Transcript of Performance Evaluation EMBA 5412 Fall 2010. 2 Performance of what? Companies Divisions Products ...
- Slide 1
- Performance Evaluation EMBA 5412 Fall 2010
- Slide 2
- 2 Performance of what? Companies Divisions Products
managers
- Slide 3
- 3 Centralization - Decentralization Total
decentralization-minimum constraints and maximum freedom for
managers at the lowest levels of an organization to make decisions
Total centralization - maximum constraints and minimum freedom for
managers at the lowest levels of an organization to make decisions
A structure is chosen based on cost vs. benefit analysis
- Slide 4
- 4 Decentralized Organizations substantial decision making
authority - the managers of subunits managers at lower levels of
the organization free to make decisions Autonomy is the degree of
freedom to make decisions. The greater the freedom, the greater the
autonomy Usually some decentralized some centralized
- Slide 5
- 5 Advantages of Decentralization Provides better information to
make decisions at the local and top management levels Leads to
gains from faster decision making quicker responses to changing
circumstances Creates greater responsiveness to local needs
Increases motivation of subunit managers Provides excellent
training for future top-level executives Sharpens the focus of
subunit managers
- Slide 6
- 6 Disadvantages of Decentralization Costly duplication of
activities Lack of goal congruence Agency Management pursues
personal goals Personal goals are incompatible with the companys
goals
- Slide 7
- 7 Why Evaluate A company evaluates subunits in order to decide
if it should expand or contract them or change their operations A
company evaluates subunit managers in order to motivate them to
take actions that maximize the value of the firm Reasons for
evaluating subunit managers: Identifies successful operations and
areas needing improvement Influences the behavior of managers
- Slide 8
- 8 Responsibility Accounting and Performance Evaluation
Responsibility accounting - managers responsible only for costs and
revenues that they can control To implement responsibility
accounting in a decentralized organization, costs and revenues are
traced to the organizational level where they can be
controlled
- Slide 9
- 9 Tracing Costs to Organizational Levels
- Slide 10
- 10 Types of responsibility centers Cost Center Revenue Center
Profit Center Investment Center
- Slide 11
- 11 Cost Centers Subunit responsible for controlling costs but
not responsible for generating revenue Most service departments are
cost centers (i.e., janitorial, maintenance, computer services,
production) Must provide service to company at a reasonable cost
Evaluation based on comparison of budgeted or standard costs with
actual costs
- Slide 12
- 12 Profit Centers Subunit responsible for generating revenues
and controlling costs Goal is to maximize profit for the division
Performance can be evaluated in terms of profitability Motivates
managers to focus their attention on ways of maximizing profit A
variety of methods are used to evaluate profitability Current
income compared to budgeted income Current income compared to past
income Comparison with other profit centers, called relative
performance evaluation
- Slide 13
- 13 Investment Centers Subunit responsible for generating
revenue, controlling costs, and investing in assets Goal is to
maximize return on investment Evaluation based on comparison with a
benchmark, previous years, or other investment centers
- Slide 14
- 14 Boyner Example A wide range of products varying from
cosmetics to sports, and from home appliances to kidswear are
presented at 24 Boyner Stores all over Turkey in stanbul, Ankara,
Adana, Antalya, Bursa, zmir, Trabzon, Mersin, Diyarbakr, Denizli
and Konya. Women, Men, Kids and Shoes at each of the Discount
Stores servicing the customers at 8 different locations all over
Turkey Outlet centers and stores could be profit or investment
centers Each store could be a revenue or profit center depending
how autonomous they are Accounting department and maintenance-cost
centers
- Slide 15
