROI Toro, manufacturer of lawn-mowing & snowblowing equip. segments its bsn according to customer type: Professional & Residential. Following is divisional info from L/Y: Sales Op. Inc. Total Assets Curr. Liab. Residential $ 635, 500 $ 63, 500 $205, 000 $ 70, 000 Professional $1, 031, 250 $165, 000 $375, 000 $150, 000 Assume management has a 25% target rate of return for each division. Assume Toro’s weighted average cost of capital is 15% and effective tax rate is 30%. ROI = Operating Income ÷ Total Assets Professional: $165, 000 ÷ $375, 000 = 44% ROI Residential: $63, 500 ÷ $205, 000 = 31% ROI
Compute Each Division’s Sales Margin and Interpret Results (continued) 31 Sales Margin Ratio = Operating income ÷ Sales Professional: $165, 000 ÷ $1, 031, 250 = 16% Sales Margin Ratio Prof Div. earns 16¢ on every $1 of Sales Revenue Residential: $63, 500 ÷ $635, 500 = 10% Sales Margin Ratio Res. Div. earns 10¢ on every $1 of Sales Revenue
Calculate Each Division’s Capital Turnover Ratio (continued) 32 Capital Turnover Ratio = Sales ÷ Total Assets Professional: $1, 031, 250 ÷ $375, 000 = $2. 75 Residential: $635, 500 ÷ $205, 000 = $3. 10 Interpret the results: Professional division generating approx. $2. 75 of sales for every dollar of assets invested in Division. Residential division even more efficient, generating approx. $3. 10 for every dollar of assets
33 Expanded ROI Formula (continued) Professional: Residential: 16 % x $2. 75 = 44% 10% x $3. 10 = 31% ROI ROI = Sales margin x Capital turnover Even though Residential division’s efficiency (as measured by the capital turnover) is higher than the professional division’s efficiency, the professional division’s profitability (as measured by the sales margin) is so much higher than residential sales margin, that it causes the professional division’s ROI to be much higher than the residential division’s ROI. Both profitability and efficiency affect each division’s ROI.
Residual Income (RI) 34 Compares division’s operating income with minimum operating income expected, given the size of the division’s assets Positive – income exceeds target rate of return Negative – income does not meet target rate of return RI = Operating income − Minimum acceptable income RI = Operating income − (Target rate of return x Total assets) Required Rate of Return based on several factors: Risk level of division’s business Interest rates if Co. getting money from borrowings Investor’s expectations Return being earned by other divisions General economic conditions
Economic Value Added 35 EVA Looks at a division’s RI through the eyes of the company’s primary stakeholders: its investors and longterm creditors. EVA considers: What income available to these stakeholders, the assets used to generate income for these stakeholders, and the minimum rate of return required by these stakeholders
RI vs. EVA 36 Both calculate whether the division created any income above and beyond expectations EVA = After-tax operating income − [(Total assets − Current liabilities) x WACC%] Differences: The EVA calculation uses after-tax operating income Total assets is reduced by current liabilities The WACC replaces management’s target rate of return
Calculate Each Division’s RI 37 Toro, manufacturer of lawn-mowing & snow blowing equip. segments its bsn according to customer type: Professional & Residential. Following is divisional info from L/Y: Sales Op. Inc. Total Assets Residential $ 635, 500 $ 63, 500 $205, 000 Curr. Liab. $ 70, 000 Professional $1, 031, 250 $165, 000 $375, 000 $150, 000 Assume management has a 25% target rate of return for each division. Assume Toro’s weighted average cost of capital is 15% and effective tax rate is 30%. Residual Inc = Op. Inc. – Minimum acceptable income Residual Inc = Op. Inc. - (Target rate of return x Total assets) Professional: $165, 000 - ($375, 000 x 25%) = $71, 250
38 Calculate Each Division’s EVA Toro, manufacturer of lawn-mowing & snow blowing equip. segments its bsn according to customer type: Professional & Residential. Following is divisional info from L/Y: Sales Op. Inc. Total Assets Curr. Liab. Residential $ 635, 500 $ 63, 500 $205, 000 $ 70, 000 Professional $1, 031, 250 $165, 000 $375, 000 $150, 000 Assume management has a 25% target rate of return for each division. Assume Toro’s weighted average cost of capital is 15% and effective tax rate is 30%. EVA = (After-tax operating income) – [(total assets – current liabilities) x
39 Profit Center Performance Reports Flexible budget for Act. Prod. Flexible budget variance $5, 243, 600 $5, 000 $243, 600 F 4. 9% F Operating expenses 4, 183, 500 4, 000 183, 500 U 4. 6% U Income from operations before service department charges 1, 060, 100 1, 000 60, 100 F 6. 0% F Service department charges (allocated) (84, 300) (75, 000) (9, 300) U 12. 4% U Operating Income $975, 800 $925, 000 $50, 800 F 5. 5% F Subunit X Sales Revenue Actual % Variance
40 Centralized Services to Divisions Top Management Decision: Provide centralized service departments? YE S NO Charge subunits for their use of centralized service departments? Centralized service department costs are allocated between subunits Subunits must provide or outsource their own services NO Centralized services are provided “free of charge”
41 Allocation of Service Department Cost The centralized payroll dept. for Gator Co. incurs annual costs of $3, 000. How should Gator Co. allocate the service dept. costs to its two divisions? Based on # of employees in each division or based on # of hours spent on processing payroll for each division? The following data relate to the potential allocation bases: Tallahassee Div. Gainesville Div Total # of employees 4, 000 8, 000 12, 000 emp. # of hours spent 30, 000 20, 000 50, 000 hrs.
