1. Chapter Twelve Performance Evaluation and Decentralization COPYRIGHT © 2012 Nelson Education Ltd.

2. Learning Objectives 1.Explain how and why firms choose to decentralize 2.Compute and explain return on investment 3.Compute and explain residual income and economic value added 4.Explain the role of transfer pricing in a decentralized firm 5.Explain the uses of the Balanced Scorecard, and compute cycle time, velocity, and manufacturing cycle efficiency 12-2

3. OBJECTIVE  1 1 Explain how and why firms choose to decentralize

4. COPYRIGHT © 2012 Nelson Education Ltd. Decentralization Delegating decision-making authority Why firms decentralize: –Ease of gathering and using local information –Focusing on central management from detailed operations to strategic planning –Training and motivating of segment managers to prepare new high-level managers –Enhanced competition, exposing segments to market forces, which allow each unit to act as an autonomous business unit Achieved by creating Divisions 12-4

5. COPYRIGHT © 2012 Nelson Education Ltd. Divisions Differentiated by: –Type of product or service provided –Geographic lines Type of responsibility given to divisional manager –Responsibility centre is a segment of business whose manager is accountable for specified sets of activities 12-5

6. COPYRIGHT © 2012 Nelson Education Ltd. Types of Responsibility Centres Cost centre –Manager is responsible only for costs Revenue centre –Manager is responsible only for sales Profit centre –Manager is responsible for revenues and costs Investment centre –Manager is responsible for revenues, costs, and investments 12-6

7. COPYRIGHT © 2012 Nelson Education Ltd. Measuring the Performance of Profit centres Preparation of segmented income statements –Two methods of computing income: Variable costing Full or Absorption costing –Methods often lead to different operating income figures 12-7

8. OBJECTIVE  2 2 Compute and explain return on investment (ROI)

9. COPYRIGHT © 2012 Nelson Education Ltd. Return on Investment (ROI) Operating Income ÷ Average Operating Assets Earnings before income and taxes (EBIT) Formula: (Beginning assets + Ending assets) ÷ 2 12-9

10. COPYRIGHT © 2012 Nelson Education Ltd. Return on Investment (ROI) Margin × Turnover Operating Income ÷ Sales Alternative Formula: Sales ÷ Average Operating Assets 12-10

11. COPYRIGHT © 2012 Nelson Education Ltd. Margin and Turnover Margin –Ratio of operating income to sales –Tells how many cents of operating income result from each dollar of sales –Expresses portion of sales available for interest, taxes, and profit Turnover –Divides sales by average operating assets –Tells how many dollars of sales result from every dollar invested in operating assets 12-11

12. COPYRIGHT © 2012 Nelson Education Ltd. Advantages of ROI Encourages managers to focus on –Relationship among: Sales Expenses Investment –Cost efficiency –Operating asset efficiency 12-12

13. COPYRIGHT © 2012 Nelson Education Ltd. Disadvantages of ROI Narrow focus on divisional profitability at expense of profitability for the overall firm Encourages managers to focus on short run at the expense of the long run 12-13

14. COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Calculate Average Operating Assets, Margin, Turnover, and Return on Investment Example: Cornerstone 12-1 Information: Sales Cost of goods sold Gross margin Selling and admin. expense $480,000 222,000 Operating income $ 48,000 $258,000 210,000 Operating Assets were $277,000 at the beginning of the year and $323,000 at the end of the year Required: Calculate: Average operating assets, Margin, Turnover, ROI 12-14

15. COPYRIGHT © 2012 Nelson Education Ltd. Example Average operating assets (Beginning assets + Ending assets)/2 = = ($277,000 + $323,000) / 2 = $300,000 12-15

16. COPYRIGHT © 2012 Nelson Education Ltd. Example MarginOperating Income / Sales = = $48,000 / $480,000 = 0.10 or 10% 12-16 TurnoverSales / Average operating assets = = $480,000 / $300,000 = 1.6

17. COPYRIGHT © 2012 Nelson Education Ltd. Example Return on Investment (ROI) Margin × Turnover = = 0.10 × 1.6 =.16 or 16% Alternatively: Operating income / Average operating assets = $48,000 / $300,000 =.16 or 16% 12-17

18. OBJECTIVE  3 3 Compute and explain residual income and economic value added

19. COPYRIGHT © 2012 Nelson Education Ltd. Residual Income Operating Income ̶ Minimum rate of return × Average operating assets If residual income is… less than zero, the co. is earning less than minimum ROI exactly zero, the co. is earning precisely minimum ROI greater than zero, the co. is earning more than minimum ROI Set by the company 12-19

20. COPYRIGHT © 2012 Nelson Education Ltd. Advantages & Disadvantages of Residual Income Advantages –Accept any project that earns above minimum rate Disadvantages –Short run orientation –Residual income is an absolute measure of profitability Direct comparison is difficult when level of investments differ 12-20

21. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 12-2 Information: Sales Cost of goods sold Gross margin Selling and admin. expense $480,000 222,000 Operating income$ 48,000 $258,000 210,000 Operating Assets were $277,000 at the start of the year and $323,000 at year end A minimum ROI of 12% is required HOW TO Calculate Residual Income Required: Calculate: Average operating assets, Residual income 12-21

22. COPYRIGHT © 2012 Nelson Education Ltd. Example Average operating assets (Beginning assets + Ending assets)/2 = = ($277,000 + $323,000) / 2 = $300,000 12-22

23. COPYRIGHT © 2012 Nelson Education Ltd. Example Residual Income Operating Income = = $48,000 - $36,000 = $12,000 ̶ Minimum rate of return × Average Operating Assets 12-23

24. COPYRIGHT © 2012 Nelson Education Ltd. Residual Income ̶ Formula: Actual percentage cost of capital × Total capital employed If EVA is positive then company is creating wealth If EVA is negative then company is destroying wealth After-tax operating income 12-24

25. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 12-3 Information: Sales Cost of goods sold Gross margin Selling and admin. $480,000 222,000 Operating income$ 48,000 $258,000 210,000 Total capital employed equalled $300,000. Actual cost of capital is 10% Less: Income taxes (@ 30%)14,400 Net income $ 33,600 HOW TO Calculate Economic Value Added Calculate Economic Value Added (EVA) for the Western Division Required: 12-25

26. COPYRIGHT © 2012 Nelson Education Ltd. Example EVA = × = $33,600 - (0.10 × $300,000) After-tax operating income Actual % cost of capital Total capital employed = $33,600 - $30,000 = $3,600 12-26

27. COPYRIGHT © 2012 Nelson Education Ltd. Advantages of EVA Encourages the right kind of behaviour Relies on true cost of capital Cost of capital is considered a corporate expense and is passed along to overall income statement Makes investment seem free to the divisions so they want more 12-27

28. OBJECTIVE  4 4 Explain the role of transfer pricing in a decentralized firm

29. COPYRIGHT © 2012 Nelson Education Ltd. Transfer Pricing Price charged for a component by the selling division to the buying division of the same company Sale is a revenue to the selling division Sale is a cost to the buying division Transfer Pricing policies: –Market price –Cost-based transfer pricing –Negotiated transfer pricing 12-29

30. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 12-4 Alpha Division –Produces cb-117 model that is used by Delta Division –Market price is $14 –Full cost of the board is $9 Delta Division – Heating and air-conditioning manufacturer Information: Omni Inc. has a number of divisions HOW TO Calculate Transfer Price 12-30

31. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.If Omni Inc. has a transfer pricing policy that requires transfer at full cost… a.What will the transfer price be? b.Do you suppose that Alpha and Delta divisions choose to transfer at that price? 2.If Omni Inc. has a transfer pricing policy that requires transfer at market price… a.What would the transfer price be? b.Do you suppose that Alpha and Delta divisions would choose to transfer at that price? Required: 12-31

32. COPYRIGHT © 2012 Nelson Education Ltd. Advantages of EVA 3.Now suppose that Omni Inc. allows negotiated transfer pricing and that Alpha Division can avoid $3 of selling expense by selling to Delta Division a.Which division sets the minimum transfer price and what is it? b.Which division sets the maximum transfer price, and what is it? c.Do you suppose that Alpha and Delta divisions would choose to transfer somewhere in the bargaining range? Required continued: 12-32

33. COPYRIGHT © 2012 Nelson Education Ltd. Example Transfer Pricing at Full Cost: Full cost transfer price $9 Delta Division would like the price, but… Alpha Division would refuse to transfer since $14 could be earned in the outside market 12-33

34. COPYRIGHT © 2012 Nelson Education Ltd. Example Transfer Pricing at Market Price: Market price is $14 Both Delta and Alpha divisions would be willing to transfer at that price (since neither division would be worse off than if it bought/sold in the outside market) 12-34

35. COPYRIGHT © 2012 Nelson Education Ltd. Example Transfer Pricing at a Negotiated Transfer Price: Minimum transfer price = $14 – $3 = $11 This price is set by Alpha division (the selling division) Maximum transfer price = $14 This price is the market price and is set by Delta division (the buying division) Alpha and Delta will negotiate a price somewhere between $11 and $14 12-35

36. OBJECTIVE  5 5 Explain the uses of the Balanced Scorecard and compute cycle time, velocity, and manufacturing cycle efficiency

37. COPYRIGHT © 2012 Nelson Education Ltd. Balanced Scorecard Strategic management system Translates an organization’s mission and strategy into: –Operational objectives –Performance measures –Four different perspectives 12-37

38. COPYRIGHT © 2012 Nelson Education Ltd. Operational Objectives and Performance Measures Financial perspective –economic consequences of actions taken Customer perspective –customer and market segments in which business unit will compete Internal business process perspective –internal processes needed to provide value for customers and owners Learning & growth (infrastructure) perspective –capabilities that an organization needs to create long-term growth and improvement 12-38

