CH 11 PERFORMANCE MEASUREMENT IN DECENTRALIZED ORGANIZATIONS I DECENTRALIZATION IN ORGANIZATIONS a Decentralized Organization organization where the decision making authority is spread throughout the organization rather than being confined to a few top executives b Advantages Disadvantages of Decentralization i Advantages 1 By delegating day to day problem solving to lower level 2 Empowering lower level managers managers top management can concentrate on bigger issues such as overall strategy decision making authority in the hands of those who tend to have the most detailed and up to date information about day to day operations to make decisions puts the 3 By eliminating layers of decision making and approvals organizations can respond more quickly to customers and to changes in the operating environment 4 Granting decision making authority helps train lower level managers for higher level positions 5 Empowering lower level managers to make decisions can increase their motivation and job satisfaction ii Disadvantages understanding the big picture 1 Lower Level managers may make decisions without fully 2 If lower level managers make their own decisions independently of each other coordination may be lacking 3 Lower level managers may have objectives that clash with the objectives of the entire organization 4 Spreading innovative ideas may be difficult in a decentralized organization Without strong direction the idea may not be shared with and adopted by other parts of the organization II RESPONSIBILITY ACCOUNTING a Decentralized organizations need responsibility accounting systems that link lower level manager s decision making authority with accountability for the outcomes of the decisions b Responsibility Center term used for any part of the organization whose manager has control over and is accountable for cost profit or investments i Cost Centers Manager has control over costs but not over revenue or the use of investment funds a Service departments accounting finance general administration legal and personnel Manufacturing facilities b Managers are expected to minimize costs while providing the level of products and services demanded by other parts of the organization ii Profit Centers Manager has control over BOTH cost and revenue but not over the use of investment funds a Evaluated by comparing actual profit to targeted or budgeted profit iii Investment Centers Manager has control over cost revenue and investments in operating assets a Often evaluated using return on investment ROI or residual income measures III EVALUATING INVESTMENT CENTER PERFORMANCE ROI a Two methods for evaluating adequate return on investment Return on Investment and Residual Income b Return on Investment ROI Formula i ROI Net Operating Income Avg Operating Assets ii The higher a business segment s ROI the greater the profit earned per dollar investment in the segment s operating assets iii Best used as part of a balanced scorecard c Net Operating Income and Operating Assets Defined i Net Operating Income EBIT Income before interest and taxes ii Operating Assets Cash accounts receivable inventory plant and equipment and all other assets held for operating purposes 1 Computed as the average of the operating assets between the beginning and the end of the year 2 Most companies use the net book value Acquisition Cost Accumulated Depreciation of depreciable assets to calculate average operating assets a Has a drawback because net book value decreases over time as the accumulated depreciation increases decreases the denominator in the ROI calculation this increasing ROI b ROI mechanically increases over time c Replacing old depreciated equipment with new equipment increases the book value of depreciable assets and decreases ROI 3 Should use gross costs instead But most do not a Depreciation is ignored ROI doesn t grow automatically over time b Replacing a fully depreciated asset with a comparably priced new asset will not adversely affect ROI d Understanding ROI i ROI Margin x Turnover 1 Margin Net Operating Income Sales a Improved by increasing selling prices reducing operating expenses or increasing unit sales 2 Turnover Sales Avg Operating Assets e Criticisms of the ROI i Just telling managers to increase ROI may not be enough IV RESIDUAL INCOME 1 May not know how or may increase ROI in way that isn t consistent with the strategy or make take actions that increase ROI in the short run but harm the company in the long run 2 ROI should be used as part of a balanced scorecard that can provide concrete guidance to managers ii Managers that takes over segment inherits committed costs over which manager has no control Costs can be relevant in assessing performance of segment but not performance of manager individually iii Manager evaluated only on ROI may reject investment opportunities that are profitable for whole company but would have negative impact on manager s performance evaluation a Residual Income Net operating income that an investment center earns above the minimum required return on its operating assets b RI NOI Avg Operating Assets X Min Required rate of Return c Economic Value Added EVA adaptation of residual income that has been adopted by many companies i Under EVA companies modify their accounting principles in various ways EX treat funds used for R D as investments rather than as expenses d When residual income or EVA is used to measure performance the objective is to maximize the total amount of residual income EVA NOT to maximize the ROI 1 2 e Motivation and Residual Income i Residual Income approach encourages managers to make investments that are profitable for the entire company but would be rejected by mangers who are evaluated using the ROI formula ii Problem and differences with ROI EX BASED FROM ABOVE 1 Company decides to purchase machine that would cost 25 000 and generates additional operating income of 4 500yr a Good investment because promises 18 rate of return 4 500 25 000 which exceeds the 15 required minimum rate 2 Residual Income Method a 3 ROI Method a b ROI is reduced because the rate of return of new machine 18 while above the minimum rate 15 is below the current ROI 20 c Would decrease the division s ROI even though it would be a good investment from company s standpoint as a whole iii Generally a manager evaluated based on ROI will reject any project whose rate of return is below the current ROI even if the rate of return is above company s minimum required rate of
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