Chapter 12: Organizational Structure and Performance Measurement Flashcards
In a broader context, performance management includes
specifying how individual units within an organization will be evaluated, what measures will be used to evaluate these units, and what actions will be taken to ensure continuous progress
Centralized organization
An organization in which decisions are made by a single manager or a small management team.
Including strategic and day-to-day operating decisions
Decentralized organization
An organization in which decision making is not confined to a few top executives but, rather, is spread throughout the organization.
Factors that will play into determining how a organization is decentralized and the extent of decentralization include:
the number of distinct business lines; the geographic spread of the organization; and the complexity and scale of various business functions like operations, purchasing, accounting and finance, and information systems
When an organization is decentralized, it is divided into different units or _______
segments
Depending on the dimension of segmentation, individual segments may represent different divisions, product lines, market territories, or even individual departments
Example: A university can have multiple levels of segmentation, the first line may be the different faculties (nursing, business, Arts, etc) and then the second line could be within those (marketing, accounting, etc)
Advantages / benefits of decentralization
1) Top management is relieved of much day-to-day problem solving and is left free to concentrate on strategy, higher-level decision making, and coordinating activities
2) Provides lower-level managers with vital experience in making decisions. Without such experience, they would be ill prepared to make decisions when they are promoted to higher level positions
3) Added responsibility and decision-making authority often result in increased job satisfaction. They make the job more interesting and motivate people to put fourth their best efforts
4) Lower level managers generally have more detailed and up to date information about conditions in their own area of responsibility than do top managers. Therefore, the decisions of lower level managers are often based on better information
5) Lower level managers will likely act in more responsible manner when they are held accountable for their actions as well as the results
Major disadvantages of decentralization
1) Lower level manager may make decisions without fully understanding the big picture. While top level managers typically have less detailed information about operations than do lower level managers, they usually have more information about the company as a whole and may have a better understanding of the company’s strategy
2) In a truly decentralized organization, there may be a lack of coordination among autonomous managers. This problem can be reduced by clearly defining the company’s strategy and communicating it effectively throughout the organization
3) Managers objectives may be different from those of the owners of an organization as a whole; this suggests a lack of goal congruence between owners and managers
4) In highly decentralized organization, it may be difficult to disseminate innovative ideas effectively. Someone in one part of the organization might have a terrific idea that would benefit other parts of the organization, but without strong central directions the idea may not be shared with, or adopted by, other parts of the organization
From a performance management perspective, there are two key issues relating to decentralization
1) Clarifying the decentralized segment manager’s scope of responsibilities
2) Deciding how the manager’s performance will be evaluated
Responsibility centres
Segments of an organization whose managers are responsible and accountable for costs, revenues, profits, or investments.
There are two key issues relating to decentralized organizations:
- Clarifying the decentralized segment manager’s scope of responsibilities and
- Deciding how the manger’s performance will be evaluated.
The three primary types of responsibility centres are:
1) Cost centres
2) Profit centres
3) investment centres
Cost centre
An organizational segment whose manager is responsible for costs but not for revenues, profits, or investments.
Examples: Accounting, finance, general administration, human resources, production)
Does not have the capability to directly generate revenue or profit
Profit centre
An organizational segment whose manager is responsible for the segment’s profitability and has the authority to strongly influence both costs and revenues.
Does not need top management approval for production, operations, and pricing decisions but does need approval for spending money on capital acquisition or disposal
An example would be managers of individual stores or a major retail chain.
Investment centre
A business segment similar to a profit centre; the manager of an investment centre is responsible for both profitability and investments in operating assets.
Example: Vice president of a product division of a large company
Evaluated using return on investment (ROI) or residual income (RI) measures
An example would be corporate headquarters.
Segment
An individual unit within an organization whose manager has the responsibility to carry out its activities.
Can be segmented by plant, geographic territory, product line, sales territory, service centre
Traceable fixed expense (or cost)
A fixed cost incurred because of the existence of a particular business segment.
If the segment were eliminated, the fixed cost would disappear
In general, should be assigned to specific segments
examples: Salaries and benefits, office equipment, building rent, selling and administrative
Common fixed expense (or cost)
A fixed cost that supports more than one business segment but is not traceable in whole or in part to any one of the business segments.
Even if a segment were eliminated, there would be no change in the common fixed costs
In general, should not be assigned to specific segments
Examples: Senior management salaries, corporate office building, legal and accounting
In general, _______ costs should be assigned to segments, but _____ costs should not be assigned to segments
traceable
Common fixed
Return on investment ROI (definition)
Net operating income divided by average operating assets. It also equals margin multiplied by turnover.
