Performance Evaluation and the Balanced Scorecard Chapter 24

Learning Objectives Explain why and how companies decentralize Explain why companies use performance evaluation systems Describe the balanced scorecard and identify key performance indicators for each perspective Use performance reports to evaluate cost, revenue, and profit centers Use ROI, RI, and EVA to evaluate investment centers 2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1 Explain why and how companies decentralize 3 Copyright © 2012 Pearson Education, Inc.

Management Pyramid CEO, Top Controller, Sales Mngr. Plant Mngr. CFO, Vice Pres. Mid-Level Supervisors Front Line/Supervisory Foremen Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Why is decentralization happening? Catch Global Competition Speed & efficiency Flat vs. vertical hierarchy Market centric management Requires decentralization of management How do we measure the performance of each segment? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Advantages and Disadvantages of Decentralization Advantages: Frees top management time Supports use of expert knowledge Improves customer relations Provides training Improves motivation and retention Disadvantages: Duplication of costs Problems achieving goal congruence 7 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Responsibility Centers A responsibility center is a part or subunit of an organization whose manager is accountable for specific activities (recall from Chapter 22) 8 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2 Explain why companies use performance evaluation systems 9 Copyright © 2012 Pearson Education,

Performance Measurement Provide a framework for performance based leadership Everyone involved needs to know if they are meeting company goals Decentralized organizations need system to communicate goals to subunit managers Primary goals: Promoting goal congruence and coordination Communicating expectations Benchmarking Providing feedback Motivating unit managers 10 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Limitations of Financial Performance Measures Traditional systems revolved almost entirely around financial performance Ultimate goal of a company is to generate profit Financial measures follow performance, not create it Just win baby leads to trouble Better to measure what causes performance Management needs lead indicators Find out what causes success, and measure that Strong indicators of future success, not just past success Top management needs signals that assess and predict performance over longer periods of time 11 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

3 Describe the balanced scorecard and identify key performance indicators for each perspective 13

Balanced Scorecard A major shift in corporate performance measurement Recognizes that financial measures are only one type of measure among many Uses key performance indicators (KPI) Management needs to consider other critical factors: Customer satisfaction Operational efficiency Employee excellence AND of course, financial performance Measures should be linked with company goals and strategies 14 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Four Perspectives of the Balanced Scorecard 16 Copyright © 2012 Pearson Education, Inc. Publishing

Financial Perspective How do we look to shareholders? Ultimate goal is to generate income for owners Strategy revolves around increasing the company’s profits, for example: Increasing revenue growth Introducing new products, gaining new customers, and increasing sales Increasing productivity/profitability Reducing costs and using the company’s assets more efficiently KPIs: Sales revenue growth Gross margin growth Return on investment 17 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Customer Perspective How do customers see us? Top priority for long-term success Customer satisfaction critical to achieving the company’s financial goals Typical customer concerns: Product price Product quality Sales service quality Product delivery time KPIs: Customer satisfaction Market share and increasing number of customers Repeat customers Rate of on-time deliveries 18 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Internal Business Perspective What business processes must we excel in to satisfy customer and financial objectives? Three factors critically affect customer satisfaction: Innovation—must continually improve existing products and develop new products Operations—lean and effective internal operations, product efficiency and product quality Post-sales service—service customers after the sale Sample KPIs: The number of new products developed or new-product development time The number of units produced per hour and defect rate The number of warranty claims received, average repair time, and average wait time 19 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Learning and Growth Perspective How can we continue to improve and create value? Measures employee skills, knowledge, motivation, and empowerment Employee capabilities–skilled, positive culture , and up-to-date technology System capabilities–must have accurate information on customers, internal processes, and finances Corporate culture–supports communication, change, and growth KPIs: Hours of employee training, employee satisfaction and turnover, and number of employee suggestions implemented Percentage of employees with access to customer data and percentage of processes with real-time feedback Employee turnover rate 20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Balance Scorecard Application Cases Four Teams of victims: Case 1 Case 2 Case 3 Case 4 List possible “Gaming” approaches by people trying to achieve the new goal. Create a balanced scorecard approach considering your experience above & explain why it will align behavior with the well being of all involved. Financial Customer Internal processes Learning/Growing Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

4 Use performance reports to evaluate cost, revenue, and profit centers 25 Copyright ©

Performance Reports Capture the financial performance of cost, revenue, and profit centers Look for large variances in % and $$$ Cost center Includes information on actual traceable costs versus budgeted costs Revenue center Includes actual revenue versus budgeted revenue Profit center Includes actual and budgeted information on both revenues and costs 26 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Cost Center Performance Report Control costs 27 Copyright © 2012 Pearson Education, Inc. Publishing

Revenue Center Performance Report Generating sales revenue 28 Copyright © 2012 Pearson Education, Inc.

