Chapter 12

1. Chapter 12 Performance Evaluation in Decentralized Organizations

2. Decentralization Practice of delegating decisions to lower-level managers LO1: Explain costs and benefits of decentralization

3. Test Your Knowledge! The benefits of decentralization include all of the following except: • it forces top levels of management to focus on individual units. • it empowers more employees at lower levels of management. • it allows for better and more timely decision making. • it trains future managers. Decentralization does not force top levels of management to focus on individual units.

4. Organization Structure • A responsibility center is the smallest unit of analysis • Almost like a mini-business • Clearly defined goals and authority • We need to put in control systems • Induce “right” use of local knowledge • Induce coordination & cooperation with other responsibility centers • Ideally, a mix of financial (profit, sales) and non-financial (yield, customer satisfaction) measures • Incentive structure depends on unit being considered • Non-trivial to link performance measures to incentives LO1: Explain costs and benefits of decentralization

5. Aaron Knight, CEO Manager, New Jersey Region Manager, New York Region Manager, Westchester Region Staff Assistant Branches Branches BranchManagers Supervisor (Copies) Supervisor (PC) Copy Center Staff PC Center Staff Typical Organization Structure LO1: Explain costs and benefits of decentralization

6. Kinds of Responsibility Centers LO1: Explain costs and benefits of decentralization

7. Goal: minimize the cost of producing a specified level of output or the cost of delivering a specified level of service Efficiency of operations is the focus Examples Machining, assembly, the entire plant Human resources, advertising, general administration Cost Center LO1: Explain costs and benefits of decentralization

8. What can a cost center manager control? Mix of inputs for a given level of output Not responsible for final products and service How should we evaluate them? Budget-based comparison for financials Center specific non-financial measures Cost Center: Duties And Measures LO1: Explain costs and benefits of decentralization

9. Kinds Of Cost Centers • Engineered cost center • Clear relation between resources consumed and output • Machining or Assembly department • Flexible budget makes sense here • Quality, service, response time are all important Critical Success Factors (CSF) • Discretionary cost center • No clear relation between resources consumed and output • Legal, Accounting, R & D • Does not make sense to flex the budget • Non-financial measures gain more importance LO1: Explain costs and benefits of decentralization

10. Profit centers aim to both minimize costs and to maximize revenues. Regional centers Product line managers What can these managers control? Input mix, product mix, selling prices Profit center typical contains revenue and cost centers Profit Centers LO1: Explain costs and benefits of decentralization

11. How should we evaluate a profit center? Budgeted vs. actual profits Baseline is master budget as manager responsible for output as well Non-financials are more strategic in nature Issues to consider include: If system encourages local profit maximization as opposed to firm-wide profit maximization? How to price transfers across profit centers? Profit Centers: Evaluation LO1: Explain costs and benefits of decentralization

12. Investment Centers • Aim to maximize the returns from invested capital, or to put the capital invested by owners and shareholders of their organizations to the most profitable use. • Large independent divisions in organizations such as Sony, Siemens, Microsoft, and Proctor and Gamble. Decision rights • What decisions can managers make? • Input mix, product mix, selling prices, capital expenditures • How should we evaluate them? • Financials focus on Investment performance • Return on Investment, Residual Income, Economic Value Added • Non-financial measures less important • Focus on strategy implementation and long-term potential LO1: Explain costs and benefits of decentralization

13. Performance Evaluation • The controllability principle • Focus on costs and benefits that reflect the consequences of the actions taken by the decision maker. • Sales for marketing manager • Costs and quality for production manager • The informativeness condition • A performance measure is informative if it provides information about a manager’s effort, even if the manager does not have control over it • Helps to filter out the noise between effort and the outcome measure • Leads to relative performance evaluation • Grading on a curve (you cannot control the class average!) LO2: Apply the principles of performance measurement

14. Involves many related decisions How to reflect decision rights assigned to the responsibility center being evaluated? What is right time horizon to consider? How do define the measure? Is investment measured at gross or net book value, at replacement cost? Implementation requires more choices What is the target level of performance? What is the timing of feedback? Choosing A Performance Measure LO2: Apply the principles of performance measurement

15. Effective Measures • An effective measure • Aligns employee and organizational goals. • Yields maximum information about the decisions or actions of the individual or organizational unit. • Is easy to measure. • Is easy to understand and communicate • No single measure has all of these characteristics • Rely on multiple measures • Financial and non-financial • Portfolio approach LO2: Apply the principles of performance measurement