39. COPYRIGHT © 2012 Nelson Education Ltd. Strategy Translation Specifying objectives, measures, targets, and initiatives for each perspective 12-39

40. COPYRIGHT © 2012 Nelson Education Ltd. Performance Measures Derived from a company’s vision, strategy, and objectives Measures must be balanced between –performance driver measures and outcome measures –objective and subjective measures –external and internal measures –financial and nonfinancial measures Must also be carefully linked to the organization’s strategy 12-40

41. COPYRIGHT © 2012 Nelson Education Ltd. Financial Perspectives Established the long- and short-term financial performance objectives Concerned with global financial consequences of the three perspectives Three strategic themes: –Revenue growth –Cost reduction –Asset utilization 12-41

42. COPYRIGHT © 2012 Nelson Education Ltd. Revenue Growth Objectives: –Increase number of new products –Create new applications for existing products –Develop new customers and markets –Adopt a new pricing strategy From objectives performance measures can be designed 12-42

43. COPYRIGHT © 2012 Nelson Education Ltd. Cost Reduction Objectives –Reducing the cost per unit of product per customer per distribution channel Trends tell whether costs are being reduced Activity-based costing can play an essential measurement role 12-43

44. COPYRIGHT © 2012 Nelson Education Ltd. Asset Utilization Principle objective –Improving asset utilization Measures –Return on investment –Economic value added 12-44

45. COPYRIGHT © 2012 Nelson Education Ltd. Customer Perspective Defines and selects customer and market segments in which company competes Objectives are to increase: –market share –customer retention –customer acquisition –customer satisfaction –customer profitability 12-45

46. COPYRIGHT © 2012 Nelson Education Ltd. Customer Perspective Measures: –market share –percentage growth of business from existing customers –percentage of repeating customers –number of new customers –ratings from customer satisfaction surveys –individual and segment profitability Activity-based costing is a key tool 12-46

47. COPYRIGHT © 2012 Nelson Education Ltd. Cycle Time and Velocity Responsiveness –Time to respond to a customer order Operational measures –Cycle Time Length of time it takes to produce a unit of output from the time raw materials are received until the good is delivered to finished goods inventory –Velocity Number of units of output that can be produced in a given period of time 12-47

48. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 12-5 Maximum units produced in a quarter, 200,000 units Actual units produced in a quarter, 160,000 units Productive hours in one quarter, 40,000 hours Information: HOW TO Compute Cycle Time and Velocity 1.Compute the theoretical cycle time (in minutes) 2.Compute the actual cycle time (in minutes) 3.Compute the theoretical velocity in units per hour 4.Compute the actual velocity in units per hour Required: 12-48

49. COPYRIGHT © 2012 Nelson Education Ltd. Theoretical Cycle Time Productive hours in one quarter × 60 minutes per hour Maximum units produced in a quarter 40,000 hours ×60 minutes per hour200,000 units 12 minutes per unit 12-49

50. COPYRIGHT © 2012 Nelson Education Ltd. Actual Cycle Time Productive hours in one quarter × 60 minutes per hour Actual units produced in a quarter 40,000 hours ×60 minutes per hour160,000 units 15 minutes per unit 12-50

51. COPYRIGHT © 2012 Nelson Education Ltd. Theoretical Velocity 60 minutes per hour Theoretical cycle time 60 minutes per hour 12 minutes per unit = 5 units per hour = 12-51

52. COPYRIGHT © 2012 Nelson Education Ltd. Actual Velocity 60 minutes per hour Actual cycle time 60 minutes per hour 15 minutes per unit = 4 units per hour = 12-52

53. COPYRIGHT © 2012 Nelson Education Ltd. Manufacturing Cycle Efficiency Time-based operational measure Measured as: –Valued-added time divided by Total time Included both value-added time and non-value added time As MCE improves, cycle time decreases –Only way to improve MCE is to decrease waste and thus reduce costs 12-53

54. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 12-6 Maximum units produced in a quarter, 200,000 units Actual units produced in a quarter, 160,000 units Productive hours in one quarter, 40,000 hours Actual cycle time, 15 minutes Theoretical cycle time, 12 minutes Information: HOW TO Calculate Manufacturing Cycle Efficiency 1.Calculate the amount of processing time and the amount of nonprocessing time 2.Calculate Manufacturing Cycle Efficiency (MCE) Required: 12-54

55. COPYRIGHT © 2012 Nelson Education Ltd. Processing and Nonprocessing Time Processing time = Theoretical time = 12 minutes Nonprocessing time = Actual Cycle Time - Theoretical Cycle Time = 15 – 12 = 3 minutes 12-55

56. COPYRIGHT © 2012 Nelson Education Ltd. Manufacturing Cycle Time (MCE) Processing time 12 (12 + 3) + Nonprocessing time 0.8 or 80 percent 12-56