- 15 Study Break #1 An investment center is responsible for:
a.Investing in long term assets b.Controlling costs c.Generating
revenues d.All of the above Answer: d. All of the above
- Slide 16
- 16 Study Break #2 Cost centers are often evaluated using:
a.Variance analysis b.Operating margin c.Return on investment
d.Residual income Answer: a. Variance analysis
- Slide 17
- 17 Study Break #3 Profit centers are often evaluated using:
a.Investment turnover b.Income targets or profit budgets c.Return
on investment d.Residual income Answer: b. Income targets or profit
budgets
- Slide 18
- 18 Accounting-Based Performance Measures Requires a six-step
design process: 1.Choose Performance Measures that align with top
managements financial goals 2.Choose the time horizon of each
Performance Measure 3.Choose a definition of the components in each
Performance Measure 4.Choose a measurement alternative for each
Performance Measure 5.Choose a target level of performance 6.Choose
the timing of feedback
- Slide 19
- 19 Step 1: Choosing among Different Performance Measures Four
common measures of economic performance: 1.Return on Investment
2.Residual Income 3.Economic Value Added 4.Return on Sales
Selecting Subunit Operating Income as a metric is inappropriate
since it obviously differs simply on the differing size of the
subunits
- Slide 20
- 20 Evaluating Investment Centers With ROI ROI is a primary tool
for evaluating the performance of investment centers = Investment
Center Income Invested Capital Focuses managements attention on
income and level of investment Most popular metric for two reasons:
Blends all the ingredients of profitability (revenues, costs, and
investment) into a single percentage May be compared to other ROIs
both inside and outside the firm Also called the Accounting Rate of
Return (ARR) or the Accrual Accounting Rate of Return (AARR)
- Slide 21
- 21 ROI Components ROI may be broken down into two components:
profit margin and investment turnover. ROI = Profit Margin x
Investment Turnover ROI = Income x____Sales_____ SalesInvested
Capital ROI = Return on Sales X Investment Turnover This is known
as the DuPont Method of Profitability Analysis
- Slide 22
- 22 Which investment? Four possible alternative definitions of
investment: 1.Total Assets Available- all assets 2.Total Assets
Employed-total assets available less any idle assets or assets
purchased for expansion in the future 3.Total Assets Employed minus
Current Liabilities 4.Stockholders Equity Gross or net?
- Slide 23
- 23 Measuring Income In calculating ROI, companies measure
income in a variety of ways net income after tax Operating income
Income before tax Most common method is NOPAT Net Operating Profit
After Taxes To calculate NOPAT, a company must add back
non-operating items to net income and adjust tax expense
accordingly
- Slide 24
- 24 NOPAT Example Tax rate 35%
- Slide 25
- 25 Measuring Income and Invested Capital for ROI In calculating
ROI, companies measure invested capital in a variety of ways
Approach used here: Total assets less non-interest-bearing current
liabilities
- Slide 26
- 26 Invested Capital Example
- Slide 27
- 27 ROI France, Germany, and Japan
- Slide 28
- 28 Most common financial measures CountryFinancial Measures
USABudgeted-Actual Income (49%)ROI (29%) EVA (14%) ROSales(3%)
AustraliaROI, Budgeted-Actual Income GermanyRevenue, Contribution
Margin(per unit) IndiaROI, Budgeted-Actual Income JapanROS(82%) ROI
(37%) NetherlandsROI, cash flows, income SingaporeROI Horngren et
al, 2006,p.799
- Slide 29
- 29 Return on Sales (ROS) Return on Sales is simply income
divided by sales Simple to compute, and widely understood
- Slide 30
- 30 Example Exercise #1 Davenport Mills is a division of Iowa
Woolen Products, Inc. For the most recent year, Davenport had net
income of $16,000,000. Included in income was interest expense of
$1,300,000. The operations tax rate is 40%. Total assets of
Davenport Mills are $225,000,000, current liabilities are
$45,000,000, and $30,000,000 of the current liabilities are
noninterest-bearing. Calculate NOPAT, invested capital, and
ROI.
