Chapter 9 Performance Measurement in Decentralized Organizations
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Chapter 9
Lecture Notes
Chapter theme: Managers in large organizations have to
delegate some decisions to those who are at lower levels in
the organization. This chapter explains how responsibility
accounting systems, return on investment (ROI),
residual income, operating performance measures, and
the balanced scorecard are used to help control
decentralized organizations.
I. Decentralization in organizations
A. A decentralized organization does not confine
decision-making authority to a few top executives;
rather, decision-making authority is spread
throughout the organization. The advantages and
disadvantages of decentralization are as follows:
i. Advantages of decentralization
1. It enables top management to concentrate
on strategy, higher-level decision making,
and coordinating activities.
2. It acknowledges that lower-level managers
have more detailed information about local
conditions that enable them to make better
operational decisions.
3. It enables lower-level managers to quickly
respond to customers.
4. It provides lower-level managers with the
decision-making experience they will need
when promoted to higher level positions.
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5. It often increases motivation, resulting in
increased job satisfaction and retention, as
well as improved performance.
ii. Disadvantages of decentralization
1. Lower-level managers may make decisions
without fully understanding the “big
picture.”
2. There may be a lack of coordination among
autonomous managers.
a. The balanced scorecard can help
reduce this problem by communicating
a company’s strategy throughout the
organization.
3. Lower-level managers may have objectives
that differ from those of the entire
organization.
a. This problem can be reduced by
designing performance evaluation
systems that motivate managers to
make decisions that are in the best
interests of the company.
4. It may be difficult to effectively spread
innovative ideas in a strongly decentralized
organization.
II. Responsibility accounting
A. Responsibility accounting systems link lower-level
managers’ decision-making authority with
accountability for the outcomes of those decisions.
The term responsibility center is used for any part of
an organization whose manager has control over, and
is accountable for cost, profit, or investments. The
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three primary types of responsibility centers are cost
centers, profit centers, and investment centers.
i. Cost center
1. The manager of a cost center has control
over costs, but not over revenue or
investment funds.
a. Service departments such as
accounting, general administration,
legal, and personnel are usually
classified as cost centers, as are
manufacturing facilities.
b. Standard cost variances and flexible
budget variances, such as those
discussed in Chapters 10 and 11, are
often used to evaluate cost center
performance.
ii. Profit center
1. The manager of a profit center has control
over both costs and revenue.
a. Profit center managers are often
evaluated by comparing actual profit to
targeted or budgeted profit.
iii. Investment center
1. The manager of an investment center has
control over cost, revenue, and
investments in operating assets.
a. Investment center managers are
usually evaluated using return on
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investment (ROI) or residual income,
as discussed later in this chapter.
III. Evaluating investment center performance – return on
investment
Learning Objective 9-1: Compute return on
investment (ROI) and show how changes in sales,
expenses, and assets affect ROI.
A. Key concepts/definitions
i. Investment center performance is often
evaluated using a measure called return on
investment (ROI), which is defined as
follows:
Net operating income
ROI Average operating assets
=
ii. Net operating income is income before taxes
and is sometimes referred to as EBIT (earnings
before interest and taxes). Operating assets
include cash, accounts receivable, inventory,
plant and equipment, and all other assets held
for operating purposes.
1. Net operating income is used in the
numerator because the denominator consists
only of operating assets.
2. The operating asset base used in the formula
is typically computed as the average of the
assets between the beginning and the end of
the year.
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iii. Net book value versus gross cost
1. Most companies use the net book value
(i.e., acquisition cost less accumulated
depreciation) of depreciable assets to
calculate average operating assets.
a. With this approach, ROI
mechanically increases over time as
the accumulated depreciation
increases. Replacing a fully-
depreciated asset with a new asset will
decrease ROI.
2. An alternative to net book value is the gross
cost of the asset, which ignores
accumulated depreciation.
a. With this approach, ROI does not grow
automatically over time, rather it stays
constant. Replacing a fully-
depreciated asset does not adversely
affect ROI.
