CHAPTER 21
Performance Management and Evaluation
REVIEWING THE CHAPTER
Objective 1: Describe how the balanced scorecard aligns performance with organizational
goals.
1.
The balanced scorecard is a framework that links the perspectives of an organization’s
four basic stakeholder groups with the organization’s mission and vision, performance
measures, strategic and tactical plans, and resources. The four groups are investors,
employees, internal business processes, and customers. To add value for these groups, an
organization determines each group’s objectives and translates them into performance
measures that have specific, quantifiable targets.
2.
During the planning phase of the management process, managers use the balanced scorecard
to translate their organization’s vision and strategy into operational objectives that will
benefit all stakeholder groups. Once they have established these objectives, they set
performance targets and select performance measures. In the performing phase, managers
use the organization’s operational objectives as the basis for decision making within their
individual areas of responsibility. Managers evaluate the effectiveness of their strategies in
meeting performance targets set during the planning stage and compare planned
performance with actual results. Managers prepare a variety of performance reports to
communicate results to stakeholder groups.
Objective 2: Discuss performance measurement, and identify the issues that affect
management’s ability to measure performance.
3.
A performance management and evaluation system is a set of procedures that account
for and report on both financial and nonfinancial performance. Such a system enables a
company to identify how well it is doing, the direction it is taking, and what improvements
will make it more profitable.
4.
Performance measurement is the use of quantitative tools to gauge an organization’s
performance in relation to a specific goal or an expected outcome. Each organization must
develop a unique set of performance measures appropriate to its specific situation that will
help managers distinguish between what is being measured and the actual measures used to
monitor performance.
Objective 3: Define responsibility accounting, and describe the role that responsibility
centers play in performance management and evaluation.
5.
Responsibility accounting is an information system that classifies data according to areas
of responsibility and reports each area’s activities by including only the revenue, cost, and
resource categories that the assigned manager can control.
6.
A responsibility center is an organizational unit whose manager has been assigned the
responsibility of managing a portion of the organization’s resources. The five types of
responsibility centers are as follows:
7.
a.
A cost center is a responsibility center whose manager is accountable only for
controllable costs that have well-defined relationships between the center’s resources
and products or services.
b.
A discretionary cost center is a responsibility center whose manager is accountable
only for costs in which the relationship between resources and products or services
produced is not well defined. These centers, like cost centers, have approved budgets
that set spending limits.
c.
A revenue center is a responsibility center whose manager is accountable primarily
for revenue and whose success is based on its ability to generate revenue.
d.
A profit center is a responsibility center whose manager is accountable for both
revenue and costs and for the resulting operating income.
e.
An investment center is a responsibility center whose manager is accountable for
profit generation; the manager can also make significant decisions about the resources
the center uses. The manager can control revenues, costs, and the investments of assets
to achieve the organization’s goals.
An organization chart is a visual representation of an organization’s hierarchy of
responsibility for the purposes of management control. A responsibility accounting system
establishes a communications network within an organization that is ideal for gathering and
reporting information about the operations of each of these areas of responsibility. The
system is used to prepare budgets by responsibility area and to report on the actual
performance of each responsibility center. The performance report for a responsibility
center should contain only controllable costs and revenues—that is, the costs, revenues,
and resources that the manager of the center can control.
Objective 4: Prepare performance reports for cost centers using flexible budgets and for
profit centers using variable costing.
8.
Performance reports allow comparisons between actual performance and budget
expectations. Such comparisons enable management to evaluate an individual’s
performance with respect to responsibility center objectives and companywide objectives
and to recommend changes. The content and format of a performance report depend on the
nature of the responsibility center.
9.
The performance of a cost center can be evaluated by comparing its actual costs with the
corresponding amounts in the flexible and master budgets. A flexible budget (also called a
variable budget) is a summary of expected costs for a range of activity levels. A flexible
budget is derived by multiplying actual unit output by predetermined unit costs for each cost
item in the report. The flexible budget is used primarily as a cost control tool evaluating
performance at the end of a period.
10. A profit center’s performance is usually evaluated by comparing its actual income statement
with its budgeted income statement. When variable costing is used, the profit center
manager’s controllable costs are classified as variable or fixed. The variable cost of goods
sold and the variable selling and administrative expenses are subtracted from sales to arrive
at the center’s contribution margin; all controllable fixed costs are subtracted from the
contribution margin to determine operating income. The variable costing income statement
takes the form of a contribution income statement rather than a traditional income statement.
A traditional income statement (also called a full costing or absorption costing income
statement) assigns all manufacturing costs to cost of goods sold. A variable costing income
statement uses only direct materials, direct labor, and variable overhead to compute variable
cost of goods sold. Fixed overhead is considered a cost of the current accounting period and
is listed with fixed selling expenses.
Objective 5: Prepare performance reports for investment centers using the traditional
measures of return on investment and residual income and the newer measure of economic
value added.
11. Return on investment (ROI) is a performance measure that takes into account both
operating income and the assets invested to earn that income. It is computed as follows:
Operating Income
Assets Invested
In this formula, assets invested are the average of the beginning and ending asset balances
for the period. Return on investment can also be examined in terms of profit margin and
asset turnover. Profit margin is the ratio of operating income to sales; it represents the
percentage of each sales dollar that results in profit. Asset turnover is the ratio of sales to
average assets invested; it indicates the productivity of assets, or the number of sales dollars
generated by each dollar invested in assets. Return on investment is equal to profit margin
multiplied by asset turnover:
Return on Investment (ROI)
=
ROI = Profit Margin × Asset Turnover
or
Operating Income
Sales
Operating Income
×
=
Sales
Assets Invested
Assets Invested
12. Residual income (RI) is the operating income that an investment center earns above a
minimum desired return on invested assets. The formula for computing residual income is
ROI
=
Residual Income = Operating Income – (Desired ROI × Assets Invested)
13. Economic value added (EVA) is an indicator of performance that measures the
shareholder wealth created by an investment center. A manager can improve the economic
value of an investment center by increasing sales, decreasing costs, decreasing assets, or
lowering the cost of capital. The cost of capital is the minimum desired rate of return on an
investment. The formula for computing economic value added is as follows:
EVA
=
After-Tax Operating Income –
Cost of Capital in Dollars
EVA
=
After-Tax Operating Income –
[Cost of Capital × (Total Assets
– Current Liabilities)]
or
Objective 6: Explain how properly linked performance incentives and measures add value
for all stakeholders in performance management and evaluation.
14. The effectiveness of a performance management and evaluation system depends on how
well it coordinates the goals of responsibility centers, managers, and the entire company.
Performance can be optimized by linking goals to measurable objectives and targets and by
tying appropriate compensation incentives to the achievement of those targets through
performance-based pay. Cash bonuses, awards, profit-sharing plans, and stock option
programs are common types of incentive compensation. Each organization’s unique
circumstances will determine its correct mix of performance measures and compensation
incentives. If management values the perspectives of all stakeholder groups, its performance
management and evaluation system will balance and benefit all interests.