16. Short term measures Focus is on efficiency Non-financial measures for operational control Real time, actionable, disaggregate Variances Financial impact Trends and patterns Long term measures Focus is on effectiveness Trend in efficiency Kaizen Investments in future Training Evaluating Cost Centers LO3: Rate the performance of cost and profit centers

17. Short-term Less reliance on non-financial measures Budget- actual comparison More macro than cost center comparison Variances for spotting trends and patterns Long-term Growth measures Sales, profit and efficiency Drivers of future profitability Non-financial measures Measuring Profit Centers LO3: Rate the performance of cost and profit centers

18. Three widely used metrics Return on Investment (and variants) Residual Income Economic Value Added Measuring Investment Centers LO4: Evaluate the performance of investment centers

19. ROI = Income/Investment We find many variations of the above formula Income definitions typically used Operating income, Net Income Investment definitions typically used Total assets, total assets - current liabilities We will use total assets and operating income The best metric depends on the purpose at hand Operating income best suited for performance evaluation Return on Investment (ROI) LO4: Evaluate the performance of investment centers

20. Sample ROI Calculations LO4: Evaluate the performance of investment centers

21. Advantages Effective summary measure Size independent (can compare across divisions) Can decompose ROI into smaller pieces Criticism Can foster underinvestment Favors older divisions because of their smaller asset base ROI: Evaluation LO4: Evaluate the performance of investment centers

22. ROI: Measurement We can measure assets at several levels In general, Match the definition in the numerator and denominator Use the measure best suited for decision at hand Use exit cost for whether to stay in business! LO4: Evaluate the performance of investment centers

23. $7,000,000 1 $7,000,000 2 $8,200,000 3 $550,000 4 1 ($7,150,000 + $6,850,000) / 2 = $7,000,000 2 ($1,100,000 + $1,300,000) / 2 = $1,200,000 $7,000,000 + $1,200,000 = $8,200,000 3 $7,150,000 + $250,000 - $6,850,000 = $550,000 4

24. ROI: Decomposition • DuPont Method • ROI = Investment turnover * Return on sales • Investment turnover = Revenues/Investment • Return on sales = Income/Revenues • This analysis helps to identify the source of the profit • Must be in line with business strategy • Suggests corrective action LO4: Evaluate the performance of investment centers

25. 0.80 1 .125 2 10% 3 1 $6,400,000 / $8,000,000 = 0.80 2 $800,000 / $6,400,000 = .125 Profit margin x asset turnover = 0.80 x .125 = 10% 3

26. Managing ROI LO4: Evaluate the performance of investment centers

27. Test Your Knowledge! When a company is attempting to increase return on investment (ROI) it should work to: • decrease sales. • decrease profits. • increase costs. • decrease operating assets. Decreasing operating assets will cause return on investment to improve if other relevant factors remain constant.

28. Residual Income (RI) • Residual Income (RI) • RI = Income - (Required rate of return * Investment) • Definition of income and investment same as under ROI • Required rate of return is the opportunity cost of capital to the company • RI is a measure of “additional” value of the project than what is expected • RI is a size sensitive measure -- bigger projects with the same ROI may show a greater RI than smaller projects LO4: Evaluate the performance of investment centers

29. Calculating RI RI has similar measurement issues Still have to define income and investment Still have to pick measurement basis (gross / net) for assets LO4: Evaluate the performance of investment centers

30. Advantages Avoids underinvestment problem present with ROI (Will explore in a few slides) Intuitive economic interpretation Disadvantages Size dependent (larger divisions have larger RI) Depends on rate used Residual Income: Evaluation LO4: Evaluate the performance of investment centers

31. RI is size dependent but ROI is not Can lead to conflicting rankings But, RI is conceptually superior because it is claimed to lead to better project selection Comparing ROI and RI LO4: Evaluate the performance of investment centers

32. Project Evaluation: ROI Vs. Ri LO4: Evaluate the performance of investment centers

33. A variation of the residual income concept involving more “careful” calculations EVA = NOPAT - (WACC [Total assets - NIBCL]) NOPAT = Net operating income after taxes WACC = Weighted average cost of capital NIBCL = Non-interest bearing current liabilities Various adjustments to GAAP to derive economic income GAAP requires treatment of some items such as R&D expenditures, failed exploration attempts, goodwill that are “inconsistent” with these items being “investments” Detailed EVA calculations will be covered in an elective class Economic Value Added (EVA) LO4: Evaluate the performance of investment centers

