Chapter 1: Performance Measurement in Decentralized Organizations PDF

Chapter 1: Performance Measurement in Decentralized Organizations ​ 1.1 Overview of Performance Evaluation ​ 1.2 Evaluating Investment Center Performance ​ 1.3 Transfer pricing 1.4 Balanced Scorecard Learning outcomes of the Lesson 1. Compute return on investment (ROI) and...

Chapter 1: Performance Measurement in Decentralized Organizations ​ 1.1 Overview of Performance Evaluation ​ 1.2 Evaluating Investment Center Performance ​ 1.3 Transfer pricing 1.4 Balanced Scorecard Learning outcomes of the Lesson 1. Compute return on investment (ROI) and show how changes in sales, expenses, and assets affect ROI. 2. Compute residual income and understand its strengths and weaknesses. 3. Compute delivery cycle time, throughput time, and manufacturing cycle efficiency (MCE). 4. Understand how to construct and use a balanced scorecard. 5. Determine the range, if any, within which a negotiated transfer price should fall. 6. Charge operating departments for services provided by service departments. 1.1. OVERVIEW Performance evaluation is the basis of a management control system. Periodic comparisons of the actual costs, revenues and investments with the budgeted costs, revenues and investments can help management in taking decisions about future allocations. Performance evaluation should be done in respect of all responsibility centers (i.e., cost centers, profit centers and investment centers) to ascertain their level of performance. The best way to encourage managers to achieve the desired level of performance is to measure their performance in comparison to budgeted results. RESPONSIBILITY ACCOUNTING Responsibility Accounting- is an internal reporting system that supports decentralization of decision making and generation of information specific to the center. Resources, revenues, and costs are accumulated and reported by levels of responsibility or by responsibility centers within the organization. Decentralization vs Centralization Decentralization is the delegation of authority and responsibility to supervisors or mid-level management. It refers to the creation of divisions or segments of an organization to become more manageable sub-units in the organization. It is managed by the supervisor delegated to decide and held accountable for his decisions. Although a company is decentralized, it should practice Goal Congruence. Goal Congruence is having departmental objectives directly aligned with the company’s overall goals and objectives. This is to make sure that the different departments have one common goal in consonance with the companies strategic objectives. Decentralization works in a Small, Medium, and Large scale business organizations. Centralized decision making leaves decision making to few top level management. Decision is cascaded to lower level management for implementation. Usually this works for Micro business organization. Advantages and Disadvantages of Decentralization 1.​ It serves as a motivational tool. It brings out the best from the lower level managers. because they are held accountable for their actions. Moreover, they are evaluated based on the attainment of objectives or outcomes delegated to them. This situation may increase job satisfaction thus lowering employee turnover. It will also enhance organizational performance and productivity. However, this may lead to too much decentralization resulting to lack of coordination among division managers. Division managers become too competitive against their peers that the tend to forget that they belong to the same company. This situation will eliminate the advantages of teamwork. A well designed evaluation system such as Balanced Scorecard will minimize this risk. 2.​ Top level management can focus on strategic issues and overall company concerns. Lower level managers are delegated to decide on operational issues encountered on a daily basis. This will allow lower level managers the capacity to have access to detailed information needed in decision making, thus improving the decision making capability of top level management to lower level management. However, this can also lead to “sub-optimization”. Sub optimization happens when lower level managers are too focused on attaining departmental objective that they tend to loose focus on the overall company objective. Say for example, a division could increase its sales territory at the expense of capturing the sales territory of a division belonging to the same company. 3.​ It allows quiker response to operational problems. Lower level managers can quikly resolve or decide on issues under their authority. These issues include but not limited to customer complaints/feedback, production efficiency, human resource, and the like. However, too much leeway granted to lower level managers in resolving issues will result to loosing sight on the “big picture”. They tend to resolve issues and ignore the overall impact of the solution to the company. This can be avoided by having clear-cut delineation of authority across the company. 4.​ It is a training ground for lower level managers. Decentralization allows lower level managers to grow professionally and develop their skills in decision making. This will enable the company to have a pool of potential future top level managers that can be promoted when the need arises. However, this may result to “in-breading.” In-breading happens when a company is deprived of new ideas or externally generated ideas because of too much relevance on lower level managers being promoted to top level positions. This tends to limit ideas within company practices and will disallow innovation. I.