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(2) The quality of services provided and their costs are not clearly linked.
• For revenue centers, the obvious performance measure is the amount of revenues earned.
Alternatively, for managers with decision authority over marketing or sales expenditures,
the performance measure would be contribution of the center (= revenues – costs).
• For completely independent profit centers that operate like autonomous companies, the
profits can be uniquely identified with the centers.
• Many companies use multiple performance measures. Still, accounting results continue
to play an important role in performance evaluation.
• Most profit centers may share facilities with other units or use headquarter staff services.
This leads to cost allocation problems.
• Profit centers may transfer intermediate goods within the organization. This leads to the
issue of transfer pricing in which the transfers must be priced so that the profit center
managers have incentives to trade with other units when it is in the organization’s best
interests. Chapter 15 discusses transfer pricing problems in more detail.
• There are no easy ways to determine how to measure performance in a profit center.
Much is left to managerial judgment.
• Effective performance measures for investment centers (commonly called business
units) combine both a measure of profit and a measure of asset usage, a topic to be
covered in Chapter 14.
LO 12-5 Understand how managers evaluate performance.
♦ Performance measurement is followed by performance evaluation.
• When diverse centers exist, management frequently establishes target levels of
performance for the individual centers and compares actual measures with the target ones.
This is known as the absolute performance evaluation.
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Example 2: In the syllabus, Professor Smith specifies the grading policy as follows:
85 – 100 points A
70 – 84 points B
60 – 69 points C
55 – 59 points D
Below 55 points F
This is an example of the absolute performance evaluation. Students who accumulate
up to a certain number of points will receive the designated grade, regardless of how
the other students have done, or the nature or the level of difficulty of the assignments
(quizzes, homework, exams, and projects, etc.)
Individual students will have a firm grasp of their performance against a fixed target.
This policy also answers one of the students’ frequently asked questions: “What do I
have to do to get an A?”
• When the responsibility centers are homogeneous in the sense that they are of the same
level, in the same line of business, located in similar geographic areas, facing similar risk
factors, or operating in similar product markets, etc., a company can compare the
performance of its centers and even encourage competition among them. This is known
as the relative performance evaluation (RPE).
Example 3: In another syllabus, Professor Smith specifies the grading policy as
follows:
Top 25% A
Next 35% B
Next 30% C
Next 5% D
Last 5% F
This is an example of the relative performance evaluation. Students are competing
against each other in order to be in a certain tier. Students who accumulate up to a
certain number of points will not know for sure the final grade until the end of the
semester when all assignments are tallied. The grade becomes a moving target. There
will be a new alignment of grades after each assignment.
Every semester slightly different student body brings in different group dynamics. The
professor can tailor the nature and the level of difficulty of the assignments to suit
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them, and the common factors that influence every student’s performance are filtered
out. This policy also answers another of the students’ frequently asked questions: “Do
you curve?”
• The evaluation of a manager is not necessarily the same as the evaluation of the
responsibility center in which the manager is in charge. As a general rule, managers are
evaluated based on a comparison of actual results to performance targets.
• The controllability concept is the idea that managers should be held responsible for
costs or profits over which they have decision-making authority. The longer the manager
is at a division, the more responsibility the manager takes for its success.
• The purpose of relative performance evaluation is to go beyond setting internal targets
and compare managers or divisions to other comparable divisions (i.e., the peer group).
♦ Performance evaluation is followed by compensation and rewards.
• Since managers are free to leave for other organizations, the firm needs to pay them the
equivalent of the best alternative offer. It is safe to assume that, if a manager is willing to
work for the organization, the pay is “sufficient.”
• An effective management control system provides the appropriate incentives for the
manager to make decisions in the organization’s interest.
• The compensation system has to reward the manager for measured performance to
provide sufficient incentives to influence the manager’s decisions.
• Compensation can be classified into two categories:
(1) Fixed compensation is paid to the manager independent of measured performance.
(2) Contingent compensation is the amount of compensation that is paid based on
measured performance.
• An important design feature of the management control system is the mix of fixed and
contingent compensation.
• If the proportion of contingent compensation is too small, its incentive effect will not be
sufficient to motivate the manager to make the decisions intended by the control system.
If the proportion is too large, the manager will view his compensation as being too risky
and needs to be compensated more.
• Shareholders can diversify and are better able to bear risks than managers, who cannot
diversify as easily. See In-Action item: Compensation and performance – AIG and
Goldman Sachs for more information.
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Example 4: A compensation system for a salesperson that includes both the fixed and
the contingent components may be represented by the following formula.
Total Compensation = Salary + Commission
= Salary + p
(Actual sales achieved – Target sales volume).
The first part, salary, is the fixed component of the compensation package. The second
part, commissions earned, represents the contingent component. The profit sharing
factor, p, is a number between 0 and 1. In general, the salesperson is encouraged to
outperform the target sales volume; otherwise, she is penalized with a reduced salary.
If salary > 0 and p = 0, the salesperson’s total compensation is a fixed one and she has
little incentive to work hard and reach high sales target.
On the other hand, if salary = 0 and p = 1, the salesperson will be solely rewarded for
her performance but at the same time is subjected to a tremendous amount of risk if she
can not reach the target sales volume.
