Copyright © 2007 Prentice-Hall. All rights reserved 1 Performance Evaluation and the Balanced Scorecard Chapter 12

Copyright © 2007 Prentice-Hall. All rights reserved 2 Objective 1 Explain why and how companies decentralize

Copyright © 2007 Prentice-Hall. All rights reserved 3 Decentralized Operations Operations are split into divisions Advantages: –Frees top management time –Supports use of expert knowledge –Improves customer relations –Provides training –Improves motivation and retention

Copyright © 2007 Prentice-Hall. All rights reserved 4 Decentralized Operations Disadvantages: –Duplication of costs –Problems achieving goal congruence

Copyright © 2007 Prentice-Hall. All rights reserved 5 Responsibility Centers Subunit whose manager is accountable for specific activities –Cost center –Revenue center –Profit center –Investment center

Copyright © 2007 Prentice-Hall. All rights reserved 6 Objective 2 Explain why companies use performance evaluation systems

Copyright © 2007 Prentice-Hall. All rights reserved 7 Goals of Performance Evaluation Systems Promoting goal congruence and coordination Communicating expectations Motivating Unit Managers Providing Feedback Benchmarking

Copyright © 2007 Prentice-Hall. All rights reserved 8 Limitations of Financial Performance Measures Management needs both –Lag indicators –Lead indicators Tendency to focus on short-term achievements

Copyright © 2007 Prentice-Hall. All rights reserved 9 Objective 3 Describe the balanced scorecard and identify key performance indicators for each perspective

Copyright © 2007 Prentice-Hall. All rights reserved 10 Balanced Scorecard Measure company’s activities in terms of its vision and strategies Financial and operational performance measures are considered Link company goals to key performance indicators

Copyright © 2007 Prentice-Hall. All rights reserved 11 COMPANY GOALS CRITICAL FACTORS (customer satisfaction, operational efficiency, employee excellence, financial profitability) CRITICAL FACTORS (customer satisfaction, operational efficiency, employee excellence, financial profitability) KEY PERFORMANCE INDICATORS (KPIs) (market share, yield rate, employee training hours, revenue growth) KEY PERFORMANCE INDICATORS (KPIs) (market share, yield rate, employee training hours, revenue growth)

Copyright © 2007 Prentice-Hall. All rights reserved 12 Four Perspectives Financial perspective Customer perspective Internal business perspective Learning and growth perspective

Copyright © 2007 Prentice-Hall. All rights reserved 13 Financial Perspective How do we look to shareholders? Strategy to increase company profits –Increase revenue growth –Increase productivity

Copyright © 2007 Prentice-Hall. All rights reserved 14 Customer Perspective How do customers see us? Strategy - Customer satisfaction –Product price –Product quality –Sales service quality –Product delivery time

Copyright © 2007 Prentice-Hall. All rights reserved 15 Internal Business Perspective At what business processes must we excel? Three factors –Innovation –Operations –Post-sales service

Copyright © 2007 Prentice-Hall. All rights reserved 16 Learning and Growth Perspective Can we continue to improve and create value? Three factors –Employee capabilities –System capabilities –Company’s climate for action

Copyright © 2007 Prentice-Hall. All rights reserved 17 E Financial Perspective- “How do we look to shareholders?” 3. Internal Business Perspective- “At what business processes must we excel?” 4. Learning and Growth Perspective-“Can we continue to improve and create value?” 2. Customer Perspective- “How do customers see us?”

Copyright © 2007 Prentice-Hall. All rights reserved Financial Perspective 3. Internal Business Perspective 4. Learning and Growth Perspective 2. Customer Perspective RevenueProductivity Price Quality Sales service Delivery time InnovationOperationsPostsales service Employee Capabilities System Capabilities Climate for Action

Copyright © 2007 Prentice-Hall. All rights reserved 19 E12-18 a.Customer perspective b.Learning and growth perspective c.Financial perspective d.Internal business perspective e.Learning and growth perspective f.Internal business perspective g.Customer perspective h.Internal business perspective

Copyright © 2007 Prentice-Hall. All rights reserved 20 E12-18 i.Customer perspective j.Financial perspective k.Internal business perspective l.Learning and growth perspective m.Internal business perspective n.Financial perspective o.Internal business perspective p.Customer perspective

Copyright © 2007 Prentice-Hall. All rights reserved 21 E12-18 q.Learning and growth perspective r.Financial perspective s.Customer perspective t.Internal business perspective u.Internal business perspective v.Learning and growth perspective w.Internal business perspective