​ RESPONSIBILITY CENTERS COMPARED Cost center is a department or segment of an organization that does not directly generate revenue but incurs costs to operate. Profit center is a branch or division that directly adds to the operating income of a company. Revenue center is a division that generates revenue from product sales or services. Investment center is a business unit within a company that requires capital outlay to operate. The following table is a comparative presentation of the different types of cost centers: TYPE OF CENTER Cost Profit Revenue Investment Revenues; Investment; Revenues; Accountability Cost and Expenses Revenues Cost and Expenses Cost and Expenses Return on Investment Standard Cost Contribution Margin; (ROI); Residual Income Evaluation Revenue Variances Variances Segment Income; (RI); Economic Value Added Analysis (EVA) Production Each sales division in a Investment in Branch; Example Marketing department department department store Investment in Subsidiary II.​ CLASSIFICATION OF COSTS IN RESPONSIBILITY ACCOUNTING 1.​ Controllable Cost - These are costs which may be directly regulated at a given level of managerial authority and time-frame. Controllability goes with authority, the higher the authority the more the controllable costs. A segment manager has direct control over short-run costs. Most common example of controllable or short-run cost is variable cost. As much as possible, consider only controllable cost when evaluating segment manager performance. 2.​ Traceable and Common Fixed Cost Traceable fixed cost, is a fixed cost that is avoidable if a segment or division is discontinued. Or, it is the fixed cost directly identified to operate a segment of an organization. In Relevant costing it is called Avoidable fixed cost. Traceable fixed costs is relevant when evaluating a responsibility center. Common fixed cost (Unavoidable fixed, Allocated fixed) is a fixed cost necessary to sustain operations of multiple segments. It can not be directly identified to a specific segment or division. The fixed cost will continue even if a division is closed. Moreover it is not controllable by a specific manager. Since common fixed cost is neither avoidable nor controllable, it is ignored in performance evaluation and in decision making. However, it is deducted against revenues when computing for operating income under Financial Accounting. In Cost Accounting, specifically under Joint and By-product costing, common fixed cost is allocated to the joint products to determine the unit cost of a finished good. 1.2​ EVALUATING RESPONSIBILITY CENTERS 1.​ Cost Center Standard cost variance analysis is used in evaluating a cost center. Please refer to the module on Standard Cost Variances for detailed discussion and presentation 2.​ Profit Center A)​ Segment Contribution Margin (SCM)- This is a short-run test of profitability. This tool is used if there is no avoidable fixed cost. Continue operating the profit center as long as contribution margin is positive. SCM = Total Revenues - Total Variable Cost B)​ Segment Income (SI) or Segment Margin- This is a long-run test of profitability because it considers Avoidable Fixed cost in evaluating performance. This is far more superior than contribution margin. It measures how much is contributed to recover common fixed cost and company profit. Continue operations as long as segment income is positive. SI = Segment Contribution Margin - Avoidable Fixed Cost Alternative approach if Net Operating Income (NI) is given SI = Net Operating Income + Common Fixed Cost 3.​ Revenue Center Revenue variance analysis is used in evaluating a Revenue center. Please refer to the module on Pricing and Revenue Variances for detailed discussion and presentation 4.​ Investment Center A)​ Return on Investment (ROI)- This is a test of profitability by comparing a desired minimum required rate of return (ROR). It measures the required investment to generate certain amount of profit. The investment center is profitable as long as the ROI is equal or greater than the minimum ROR. It is preferred that the company uses the Weighted Average Cost of Capital (WACC) as the minimum ROR. As an alternative, the company may opt to use the financing cost specific to the investment. ROI = Operating Income / Average Investment or Assets Operating income is earnings before interest and taxes (EBIT). Interest and taxes are non-controllable cost, thus excluded in the ROI formula. Average Investment or Assets are composed of current and non-current assets needed to sustain operations of the center. It should not include assets that are not utilized by the center, or idle assets. It can either be valued at Book or Market value, or gross or net. Since ROI is not  governed by any reporting standard, it is a matter of company policy on the valuation base. However, it is suggested that the net book value will be used because it is readily available from Financial Accounting reports. ROI can be expanded to measure asset utilization and sales profitability analysis by multiplying Rate of Return on Sales to Asset Turnover. The equation is expanded to: Operating Income​ ​ ​ ​ Sales ROI= -------------------------​ x​ -------------------------------------- Sales​ ​ ​ Average Investment or Assets Return on sales is a test of how efficient a company turns sales into profits. While Asset Turnover is a test of activity that measures how well a company utilizes its assets to generate revenues. Since ROI is stated in percentage, it allows the comparison of different investment alternative of different sized. However, ROI has its own pitfalls. Managers easily manipulate ROI most specialy if it is used as a performance metric. The easiest way is to manipulate the valuation of the investment base as stated in the above discussions. Managers can even defer operating expenses in the current period to the next to increase current year profits. Managers tend to become myopic and ignore the long term effects of their actions. A major pitfall of ROI is managers tend to reject investments with lower ROI than his won but would have increased the overall company ROI. This is an inherent disadvantage of decentralization. Moreover, ROI is stated as a percentage. Percentage is a measurement of rate and not an absolute value of money. B)​ Residual Income (RI)- measures the absolute peso return of an investment over the minimum ROR. It is almost the same with ROI but stated in money. The investment center is profitable as long as RI is positive. The higher the RI, the better. Between ROI and RI, managers tend to rely more on RI because it measures absolute peso