- Slide 31
- 31 Example Exercise #1 Solution NOPAT =Net income + interest
expense (1 - tax rate) =$16,000,000 + $1,300,000 (1 -.40)
=$16,780,000 Invested Capital = Total assets - noninterest-bearing
current liabilities = $225,000,000 - $30,000,000 =
$195,000,000
- Slide 32
- 32 Example Exercise #1 Solution ROI = NOPAT Invested capital =
$16,780,000 $195,000,000 = 86.05%
- Slide 33
- 33 Problems with ROI Invested capital is typically based on
historical costs Fully depreciated assets lead to a low invested
capital number resulting in high ROI Makes comparison of investment
centers using ROI difficult Managers may put off purchase of new
equipment May lead to underinvestment Possible alternative
definitions of cost: 1.Current Cost 2.Gross Value of Fixed Assets
3.Net Book Value of Fixed Assets
- Slide 34
- 34 Problems of Overinvestment and Underinvestment Evaluation
using Profit can lead to overinvestment Managers may be motivated
to make investments that earn a return that is less than the cost
of capital Evaluation using ROI can lead to underinvestment
Managers may not take on projects that have a low ROI just to
increase profit if they are evaluated in terms of the return they
earn
- Slide 35
- 35 Residual Income (RI) Net operating profit after taxes of an
investment center in excess of its required profit Required profit
is equal to the investment centers required rate of return times
the level of investment in the center RI = NOPAT Required Profit
Required rate of return is generally the cost of capital for the
investment center
- Slide 36
- 36 Residual Income Residual Income (RI) is an accounting
measure of income minus a dollar amount for required return on an
accounting measure of investment RI = Income (RRR x Investment) RRR
= Required Rate of Return Required Rate of Return times the
Investment is the imputed cost of the investment Imputed costs are
costs recognized in some situations, but not in the financial
accounting records
- Slide 37
- 37 Example Exercise #2 Using the same information as in Example
Exercise #1, calculate the residual income if the companys cost of
capital is 10%.
- Slide 38
- 38 Example Exercise #2 Solution Residual Income = NOPAT (Cost
of Capital x Invested Capital) = $16,780,000 (10% x $195,000,000) =
($2,720,000)
- Slide 39
- 39 Decision Making
- Slide 40
- 40 Economic Value Added (EVA) EVA is residual income adjusted
for accounting distortions that arise from GAAP A performance
measure approach to solving overinvestment and underinvestment
problems Advantage is that managers are less tempted to cut those
costs that distort income under GAAP For example, under GAAP
research and development costs are expensed, but the costs benefits
future periods Thus, under EVA research and development is
capitalized and amortized over future periods
- Slide 41
- 41 Economic Value Added (EVA ) EVA is a specific type of
residual income calculation that has recently gained popularity
Weighted-average cost of capital equals the after-tax average cost
of all long-term funds in use
- Slide 42
- 42 Residual Income NIBCL = Net Income Before Current
Liabilities(excluding debt)
- Slide 43
- 43 Study Break #4 Use of profit as a performance measure: a.May
lead to overinvestment in assets b.Is appropriate for an investment
center c.Is appropriate as long as profit is calculated using GAAP
d.Encourages managers to finance operations with debt rather than
equity Answer: a. May lead to overinvestment in assets
- Slide 44
- 44 Study Break #5 Investment centers are often evaluated using:
a.Standard cost variances b.Return on investment c.Residual
income/EVA d.Both b and c Answer: d. Both b and c
- Slide 45
- 45 EVA
- Slide 46
- 46 Economic Profit Economic Value Added EVA* yardstick to
measure if the business is earning above its cost of capital of
resources it employs developed by Stern Stewart and Co. EVA= NOPAT
C*k NOPAT = operating profit after tax (adjusted) C = capital base
employed net of depreciation k = weighted average cost of
capital
- Slide 47
- 47 EVA Adjustments to NOPAT- Operating leases operating lease
expenses: in a sense the assets under operating lease should be
part of the capital employed thru off balance sheet financing
operating lease (net of tax) is added back to operating profit
therefore future payments of the operating lease is discounted and
added to assets and a related liability is also established then
the present value of the operating lease is amortized over an
appropriate period such as the contract period, and this derived