Copyright © 2007 Prentice-Hall. All rights reserved 22 Objective 4 Use performance reports to evaluate cost, revenue, and profit centers

Copyright © 2007 Prentice-Hall. All rights reserved 23 Performance Reports Report financial performance of responsibility centers Cost center – focus on flexible budget variance Revenue center – focus on flexible budget variance and sales volume variance Profit center – focus on flexible budget variance –Includes allocated charges from service departments

Copyright © 2007 Prentice-Hall. All rights reserved 24 E12-19 Racer-Subunit X Actual Flexible budget Flexible budget variance % Variance Direct materials$28,100$26,000 Direct labor13,50014,000 Indirect labor26,00023,000 Utilities12,00011,000 Depreciation25,000 Repair & Maint4,3005,000 Total$108,900$104,000 $2,100 U8.08% U 500 F3.57% F 3,000 U13.04% F 1,000 U9.09% U F14.00% F 4,900 U4.71% U

Copyright © 2007 Prentice-Hall. All rights reserved 25 Objective 5 Use ROI, RI, and EVA to evaluate investment centers

Copyright © 2007 Prentice-Hall. All rights reserved 26 Investment Centers Financial evaluation must measure –Income generated –Effective use of center’s assets Performance measures –Return on investment (ROI) –Residual income (RI) –Economic value added (EVA)

Copyright © 2007 Prentice-Hall. All rights reserved 27 Return On Investments Operating income ÷ Total assets Or Operating income Sales Total assets X

Copyright © 2007 Prentice-Hall. All rights reserved 28 ROI Operating income Sales Total assets X Sales margin = Operating income Sales Capital turnover = Sales Total assets

Copyright © 2007 Prentice-Hall. All rights reserved 29 ROI Advantages Expanded equation provides additional information Can be used to compare across divisions and with other companies Useful for resource allocation

Copyright © 2007 Prentice-Hall. All rights reserved 30 E12-21 Req 1 Professional: $173,000 ÷ $420,000 = 41.19% Residential: $62,000 ÷ $188,000 = 32.98% ROI = Operating income ÷ Total assets

Copyright © 2007 Prentice-Hall. All rights reserved 31 E12-21 Req 2 Professional: $173,000 ÷ $1,030, % Residential: $62,000 ÷ $555, % Sales Margin = Operating income ÷ Sales

Copyright © 2007 Prentice-Hall. All rights reserved 32 E12-21 Req 3 Professional: $1,030,000 ÷ $420, Residential: $555,000 ÷ $188, Capital Turnover = Sales ÷ Total Assets

Copyright © 2007 Prentice-Hall. All rights reserved 33 E12-21 Req 4 Professional: 16.80% x % Residential: 11.17% x % ROI = Sales margin x Capital turnover

Copyright © 2007 Prentice-Hall. All rights reserved 34 Residual Income 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 © 2007 Prentice-Hall. All rights reserved 35 RI Operating income – Minimum acceptable income Minimum acceptable income = Target rate of return x Total assets

Copyright © 2007 Prentice-Hall. All rights reserved 36 RI Advantages: Promotes goal congruence better than ROI Incorporates management’s minimum required rate of return Can use different target rates or return for divisions with different levels of risk

Copyright © 2007 Prentice-Hall. All rights reserved 37 E12-22 Req 1 Professional: $173,000 - ($420,000 x 25%) = $68,000 Residential $62,000 - ($188,000 x 25%) = $15,000 Residual Income = Operating income – Minimum acceptable income

Copyright © 2007 Prentice-Hall. All rights reserved 38 Economic Value Added After-tax operating income – [(Total assets – Current liabilities) x WACC%] WACC% - weighted average cost of capital

Copyright © 2007 Prentice-Hall. All rights reserved 39 E12-22 Req 2 Professional: ($173,000 x 70%) – [($420,000 - $150,000) x 15%] $80,600 Residential ($62,000 x 70%) – [($188,000 - $68,000) x 15%] $25,400 EVA = (After-tax operating income) – [(total assets – current liabilities) x WACC%]

Copyright © 2007 Prentice-Hall. All rights reserved 40 EVA Advantages Considers wealth created just for investors and long-term creditors Promotes goal congruence

Copyright © 2007 Prentice-Hall. All rights reserved 41 Limitations of Financial Performance Measures Measurement issues - how to define “total assets” Short-term focus

Copyright © 2007 Prentice-Hall. All rights reserved 42 End of Chapter 12