Chapter 23

Explain why and how companies decentralize

 Companies decentralize as they grow  Split operations into different divisions or operating units  Top management delegates decision-making to unit managers  Decentralization may be based on: ◦ Geographic area ◦ Product line ◦ Customer base ◦ Business function Copyright (c) 2009 Prentice Hall. All rights reserved.3

AdvantagesDisadvantages  Frees top management time  Supports use of expert knowledge  Improves customer relations  Provides training  Improves motivation and retention  Duplication of costs  Problems achieving goal congruence Copyright (c) 2009 Prentice Hall. All rights reserved.4

Advantages of decentralization Disadvantages of decentralization 5

 Subunit of an organization whose manager is accountable for specific activities Copyright (c) 2009 Prentice Hall. All rights reserved. Responsibility Center Manager is responsible for: Cost centerControlling costs Revenue centerGenerating sales revenue Profit centerProducing profit by generating sales and controlling costs Investment centerProducing profit and managing the division’s invested capital 6

Explain why companies use performance evaluation systems

 When companies decentralize, top management needs a system to communicate goals to subunit managers  Primary goals: ◦ Promoting goal congruence and coordination ◦ Communicating expectations ◦ Motivating unit managers ◦ Providing feedback ◦ Benchmarking Copyright (c) 2009 Prentice Hall. All rights reserved.8

 Financial measures tend to be lag indicators ◦ “After the fact”  Management also needs lead indicators  “Before the fact”  Tendency to focus on short-term achievements Copyright (c) 2009 Prentice Hall. All rights reserved.9

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

 Management must consider both financial and operational performance measures  Measures should be linked with company goals and strategy  Financial measures are only one measure among many  Uses key performance indicators Copyright (c) 2009 Prentice Hall. All rights reserved.11

Copyright (c) 2009 Prentice Hall. All rights reserved. COMPANY GOALS CRITICAL FACTORS KEY PERFORMANCE INDICATORS Examples of critical factors and corresponding KPIs Operational efficiency Employee excellence Financial profitability Market share Yield rate Training hours Revenue growth Customer satisfaction 12

FinancialCustomer Internal Business Learning and Growth Copyright (c) 2009 Prentice Hall. All rights reserved.13

 How do we look to shareholders? ◦ Ultimate goal is to generate income for owners  KPIs: ◦ Sales revenue growth ◦ Gross margin growth ◦ Return on investment Copyright (c) 2009 Prentice Hall. All rights reserved.14

 How do customers see us? ◦ Top priority for long-term success  Customer concerns: ◦ Product price ◦ Product quality ◦ Sales service quality ◦ Product delivery time  KPIs: ◦ Customer satisfaction ◦ Market share ◦ Number of customers and repeat customers ◦ Rate of on time deliveries Copyright (c) 2009 Prentice Hall. All rights reserved.15

 At what business processes must we excel?  Three factors: ◦ Innovation  KPI: Number of new products developed ◦ Operations  KPIs:  Product efficiency – number of units produced  Product quality – defect rate ◦ Post-sales service  KPIs  Number of warranty claims  Average wait time on phone for customer service Copyright (c) 2009 Prentice Hall. All rights reserved.16

 How can we continue to improve and create value?  Three factors: ◦ Employee capabilities  KPIs:  Hours of employee training  Employee satisfaction and turnover  Number of employee suggestions implemented ◦ System capabilities  KPIs:  Percentage of employees with online access to customer data  Percentage of processes with real-time feedback ◦ Company’s climate for action Copyright (c) 2009 Prentice Hall. All rights reserved.17

Copyright (c) 2009 Prentice Hall. All rights reserved.18

Copyright (c) 2009 Prentice Hall. All rights reserved.19

Use performance reports to evaluate cost, revenue, and profit centers

 Report financial performance of responsibility centers  Cost center ◦ Focus on the flexible budget variance  Difference between actual results and flexible budget  Revenue center ◦ Flexible budget variance  Due to difference in sales price ◦ Sales volume variance  Due to selling more or less units than expected  Profit center ◦ Focus on both revenue and cost variances Copyright (c) 2009 Prentice Hall. All rights reserved.21

 Management by exception ◦ Only material variances are investigated  Should focus on information, not blame  Some variances are uncontrollable ◦ Example: increase in costs due to a natural disaster Copyright (c) 2009 Prentice Hall. All rights reserved.22

Use ROI, RI, and EVA to evaluate investment centers

 Investment center managers are responsible for: ◦ Generating profit ◦ Effective use of assets  Performance measures: ◦ Return on investment (ROI) ◦ Residual income (RI) ◦ Economic value added (EVA) Copyright (c) 2009 Prentice Hall. All rights reserved.24

Copyright (c) 2009 Prentice Hall. All rights reserved. ROI Operating income Total assets ROI Profit margin Capital turnover 25

Copyright (c) 2009 Prentice Hall. All rights reserved. Operating income Total assets Sales Profit margin Capital turnover Sales 26

Copyright (c) 2009 Prentice Hall. All rights reserved. ROI Operating income Total assets Residential $63,700 $196, % Professional $162,400 $406,000 40% 27

Copyright (c) 2009 Prentice Hall. All rights reserved. Profit margin Operating income Sales Residential $63,700 $580, % $162,400 Professional $1,100, % 28

Copyright (c) 2009 Prentice Hall. All rights reserved. Total assets Capital turnover Sales $580,000 Residential $196, Professional 2.71 $1,100,000 $406,000 29

Copyright (c) 2009 Prentice Hall. All rights reserved. ROI Profit margin Capital turnover Residential 10.98% % Professional 14.76% % 30

 Compares division’s operating income with minimum operating income expected given the size of the division’s assets ◦ Positive – income exceeds target rate of return ◦ Negative – income does not meet target rate of return Copyright (c) 2009 Prentice Hall. All rights reserved.31

Copyright (c) 2009 Prentice Hall. All rights reserved. Operating income RI Minimum acceptable income minus Minimum acceptable income Target rate of return Total assets 32

 Promotes goal congruence better than ROI  Incorporates management’s minimum required rate of return  Can use different target rates of return for divisions with different levels of risk Copyright (c) 2009 Prentice Hall. All rights reserved.33

 Special type of RI calculation ◦ Takes view of company‘s primary stakeholders  Investors and long-term creditors  Considerations: ◦ Income available to stakeholders ◦ Assets used to generate income for stakeholders ◦ Minimum rate of return required by stakeholders  Weighted-average cost of capital (WACC) Copyright (c) 2009 Prentice Hall. All rights reserved.34

Copyright (c) 2009 Prentice Hall. All rights reserved. EVA After-tax operating income Total assets Current liabilities WACC % minus 35

Return on investments Provides information on profitability & efficiency Can compare across divisions & companies Useful for resource allocation Residual income Promotes goal congruence Uses management’s minimum rate of return Can use different rates for divisions based on risk Economic value added Considers income earned for investors and long-term creditors Promotes goal congruence Copyright (c) 2009 Prentice Hall. All rights reserved.36

 Measurement issues ◦ Total asset figure in equation  Nonproductive assets  Gross book value vs. net book value  Depreciation may artificially inflate measures  Short-term focus ◦ Figures are for a one-year time frame ◦ Incentive to management to cut essential spending to increase measurement Copyright (c) 2009 Prentice Hall. All rights reserved.37