Managerial Accounting, Chapter 8 by Crosson, Needles

Chapter 8

Performance Management

and Evaluation

Copyright © Houghton Mifflin Company. All rights reserved. 8 | 2

Organizational Goals and the Balanced Scorecard

Objective 1– Describe how the balanced scorecard aligns

performance with organizational goals.


The Balanced Scorecard

A framework that links the perspectives of an organization’s four basic stakeholder groups with the organization’s mission

and vision, performance measures, strategic and tactical plans, and resources

Developed by Robert S. Kaplan and David P. Norton


1. Financial (investors)

2. Learning and growth (employees)

3. Internal business processes

4. Customers

Stakeholder Groups

To succeed, an organization must add value for all groups in both the short and

the long term


Provides a framework that enables managers to translate a vision into operations

Planning

Balanced Scorecard


• Financial (investors)– To achieve our organization’s vision, how

should we appear to our shareholders?

• Learning and growth (employees)– To achieve our organization’s vision, how

should we sustain our ability to improve and change?

Planning (cont’d)


• Internal business processes– To succeed, in which business processes must

our organization excel?

• Customers– To achieve our organization’s vision, how

should we appeal to our customers?

Planning (cont’d)


Once the organization’s objectives are set, managers can select performance measures

and set performance targets.

Managers translate

objectives into an action plan

Planning (cont’d)


If Vail Resorts’ collective vision and strategy is customer satisfaction, its managers might establish the following overall objectives:

Planning Illustrated

Financial (investors) Increase guests’ spending at resorts

Learning and growth Continually cross-train (employees) employees

Internal business processes Leverage market position by introducing and improving innovations that benefit guests

Customers Premium-price experiences and facilities for vacations in all seasons

Perspective Objective


For ski lift manager:– Financial

• Hourly lift cost• Lift ticket sales in dollars and in units

Planning Illustrated (cont’d)

Translate overall objectives into specific performance objectives and measures for

managers at Vail


– Learning and growth• Number of cross-trained tasks per employee

• Employee turnover

– Internal business processes• Number of accident-free days

• Number and cost of mechanical breakdowns

• Average lift cycle time

– Customers• Average number of ski runs per daily lift ticket

• Number of repeat customers

• Number of PEAKS points redeemed

Planning Illustrated (cont’d)


Linked Objectives, Performance Measures, and Targets


Performing

• Balance the needs of all stakeholder groups when making management decisions– Use mutually agreed-on strategic and tactical

objectives for the entire organization as the basis for decision making

• Improve performance by verifying and tracking causal relationships


Evaluating

• Evaluate performance by comparing financial and nonfinancial results with performance measurement targets

• Analyze results and recommend changes• Determine…

– If the targets were met

– What measures need to be changed

– What strategies or objectives need revision


Communicating

– Financial performance reports– Customer PEAKS statements– Internal business processes reports for

targeted performance measures and results– Performance appraisals of individual

employees

Prepare reports of interest to stakeholder groups


Stop & Review

Q. With regard to evaluating the company vision from the perspective of the learning and growth (employee) stakeholder group, what key question would managers want to answer?

A. To achieve our organization’s vision, how should we sustain our ability to improve and change?


Performance Measurement

Objective 2– Discuss performance measurement, and

identify the issues that affect management’s ability to measure performance.


Performance Management and Evaluation System

Used to identify:– How well a company is doing– Where it is going– What improvements will make it more

profitable

A set of procedures that account for and report on both financial and

nonfinancial performance


Performance Measurement

The use of quantitative tools to gauge an organization’s

performance in relation to a specific goal or an expected

outcome

To succeed, managers must be able to distinguish between what

is being measured and the actual measures used to monitor performance


Other Measurement Issues

– What performance measures can be used?– How can the level of product or service quality to monitored?– How can areas that need improvement be identified? – How can customer satisfaction be measured?– How can financial performance be monitored?– Are there other stakeholders to whom a manager is accountable?– What performance measures do government entities impose on

the company?– How can the company’s effect on the environment be

measured?

Issues to consider other than what to measure and how to measure it


Stop & Review

Q. What does a performance management and evaluation system identify?

A. How well a company is doing, where it is going, and what improvements will make it more profitable.


Responsibility Accounting

Objective 3– Define responsibility accounting, and describe

the role that responsibility centers play in performance management and evaluation.


Responsibility Accounting

• Assign resources to specific areas of responsibility

• Track how the managers of those areas use those resources

• Evaluate managers at all levels in terms of their ability to manage their area of responsibility in keeping with organizational goals

Performance management systems


Responsibility Accounting (cont’d)

• Is an information system

• Classifies data according to areas of responsibility

• Reports each area’s activities by including only the revenue, cost, and resource categories that the assigned manager can control


Responsibility Center

The activities of a responsibility center dictate the extent of a manager’s

responsibility.

