Chapter 19 - Strategic Performance Measurement—Investment Centers
18-1
Performance evaluation can be thought of as the process by which managers at all levels in the firm gain information about the performance of tasks within the firm and judge that performance agains againstt pre-es pre-estab tablilishe shed d criter criteria ia as set out in budget budgets, s, plans, plans, and goals. goals. In manage managemen mentt accounting there are two types of performance evaluation -- management control and operational contro control. l. Manag Manageme ement nt contro controll refers refers to the evaluat evaluation ion by upperupper-lev level el manage managers rs of the performanc performance e of mid-level mid-level managers. managers. Operation Operational al control refers to the evaluatio evaluation n of operating level employees by mid-level managers.
18-2
trate trategi gic c perfor performan mance ce measur measureme ement nt is a manage managemen mentt accoun accounti ting ng system system used used by top management management for the evaluation evaluation of business unit managers. managers. It is used when the conditions conditions are such that responsibility can be effectively delegated to business unit managers, and there are ade!uate measures for evaluating the the performance of the managers. It is important for effective effective manage managemen mentt becaus because e it helps helps the decent decentral rali"e i"ed d firm firm evalua evaluate te manage managers rs of decent decentral rali"e i"ed d business units of the f irm.
18-3
#n effective performance evaluation system must consider both the individual and team aspects of work and performance in the firm. In management accounting, we focus on the individual aspects primarily in strategic performance measurement systems. $owever, strategy-focused firms will also develop methods to evaluate teams using techni!ues such as bonuses based on team performance and balanced scorecards based on performance measures that are commonly controlled within the team.
18-4
%he systems for management control are of two types -- formal and informal. &ormal systems are devel develop oped ed from from e'pl e'plic icit it mana manage geme ment nt guid guidan ance ce,, whil while e info inform rmal al syst system ems s aris arise e from from the the unmana unmanaged ged,, and someti sometimes mes uninte unintende nded, d, behavi behavior or of manage managers rs and employ employees ees.. Infor Informal mal systems reflect the managers( and employees( reactions and feelings that arise from the positive and negative aspects of the work environment, for e'ample, the positive feelings of security and acceptance of an employee in a company that has a successful product and generous employee benefits. benefits. &ormal &ormal and informal informal control systems systems can be implemented implemented at both the level of the indivi individua duall manage managerr or that that of a team team of manage managers rs or employ employees ees.. trat trategi egic c perfor performan mance ce measurement is a type of formal control system at the individual level.
18-5
%he two organi"ational designs are centrali"ed centrali"ed and decentrali"ed. # centrali"ed firm reserves reserves much of the decision-making at the top management level. In contrast, a decentrali"ed firm delegates a significant amount of responsibility to lower level managers. )oth the centrali"ed and decentrali decentrali"ed "ed firms are called hierarchical , because responsibility and reporting relationships follow a top to bottom pattern. *esponsibility flows top-down and reporting relationships flow bottom-up.
18-6
# cost center is a production production or support unit within within a firm that that is evaluated on the basis of cost. cost. # revenue center focuses on the selling function and is defined either by product line or by geographical area. # profit profit center generates generates both revenues and incurs incurs the major portion portion of the cost for producing these revenues.
#n investment center center evaluation includes includes assets employed by the center as well as profits in the performance evaluation. %he goal of each type of is center as follows+ ost center+ produce a product or service of given !uality !uality at lowest cost. 19-1 Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
*evenue center+ to meet sales goals within a given e'pense budget. Profit center : achieve desired profit goals. Investment center+ achieve desired profit goals for a given amount of assets. 18-7
hile net income determined using full costing is affected by changes in inventory levels, net income income using using variable variable costing is not affected. affected. %his means that the proper interpreta interpretation tion of net income under full costing, unlike variable variable costing, re!uires an adjustment for changing inventory inventory levels. %his difference is important because users of financial statements prepared under full costing can be misled about the actual performance of the firm if there are significant changes in inventory level for the firm.
18-8
%here are four behavioralimplementation behavioralimplementation issues for )/s+ 0. ost ost shifti shifting, ng, where wherein in a depar departme tment nt replac replaces es its contro controllllabl able e costs costs with with nonnoncontrollable costs. &or e'ample, a manager might attempt to replace variable costs such as manufacturing labor with fi'ed costs such as advanced e!uipment if the manager is evaluated on the basis of contribution margin only 1i.e., fi'ed costs are e'cluded2. 3. hort term focus, where the concern is that strategic performance measurement, done improperly, will motivate managers to focus on short-term profits and neglect long-term strategic issues. 4. )udg )udget et slac slack k whic which h is ofte often n view viewed ed nega negati tive vely ly,, can can have have a posi positi tive ve effe effect ct in management control. lack is sometimes viewed as a dysfunctional aspect of )/s, a result of managers attempting to make their performance goals easier, and therefore an indication of an overall lower than appropriate level of performance. %he positive view of slack is that it addresses effectively the the decision making and fairness objectives of performance evaluation. evaluation. )y limiting managers( e'posure to environmental uncertainty, it reduces the relative risk aversion of the managers.