42 Allocation of Service Department Cost Calculate costs allocated to each division using each allocation base. Comment on which allocation base is preferable. # of employees as an Allocation Base Tallahassee Division: = (4, 000/12, 000) x $3, 000 = $1, 000 Gainesville Division: = (8, 000/12, 000) x $3, 000 = $2, 000 # of hours as an Allocation Base Tallahassee Division: = (30, 000/50, 000) x $3, 000 =
Transfer Pricing 43 The price charged for the internal sale between two different divisions of the same company 2 of Ford Motor Co. ’s many Divisions: Battery Division (makes batteries for all Ford cars & trucks) Truck Division buys batteries from Battery Division What should price of Battery (transfer price) be? � Market Price? � Variable Cost? � Full Product Cost + Profit? � Negotiated Price? Both divisions of same Co. , so intercompany sales revenue not recognized on F/Sts �
44 Transfer Pricing and Income Taxes Why would Co. such as Microsoft or Pfizer sell a patent to a subsidiary in a low tax country such as Ireland at a below-market-value price? Incentive is to avoid taxes. Suppose Microsoft sells a patent worth $10 m to a sub in Ireland for $1 million. Tax rate in U. S. is 35 %, tax rate in Ireland is 12. 5%. With this arrangement, U. S. parent Co. deducts research & dev. expenses in U. S. saving 35% of the cost, and it recognizes little taxable revenue on the sale of the intellectual property. Meanwhile, if the subsidiary in Ireland is able to license the technology to other companies, the related revenue will only be taxed at 12. 5% According to a survey by Ernst & Young, “transfer pricing is the top tax issue facing multinational corps. Of the international tax directors at 582 multinational organizations polled in the survey, 75% expect their company to face a transfer-pricing audit by the IRS within the next two years. IRS very concerned that Co. 's use transfer pricing manipulations to shift income from high tax jurisdictions (U. S. ) to low tax jurisdictions.
45 Limitations of Financial Performance Measures Measurement issues � Total Assets beginning or end of year � All Assets or exclude nonproductive assets � Use Gross Book Value vs Net Book Value Short-term focus � Time frame of one year or less Management needs both: � Lag indicators – reveal results of past actions/decisions � Lead indicators – predict future performance
Balanced Scorecard 46 Measure company’s activities in terms of its vision and strategies Financial and operational performance measures are considered � Financial performance & � Customer satisfaction � Operational efficiency � Employee excellence Link company goals to key performance indicators (KPIs)
Balanced Scorecard 47 COMPANY GOALS CRITICAL FACTORS (customer satisfaction, operational efficiency, employee excellence, financial profitability) KEY PERFORMANCE INDICATORS (KPIs) (market share, yield rate, employee training hours, revenue growth)
Four Perspectives 48 Financial perspective � How do we look to shareholders? Customer perspective � How do customers see us? Internal business perspective; Operational Efficiency � At what business processes must we excel to satisfy customer and financial objectives? Learning & growth perspective; Employee Excellence
49 Classify KPI’s by Balanced Scorecard Perspective Financial perspective; customer perspective, internal business (operational efficiency) perspective; learning & growth perspective (employee excellence) a. Number of customer complaints b. # of information system upgrades (to provide timely info to employees) completed c. Economic Value Added (EVA) d. New product development time e. Employee turnover rate f. Percentage of products with online help manuals g. Customer retention h. Percentage of compensation based on performance i. Percentage of orders filled each week j. Gross margin growth
50 Summary Performance Measures for Investment Centers Return on Investment (ROI) ROI = Operating income Total assets • Useful for resource allocation • Mgt can compare ROI across divisions & w/other Cos. • Expanded equation provides Div. Mgr w/info on how to improve ROI: cutting These three measures take into consideration: 1. The division’s operating income 2. The division’s assets Residual Income (RI) RI = Operating income − Minimum acceptable income • Promotes goal congruence better than ROI • Incorporates Mgt’s minimum rate of return • Mgt can use different target rates of return for divisions w/different levels Economic Value Added (EVA) EVA = After-tax operating income − [(Total assets − Current liabilities) WACC%] • Considers income generated for investors & long-term creditors in excess of their expectations • Promotes goal congruence
END OF SEGMENT Professor Garvin, JD; CPA – ACG 2071
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