return. It eliminates the weakness of ROI of rejecting investment that would increase overall company ROI. Because of this, RI supports the principle of goal congruence. Meaning investments are accepted because it will improve the profitability of the center as well as the company as a whole. Unfortunately, RI does not allow the comparison of different investment alternative with different sizes because it is stated in pesos. RI = Operating Income - (minimum ROR x Average investment or Assets) C)​ Economic Value Added (EVA) - is a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its Earnings Before Interest but After Tax (EBIAT) or Net Operating Profit After Tax (NOPAT). EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company. It is also a measure of return to the company’s stakeholders because it tends to measure the absolute peso return after recovering financing cost from Long-term Sources of Financing. It is the only tool that considers tax effects, because interest on debt financing is tax deductible. A positive EVA shows a project is generating returns in excess of the required minimum return, hence profitable. The higher the EVA, the better. EVA​= EBIAT - (WACC x Total Long-term Sources of Financing) = NOPAT - (Total Assets - Current Assets ) x WACC 1.3 TRANSFER PRICING Definition - is the price charged by one segment of an organization for a product or service that it supplies to another segment of an organization. Transfer prices are necessary to compute for the revenues and costs of the Cost, Profit, Revenue, and Investment center. Simply stated, it is the selling/purchase price within the same company. Transfer prices are only intended for performance evaluation. It will not affect the overall profit of an organization. I.​ Transfer Price Range ​ The division that is selling the good or service would prefer a high transfer price because it will be evaluated based on the revenue/profit it generates. However, the division that is buying would prefer a low transfer price because it will be evaluated based on its cost. The acceptable transfer price is between the highest transfer price of the buying division and the lowest acceptable transfer price of the selling division. The highest/maximum transfer price of the buying division. The highest price the buying division would be willing to pay is the external price it pays from an outside supplier. The external price is net of trade discount if any. The buying division would be willing to agree on a transfer price that is lower than the external price. This situation will be fully discussed under Make or Buy analysis of relevant costing. The lowest/minimum acceptable transfer price for the selling division. The selling division would like for the transfer price to be as high as possible, but the lowest price he is willing to accept is the variable cost per unit of his division. The variable cost is the lowers price provided there is no opportunity cost and fixed costs remain unaffected. Opportunity cost is the contribution margin that is lost on units that cannot be produced and sold as a result of the transfer. Opportunity costs is inversely correlated with idle capacity. If there is no idle capacity, opportunity cost will increase. Inversely if there is enough idle capacity, opportunity cost is zero. Lowest/Minimum price Total Contribution Margin of Lost Sales = Variable cost per unit + ​ -------------------------------------------------- Total Units Transferred II.​ Alternative Transfer Prices Negotiated transfer price- is a price agreed for goods or services between the buying and selling division without basing it on market price. Negotiated transfer price will work provided the division managers understand their own business and are willing to cooperate with the other managers. The negotiated transfer price will lower the profit of the selling division and will increase the cost of the buying division. The acceptable transfer price is determined on what the two divisions are willing to sacrifice that will benefit the entire company. Cost-based transfer prices- transfers are recorded at variable cost, at full cost, or at variable or full cost-plus mark-up. These transfer pricing systems are easy to administer, but suffer from serious limitations. Market-based transfer prices- When there is a competitive outside market for the good or service transferred between the divisions, the market price is often used as a transfer price. This solution is reasonably easy to administer and provides a theoretically correct transfer price when there is no idle capacity. However, when there is idle capacity in the selling division, the transfer price will be too high and the buying division may inappropriately purchase from an outside supplier or cut back on volume. Dual transfer price- the selling division records one price whereas the buying division is charged a different price for the same product or service. 1.4 BALANCED SCORECARD I. INTRODUCTION ​ A balanced scorecard consists of an integrated set of performance measures that are derived from and support the company’s strategy throughout the organization. It is a strategic management system that translates the vision and strategy of an organization into operational objectives and measures. The Balanced Scorecard is compatible with activity-based responsibility accounting because it focuses on processes and requires the use of activity-based information to implement many of its objectives and measures. II.​ THE FOUR PERSPECTIVES OF BALANCED SCORECARD The Balanced Scorecard permits an organization to create a strategic focus by translating an organization’s strategy into operational objectives and performance measures. The Balanced Scorecard typically identifies objectives and measures for four different perspectives. 1.​ The financial perspective 2.​ The customer perspective 3.​ The internal business process perspective 4.​ The learning and growth (infrastructure) perspective​ ​ Strategy is defined as choosing the market and customer segments the business unit intends to serve, identifying the critical internal and business processes that the unit must excel at to deliver the value propositions to customers in the targeted market segments, and selecting the individual and organizational capabilities required for the internal, customer, and financial objectives. A.