34. Advantages Presents true economic picture Provides managers with information about cost of capital used in their business Specifies what to measure and how to measure Disadvantages More complex calculations as it requires numerous adjustments to GAAP income statements While used by many firms, not as popular as ROI EVA Evaluation LO4: Evaluate the performance of investment centers

35. ROI, RI, and EVA calculations are for a single time period (one year) Many companies use annual bonus plans based on such measures Could promote investment myopia Investments may hurt these measures in the short run because benefits realize only in the future years Using NPV analysis to make investment decisions is consistent with using multi-year RI to evaluate managers’ performances Choosing Time Horizons LO4: Evaluate the performance of investment centers

36. Divisions transact with each other Vertical integration Synergy in operations Transfer price is a internal price for such transactions No cash changes hands What Is A Transfer Price? LO5: Describe transfer pricing

37. Computing product cost Determine divisional profit and provide economic signal for Resource allocation Performance evaluation (support decentralization) Value due to minority shareholders Calculate taxes payable in different jurisdictions Roles often conflict Demand For Transfer Prices LO5: Describe transfer pricing

38. $243,000 ($431,300) 1 2 1 $1,405,600 – [0.18 ($10,450,000 - $245,000)] = ($431,300) 2 $756,000 – [0.18 ($2,500,000 - $650,000)] = $243,000

39. Accounting Treatment LO5: Describe transfer pricing

40. Cooperation among divisions Increase “surplus” Maximize corporate profit Sum of divisional profits Competition among divisions Dividing surplus is “zero sum” Focus on divisional profit maximization Theoretical solution can be derived (see appendix) but is not practically feasible Conflict In Transfer Pricing LO5: Describe transfer pricing

41. Market-based transfer pricing Price in the intermediate product market Cost-based transfer pricing Variable cost-based transfer price Unit variable cost plus a markup Full-cost based transfer price Full cost plus a markup Negotiated transfer price Practical Solutions LO5: Describe transfer pricing

42. Market based prices Preferred when available 30-50% Cost based prices Full cost is common 25-50% Negotiated prices Usually market or cost is the starting point for negotiations Usage Patterns LO5: Describe transfer pricing

43. Corporate tax planning affects where to recognize income Incentives can also arise because of Competitive reasons Subsidies Regulatory reasons Restrictions on capital flow Tax planning incentives can override other issues (e.g., providing best economic signals) when setting transfer price International Transfer Prices LO5: Describe transfer pricing

44. Governments recognize corporate incentives\ Impose extensive rules and regulations on what is allowed Could impose sanctions Penalty for dumping Tariffs Setting transfer prices to optimize the various tensions is a very difficult exercise Rules & Regulations LO5: Describe transfer pricing

45. Game playing means profitable transfers might not take place Sub-optimization Should HO intervene? Feasibility is an issue Need detailed information about operations Gains surplus by forcing transaction Undercuts benefits due to decentralization Intervention LO5: Describe transfer pricing

46. Appendix TRANSFER PRICING

47. Selling Division Value = TP- Controllable cost Value ≥ Opportunity cost TPMIN = Controllable cost + Opportunity cost Buying division TPMAX= Opportunity cost Acceptable Transfer Prices Appendix

48. TPMAX = TPMIN No surplus from transfer Corporate does not care At the one agreeable price, divisional profit the same with or without transfer Competitive market for transferred item Congruence between divisional and corporate objectives TPMAX < TPMIN Negative surplus from transfer Corporate does not want transfer Divisions cannot agree on price Congruence between divisional and corporate objectives! Three Cases Appendix

49. TPMAX >TPMIN Surplus from transfer Surplus = TPMAX – TPMIN There is a price at which both divisions are willing to voluntarily enter transaction Congruence between divisional and corporate objectives Three Cases Appendix

50. For the chip division, the contribution margin from an external sale = $18.00 per chip and the controllable cost = $12.50 per chip. Thus, TPMIN = $12.50 + $18.00 = $30.50 per chip. For the phone division, TPMAX is still $32 = $52 total variable cost of buying externally - $20 variable phone cost of buying internally. Thus, the range of acceptable transfer prices is $30.50 to $32.00. If the transfer price is set anywhere in this range, the company as a whole saves $1.50 for every chip that is internally transferred.