Profit Center Performance Report Producing profit through generating sales and controlling costs 29 Copyright

Performance Reports Use management by exception to determine which variances are worth investigating Investigate material variances first Don’t play the blame game Focus on understanding underlying reasons for performance and take corrective action The numbers indicate where to start action They are not an excuse to blame and torture Recognize some variances are uncontrollable 30 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

5 Use ROI, RI, and EVA to evaluate investment centers 31 Copyright © 2012

Investment Centers Managers are responsible for: Maximizing earnings Minimizing assets utilized to minimize financing required How can we measure to two counter goals? Basic: Use a ratio to compare the two items ROI = Return ÷ Investment Complex: Use residuals to assess earnings Performance measures: How much operating income the division is generating How efficiently the division is using its assets KPIs 32 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

KPIs for Investment Centers 33 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice

Evaluating Segment Performance: ROI and Residual Income Both methods are useful in evaluating the performance of investment centers. ROI is size-independent, easily comparing small to large divisions. Residual income removes a curious side effect of ROI which leads managers to sometimes decline profitable projects. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Return on Investment (ROI) Formula Income earned by the segment ROI = Operating income Average total assets Cash, accounts receivable, inventory, plant and equipment, and other productive assets. (L+OE) Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Return on Investment (ROI) Basic Formula Royal Division reports the following: Operating income $ 30, 000 Average total assets $ 200, 000 Sales $ 500, 000 ROI = $30, 000 $200, 000 = 15% Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Controlling the Rate of Return Three ways to improve ROI. . . Increase Sales ROI = Reduce Expenses Reduce Assets Operating income Average total assets Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Managing the Rate of Return Using The Du. Pont Method ROI = Profit margin Asset turnover This expanded equation allows a quick view of two determinates of Return on Investment: Profit Margin: Does a healthy portion of sales make it to the bottom line? Expense control. Pricing power. Asset Turnover: Are our assets used efficiently to generate sales volume? Lean assets. Strong sales. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Using the Du Pont Framework Royal division reports the following: Operating income $ 30, 000 Average total assets $ 200, 000 Sales $ 500, 000 ROI = 15% = = Profit margin $30, 000 $500, 000 x 6% x Asset turnover $500, 000 $200, 000 250% Royal division Boosts operating income to $50, 000 by cutting expenses ROI = $50, 000 $500, 000 x 25% = 10% x 39 $500, 000 $200, 000 250% Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Using the Du Pont Framework Royal division reports the following: Operating income $ 30, 000 Average total assets $ 200, 000 Sales $ 500, 000 ROI = 15% = = Profit margin $30, 000 $500, 000 x 6% x Asset turnover $500, 000 $200, 000 250% Royal division Boosts operating income to $50, 000 by Raising Sales $333, 333 ROI = 25% = 40 $50, 000 $833, 333 6% x x $833, 333 $200, 000 417% Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Using the Du Pont Framework Royal division reports the following: Operating income $ 30, 000 Average total assets $ 200, 000 Sales $ 500, 000 ROI = 15% = = Profit margin $30, 000 $500, 000 x 6% x Asset turnover $500, 000 $200, 000 250% Royal division Boosts ROI to 25% by eliminating non-productive assets ROI = 25% = 41 $30, 000 $500, 000 6% x x $500, 000 $120, 000 ? #2 ? #1 417% Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Using the Du Pont Framework Royal division reports the following: Operating income $ 30, 000 Average total assets $ 200, 000 Sales $ 500, 000 ROI = 15% = = Profit margin $30, 000 $500, 000 x 6% x Asset turnover $500, 000 $200, 000 250% Benchmarking Royal Division’s performance against company standards 25% = ROI = 42 8% $44, 000 $550, 000 x 313% x $550, 000 $175, 718 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Extreme Sports Company has two divisions based on the climate required for the sporting goods they sell: Snow sports and Nonsnow sports. The following divisional information is available for the past year: Sales Snow sports Non-snow sports Operating Income Average Total Assets Current Liabilities ROI $ 5, 500, 000 $ 935, 000 $ 4, 500, 000 $ 420, 000 20. 8% 8, 400, 000 1, 428, 000 6, 700, 000 695, 000 21. 3% 1. Calculate their ROI using the Du. Pont method. Compare the profitability of both segments Compare the asset turnover of both segments Compare and interpret the two segments’ overall ROI performance 43 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Extreme’s management has specified a 16% target rate of return. The company’s weighted average cost of capital (WACC) is 10% and its effective tax rate is 38%. 1. Calculate each division’s profit margin. Interpret your results. Profit Margin = Operating Income ÷ Sales Operating income ÷ Sales Profit margin Snow Sports Non-snow Sports 935, 000 1, 428, 000 ÷ 5, 500, 000 ÷ 8, 400, 000 17% Interpret: Both divisions had 17% sales margins. This means that both divisions were able to earn $0. 17 of income on each dollar of sales. In other words, they were both equally profitable on sales. 44 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Refer to the information in S 24 -7. 1. Compute each division’s asset turnover (round to two decimal places). Interpret your results. Asset Turnover = Sales ÷ Total Assets Sales ÷ Total assets Asset turnover Snow Sports Non-snow Sports 5, 500, 000 8, 400, 000 ÷ 4, 500, 000 ÷ 6, 700, 000 1. 22 (rounded) 1. 25 (rounded) Interpret: The Non-snow Sports Division had a higher asset turnover (1. 25) than the Snow Sports Division (1. 22). This means that the Non-snow Sports Division was able to generate $1. 25 of sales for every dollar of assets invested in the division, whereas the Snow Sports Division was able to generate $1. 22 for every dollar of assets invested. The Non-snow Sports Division was able to use its assets more efficiently to generate sales revenue. The higher asset turnover accounts for its higher ROI. 45 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Refer to the information in S 24 -7. 2. Use your answers to Requirement 1, along with the profit margin, to recalculate ROI using the expanded formula. Do your answers agree with the basic ROI in S 24 -7? ROI = Sales Margin × Asset Turnover Profit margin (from S 23 -7) × Asset turnover (from part 1) ROI Snow Sports 17% × 1. 22 (rounded) 20. 7% Non-snow Sports 17% × 1. 25 (rounded) 21. 3% The results of the expanded ROI formula agree, with slight rounding variance, to those found using the simple ROI formula. 46 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