An organizational unit whose manager has been assigned the responsibility of managing

a portion of the organization’s resources


Types of Responsibility Centers

1. Cost centers

2. Discretionary cost centers

3. Revenue centers

4. Profit centers

5. Investment centers


Cost Center

• A responsibility center whose manager is accountable only for controllable costs that have well-defined relationships between the center’s resources and products or services

• Performance evaluated by comparing an activity’s actual cost with its budgeted cost and analyzing the resulting variances

Companies like Coach, Inc., Apple Computer, and Kraft use cost centers to

manage assembly plants


Cost Center Examples

– Assembly plants in manufacturing organizations

• Relationship between the costs of resources and resulting products is well defined

– Food services in hospitals and nursing homes• Clear relationship between costs of food and direct

labor and the number of inpatient meals served


Discretionary Cost Center

– Cost-based measures cannot usually be used to evaluate performance

A responsibility center whose manager is accountable for costs only and in which the relationship between resources and products or services produced is not well defined


Discretionary Cost Center Examples

– Administrative activities• Accounting

• Human resources

• Legal services

– Research and Development• Might measure number of patents obtained and number of

cost-saving innovations developed

– Service organizations• United Way might measure administrative activities by how

low their costs are as a percentage of total contributions


Revenue Center

A responsibility center whose manager is accountable primarily for revenue and whose success is based on its ability to

generate revenue

Examples: • Car rental reservation center• Clothing retailer’s

ecommerce order department

Performance measures:• Sales dollars• Sales revenue per minute• Number of sales


Profit Center

Performance evaluated by comparing the figures from actual income statements

with the figures in its master or flexible budget income statement

A responsibility center whose manager is accountable for both revenue and costs and for the resulting operating

income

Local Jiffy Lube


Investment Center

A responsibility center whose manager is accountable for profit generation and can also make significant decisions about the resources the center uses

Performance of both manufacturing and service organizations usually evaluated using measures such as:

• Return on investment

• Residual income• Economic value added


Types of Responsibility Centers


Organizational Structure and Performance Management

• Organization chart – visual representation of an organization's hierarchy of responsibility for purposes of management control

A company’s organizational structure formalizes its lines of managerial

authority and control


Organizational Structure and Performance Management (cont’d)• Responsibility accounting systems establish

communications network within an organization– Ideal for gathering and reporting information about the

operations of each area of responsibility

– Budgets can be prepared by responsibility area

– Actual results reported by responsibility area


Controllable Costs and Revenues

• The report for a responsibility center should contain only controllable costs and revenues– The costs, revenues, and resources that the

manager of a center can control

A responsibility accounting system assures managers will not be held responsible for items

they cannot change


Partial Organization Chart of Café Cubano, a Restaurant Chain


Performance Reports

• Performance reports for each level of management are tailored to each manager’s individual needs for information

• The same information may appear in various formats in several different reports– Information from reports for lower-level

managers is usually summarized and condensed when it appears in upper-level managers’ reports


Stop & Review

Q. What is the difference between a cost center and a discretionary cost center?

A. The managers of cost centers are accountable for controllable costs that have well-defined relationships between the center’s resources and products or services. The managers of discretionary cost centers are accountable for costs in which the relationship between resources and products or services produced is not well defined. Therefore, cost-based measures cannot usually be used to evaluate performance.


Performance Evaluation of Cost Centers and Profit Centers

Objective 4– Prepare performance reports for cost centers

using flexible budgets and for profit centers using variable costing.


Performance Reports

If a performance report includes items that the manager cannot control, the credibility of the entire responsibility

accounting system can be called into question.

– Allow comparisons between actual performance and budget expectations

• Contain information about costs, revenues, and resources controllable by individual managers

– Allow evaluation of an individual’s performance with respect to responsibility center objectives and companywide objectives

– Recommend changes


Evaluating Cost Center Performance Using Flexible Budgeting

Orlena Torres, the VP of food products at Café Cubano, is responsible for the central kitchen, where the food products the restaurants sells are prepared.

• The central kitchen is a cost center (well-defined relationships with resulting products)

• Torres has decided to evaluate the performance of each food item produced

• A separate report will be prepared for each product comparing actual costs with budgeted costs


Central Kitchen’s Performance Report on Café Cubano’s House Dressing

Note the difference in variance when actual costs are compared to flexible budget amounts versus the

master budget amounts.


