1. Performance Measurement Chapter 23

2. Financial and Nonfinancial Performance Measures Some organizations present financial and nonfinancial performance measures for their subunits in a single report – the balanced scorecard. Most scorecards include: – profitability measures – customer-satisfaction measures – internal measures of efficiency, quality, and time – learning and growth (innovation) measures

3. Management Control Systems A management control system is a means of gathering and using information to coordinate the planning and control functions of the company. It guides the behavior of managers towards attaining the goals shown in the Balanced Scorecard.

4. Evaluating Management Control Systems MotivationGoal congruenceEffort Lead to rewards MonetaryNonmonetary

5. Organization Structure Total centralization Total decentralization

6. Benefits of Decentralization Allows for greater responsiveness to local needs Leads to gains from quicker decision making Increases motivation of subunit managers Assists management development and learning Allows top management to focus on strategy

7. Costs of Decentralization Suboptimal decision making may occur Focuses the manager’s attention on the subunit rather than the organization as a whole Lack of coordination among autonomous managers Results in duplication of activities

8. Responsibility Centers Cost center Revenue center Investment center Profit center

9. Measuring Managers Performance Cost/Revenue Center Standard Cost/Flexible Budget Variances Profit Center Budgeted income statement Investment Center Return on investment, residual income and EVA Evaluation Tool

10. Accounting-Based Performance Measure Example Relax Inns owns three small hotels – one each in Boston, Denver, and Miami. At present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels.

11. Denver Hotel Current assets$ 400,000 Long-term assets 600,000 Total assets$1,000,000 Current liabilities$ 150,000 Revenues$1,200,000 Variable costs 310,000 Fixed costs 650,000 Operating income$ 240,000

12. Relax Inns Balance Sheet Total current assets$1,350,000 Total long-term assets 6,150,000 Total assets$7,500,000 Total current liabilities$ 500,000 Long-term debt 4,800,000 Stockholders’ equity 2,200,000 Total liabilities and equity$7,500,000

13. Approaches to Measuring Performance Three approaches include a measure of investment: Return on investment (ROI) Residual income (RI) Economic value added (EVA ® ) A fourth approach, return on sales (ROS), does not measure investment.

14. Return on Investment Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income ÷ Investment

15. What is the return on investment for the Denver Hotel? Return on Investment Denver Hotel:$240,000 Operating income ÷$1,000,000 Total assets=24%

16. The DuPont method of profitability analysis recognizes that there are two basic ingredients in profit making: DuPont Method 1. Using assets to generate more revenues 2. Increasing income per dollar of revenues

17. DuPont Method Investment turnover = Revenues ÷ Investment Return on sales = Income ÷ Revenues ROI = Return on sales × Investment turnover

18. DuPont Method How can Relax Inns attain a 30% target ROI for the Denver Hotel? Present situation: Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 Operating income ÷ Revenues = $240,000 ÷ $1,200,000 = 0.20 1.20 × 0.20 = 24%

19. DuPont Method Alternative A: Decrease assets, keeping revenues and operating income per dollar of revenue constant. Revenues ÷ Total assets = $1,200,000 ÷ $800,000 = 1.50 1.50 × 0.20 = 30%

20. DuPont Method Alternative B: Increase revenues, keeping assets and operating income per dollar of revenues constant. Revenues ÷ Total assets = $1,500,000 ÷ $1,000,000 = 1.50 1.50 × 0.20 = 30% Operating income ÷ Revenues = $300,000 ÷ $1,500,000 = 0.20

21. DuPont Method Alternative C: Decrease costs to increase operating income per dollar of revenues, keeping revenues and assets constant. Revenues ÷ Total assets = $1,200,000 ÷ $1,000,000 = 1.20 1.20 × 0.25 = 30% Operating income ÷ Revenues = $300,000 ÷ $1,200,000 = 0.25

22. Residual Income Residual income (RI) = Income – (Required rate of return × Investment) Assume that Relax Inns’ required rate of return is 12%. What is the residual income from the Denver hotel?

23. Residual Income Denver Hotel: Residual Income = $240,000 - ($1,000,000 X 12%) = $120,000

24. Economic Value Added Economic value added (EVA ® ) = After-tax operating income – [Weighted-average cost of capital × (Total assets – current liabilities)]

25. Economic Value Added Total assets minus current liabilities can also be computed as: Long-term assets + Current assets – Current liabilities, or… Long-term assets + Working capital

26. Economic Value Added Economic value added (EVA ® ) substitutes the following specific numbers in the RI calculations: 1.Income equal to after-tax operating income 2. A required rate of return equal to the weighted-average cost of capital 3. Investment equal to total assets minus current liabilities

27. Economic Value Added Example Assume that Relax Inns has two sources of long-term funds: 1. Long-term debt with a market value and book value of $4,800,000 issued at an interest rate of 10% 2. Equity capital that also has a market value of $4,800,000 and a book value of $2,200,000 Tax rate is 30%.

28. Economic Value Added Example What is the after-tax cost of debt? 0.10 × (1 – Tax rate) = 0.07, or 7% Assume that Relax Inns’ cost of equity capital is 14%. What is the weighted-average cost of capital?

29. Economic Value Added Example WACC = [(7% × Market value of debt) + (14% × Market value of equity)] ÷ (Market value of debt + Market value of equity) WACC = [(0.07 × 4,800,000) + (0.14 × 4,800,000)] ÷ $9,600,000 WACC = $336,000 + $672,000 ÷ $9,600,000 WACC = 0.105, or 10.5%

30. Economic Value Added Example What is the after-tax operating income for the Denver Hotel? Denver Hotel: Operating income $240,000 × 0.7 = $168,000

31. Economic Value Added Example What is the investment? Denver Hotel: Total assets $1,000,000 – Current liabilities $150,000 = $850,000

32. Economic Value Added Example What is the weighted-average cost of capital times the investment for Denver? Denver Hotel: $850,000 × 10.5% = $89,250

33. Economic Value Added Example What is the economic value added? Denver Hotel: $168,000 – $89,250 = $78,750 The EVA® charges managers for the cost of their investments in long-term assets and working capital.

34. Return on Sales The income-to-revenues (sales) ratio, or return on sales (ROS) ratio, is a frequently used financial performance measure. What is the ROS for the Denver hotel? Denver Hotel: $240,000 ÷ $1,200,000 = 20%