Lecture 11

Performance Evaluation in
Decentralized Organizations

Decentralization of Decision
Making
The delegation of freedom to make decisions is
decentralization.
The lower in the organization this freedom exists, the
greater the decentralization.
Benefits of decentralization:
Timely decisions/Quick reaction to competitors
Leadership continuity
Empowers employees

Costs of decentralization
Lower level managers may take decisions that are not in the
best interests of the organization.
Duplication of services
May lead to costly coordination
2

Responsibility Accounting
Thepurpose
purposeof
ofaaRESPONSIBILITY
RESPONSIBILITYACCOUNTING
ACCOUNTINGsystem
systemisistoto
The
ensurethat
thateach
eachmanager
managerand
andworker
workerininthe
theorganization
organizationisis
ensure
strivingtoward
towardthe
theoverall
overallgoals
goalsset
setby
bytop
topmanagement
management
striving
RESPONSIBILITYCENTER
CENTERisisaasubunit
subunitininan
anorganization
organization
AARESPONSIBILITY
whosemanager
managerisisheld
heldaccountable
accountablefor
forspecified
specifiedfinancial
financial
whose
andnonfinancial
nonfinancialresults
resultsof
ofthe
thesubunits
subunitsactivities
activities
and

Cost
Cost
Center
Center

Discretionary
Discretionary
Cost
Cost
Center
Center

RESPONSIBILITY
RESPONSIBILITY
CENTERS
CENTERS

Revenue
Revenue
Center
Center

Investment
Investment
Center
Center

Profit
Profit
Center
Center

Responsibility Accounting
RESPONSIBILITYCENTERS
CENTERS
RESPONSIBILITY

Cost
Cost
Center
Center

well-definedinput-output
input-output relationships
relationships
well-defined
themanager
managerisisresponsible
responsiblefor
forthe
thecost
costof
ofactivities
activities
the

Discretionary
Discretionary
Cost Center
Center
Cost

input-output relationships
relationshipsare
arenot
notwell
wellspecified
specified
input-output
themanager
managerisisresponsible
responsiblefor
forthe
thecost
costof
ofactivities
activities
the

Revenue
Revenue
Center
Center

themanager
managerisisresponsible
responsiblefor
forthe
therevenue
revenueofofthe
the
the
subunit
subunit

Profit
Profit
Center
Center

themanager
managerisisresponsible
responsiblefor
forthe
thesubunits
subunitsprofit
profit
the

Investment
Investment
Center
Center

themanager
managerisisresponsible
responsiblefor
forthe
theprofit
profitand
andthe
the
the
investedcapital
capitalused
usedto
togenerate
generatethe
theprofit
profit
invested

Principles of performance
measurement
You get what you measure!
A performance measure is controllable, if the manager
exercises control over the measure.
It appears that controllable performance measures ought to
be used in performance evaluation.
A performance measure is informative, if it provides
information about what a manager does or does not do.
Not all controllable measures are informative and not all
informative measures are controllable.
An ideal performance measure should:
Align goals
Be easy to measure, understand and communicate
Be informative about the actions of individual managers or
organizational subunits.
5

Evaluation of cost and profit

centers
Cost centers
Usually input based measures
For short term evaluation, use budget variances.
For long term evaluation, use benchmarking and kaizen principles.

Profit centers
Measures should be based on both inputs and outputs
Along product lines or matrix structure.
Profit measure should ideally exclude non-traceable costs to the
cost centers.
Variety of benchmarks are possible. Budgeted profit or growth in
profit.

Financial measures alone may not be adequate. May need

non-financial measures that may lead financial measures.

Evaluation of Investment
Centers
Measures should be based on inputs, outputs and
the invested capital.
Profit
ROI

Return on Investment (ROI)

Investment

Profit should be controllable profit

Investments should be controllable assets
Usually, average operating assets are used
May use accounting value of assets (either net book
value or gross book value) OR economic value of assets
(either current value or replacement value)
Size adjusted Comparison is easier. Decomposable.
Promotes underinvestment OR overinvestment
Promotes short term thinking
7

Evaluation of Investment
Centers
Decomposition of ROI
Profit
Profit
Sales
ROI

Profit margin x Asset turnover

Investment Sales Investment

Re-express Profit margin as

Profit Sales operating expenses
Operating expenses
Profit margin

1
Sales
Sales
Sales

Evaluation of Investment
Centers
Residual Income (RI)
Residual income is the operating income
less an imputed charge on investment
RI = Profit (Required return x Investment)
Unlike ROI, RI does not lead to under/over
investment.
Notice that this measure is not size
adjusted making comparisons difficult.
Choice of required return in RI
computation can flip the rankings of RI
9

Evaluation of Investment
Centers
Economic Value Added (EVA)
Developed by Stern Stewart & Company
EVA = NOPAT [WACC x (Invested
capital CL)
Where NOPAT = Net Operating Profit After
Taxes
WACC = Weighted Average Cost of Capital
CL = Current Liabilities

Other long run measures

Market share, Customer Satisfaction,
Growth in new product sales 10

Transfer Pricing
When goods are transferred from one
responsibility center to another
responsibility center, an internal price is
attached to the units transferred.
This internal price is called Transfer Price
(TP)
Two main reasons for transfer pricing:
Tax reasons
Incentives and performance measurement of
responsibility centers
11

Transfer pricing approaches

Variable cost based transfer price
Appropriate when selling division has excess capacity

Full (i.e. Absorption) cost based transfer price

When selling division has no spare capacity

Market based transfer price

Theoretically the right approach when selling division
has no spare capacity AND market price provides the
best estimate of the opportunity cost

Negotiated transfer price

Due to conflict of interests of the negotiating parties,
this may be a tedious solution.
12

Ideal Transfer Price

Selling division: Minimum Acceptable TP = TPMin
Variable cost of transfer + Selling divisions
opportunity cost of transfer.
Buying division: Maximum Acceptable TP = TPMax
Buying divisions opportunity cost of transfer.
Goods will be transferred for any TP in between
TPMin and TPMax.
In a competitive product market, if selling
divisions capacity is fully utilized, then TPMin =
TPMax = Market price.
13

General-Transfer-Pricing
Rule
The ideal transfer price allows each division manager to make decisions that
maximize the companys profit, while attempting to maximize his/her own
divisions profit.

Ideal
Transfer
price

Additional outlay
cost per unit incurred by
the selling division
because goods are
transferred

Opportunity cost per

unit to the selling
division because of
the transfer