Evaluating Profit Center Performance Using Variable Costing

Profit center performance is usually evaluated by comparing actual income

statement results to the budgeted income statement


Variable Costing

• Method of preparing profit center performance reports that classifies a manager’s controllable costs as either variable or fixed

• Instead of a traditional income statement, a variable costing income statement is produced– Same as a contribution income statement

– Useful because it focuses on cost variability and the profit center’s contribution to operating income


Evaluating Profit Center Performance Using Variable Costing• When using variable costing to evaluate profit

center performance– Variable cost of goods sold and variable selling and

administrative expenses are subtracted from sales to arrive at the contribution margin for the center

– All controllable fixed costs are subtracted from gross margin to determine the operating income

• Includes fixed manufacturing costs and fixed selling and administrative expenses


Evaluating Profit Center Performance Using Variable Costing (cont’d)

• When preparing a traditional income statement– All manufacturing costs are assigned to cost of

goods sold– Cost of goods sold is subtracted from sales to

arrive at the gross margin– Variable and fixed selling expenses are

subtracted from gross margin to determine operating income


Variable Costing Income Statement Traditional Income Statement Sales Sales Less all variable costs Less cost of goods sold Equals contribution margin Equals gross margin Less all fixed costs Less all period costs Equals profit center income Equals profit center income

• Variable costing income statement– Groups costs according to whether they are variable or fixed

• Traditional income statement– Groups cost according to whether they are costs of goods sold

or period costs



Variable Costing Income Statement Versus Traditional Income Statement for a

Trenton Restaurant


Financial performance reports:• Vary in format depending on

the type of responsibility center

• Share common themes– Compare a center’s actual

results to its budgeted figures– Focus on the differences– Only items managers can

control are included

The manager of a profit center may also want to measure and

evaluate nonfinancial information



Stop & Review

Q. How does a variable costing income statement arrive at profit center income?

A. Variable cost of goods sold and variable selling and administrative expenses are subtracted from sales to determine the contribution margin. All fixed manufacturing costs and fixed selling and administrative expenses are subtracted from the contribution margin to arrive at profit center income.


Performance Evaluation of Investment Centers

Objective 5– Prepare performance reports for

investment centers using the traditional measures of return on investment and residual income and the newer measure of economic value added.


Performance Evaluation of Investment Centers

• Comparison of controllable revenues and costs with budgeted amounts

• Performance measures for capital investments that mangers control

Performance evaluation of an investment center should include:


Return on Investment

Invested Assets

Income Operating (ROI) Investmenton Return

Assets invested is the average of the beginning and ending asset balances

for the period.

Takes both operating income and assets invested to earn that income into account


Performance Report Based on Return on Investment for the Café Cubano

Restaurant Division


Return on Investment (cont’d)

• The ROI computation is the aggregate measure of many interrelationships– The basic ROI equation can be rewritten to show the

many elements a manager can influence

Invested Assets

Income Operating ROI

Invested Assets

Sales

Sales

Income Operating ROI

TurnoverAsset Margin Profit ROI



Two important indicators of performance:– Profit margin

• Ratio of operating income to sales• Represents the percentage of each sales dollar the

results in profit

– Asset turnover• Ratio of sales to average assets invested• Indicates the productivity of assets

– Number of sales dollars generated by each dollar invested in assets


• Profit margin and asset turnover help to explain– Changes in ROI for a single investment center– Differences in ROI among investment centers

• ROI formula is useful for analyzing and interpreting the elements that make up a business’s overall return on investment



• A single ROI number is a composite index of many cause-and-effect relationships and interdependent financial elements

• Managers can improve ROI by– Increasing sales– Decreasing costs– Decreasing assets



Factors That Affect the Return on Investment Calculation


• ROI should be used cautiously in evaluating performance– Affected by many factors

• If overemphasized– Investment center managers may make business

decisions that favor their personal ROI • At the expense of companywide profits or long-term success

of other investment centers

– To avoid this problem, always use other performance measures in conjunction with ROI



Other Performance Measures Used Along With ROI– Comparisons of revenues, costs, and operating income

with budgeted amounts or past trends

– Sales growth percentages

– Market share percentages

– Other key variables in the organization's activity

– Ratio of ROI to budgeted goals and past ROI trends• Changes in this ratio over time can be more revealing than any

single number


Residual Income (RI)

Developed because of pitfalls in using ROI as a performance measure

The operating income that an investment center earns above a minimum desired return

on invested assets

The desired RI will vary among investment centers depending on the type of business and

level of risk assumed


Residual Income (cont’d)

• Is not a ratio but a dollar amount– Amount of profit left after subtracting a

predetermined desired income target for an investment center

Invested) Assets ROI (Desired Income Operating Income Residual

As with ROI computations, assets invested is the average of the center’s beginning and ending asset balances for the period


Performance Report Based on Residual Income for the Café Cubano

Restaurant Division


Residual Income Analysis

• Comparisons with other RI figures will strengthen the analysis

• To add context to the analysis, the following questions should be answered– How does the division’s RI for this year compare with

previous years?