ROI Recap A division with a higher ROI is performing better more likely to receive extra funds, putting more assets under the control of the more successful managers Lower ROE divisions may be under more operational scrutiny, or divestment pressure Drawback to using ROI Tempts management to choose only projects that meet or exceed current ROIs Rejecting profitable projects may be harmful to the company 47 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Exploring an ROI shortcoming As division manager your pay includes a bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus. The company wide ROI stands at 15% -- your division has a much higher ROI. You rather like your enormous bonus checks. You have an opportunity to add a new product line in your division that will produce an ROI greater than 15%, but lower than your division’s ROI. What is this new product line going to do to your division’s ROI? To your bonus? Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Residual Income (RI) This KPI better aligns incentives with business goals Compares segment profits with profits at the required rate of return Positive–income exceeds target rate of return Negative–income does not meet target rate of return General formula: Applicable formula: 51 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

ROI, Example of the problem with it Copyright © 2012 Pearson Education, Inc. Publishing

Criticisms of ROI Gee. . . I thought we were supposed to do what was best for the company! As division manager, I wouldn’t invest in that project because it would lower my pay! Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Residual Income – Core Concept Reminder RI Measures operating income above the minimum acceptable operating income as established by the target ROI Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Calculating Residual Income and Comparing to ROI: Note 12% required rate of return Copyright

