Introduction to Managerial Accounting
Professor Tatianna Gershberg
Lecture: Performance Evaluation Systems
Advantages and Disadvantages of Decentralization 0:45
Performance Measurement 3:20
Performance Reports 7:36
Example S24-2 - Decentralization: 16:00
ROI, RI, & EVA To Evaluate Investment Centers: 22:20
Investment Centers: 22:33
KPI's for Investment Centers: 25:45
Return on Investment (ROI): 27:02
ROI Expanded: 28:53
Example S24-7 - Use ROI, RI, & EVA to
Evaluate Investment Centers: 30:18
Example S24-8: 32:51
Residual Income (RI): 37:05
Economic Value Added (EVA): 40:37
Economic Value Added Evaluated: 41:34
Example S24-7 - Using ROI, RI, & EVA
to Evaluated Investment Centers: 43:12
Example S24-9 (Solution): 44:10
Example S24-10 (Solution): 45:51
Multiple Choice Questions: 47:55
Performance Measurements are used to "provide top management a framework for maintaining control." We use these performance reports to evaluate cost, revenue, and profit centers, which is a very important part of performance evaluation systems. Professor Gershberg goes over many different examples with the class in order to help them understand the whole concept.
The advantages of decentralization is that it frees up the time of top management so that it can be focused on more pressing things. It also supports the use of expert knowledge, improves customer relations, provides training, and improves motivation and retention. The disadvantages include duplication of costs, and potential problems in achieving goal congruence.
Performance measurements provide top management with a framework for maintaining control. Top management needs to know if the decisions at the subunit level are effectively meeting company goals. Decentralized organizations need systems to communicate goals to subunit managers. The primary goals is promoting goal of performance measurement is to promote goal congruence and coordination, properly communicate expectations, motivate unit managers, provide feedback, and partake in benchmarking.
Performance reports capture the financial performance of cost, revenue, and profit centers. Cost centers' performance reports include information on actual costs vs. budgeted costs (i.e. flexible budget variance). Revenue centers' performance reports include actual revenue vs. budgeted revenue (highlight both the flexible budget variance & sales volume variance). Profit centers' performance reports include actual and budgeted information on both revenues and costs (producing profit through generating sales and controlling costs).
Unit managers are responsible for maximizing income in relation to the company's invested capital. Using company assets efficiently by making the best use of the investment center's assets. This is done because managers have a decision making responsibility over the entire division's assets. Thus, investment centers cannot be evaluated in the same manner as profit centers. Performance measures for investment centers include how much operating income the division is generating, and how efficiently the division is using its assets. KPIs (key process indicators) include ROI (return on investment) RI (residual income), and EVA (economic value added).
Return on investment is the amount of income an investment center earns relative to the amount of its assets. It is defined as operating income divided by the average total assets. A division with a higher ROI is more likely to receive extra funds because it is providing a higher return. ROI is compared across divisions and time, and can be used as a benchmark to compare against the industry and competitors.
Management often restates the ROI equation to determine what drives a given divisions ROI. The expansion shows two components - profit margin (how much operating income the division earns on every dollar of sales) and asset turnover (how efficiently a division uses its average total assets to generate sales).
Residual income is another commonly used KPI for evaluating an investment center. It takes both the divisions operating income and its average total assets into consideration. It measures the division's profitability and the efficiency with which the division uses its average total assets. It compares the division's operating income with the minimum operating income expected given the size of the division's assets (a positive RI means income exceeds the target rate of return, while negative means income fails to meet the target rate of return).
EVA is a special type of RI calculation. It looks at a divisions' residual income through the eyes of the company's primary stakeholders (which are investors / owners, and creditors / bondholders). Stakeholders want to evaluate how efficiently a division is using its assets. Both RI and EVA calculate whether any operating income was above / beyond expectations.