Performance Evaluation Chapter 15 Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 15-2 Learning Objective 1 Describe the concept of decentralization. 15-3 Decision Making is Pushed Down Decentralization often occurs as organizations continue to grow. Decentralization 15-4 An accounting system that provides information... Responsibility Accounting Relating to the responsibilities of individual managers. To evaluate managers on controllable items. 15-5 Cost Center A business segment that incurs expenses but does not generate revenue. Cost Responsibility Centers 15-6 Profit Center A part of the business that has control over both revenues and expenses, but no control over investment funds. Responsibility Centers Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Other 15-7 Investment Center A profit center where management also makes capital investment decisions. Corporate Headquarters Responsibility Centers 15-8 Im in control Controllability Concept Managers should only be evaluated on revenues or costs they control. Since the exercise of control may be clouded, managers are usually held responsible for items over which they have predominant rather than absolute control. 15-9 Learning Objective 2 Distinguish between flexible and static budgets. 15-10 Preparing Flexible Budgets The master budget, sometimes called a static budget, is based solely on the planned volume of activity. Flexible budgets differ from static budgets in that they show expected revenues and costs at a variety of volume levels. 15-11 Static and Flexible Budgets From the standard cost information, Melrose prepares the following static and flexible budgets. 18,000 $80 = $1,440,000 15-12 Learning Objective 3 Classify variances as being favorable or unfavorable. 15-13 Determining Variances for Performance Evaluation The differences between standard and actual amounts are called variances. A variance may be favorable or unfavorable. When actual sales exceed expected sales, variances are favorable. When actual sales are less than expected sales, variances are unfavorable. When actual costs exceed standard costs, variances are unfavorable. When actual costs are less than standard costs, variances are favorable. 15-14 Learning Objective 4 Compute and interpret sales and variable cost volume variances. 15-15 Volume Variances Sales and variable cost volume variances: the difference between the static budget amount and the flexible budget amount. 15-16 Interpreting the Volume Variances In the case of Melrose, the marketing manager exceeded planned sales volume by 1,000 units, resulting in an $80,000 favorable revenue variance ($80 1,000). The unfavorable cost variances are somewhat misleading. Melrose incurred higher costs because it manufactured and sold more units than planned. 15-17 Fixed Cost Per Unit, Budgeted & Actual Because actual volume is not known until the end of the period, the selling price must be based on planned volume. Fixed cost per unit is considered. At the planned volume of 18,000 units, Melroses fixed cost per unit is budgeted as: Based on actual volume, fixed cost per unit would be $15.35 ($291,600 19,000 actual units). 15-18 Learning Objective 5 Compute and interpret flexible budget variances. 15-19 Flexible Budget Variances Management will compare the actual results achieved to the flexible budget at the actual volume achieved (rather than the static, planned volume). First compare the per unit standard (budgeted) cost and the per unit actual cost achieved in the current period. 15-20 Flexible Budget Variances Second compare actual results achieved with budgeted amounts for the actual volume of the 19,000; flexible budget compared to actual results, both at 19,000 units. $78 19,000 = $1,482,000 15-21 Calculating Sales Price Variance or 15-22 Need for Standard Costs Management by exception Standard costs help managers plan and establish benchmarks against which actual performance can be judged. Management by exception focuses on material differences between actual and expected results. 15-23 Learning Objective 6 Evaluate investment opportunities using the return on investment techniques. 15-24 Evaluation Measures Profit Center Profitability Investment Center Return on investment (ROI) Residual income (RI) Cost Center Cost control Quantity and quality of services Managerial Performance Measurement & Evaluation 15-25 Return on investment is the ratio of income to the investment used to generate the income. ROI = Operating Income Operating Assets Return on Investment 15-26 Return on Investment Lets calculate ROI. Assume Panther Holding Company has three operating divisions. 15-27 Return on Investment ROI = Operating Income Operating Assets 15-28 Measuring Operating Assets Using the book value of operating assets to calculate ROI will result in a higher ROI. 15-29 ROI = Operating Income Operating Assets Margin Turnover Return on Investment ROI = Sales Operating Assets Operating Income Sales 15-30 Improving ROI ROI = Sales Operating Assets Operating Income Sales Margin is a measure of managements ability to control operating expenses relative to the level of sales. Turnover is a measure of the amount of operating assets employed to support the achieved level of sales. 15-31 Improving R0I Sales of $600,000. Operating income of $60,000. Operating assets $300,000. Sales of $600,000. Operating income of $60,000. Operating assets $300,000. Lets calculate the ROI for the Lumber Manufacturing Division. ROI = Operating income x Sales Sales Operating assets 15-32 Improving R0I Lets calculate the ROI for the Lumber Manufacturing Division. ROI = Operating income x Sales Sales Operating assets = $60,000 x $600,000 $600,000 $300,000 =.10 x 2 = 20% 15-33 Learning Objective 7 Evaluate investment opportunities using the residual income technique. 15-34 ROI - A Major Drawback As division manager of the Lumber Manufacturing Division, your compensation package includes a salary plus bonus based on your divisions ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 18% on all new investments -- your division has been producing an ROI of 20%. You have an opportunity to invest in a new project that will produce an ROI of 19% which is 1% less that current ROI. As division manager of the Lumber Manufacturing Division, your compensation package includes a salary plus bonus based on your divisions ROI -- the higher your ROI, the bigger your bonus. The company requires an ROI of 18% on all new investments -- your division has been producing an ROI of 20%. You have an opportunity to invest in a new project that will produce an ROI of 19% which is 1% less that current ROI. As division manager would you invest in this project? 15-35 ROI - A Major Drawback As division manager, I wouldnt invest in that project because it would lower my pay! Gee... I thought we were supposed to do what was best for the company! 15-36 Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. 15-37 Residual Income Operating Income Investment charge = Residual income Investment Desired ROI = Investment charge Investment centers cost of acquiring investment capital 15-38 Residual Income Investment centers cost of acquiring investment capital Operating Income= $60,000 Investment charge = 54,000 = Residual income= $ 6,000 Investment = $300,000 Desired ROI = 18% = Investment charge = $ 54,000 15-39 Residual Income As a manager of the Lumber Manufacturing Division, would you invest $50,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI? As a manager of the Lumber Manufacturing Division, would you invest $50,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI? 15-40 Residual Income Operating income = $50,000 X.19 = $9,500 Residual income = Operating income - (Operating assets x Desired ROI) = $9,500 - ($50,000 X.18) = $9,500 - $9,000 = $500 Accepting the new project would add $500 to LMDs residual income. Operating income = $50,000 X.19 = $9,500 Residual income = Operating income - (Operating assets x Desired ROI) = $9,500 - ($50,000 X.18) = $9,500 - $9,000 = $500 Accepting the new project would add $500 to LMDs residual income. 15-41 Responsibility Accounting and the Balanced Scorecard The balance scorecard is a holistic approach to evaluating managers. Balanced Scorecard Multiple financial measures Multiple nonfinancial measures 15-42 End of Chapter Fifteen