– Did actual RI exceed budgeted RI?

– How does this division’s RI compare with the RI of other investment centers of the company?


Residual Income Analysis

• When comparing a division’s RI with the RI of other investment centers of the company, caution should be used– For RI figures to be comparable, all investment centers

must have • Equal access to resources• Similar asset investment bases

– Managers may be able to produce a larger RI simply because their investment centers are larger

• May not reflect better performance


Economic Value Added (EVA)

• Used as an indicator of performance• Is a registered trademark of the consulting

firm Stern Stewart & Company

The shareholder wealth created by an investment center


Economic Value Added (cont’d)

• Calculation can be complex– Makes various cost of capital and accounting principles

adjustments

• EVA is expressed as a dollar amount

Dollarsin Capital ofCost Income OperatingTax -After EVA

Cost of capital is the minimum desired rate of return on an investment, such as assets invested in an investment center

Income OperatingTax -After EVA s)]LiabilitieCurrent Assets (Total Capital of[Cost

or


Performance Report Based on Economic Value Added for the Café Cubano

Restaurant Division



Compare the current EVA with:– EVAs from previous periods

– Target EVAs

– EVAs from other investment centers

CautionUse care when evaluating performance using EVA. Many factors affect the economic value of an investment center.•Pricing •Sales Volume•Taxes•Cost of capital


Factors Affecting the Computation of Economic Value Added



• The EVA number is a composite index drawn from many cause-and-effect relationships and interdependent financial elements

• Managers can improve the EVA of an investment center by– Increasing sales– Decreasing costs– Decreasing assets– Lowering the cost of capital


The Importance of Multiple Performance Measures

• To be effective, a performance management system must consider both operating results and multiple performance measures, such as ROI, RI, and EVA– Comparing actual results to budgeted figures adds

meaning to the evaluation


The Importance of Multiple Performance Measures (cont’d)

• Performance measures such as ROI, RI, and EVA – Indicate whether an investment center is effective in

coordinating its goals with companywide goals• Take into account both operating income and the assets used to

produce that income

– Are limited by their focus on short-term financial performance

• Management should break these measures down into their components, analyze information over time, and compare current results to targeted amounts


Stop & Review

Q. What may happen if return on investment is overemphasized as a performance measure?

A. Investment center managers may make business decisions that favor their personal ROI at the expense of companywide profits or long-term success of other investment centers. To avoid this problem, always use other performance measures in conjunction with ROI.


Performance Incentives and Goals

Objective 6– Explain how properly linked performance

incentives and measures add value for all stakeholders in performance management and evaluation.


Performance Incentives and Goals

• Two key factors– Logical linking of goals to measurable objectives and

targets

– Performance-based pay

The effectiveness of a performance management and evaluation system depends on successful

coordination of goals between…

Managers

Responsibility centers Entire company


Linking Goals, Performance Objectives, Measures, and Performance Targets

• The causal links between an organization’s goals, performance objectives, measures, and targets must be apparent

Goal Objective Measure Performance Target To be an

environmental steward

To reduce, reuse, recycle

Number of tons recycled per year

To recycle at least one pound per guest

Recall that the balanced scorecard also links objectives, measures, and targets


Performance-Based Pay

Increases likelihood that the goals of responsibility centers, managers, and the

entire organization will be well coordinated

Linking of employee compensation to the achievement of measurable business targets


Common Types of Incentive Compensation– Cash bonuses

• Usually awarded for short-term performance

– Awards• May be a trip or some other form of recognition

– Profit-sharing plans• Reward employees with a share of the company’s profits

– Stock programs• Used to motivate employees to achieve financial targets that

increase the company’s stock price


Input From Employees and Managers on Incentives

• When should the reward occur?• Whose performance should be rewarded?• How should the reward be computed?• On what should the reward be based?• What performance criteria should be used?• Does the performance incentive plan address

the interests of all stakeholders?


Coordination of Goals

• The effectiveness of a performance management and evaluation system relies on the coordination of responsibility center, managerial, and company goals– Can be optimized by

• Linking goals to measurable objectives and targets

• Tying appropriate compensation incentives to the achievement of the targets


Stop & Review

Q. The successful coordination of goals between responsibility centers, managers, and the entire company is dependent upon what two key factors?

A. The logical linking of goals to measurable objectives and targets and performance-based pay.


Chapter Review

1. Describe how the balanced scorecard aligns performance with organizational goals.

2. Discuss performance measurement, and identify the issues that affect management’s ability to measure performance.


Chapter Review (cont’d)

3. Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation.

4. Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing.


5. Prepare performance reports for investment centers using the traditional measures of return on investment and residual income and the newer measure of economic value added.

6. Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.

Chapter Review (cont’d)

Documents

Managerial Accounting, Chapter 8 by Crosson, Needles