B. Understanding ROI
i. DuPont pioneered the use of ROI and
recognized the importance of looking at the
components of ROI, namely margin and
turnover.
1. Margin is computed as shown and is
improved by increasing unit sales,
increasing selling prices, or reducing
operating expenses. The lower the operating
expenses per dollar of sales, the higher the
margin earned.
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2. Turnover is computed as shown. It
incorporates a crucial area of a manager’s
responsibility – the investment in operating
assets. Excessive funds tied up in operating
assets depress turnover and lower ROI.
Helpful Hint: Emphasize that both margin and turnover
affect profitability. As an example, ask students to
compare the margins and turnovers of grocery stores to
jewelry stores. In equilibrium, every industry should
have roughly the same ROI. Groceries, because of their
short shelf life, have high turnovers relative to fine
jewelry. If the ROIs are to be comparable in grocery
stores and in jewelry stores, the margins would have to
be higher in jewelry stores.
ii. To illustrate how to increase ROI, assume that
Regal Company reports the results shown:
1. Given this information, its current ROI is
15%.
2. Suppose that Regal’s manager invests in a
$30,000 piece of equipment that increases
sales by $35,000 while increasing operating
expenses by $15,000.
a. In this case, the ROI increases from
15% to 21.8%.
C. Criticisms of ROI
i. Just telling managers to increase ROI may not
be enough. Managers may not know how to
increase ROI in a manner that is consistent
with the company’s strategy.
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1. This is why ROI is best used as part of a
balanced scorecard.
ii. A manager who takes over a business segment
typically inherits many committed costs over
which the manager has no control. This may
make it difficult to assess this manager relative
to other managers.
iii. A manager who is evaluated based on ROI may
reject investment opportunities that are
profitable for the whole company but that
would have a negative impact on the manager’s
performance evaluation.
Helpful Hint: When discussing the criticisms of ROI
and other measures of profitability, ask students to play
the role of a manager who anticipates a short tenure.
This manager will want to increase ROI as quickly as
possible. Ask students to list the activities that could be
undertaken to increase ROI that, in reality, would hurt
the company as a whole.
IV. Residual income
Learning Objective 9-2: Compute residual income
and understand its strengths and weaknesses.
A. Defining residual income
i. Residual income is the net operating income
that an investment center earns above the
minimum required return on its assets.
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1. Economic Value Added (EVA®) is an
adaptation of residual income. We will not
distinguish between these two terms.
B. Calculating residual income
i. The equation for computing residual income is
as shown. Notice:
1. This computation differs from ROI. ROI
measures net operating income earned
relative to the investment in average
operating assets. Residual income measures
net operating income earned less the
minimum required return on average
operating assets.
ii. Zepher, Inc. – an example
1. Assume the information as given for a
division of Zepher, Inc.
2. The residual income ($10,000) is computed
by subtracting the minimum required return
($20,000) from the actual income ($30,000).
C. Motivation and residual income
i. The residual income approach encourages
managers to make investments that are
profitable for the entire company but that
would be rejected by managers who are
evaluated using the ROI formula. More
specifically:
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1. It motivates managers to pursue investments
where the ROI associated with those
investments exceeds the company’s
minimum required return but is less than the
ROI being earned by the managers.
Quick Check – ROI versus residual income
D. Divisional comparison and residual income
i. The residual income approach has one major
disadvantage. It cannot be used to compare the
performance of divisions of different sizes.
ii. Zepher, Inc. – continued
1. Recall that the Retail Division of Zepher had
average operating assets of $100,000, a
minimum required rate of return of 20%, net
operating income of $30,000, and residual
income of $10,000.
2. Assume that the Wholesale Division of
Zepher had average operating assets of
$1,000,000, a minimum required rate of
return of 20%, net operating income of
$220,000, and residual income of $20,000.
