Performance Evaluation

Chapter 10
 Objective 1
Understand decentralization and describe
different types of responsibility centers

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 Decentralization
• Splitting operations into different operating segments
• Advantages
– Frees top management’s time
– Use of expert knowledge
– Improves customer relations
– Provides training
– Improves motivation and retention
• Disadvantages
– Duplication of costs
– Potential problems achieving goal congruence
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Performance Evaluation Systems
– Provide upper management with feedback
– To be effective, performance evaluation systems
should:
• Clearly communicate expectations
• Provide benchmarks that promote goal congruence
and coordination between segments
• Motivate segment managers

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 Responsibility Accounting
• Responsibility Center—part of an organization
whose manger is accountable for planning and
controlling activities.

• Responsibility Accounting—system for

evaluating performance of each responsibility
center and its manger.

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Types of Responsibility Centers

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 Objective 2
Develop performance reports

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Responsibility Center Performance Reports

• Performance report—Compares actual

revenues and expenses to budgeted figures
• Variance—Difference between actual and
budget
– Favorable variance: Causes operating income to be
higher than budgeted
– Unfavorable variance: Causes operating income to
be lower than budgeted
• Management by exception
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Exhibit 10-3: Partial Performance Report for
Revenue Center

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 Segment Margin
The operating income generated by a profit or
investment center before subtracting common
fixed costs that have been allocated to the
center.

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Exhibit 10-4: Performance Report Highlighting Segment Margin

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 Organization-Wide Performance Reports

• Performance reports for each level of

management flow up
• Controllable vs. uncontrollable variances

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 Objective 3
Calculate ROI, sales margin, and capital
turnover

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 Evaluation of Investment Centers
• Duties of investment center manager similar
to CEO
• To assess performance
– Return on Investment (ROI)
– Residual Income (RI)

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 Return on Investment (ROI)
• Measures the amount of income an
investment center earns relative to the size of
its assets
• ROI = Operating income
Total assets

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Sales Margin and Capital Turnover
• ROI = Operating income x Sales___
Sales Total assets

(ROI = Sales margin x Capital turnover)

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 S10-6

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 S10-6
Functional ingredients
• Sales margin $5,720 / $22,000 = 26.0%
• Capital turnover $22,000 / $10,000 = 2.2
• ROI 26.0% x 2.2 = 57.2%

Consumer markets
• Sales margin $2,675 / $21,400 = 12.5%
• Capital turnover $21,400 / $10,700 = 2.0
• ROI 12.5% x 2.0 = 25%

Performance markets
• Sales margin $4,810 / $18,500 = 26.0%
• Capital turnover $18,500 / $18,500 = 1.0
• ROI 26.0% x 1.0 Copyright
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 Residual Income
• Determines whether the division has created
any excess (residual) income above
management’s expectations
• Incorporates target rate of return

RI = Operating income - minimal acceptable income

RI = Operating income - (target rate of return x total assets)

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 S10-9

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 S10-9

Office wear = $35,000 – ($52,000  15%) = $27,200

Casual wear = $29,000 – ($48,000  15%) = $21,800

Both categories have positive residual income. This means that

the divisions are earning income at a rate that exceeds
management’s minimum expectations. This result is consistent
with the ROI calculations.

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 Goal Congruence
Residual Income enhances goal congruence,
whereas ROI may or may not

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 Measurement Issues
• Which balance sheet data should we use?
• Should we include all assets?
• Should we use gross book value or net book
value of the assets?
• Should we make other adjustments to income
or assets?

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 Limitations of Financial Performance
Evaluation
• Short-term focus
• Potential Remedy: management can measure
financial performance using a longer time
horizon
– Incentivizes segment managers to think long term
rather than short term

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 Objective 4
Describe strategies and mechanisms for
determining a transfer price

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 Transfer Pricing
• The price charged for the internal sale
between two different divisions of the same
company
• Encourage transfer only if the company would
benefit by the exchange
• Vertical Integration

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Exhibit 10-9: Strategies to Determine Transfer
Price

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 Global Considerations
• Do the divisions operate under different taxing
authorities such that income tax rates are
higher for one division?
• Would the amount paid to customs and duties
be impacted by the transfer price used?

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 Objective 5
Prepare and evaluate flexible budget
performance reports

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 Flexible Budget
• A budget prepared for a different level of volume than that which
was originally anticipated
• Master Budget Variance—Difference between the actual
revenues and expenses and the master budget
– “Apples-to-oranges” comparison

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Exhibit 10-11 Creating a Flexible Budget Performance Report

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 Volume Variance
• The difference between the master budget
and the flexible budget
– Arises only because the actual volume differs from
the volume originally anticipated in the master
budget

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Exhibit 10-12 Volume Variances

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 Flexible Budget Variance
The difference between the flexible budget and
the actual results

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Exhibit 10-13 Flexible Budget and Volume Variances

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Underlying Causes of the Variances
• Management by exception
• Use performance reports to see how
operational decisions affected company’s
finances

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Master Budget Variance: A Combination of
Variances

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 Objective 6
Describe the balanced scorecard and
identify KPIs for each perspective

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Nonfinancial Performance Measurement

• Lag indicators—Reveal the results of past

actions and decisions
• Lead indicators—Predict future performance

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 The Balanced Scorecard
• Management must consider both financial and
operational performance measures
• Major shift: Financial indicators are no longer
the sole measure of performance

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 Four Perspectives of the Balanced
Scorecard
• Financial
• Customer
• Internal business
• Learning and growth

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 Key Performance Indicator (KPI)
• Summary performance metric; assesses how
well the company is achieving its goals
• Continually measured
• Reported on performance scorecard or
performance dashboard

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 Financial Perspective
• “How do we look to shareholders?”
• Must continually attempt to increase profits
– Increase revenues
– Control costs
– Increase productivity

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 Customer Perspective
• “How do customers see us?”
• Customers concerned with four
product/service attributes:
– Price
– Quality
– Sales service
– Delivery time

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 Internal Business Perspective
• “At what business processes must we excel to
satisfy customer and financial objectives?”
• Three factors:
– Innovation
– Operations
– Post-sales support

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 Learning and Growth Perspective
• “Can we continue to improve and create
value?”
• Three factors:
– Employee capabilities
– Information system capabilities
– Company’s “climate for action”

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Sustainability and Performance Evaluation

• Sustainability—Related KPIs
• Fifth perspective—“Sustainability”
• Sixth perspective—“Community”

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End of Chapter 10

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All rights reserved. No part of this publication may be
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