Week 3- Performance evaluation and measurement systems Flashcards
what is decentralisation?
the delegation of decision making due to growth of business
what are the advantages of decentralisation?
- Allows quicker response to events
- frees top management from day to day activities
- Uses specialized knowledge and skills of managers
what are the disadvantages of decentralisation?
-Goal congruenece: challenging for top managers to monitor that lower mangers are making decisons that acheive the top management goals
What is responsibility accounting?
Used to measure the performance of people and departments to foster goal congruence
what is a responsibility centre?
a subunit within a business whose manager is held accountable for specified financial results ( a unit that has been delegated decison making)
What re the four types of responsibilty centre?
1) Cost centre
2) Revenue centre
3) Profit centre
4) investment centre
what does a cost centre have control over?
cost
what does a profit centre have control over?
Both costs and revenues
What does a investement centre have control over?
Profits and invested capital
how is an investment centers performance measured?
Profit is compared with the assets employed in earning it
what are the conditions for delegating responsibility?
- The lower manager should have access to the relevant information needed for making decision making
- There should be ways to measure the effectiveness of the tradeoffs the manager has made
- Important to have a good performance measurement system to evaluate the effectiveness of the manager
what are the advantages of profit centres?
- the quality of the decision may improve if the manager making it has enough knowledge to make them
- Provides a training ground for managers
- Profit conciousness is enhanced- will focus on maximising profit
what are the disadvantages of profit centres?
- Loss of control
- Lack of competent managers will lead to reduced profit
- Too much emphasis on short run profitability- maangers may decide to cut down costs such as R+D that generate costs in the long run
what is the investment base?
The sum of the assets in an investment centre. allows them to generate the profit
how are financial performance measures usually used?
Usually used at the top of the hierachy - eg. have they met the sales target for the quarter
where are operational performance measures usually used?
Lower levels of the firm eg. volume sold, lead times, quality of product
what is the disadvantage of using share price to measure performance?
Other factors affect share price, not just employee performance
what re the two primary ways of evaluating the performance of an investment centre?
Return on investment and residual income
what is the calculation to work out return on investment?
Income/ invested capital
If ROI is < mean ROI for the business then what will the managers do?
Reject the project
what is underinvestment in terms of ROI?
When the ROI for a project is lower that the mean business ROI but higher than the Cost of capital (coc). Managers should accept the investment
what is overinvestment in terms of ROI?
When the ROI is higher than the mean ROI but lower than the cost of capital. this is when the manger is incentivised to accept the investment but shouldnt
what are other disadvantages of using ROI?
-Income does not include value increases
-Total assets exclude intangible assets
-ROI also provides incentives for managers to keep old assets in the books
Makes firms with old assets look like they have superior performance
what re the three main ways of improving ROI?
1) increase sales price
2) Decrease expenses
3) Lower invested capital- although this may not benefit the manager in the long run if the manager is cutting long term perofitability projects eg. R+D
what is a performance report?
They show the budgeted and actual revenues and costs and the difference in between (the variance). Show whether the subunit is doing better than predicted or worse
how do you calculate RI (residual income)?
Operating profit- capital charge (investment base *cost of capital)
when RI is > 0 what will business subunits do?
accept the project
what is the advantage of RI over ROI?
It aids sound investment decision making by fostering goal congruent decisions by aligning shareholders wealth with managers targets
what is the best way of measuring performance of investment centers?
Economic value added (EVA)
what is the difference between ROI, RI and EVA?
ROI and RI use book values but EVA uses adjusted figures to make the numbers reflect the business more accurately
how do you calculate EVA?
Adjusted net operating profits after taxes - (cost of capital * adjusted assets employed)
what are the factors that influence which adjustment will be made in EVA?
Magnitude of change
Data availiability
Easiness of communicating the required changes to managers
The effect of the changes on decisions
what are the advantages of EVA?
- Aligns Decisions with shareholder wealth
- Overcomes multiple and inconsistent goals because as managers are maximising EVA they are also increasing shareholder wealth. Therefore it is much more than a performance measurement tool.
- the most accurate measurement tool of performance because it uses adjusted figures
why is it important for managers to have control over the financial are they are being measured against?
The financial performance measures wont reflect the actions of the manager