Somewhere between these two cases, a compensation system should find a mix that
will balance risks and incentives and will motivate the salesperson to perform and to
meet the organization’s goals.
Sometimes, the company provides a menu of compensation packages with various
combinations of higher (lower) salaries and lower (higher) profit sharing factors from
which the salesperson can choose, thereby revealing her “type” to the company.
• The In-Action box mentions that a common approach to linking compensation with
performance at the executive level is to pay a bonus for performance that exceeds some
level. It is also common in these plans to have a maximum bonus paid. The presence of
thresholds can lead to dysfunctional behavior on the part of managers. One solution is to
set the thresholds so that they are unlikely to be close to the actual outcomes.
• The compensation system can be used to better align the risk preferences of the
manager and the firm.
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LO 12-6 Analyze the effect of dual- versus single-rate allocation systems.
♦ If cost allocations are used in part to measure performance, the cost accountant has to consider
the role of cost allocation in the management control system.
• An effective cost allocation system will ensure that the managers who have the decision
authority over factors that affect the performance measures (such as costs) will be
evaluated according to the performance measures.
• A dual rate method allocates costs by separating a common cost into fixed and
variable components and then allocating each component using a different allocation base.
That is,
Common cost (such as corporate overhead) = Fixed component + Variable component.
Example 5: A possible allocation scheme may involve targeted fixed costs (the base for
fixed costs) and actual division revenues (the base for variable costs), or
Allocated overhead = x% of targeted fixed costs + y% of actual division revenues.
Both x% and y% can be negotiated or determined ahead of time. In this case, since the
division manager can not influence the fixed component of the corporate overhead, he
will be shielded from changes in fixed costs by sticking with a targeted level of fixed
costs.
For the variable component, the division manager is responsible for the actual division
revenues achieved and is therefore allocated variable costs accordingly.
• To determine the appropriate bases and rates, consider why actual corporate overhead
may vary from the target.
(1) Actual fixed costs can be different from the targeted fixed costs.
(2) The actual rate can be different from the targeted rate.
(3) The actual revenues may be different from the target revenues.
• Two more considerations about the dual rate method of allocation are:
(1) The fixed costs could be allocated in any way as long as it is done the same way for
the target and for the actual computation of operating profit. The system allocates
only the target, and not the actual, corporate fixed costs.
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(2) There can be corporate costs that are left unallocated to the divisions. The difference
between the costs allocated and the costs incurred can be used as a performance
measure for the corporate-level manager.
======================
Demonstration Problem
Archery Equipment Corporation (AEC) manufactures lawn mowers in two divisions:
Commercial and Consumer. Both divisions require the support of Product Development, an
engineering service department that designs new products based on marketing data. The
following annual information is available:
Budgeted fixed costs of running Product Development
$1,500,000
Budgeted variable cost of running Product Development per hour
120
Budgeted usage of Product Development
Commercial Division
4,000 hours
Consumer Division
3,500 hours
Actual usage of Product Development
Commercial Division
4,500 hours
Consumer Division
3,000 hours
Required:
1. Determine the allocation of Product Development costs to the two divisions using the
single rate method where the actual hours of usage will be the allocation base.
2. Determine the allocation of Product Development costs to the two divisions using the
dual rate method, assuming fixed costs use budgeted hours while variable costs use actual
hours of usage as allocation bases.
Solution:
1. The budgeted total costs of running Product Develop can be calculated as
$1,500,000 + $120 × (4,000 + 3,500) = $2,400,000.
The single rate of allocation will be $320 per hour (= $2,400,000 ÷ 7,500 hours) that
includes fixed cost of $200 per hour ($1,500,000 ÷ 7,500 hours) and variable cost of $120
per hour. The allocation becomes
Commercial Division: $320 per hour × 4,500 hours =
$1,440,000
Consumer Division: $320 per hour × 3,000 hours =
960,000
$2,400,000
2. Under the dual rate method, the fixed cost rate can be calculated as
$1,500,000 ÷ 7,500 hours = $200 per hour.
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The variable cost rate remains at $120 per hour.
The allocation is as follows.
Commercial Division:
$200 per hour × 4,000 hours + $120 per hour × 4,500 hours =
$1,340,000
Consumer Division:
$200 per hour × 3,500 hours + $120 per hour × 3,000 hours =
1,060,000
$2,400,000
======================
LO 12-7 Understand the potential link between incentives and illegal or
unethical behavior.
♦ If high-pressure performance evaluation systems are adopted, the pressure motivates
employees to perform. The pressure may also drive employees to commit fraud, taking actions
that not only are not in the interest of the company financially, but also illegal or unethical.
• The pressure to perform will permeate the whole organization, from employees, middle
managers all the way to top executives.
• In 1987, the Treadway Commission issued “Report of the National Commission on
Fraudulent Financial Reporting” that linked incentives and fraud.
• The commission concluded that fraudulent financial reporting occurred because of a
combination of pressure, incentives, opportunities, and environment.
• A frequent incentive for fraud in financial reporting was the desire to improve a
company’s financial appearance to obtain a higher stock price or escape a penalty for
poor performance.
• Examples of pressures that may lead to financial fraud include:
(1) Unrealistic budget pressures, particularly for short-term results.
(2) Financial pressure resulting from bonus plans that depend on short-term economic
performance.