Why Use Residual Income? Benefits: Promotes goal congruence better than ROI, minimizes gaming Incorporates management’s minimum required rate of return Advantages: Divisions will be motivated to take the action that top management desires Can use different target rates of return for divisions with different levels of risk Disadvantages: 57 Complex, we fear change Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Extreme Sports Company has two divisions based on the climate required for the sport: Snow sports and Non-snow sports. The following divisional information is available for the past year: Sales Snow sports Non-snow sports Operating Income Average Total Assets Current Liabilities ROI $ 5, 500, 000 $ 935, 000 $ 4, 500, 000 $ 420, 000 20. 8% 8, 400, 000 1, 428, 000 6, 700, 000 695, 000 21. 3% Extreme’s management has specified a 16% target ROI. Calculate Extreme’s Residual Income for each segment and compare. 58 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Refer to the information in S 24 -7. 1. Compute each division’s RI. Interpret your results. Are your results consistent with each division’s ROI? RI = Operating income − Minimum acceptable income = Operating income − (Target rate of return × Total assets) Snow Sports RI = $935, 000 – ($4, 500, 000 × 16%) = $935, 000 – $720, 000 = $215, 000 Non-snow Sports RI = $1, 428, 000 – ($6, 700, 000 × 16%) = $1, 428, 000 - $1, 072, 000 = $356, 000 Both divisions have positive residual income. Positive residual income means that the divisions are earning income at a rate that exceeds management’s minimum expectations. This result is consistent with the ROI calculations. 59 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Economic Value Added (EVA) Special type of Residual income calculation Looks at a division’s residual income through the eyes of the company’s primary stakeholders Investors (Owners) Creditors (Bondholders) Uses a weighted-average cost of capital, instead of Non-investor perspective basis for calculating minimum ROI Calculating WACC Considerations: After-tax income available to stakeholders Very appropriate for whole company analysis Omit assets committed to paying current liabilities 60 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Economic Value Added Evaluated Compare the EVA equation with the RI equation Both calculate whether any operating income was above and beyond expectations Differences: EVA uses after-tax operating income (income available to stakeholders) EVA reduces average total assets by current liabilities (funds not available for generating income) Replace management’s target rate of return with WACC (rate of return expected by stakeholders) 61 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Extreme Sports Company has two divisions based on the climate required for the sport: Snow sports and Non-snow sports. The following divisional information is available for the past year: Sales Snow sports Non-snow sports Operating Income Average Total Assets Current Liabilities ROI $ 5, 500, 000 $ 935, 000 $ 4, 500, 000 $ 420, 000 20. 8% 8, 400, 000 1, 428, 000 6, 700, 000 695, 000 21. 3% The company’s weighted average cost of capital (WACC) is 10% and its effective tax rate is 38%. 1. Calculate each segment’s Economic Value Added. 64 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Refer to the information in S 24 -7. 1. Compute each division’s EVA. Interpret your results. Snow EVA = = Non-snow EVA = = ($935, 000× 62%) − [($4, 500, 000 − $420, 000) × 10%] $579, 700 − ($4, 080, 000 × 10%) $579, 700 − $408, 000 $171, 700 ($1, 428, 000 × 62%) − [($6, 700, 000 − $695, 000) × 10%] $885, 360 − ($6, 005, 000 × 10%) $885, 360 − $600, 500 $284, 860 Both divisions have positive economic value added (EVA). This means that the divisions are generating income for investors and long-term creditors at a rate that exceeds the expectations of these two groups of stakeholders. 65 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Final Exam tip time? 66 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice

Chapter 24 Summary As companies grow, they often decentralize by geographic area, product line, customer base, business function, or some other characteristic. Decentralization frees top management’s time by delegating decision making, supports the use of expert knowledge, improves customer relations, provides training for managers, and improves employee motivation and retention. Disadvantages of decentralization include possible cost duplications and difficulty achieving goal congruence among decentralized divisions. 67 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 24 Summary Performance evaluation systems provide top management with a framework for maintaining control over the entire organization once it is decentralized. Such systems should help management promote goal congruence, provide a tool for communications, motivate unit managers, provide feedback, and allow for benchmarking. These measures should not revolve around just financial performance measures, however. 68 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 24 Summary The balanced scorecard focuses performance measurement on progress toward the company’s goals in each of the four perspectives. In designing the scorecard, managers start with the company’s goals and its strategy for achieving those goals and then identify the most important measures of performance that will predict long-term success. Some of these measures are lead indicators, while others are lag indicators. Managers must consider the linkages between strategy and operations and how those operations will affect finances now and in the future. 69 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 24 Summary Responsibility accounting performance reports capture the financial performance of cost, revenue, and profit centers. They compare actual amounts to budgeted amounts to determine variances. Then, management investigates to identify if the cause of the variance was controllable or uncontrollable. Management can then make decisions to take corrective actions for controllable variances. 70 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 24 Summary To evaluate an investment center’s financial performance, companies need summary performance measures—or KPIs—that include both the division’s operating income and its assets. Commonly used KPIs for evaluating an investment center’s financial performance are return on investment (ROI), residual income (RI), and economic value added (EVA). Each of these financial KPIs must be considered in conjunction with KPIs that come from all four of the balanced scorecard perspectives. 71 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

72 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 73 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.