​ The Financial Perspective, Objectives and Measures ​ The financial perspective establishes the long- and short-term financial performance objectives expected from the organization’s strategy and simultaneously describes the economic consequences of actions taken in the other three perspectives. Thus, the objectives and measures of the other perspectives should be chosen so that they cause or bring about the desired financial outcomes. The financial perspective has three strategic themes: revenue growth, cost reduction, and asset utilization. The three themes are constrained by the need for managers to manage risk. B.​ Customer Perspective, Objectives and Measures ​ The customer perspective is the source of the revenue component for the financial objectives. This perspective defines the customer and market segments in which the business unit will compete and describes the way that value is created for customers. Failure to deliver the right kinds of products and services to the targeted customers means revenue will not be generated. ​ Once the customers and segments are defined, then core objectives and measures are developed which will be common across all organizations. There are five key core objectives: 1.​ Increase market share 2.​ Increase customer retention 3.​ Increase customer acquisition 4.​ Increase customer satisfaction 5.​ Increase customer profitability ​ In addition to the core measures and objectives, measures are needed that drive the creation of customer value and, thus, drive the core outcomes. Customer value is the difference between realization and sacrifice, where realization is what the customer receives and sacrifice is what is given up. C.​ Process Perspective, Objectives and Measures ​ The internal business process perspective describes the internal processes needed to provide value for customers and owners. Processes are the means by which strategies are executed. Thus, the process perspective entails the identification of the processes needed to achieve customer and financial objectives. To provide the framework needed for this perspective, a process value chain is defined. The process value chain is made up of three processes: the innovation process, the operations process, and the post-sales service process. ​ The innovation process anticipates the emerging and potential needs of customers and creates new products and services to satisfy those needs. The operations process produces and delivers existing products and services to customers. The post-sales service process provides critical and responsive services to customers after the product or service has been delivered. Internal business process performance measures. a.​ Delivery Cycle Time. This is the total elapsed time between when an order is placed by a customer and when it is shipped to the customer. Part of this time is wait time that occurs before the order is placed into production. The remainder of this time is the throughput time. b.​ Throughput (Manufacturing Cycle) Time. This is the total elapsed time between when an order is started into production and when it is shipped to the customer. It consists of process time, inspection time, move time, and queue time. The only element that adds value is processing time. Inspection time, move time, queue time, and their associated activities do not add value and should be minimized. c.​ Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time (i.e., process time) to total throughput time. It represents the percentage of time an order is in production in which useful work is being done. The rest of the time represents non-value-added time (i.e., inspection time, move time, and queue time). d.​ Velocity is the number of units of output that can be produced in a given period of time. MANUFACTURING CYCLE EFFICIENCY ​ Manufacturing cycle efficiency (MCE) is a measure of how much throughput time actually adds value. MCE is defined by: ​ If the MCE is less than 1, the production process contains “non-value-added” time. ​ An MCE of 0.4 indicates that 60% (1.0 – 0.4 = 0.6) of the total production time consists of queuing, inspection, and move time, and therefore only 40% of the total time is productive. ​ Reducing the non-value-added activities of queuing, inspection, and moving will lead to improvement in MCE. D.​ Learning and Growth Perspective ​ The learning and growth (infrastructure) perspective defines the capabilities that an organization needs to create long-term growth and improvement. It is the source of the capabilities that enable the accomplishment of the other three perspectives’ objectives. This perspective has three major objectives: 1.​ Increase employee capabilities 2.​ Increase motivation, empowerment, and alignment 3.​ Increasing information systems capabilities ​ ​ The diagram below shows the inter-relationship of the four perspectives of the balances score card. THE BALANCED SCORECARD (Garrison 8th ed)  ​ Improvement starts off with the Learning and Growth perspective. Employees will underdo training and development to improve their skills. In return it will enhance their capability of providing innovative products that caters to the needs of the target customers. Hence the Business Process perspective will improve. Because of the same training and development, the workers become more efficient and faster in the production process saving on both time and input resources. Because of the improved product innovation and fast throughput, it will create significant improvement in customer satisfaction, thus improving the Customer perspective. Because the customers are satisfied beyond expectations, the company will be able to increase its market share or even create new markets thus improving the Financial perspective. For balance scorecard to work in the company, the four perspectives must be in tuned with each other. Improvement should start within the company to become financially successful as well as in the market place.