amortization amount is deducted from net income
- Slide 48
- 48 EVA Adjustments to NOPAT- Research and Development and
Advertising and Promotional Expenses the benefits extend into the
future therefore R&D and A&P expenses are removed from the
income determination R&D and A&P expenses are capitalized
and amortized over a reasonable period the amortized amount is then
deducted in the income determination
- Slide 49
- 49 EVA Adjustments to NOPAT- Inventory Value Adjustment
(LIFO)and Deferred tax when companies use LIFO as their inventory
cost flow, then the value of the inventories on the balance sheet
will be different from its current value because the amount that
appears on the balance sheet is based on old cost figures recent
additions to inventory become part of COGS thus inventories are
restated to current higher (the method is usually used under
inflationary conditions) values with an offsetting increase to
earnings- add back the change in LIFO reserves to income add the
changes in deferred taxes to NOPAT
- Slide 50
- 50 EVA Adjustments to NOPAT- Goodwill any amortization of
goodwill is added back to operating profit before tax assumption :
total amount of goodwill should be reflected in the balance sheet
because this asset is a permanent part of the capital base so
adjust NOPAT by the amount of amortization and balance sheet to
reflect the total amount of goodwill IFRS-watch for goodwill
impairment
- Slide 51
- 51 EVA Adjustments to Capital Base Non-operating assets: such
assets should be excluded from the capital base because they are
not used in generation of earnings
- Slide 52
- 52 Step 1 - Calculate the capital base Current assets
(excluding cash) + Net Fixed Assets + Capitalization of Operating
Leases + Other Long-term Assets +/- Equity Equivalents - Current
Liabilities (excluding debt) - Long term liabilities (excluding
debt) = Capital Employed ( Capital Base) How to compute EVA*
- Slide 53
- 53 Step 2 - Calculate net operating profit after tax EBIT +/-
Change in equity equivalents + operating lease payments - Cash tax
= NOPAT How to compute EVA*
- Slide 54
- 54 Step 3 - Calculate Capital Charge = Cost of Capital *
Capital base (opening) Step 4 - Calculate EVA *= NOPAT - Capital
Charge How to compute EVA*
- Slide 55
- 55 EVA* example Tax rate 30%
- Slide 56
- 56 EVA* example
- Slide 57
- 57 EVA* example
- Slide 58
- 58 Example - comparison
- Slide 59
- 59 Discussion of financial measures Growth- may lead to over
investment- investing in projects with lower returns ROI may lead
to under investment lower capital base produces higher returns
Residual Income affected by the accounting standards EVA* -
motivates good investment decisions because EVA increases as good
investment decisions are made effects of accounting standards are
eliminated However, they are all backward looking based on
historical performance
- Slide 60
- 60 Cash flow ROI-CFROI represents companys economic performance
developed by Holt Value Associates based on transforming financial
results to current dollar cash flow return on investment many
adjustments when applied to future cash flows and combined with
projected growth in the companys assets can be used to estimate the
companys market value culminates the concept of Cash Value Added
CVA- finding the economic value created by successful business
strategies and investments over and above earning the cost of
capital on a discounted cash flow basis
- Slide 61
- 61
- Slide 62
- 62 Financial and Nonfinancial Measures Firms are increasingly
presenting financial and nonfinancial performance measures for
their subunits in a Balanced Scorecard, and its four perspectives:
1.Financial 2.Customer 3.Internal Business Process 4.Learning and
Growth
- Slide 63
- 63 Balanced Scorecard Flow Firms assume that improvements in
learning and growth will lead to improvements in internal business
processes Improvements in the internal business processes will lead
to improvements in the customer and financial perspectives
- Slide 64
- 64 The Balanced Scorecard The balanced scorecard translates an
organizations mission and strategy into a set of performance
measures that provides the framework for implementing its strategy
It is called the balanced scorecard because it balances the use of
financial and nonfinancial performance measures to evaluate
performance
- Slide 65
- 65 Balanced Scorecard Perspectives 1.Financial 2.Customer
3.Internal Business Perspective 4.Learning and Growth
- Slide 66