3. The residual income numbers suggest that
the Wholesale Division outperformed the
Retail Division because its residual income
is $10,000 higher. However:
a. The Retail Division earned an ROI of
30% compared to an ROI of 22% for
the Wholesale Division. The
Wholesale Division’s residual income
is larger than the Retail Division
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simply because it is a bigger
division.
V. Operating performance measures
Learning Objective 9-3: Compute delivery cycle time,
throughput time, and manufacturing cycle efficiency
(MCE).
A. Key definitions/concepts
i. Delivery cycle time is the elapsed time from when
a customer order is received to when the completed
order is shipped.
ii. Throughput (manufacturing cycle) time is the
amount of time required to turn raw materials into
completed products.
1. This includes process time, inspection
time, move time, and queue time. Process
time is the only value-added activity of the
four mentioned.
iii. Manufacturing cycle efficiency (MCE) is
computed by dividing value-added time by
throughput time.
An MCE less than 1.0 indicates that non-
value-added time is present in the
production process.
Quick Check – internal business process measures
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VI. Balanced scorecard
Learning Objective 9-4: Understand how to construct
and use a balanced scorecard.
A. Key concepts
i. A balanced scorecard consists of an integrated set
of performance measures that are derived from and
support a company’s strategy. Importantly, the
measures included in a company’s balanced
scorecard are unique to its specific strategy.
ii. The balanced scorecard enables top management to
translate its strategy into four groups of
performance measures – financial, customer,
internal business process, and learning and
growth − that employees can understand and
influence.
1. The premise of these four groups of
measures is that learning is necessary to
improve internal business processes, which
in turn improves the level of customer
satisfaction, which in turn improves
financial results.
a. Note the emphasis on improvement,
not just attaining some specific
objective.
iii. The balance scorecard relies on non-financial
measures in addition to financial measures for two
reasons:
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1. Financial measures are lag indicators that
summarize the results of past actions. Non–
financial measures are leading indicators of
future financial performance.
2. Top managers are ordinarily responsible for
financial performance measures – not lower
level managers. Non-financial measures are
more likely to be understood and
controlled by lower level managers.
iv. While the entire organization has an overall
balanced scorecard, each responsible individual
should have his or her own personal scorecard as
well.
1. A personal scorecard should contain
measures that can be influenced by the
individual being evaluated and that support
the measures in the overall balanced
scorecard.
v. A balanced scorecard, whether for an individual or
the company as a whole, should have measures that
are linked together on a cause-and-effect basis.
1. Each link can be read as a hypothesis in the
form “If we improve this performance
measure, then this other performance
measure should also improve.”
2. In essence, the balanced scorecard lays out a
theory of how a company can take concrete
actions to attain desired outcomes. If the
theory proves false or the company alters its
strategy, the measures within the scorecard
are subject to change.
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vi. Incentive compensation for employees probably
should be linked to balanced scorecard
performance measures.
1. However, this should only be done after the
organization has been successfully managed
with the scorecard for some time – perhaps
a year or more. Managers must be
confident that the measures are reliable, not
easily manipulated, and understandable by
those being evaluated with them.
B. The balanced scorecard – an example
i. Assume that Jaguar pursues a strategy as shown
on this slide. Examples of measures that Jaguar
might select with their corresponding cause-and-
effect linkages include:
1. If “employee skills in installing options”
increases, then the “number of options
available” should increase and the “time to
install an option” should decrease.
2. If the “number of options available”
increases and the “time to install an
option” decreases, then “customer
surveys: satisfaction with options
available” should increase.
3. If the “customer surveys: satisfaction with
options available” increases, then the
“number of cars sold” should increase.
4. If the “time to install an option” decreases
and the “customer surveys: satisfaction
with options available” increases, then the
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“contribution margin per car” should
increase.
5. If the “number of cars sold” and the
“contribution margin per car” increase,
then the “profit” should increase.
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