Performance Evaluation

1. Performance Evaluation EMBA 5412 Fall 2010

2. Performance of what? • Companies • Divisions • Products • managers

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

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

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

6. Disadvantages of Decentralization • Costly duplication of activities • Lack of goal congruence • Agency • Management pursues personal goals • Personal goals are incompatible with the company’s goals

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

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

9. Tracing Costs to Organizational Levels

10. Types of responsibility centers • Cost Center • Revenue Center • Profit Center • Investment Center

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

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

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

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 İstanbul, Ankara, Adana, Antalya, Bursa, İzmir, Trabzon, Mersin, Diyarbakır, 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

15. Study Break #1 • An investment center is responsible for: • Investing in long term assets • Controlling costs • Generating revenues • All of the above Answer: d. All of the above

16. Study Break #2 • Cost centers are often evaluated using: • Variance analysis • Operating margin • Return on investment • Residual income Answer: a. Variance analysis

17. Study Break #3 • Profit centers are often evaluated using: • Investment turnover • Income targets or profit budgets • Return on investment • Residual income Answer: b. Income targets or profit budgets

18. Accounting-Based Performance Measures • Requires a six-step design process: • Choose Performance Measures that align with top management’s financial goals • Choose the time horizon of each Performance Measure • Choose a definition of the components in each Performance Measure • Choose a measurement alternative for each Performance Measure • Choose a target level of performance • Choose the timing of feedback

19. Step 1: Choosing among Different Performance Measures • Four common measures of economic performance: • Return on Investment • Residual Income • Economic Value Added • Return on Sales • Selecting Subunit Operating Income as a metric is inappropriate since it obviously differs simply on the differing size of the subunits

20. Evaluating Investment Centers With ROI • ROI is a primary tool for evaluating the performance of investment centers = Investment Center Income Invested Capital Focuses management’s 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)

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_____ Sales Invested Capital • ROI = Return on Sales X Investment Turnover • This is known as the DuPont Method of Profitability Analysis

22. Which investment? • Four possible alternative definitions of investment: • Total Assets Available- all assets • Total Assets Employed-total assets available less any idle assets or assets purchased for expansion in the future • Total Assets Employed minus Current Liabilities • Stockholders’ Equity • Gross or net?

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

24. NOPAT Example Tax rate 35%

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

26. Invested Capital Example

27. ROI – France, Germany, and Japan

28. Most common financial measures Horngren et al, 2006,p.799

29. Return on Sales (ROS) • Return on Sales is simply income divided by sales • Simple to compute, and widely understood

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 operation’s 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.

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

32. Example Exercise #1 Solution • ROI = NOPAT ÷ Invested capital = $16,780,000 ÷ $195,000,000 = 86.05%

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: • Current Cost • Gross Value of Fixed Assets • Net Book Value of Fixed Assets

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

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 center’s 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

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

37. Example Exercise #2 • Using the same information as in Example Exercise #1, calculate the residual income if the company’s cost of capital is 10%.

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)

39. Decision Making

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

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

42. Residual Income NIBCL = Net Income Before Current Liabilities(excluding debt)

43. Study Break #4 • Use of profit as a performance measure: • May lead to overinvestment in assets • Is appropriate for an investment center • Is appropriate as long as profit is calculated using GAAP • Encourages managers to finance operations with debt rather than equity Answer: a. May lead to overinvestment in assets

44. Study Break #5 • Investment centers are often evaluated using: • Standard cost variances • Return on investment • Residual income/EVA • Both b and c Answer: d. Both b and c

45. EVA

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

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

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

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

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”