- 66 The Financial Perspective Evaluates the profitability of the
strategy Uses the most objective measures in the scorecard The
other three perspectives eventually feed back into this
dimension
- Slide 67
- 67 The Customer Perspective Identifies targeted customer and
market segments and measures the companys success in these
segments
- Slide 68
- 68 The Internal Business Prospective Focuses on internal
operations that create value for customers that, in turn, furthers
the financial perspective by increasing shareholder value Includes
three subprocesses: 1.Innovation 2.Operations 3.Post-sales
service
- Slide 69
- 69 The Learning and Growth Perspective Identifies the
capabilities the organization must excel at to achieve superior
internal processes that create value for customers and
shareholders
- Slide 70
- 70 Balanced Scorecard Set of performance measures constructed
for four dimensions of performance Financial Critical measures even
if they are backward looking Customer Examines the companys success
in meeting customer expectations Internal Processes Examines the
companys success in improving critical business processes Learning
and Growth Examines the companys success in improving its ability
to adapt, innovate, and grow
- Slide 71
- 71 Balanced Scorecard Company develops three to five
performance measures for each dimension Measures should be tied to
company strategy Balance among the dimensions is critical
- Slide 72
- 72 Balanced Scorecard
- Slide 73
- 73 How Balance is Achieved in a Balanced Scorecard Performance
is assessed across a balanced set of dimensions Balance
quantitative measures with qualitative measures There is a balance
of backward- looking measures and forward- looking measures
- Slide 74
- 74 The Balanced Scorecard Flowchart
- Slide 75
- 75 Balanced Scorecard Implementation Must have commitment and
leadership from top management Must be communicated to all
employees
- Slide 76
- 76 Developing a Strategy Map for a Balanced Scorecard A
strategy map is a diagram of the relationships of the strategic
objectives across the four dimensions Used to test the soundness of
the strategy Identifies how strategy is linked to measures on the
scorecard Communicates strategic objectives to employees
- Slide 77
- 77 Strategy Map Example
- Slide 78
- 78 Features of a Good Balanced Scorecard Tells the story of a
firms strategy, articulating a sequence of cause-and-effect
relationships: the links among the various perspectives that
describe how strategy will be implemented Helps communicate the
strategy to all members of the organization by translating the
strategy into a coherent and linked set of understandable and
measurable operational targets
- Slide 79
- 79 Keys to a Successful Balanced Scorecard Targets For each
measure, there should be a target so managers know what they are
expected to achieve Initiatives For each measure, the company must
identify actions that will be taken to achieve the target
Responsibility A particular employee must be given responsibility
and held accountable for successfully implementing each initiative
Funding Initiatives must be funded appropriately Top Management
Support It is crucial to have the full support of top
management
- Slide 80
- 80 Features of a Good Balanced Scorecard Must motivate managers
to take actions that eventually result in improvements in financial
performance Predominately applies to for-profit entities, but has
some application to not-for-profit entities as well Limits the
number of measures, identifying only the most critical ones
Highlights less-than-optimal tradeoffs that managers may make when
they fail to consider operational and financial measures
together
- Slide 81
- 81 Balanced Scorecard Implementation Pitfalls Managers should
not assume the cause-and-effect linkages are precise: they are
merely hypotheses Managers should not seek improvements across all
of the measures all of the time Managers should not use only
objective measures: subjective measures are important as well
- Slide 82
- 82 Balanced Scorecard Implementation Pitfalls Managers must
include both costs and benefits of initiatives placed in the
balanced scorecard: costs are often overlooked Managers should not
ignore nonfinancial measures when evaluating employees Managers
should not use too many measures
- Slide 83
- 83 Distinction between Managers and Organization Units The
performance evaluation of a manager should be distinguished from
the performance evaluation of that managers subunit, such as a
division of the company
- Slide 84