Good for comparing any size companies as it is standardized
Return on investment ROI (equation)
Net operating income / average operating assets
High or low ROI? Which is good?
The higher on ROI of a business segment, the greater the profits generated per dollar invested in the segments operating assets
Net operating income (AKA EBIT)
Income before interest and income taxes have been deducted.
EBIT
Earnings before interest and taxes
Operating assets
Cash, accounts receivable, inventory, plant and equipment, and all other assets held for productive use in an organization.
Examples of assets not included in operating assets inclide:
Land held for future use
An investment in another company
Factory building rented to someone else
Net book value or gross cost for plant and equipment?
one widely used approach is to include only the plant and equipment’s net book value - that the plant’s original cost less accumulated depreciation
Second approach is to ignore depreciation, including the plant’s entire gross cost in the operating asses base
Net book value methods
Consistent with how the plant and equipment are reported on the balance sheet (cost less accumulated depreciation to date)
ROI will tend to increase over time as next book value declines due to depreciation
It is consistent with the computation of operating income, which includes depreciation as an operating expense
Replacing fully depreciated equipment with new equipment can have a dramatic adverse effect on ROI
Gross cost method
Eliminates both the age of equipment and the method of depreciation as factors in RI computations
It does not discourage replacement of old, worn-out equipment
ROI improved (equation) =
(Net operating income / Sales) x (Sales / average operating assets)
Margin = (equation)
Net operating income / Sales
Margin (definition)
A measure of management’s ability to control operating expenses in relation to sales. Calculated as net operating income divided by sales.
The lower the operating expense per dollar of sales, the higher the margin earned
Turnover = (equation)
Sales / average operating assets
Turnover (definition)
The measure of the sales generated for each dollar invested in operating assets. Computed by dividing sales by the average operating assets figure.
Simplified ROI = (equation)
Margin x Turnover (slide above have each part)
DuPont pioneered a ROI concept that assessed manager performance by looking at both:
1) Margin
2) Turnover
An investment center manager can increase ROI in three ways
1) Increase sales
2) Reduce expenses
3) Reduce assets
Criticisms of ROI
1) Just telling manager to increase ROI may not be enough. Managers may not know how to increase ROI, they may increase ROI in a way that is inconsistent with the company’s strategy, or they may take actions that increase ROI in the short run but harm the company in the long run (such as cutting R&D)
2) A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. These committed costs make it difficult to asses the performance of the manager failry relative to other managers
3) A manager who is evaluated on the basis of ROI may reject investment opportunities that are profitable for the company as a whole
Residual income (RI) (definition)
The net operating income that an investment centre earns above the required return on its operating assets.
Residual income (RI) (equation) =
Net operating income - (required rate of return x Average operating assets)
ROI vs RI, why?
RI is better to use as it benefits the entire company. When looking at RI it will show returns that will be great and help the entire company. When looking at ROI it may show a decrease as positive changes are suggested, giving a false negative
A manager evaluated on the basis of ROI will tend to reject any project whose rate of return is below the divisions current ROI, even if the rate is above the minimum rate for the entire company
Managers evaluated on the basis of residual income (RI) will tend to make better decisions
concerning investment projects than ones evaluated on the basis of ROI
RI = WIN Win situation
Major disadvantage to the residual income approach
It cannot be used to compare the performance of divisions of different sizes
This problem can be slightly reduced by focusing on the percentage change in RI from year to year, rather than on the absolute amount of the RI.
Transfer price
The price charged when one segment of an organization provides goods or services to another.
What is included in transfer price?
It is hard to say, and can cause tension. Organization establish guidelines that govern the determination of transfer price
Generally, three methods can be used to calculate transfer price
1) Market-based price
2) Cost-based price
3) Negotiated price
The objective should always be to motivate manager to do what is best for both the overall company and the individual segment.
Why is it not ideal to only use financial measures for performance
1) Financial measures are typically outcome measures that provide after-the-fact information,
2) Financial measures are only one dimension of performance
Balanced scorecard
A multi-dimensional performance measurement system that contains measures along at least four dimensions: (1) financial,
(2) customer,
(3) internal business process, and
(4) learning and growth.
Average operating assets
Cash, accounts receivable, inventory, plant and equipment, and other productive assets.
The operating asset base used in the formula is typically computed as
the average of the operating assets between the beginning and end of year
