Performance Evaluation & Measurement Systems Flashcards
Why evaluate divisions and not solely overall performance?
- hard to pinpoint true cause of the problem
- motivation and contributions of each division
Modern changes on performance evaluation
- large companies: decentralization is unavoidable
- need to delegate decision making authorities to each division
Advantages of decentralization
- organizations respond more quickly to issues: simultaneous problem solving
- specialized knowledge of divisional managers that top management might not have
- frees top management from daily operations: focus on strategic levels for the whole
Challenges of decentralization
- goal congruence: coordination throughout top and middle managers
- company has to express overall strategy to all levels
Responsibility accounting
- system to track, report, and evaluate performance of divisional management at all levels
- fosters goal congruence
Responsibility centers
- cost center
- profit center
- investment center
- revenue center
How to measure employee performance at all levels
- financial measures: top managers
- non-financial measures: bottom of hierarchy
Disadvantages of using only one measure (financial or non) for bottom or top hierarchy
- only using non-financial measures for low level employees might not give right incentive (ignore their financial impacts)
- using non-financial measures for top management makes sure they are aware of issues and encourages to check on middle-bottom managers
- operational and financial measures should supplement each other
Advantages of profit centers
- quality of decisions likely to improve (divisional managers have better market knowledge)
- provides training for managers, prepares them for top promotions
- profit consciousness is enhanced
Difficulties of profit centers
- loss of control: inconsistency in decisions
- lack of competent general managers: get used to delegating decisions, become less prepared
- too much emphasis on short run profits: hinders long term profitability
Investment centers
How much profit increases whilst taking capital invested into account
3 methods of evaluating performance of an investment center
- Return on Investment (ROI)
- Residual Income (RI)
- Economic Value Added (EVA)
Advantages of using accounting measures for divisional performance evaluation
- income statement and balance beet provide comprehensive measures
- this data is readily available
Alternative of using accounting measures for divisional performance evaluation
- using market measures
- share price (stock market)
Disadvantages of using market measures for performance evaluation
- volatile: external impacts which manager has no control over
- unavailable for private firms
- employee efforts does not affect share price
Return on Investment theoretic calculation
ROI = profit / assets
How ROI lead to underinvestment
- if ROI is higher than Cost of Capital, project should be accepted
- however, managers are incentivized to decline projects that have lower ROI than the average ROI
E.g.
ROI = 15%
ave. ROI = 16%
CoC = 14%
How ROI leads to overinvestment
- if ROI is lower than Cost of Capital, project should be rejected
- managers are incentivized to accept projects that have higher ROI than average ROI
E.g.
ROI = 17%
ave. ROI = 15%
CoC = 18%
Problems with using ROI to measure performance
- managers are incentivized to keep old assets in the books as this results in a lower denominator and in turn a higher ROI
- misleading performance signals: portrays performance at a positive light
- horizon problems: short term (myopic) view incentivizes managers to increase ROI in the short run
Advantages of using financial measures for performance evaluation
- helps assign financial responsibilities to subunits
- controllability principle: hold managers accountable for their decisions
Using performance evaluation to prepare performance reports
- calculate variances between budgeted and actual amounts
3 ways to improve ROI (increase ratio)
- increase sales prices (revenue center)
- decrease expenses (cost center)
- lower invested capital (investment center)
Residual Income calculation
RI = operating profit - capital charge
Capital charge = investment base x cost of capital
Investment base = assets
Acceptance rule for RI
- accept: RI is greater than 0 (positive)
Advantages of RI for performance evaluation
- aligns decisions with shareholder wealth
- financial measure: easy to retrieve and compute
- overcomes ROI disadvantages:
• fosters goal congruency
• focuses on operational profit only
Disadvantages of RI for performance evaluation
- does not overcome misleading signals of ROI: management of book values to project in positive light
- only in longer run does RI result in optimal decisions
Economic Value Added calculation
EVA = adjusted net operating profits after taxes - CoC x adjusted assets employed
Advantages of EVA for performance evaluation
- overcomes problem of ROI/RI using book values
- an ‘adjusted’ version of RI, more reflective/accurate measure
- aligns decisions with shareholder wealth
- simple and easy to understand
- Overcomes disadvantage of multiple inconsistent goals
Main adjustments made to the EVA
- undo ‘accounting conservatism’ ideal
- discourage earnings management
- take into account past errors when computing