- 84 The Trade-Off: Creating Incentives vs. Imposing Risk An
inherent trade-off exists between creating incentives and imposing
risk An incentive should be some reward for performance An
incentive may create an environment in which suboptimal behavior
may occur: the goals of the firm are sacrificed in order to meet a
managers personal goals
- Slide 85
- 85 Moral Hazard Moral Hazard describes situations in which an
employee prefers to exert less effort (or report distorted
information) compared with the effort (or accurate information)
desired by the owner because the employees effort (or the validity
of the reported information) cannot be accurately monitored and
enforced
- Slide 86
- 86 Intensity of Incentives Intensity of Incentives how large
the incentive component of a managers compensation is relative to
their salary component
- Slide 87
- 87 Preferred Performance Measures Preferred Performance
Measures are those that are sensitive to or change significantly
with the managers performance They do not change much with changes
in factors that are beyond the managers control They motivate the
manager as well as limit the managers exposure to risk, reducing
the cost of providing incentives May include Benchmarking
- Slide 88
- 88 Preferred Performance Measures Preferred Performance
Measures are those that are sensitive to or change significantly
with the managers performance They do not change much with changes
in factors that are beyond the managers control They motivate the
manager as well as limit the managers exposure to risk, reducing
the cost of providing incentives May include Benchmarking
- Slide 89
- 89 Performance Measures at the Individual Activity Level Two
issues when evaluating performance at the individual activity
level: 1.Designing performance measures for activities that require
multiple tasks 2.Designing performance measures for activities done
in teams
- Slide 90
- 90 Compensation for Multiple Tasks If the employer wants an
employee to focus on multiple tasks of a job, then the employer
must measure and compensate performance on each of those tasks
- Slide 91
- 91 Team-Based Compensation Companies use teams extensively for
problem solving Teams achieve better results than individual
employees acting alone Companies must reward individuals on a team
based on team performance
- Slide 92
- 92 Executive Compensation Plans Based on both financial and
nonfinancial performance measures, and include a mix of: Base
Salary Annual Incentives, such as cash bonuses Long-Run Incentives,
such as stock options Well-designed plans use a compensation mix
that balances risk (the effect of uncontrollable factors on the
performance measure, and hence compensation) with short-run and
long-run incentives to achieve the firms goals
- Slide 93
- 93 Step 2: Choosing the Time Horizon of the Performance
Measures Multiple periods of evaluation are sometimes appropriate
ROI, RI, EVA, and ROS all basically evaluate one period of time
ROI, RI, EVA, and ROS may all be adapted to evaluate multiple
periods of time
- Slide 94
- 94 Step 3: Choosing Alternative Definitions for Performance
Measures Four possible alternative definitions of investment:
1.Total Assets Available 2.Total Assets Employed 3.Total Assets
Employed minus Current Liabilities 4.Stockholders Equity
- Slide 95
- 95 Step 4: Choosing Measurement Alternatives for Performance
Measures Possible alternative definitions of cost: 1.Current Cost
2.Gross Value of Fixed Assets 3.Net Book Value of Fixed Assets
- Slide 96
- 96 Step 5: Choosing Target Levels of Performance Historically
driven targets used to set target goals Goal may include a
Continuous Improvement component
- Slide 97
- 97 Step 6: Choosing the Timing of the Feedback Timing of
feedback depends on: How critical the information is for the
success of the organization The specific level of management
receiving the feedback The sophistication of the organizations
information technology
- Slide 98
- 98 Performance Measurement in Multinational Companies
Additional Difficulties faced by Multinational Companies: The
economic, legal, political, social, and cultural environments
differ significantly across countries Governments in some countries
may impose controls and limit selling prices of a companys products
Availability of materials and skilled labor, as well as costs of
materials, labor, and infrastructure may differ across countries
Divisions operating in different countries account for their
performance in different currencies
- Slide 99
- 99