Performance Measurement in Decentralized Organizations Learning Objectives Define

Performance Measurement in Decentralized Organizations

Learning Objectives • Define decentralization and identify its advantages and disadvantages • Differentiate between cost centers, profit centers, and investment centers, and explain how performance is measured in each • Analyze segment profitability based on return on investment (ROI) and residual income (RI) • Understand the strength and weaknesses of ROI relative to RI • Understand balanced scorecard and its uses

Advantage of Decentralization Benefits of decentralization, i. e. , spreading decision making authority throughout the organization: • Top management can 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

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

Responsibility Centers Decentralized companies segment/divide their operations into: – Cost centers – Profit centers – Investment centers

Cost, Profit, and Investments Centers Co st Cost Center A segment whose manager has control over costs, but not over revenues or investments.

Cost, Profit, and Investments Centers Revenues Profit Center A segment whose manager has control over both costs and revenues, but no control over investments. Sales Interest Other Costs Mfg. costs Commissions Salaries Other

Cost, Profit, and Investments Centers Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets. Television Division

Cost, Profit, and Investments Centers Cost Center Profit Center Investment Center Cost, profit, and investment centers are all known as Responsibility responsibility Center centers, meaning they have control over cost, profit, or investment.

Measuring Management Performance • Cost centers are evaluated either in terms of meeting standards or measures of continuous improvement. • Profit centers are evaluated in terms of meeting sales and cost objectives. • Investment centers are evaluated in terms of rate of return on invested capital, or residual income.

Return on Investment (ROI) Net operating income ROI = Average operating assets • Operating income is income before interest and taxes (EBIT). • Operating assets include cash, receivables, inventory, and other productive assets. • Most companies use book value (not cost) of assets.

Return on Investment (ROI) ROI = Net operating income Sales (Margin) * * Sales Average operating assets (Turnover) • Margin is a measure of the ability to control costs. • Turnover is a measure of the efficiency in the use of assets. • Margin by itself overlooks a crucial area of management’s responsibility: control of investment in operating assets.

Return on Investment (ROI) – Example • A division of Regal Company reports the following: – Net operating income $30, 000 – Sales 500, 000 – Average operating assets 200, 000 ROI = Margin * Turnover = $ 30, 000 $500, 000 * $500, 000 $200, 000 = 6% * 2. 5 = 15%

Improving the ROI • There are three ways to improve ROI: – Increase sales – particularly significant because it can affect the margin and the turnover – Reduce expenses – often the easy route is to cut the fat – Reduce operating assets – reduce receivables, inventory, etc. • For example, if Regal was able to increase advertising, increasing sales to $600, 000 and increasing operating income to $42, 000, then: – ROI = 7 % * 3. 0 = 21%

Let’s get to work on my ROI. . .

Criticism of ROI • Managers may reject profitable investment projects that reduce their segments’ ROI. • ROI tends to emphasize short-term rather than long-term profitability. – Managers may not replace old assets on a timely basis • ROI is not consistent with the cash flow models used for evaluating capital expenditures. • ROI may not be fully controllable by segment managers because of committed costs.

Residual Income – Another Measure of Performance • Residual income (RI) is the net operating income above some minimum return on operating assets. • Residual income is closely related to economic value added (EVA). • The objective under this approach is to maximize the residual income.

Residual Income – Another Measure of Performance • For example, a division of Regal Company reports the following: – Average operating assets $100, 000 – Operating income 30, 000 – Required rate of return 20% Computation of residual income: – Actual return $ 30, 000 – Required return ($100, 000 * 20%) 20, 000 – Residual income $ 10, 000

Advantages and Disadvantages of Residual Income • Residual income approach overcomes the main (first) objection to ROI approach. • RI for segments, however, cannot be compared.

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%

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% ROI = NOI/Average operating assets c. 15% = $60, 000/$300, 000 = 20% d. 20%

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

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 ROI = $78, 000/$400, 000 = 19. 5% b. No This lowers the division’s ROI from 20. 0% down to 19. 5%.

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

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 The return on the investment b. No exceeds the minimum required rate of return.

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

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 Net operating income $60, 000 c. $ 15, 000 Required return (15% of $300, 000) (45, 000) Residual income $15, 000 d. $ 51, 000

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

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 Net operating income $78, 000 Required return (15% of $400, 000) (60, 000) b. No Residual income $18, 000 Yields an increase of $3, 000 in the residual income.

The Balanced Scorecard Management translates its strategy into performance measures that employees understand accept. Customers Financial Performance measures Internal business processes Learning and growth

The Balanced Scorecard How do we look to the owners? In which internal business processes must we excel? How can we continually learn, grow, and improve? How do we look to customers?

The Balanced Scorecard Learning improves business processes. Improved business processes improve customer satisfaction. Improving customer satisfaction improves financial results.

The Balanced Scorecard: From Strategy to Performance Measures Financial Has our financial performance improved? Customer Do customers recognize that we are delivering more value? Internal Business Processes Have we improved key business processes so that we can deliver more value to customers? Learning and Growth Are we maintaining our ability to change and improve? What are our financial goals? What customers do we want to serve and how are we going to win and retain them? What internal business processes are critical to providing value to customers? Vision and Strategy

The Balanced Scorecard A balanced scorecard should have measures that are linked together on a cause-and-effect basis. If we improve one performance measure. . . Then Another desired performance measure will improve. The balanced scorecard lays out concrete actions to attain desired outcomes.

The Balanced Scorecard and Compensation Incentive compensation should be linked to balanced scorecard performance measures.

The Balanced Scorecard Example Profit Financial Contribution per car Number of cars sold Customer satisfaction with options Internal Business Processes Learning and Growth Number of options available Time to install option Employee skills in installing options

The Balanced Scorecard Example Profit Contribution per car Number of cars sold Customer satisfaction with options Strategies Increase Options Increase Skills Number of options available Time to install option Employee skills in installing options Results Satisfaction Increases Time Decreases

The Balanced Scorecard Example Profit Contribution per car Results Number of cars sold Customer satisfaction with options Number of options available Time to install option Employee skills in installing options Cars sold Increase Satisfaction Increases

The Balanced Scorecard Example Profit Results Contribution per car Contribution Increases Number of cars sold Customer satisfaction with options Number of options available Time to install option Employee skills in installing options Satisfaction Increases Time Decreases

The Balanced Scorecard Example Results Profit If number of cars sold and contribution per car increase, profits increase. Profits Increase Contribution per car Number of cars sold Customer satisfaction with options Number of options available Time to install option Employee skills in installing options Contribution Increases Cars Sold Increases