18-9
# pervasive issue when using cost centers is how the jointly incurred costs of service departments -- such as data processing, engineering, human resources, or maintenance -- are to be allocated to the departments using the service. %he various cost allocation methods are e'plained e'plained in hapter 5. %he choice choice of method method will affect the amount amount of cost allocated allocated to each cost center, and therefore it is critical in effective cost center evaluation.
18-10
trategic performance measurement can be used for both service and not-for-profit firms as well as manufacturing firms. firms. ost centers are particularly particularly appropriate across all organi"ation types, as the organi"ation attempts to identify responsibility for costs and to develop a system for record recording ing,, report reporting ing and evalua evaluatin ting g perfor performan mance ce in managi managing ng costs. costs. #n e'ample e'ample of an application of strategic performance measurement in banking is presented in the chapter.
18-11
ost centers are used when the firm wishes to focus the manager6s attention e'clusively on costs. %his makes sense particularly when for e'ample the manager is producing a product that re!uires little coordination with marketing or design. %here are therefore few times when the manager will need to adjust the functionality of the product or adjust the production schedule to suit the needs of a certain customer. %he manager can then focus her or his a ttention primarily on the cost of manufacture. %he revenue center is used for marketing and sales organi"ations where the principal focus is sales volume. %he profit center is used when the manager has effective control over both revenues a nd costs in the unit, and when there is a need for coordination between the marketing and production areas, as for e'ample, in handling special orders or rush orders. 7valuation on profit provides the incentive incentive for the departments departments to work together. together. #lso, #lso, profit centers are used to set a desirable desirable competitive tone8 all departments have the profit incentive to compete with other providers of the good or service, inside or outside the firm.
18-12
1ee also 09-:2 entrali"ed firms have a strong hierarchical organi"ation in which information flows upward and management flows downward downward in the hierarchy. entrali"ed firms are effective effective 19-2
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Chapter 19 - Strategic Performance Measurement—Investment Centers
in !uickly implementing policy changes and in controlling operations according to the goals of top management management.. ;ower level level managers are given limited limited autonomy, autonomy, and have a limited limited range of decision making. %heir role is to provide information and to implement top management policies.
%he marketing marketing department department can be viewed viewed as both a revenue center center and a cost center. center. %he marketing department is viewed as a revenue center because there is a revenue-generating process. %he marketing manager must therefore therefore report revenues, typically typically by product line, and someti sometimes mes also also by sales sales area area and salesp salespers erson. on. In additi addition, on, the market marketing ing depart departmen mentt is commonly viewed as a cost center. center. In certain industries, such as pharmaceuticals, pharmaceuticals, cosmetics, software, games and toys, and speciali"ed electrical e!uipment, the cost of advertising and promotion is a significant portion of the total cost of producing and selling the product.
18-20 In the short run, Pepper6s will lose =0>>,>>> in profits, shown by the ontrollable ontrollabl e Margin for intake valves. $owever, in the long run, Pepper6s will be able to save =0:>,>>> in noncontrollable costs, leading to a net increase in profits of =:>,>>> by dropping intake valves from its production line.
09-34 &or the inter Outerwear Outerwear division, the the short-term short-term effect would be be a loss of =:>>,>>> in profits as shown by the ontrollable Margin. %he long-term effect would be an increase of =3:>,>>> in profits, shown shown by the P. &or the $igh-7nd $igh-7nd uits uits the short-ter short-term m effect effect would be a loss of =0,>>>,>>> in profits and a long-term increase in profits by =:>>,>>>. =:>>,>>>. %he decision decision would be based based on whether whether the compan company y was was more more conce concerne rned d with with shortshort-ter term m or long-te long-term. rm. If Manu Manuel el Inc. Inc. is more more conc concer erne ned d abou aboutt shor shortt-te term rm effe effect cts s from from dropping a division, it would most likely drop the inter Outerwear divisi division on due to a smalle smallerr loss loss in initial initial profit profits. s. $oweve $oweverr, if the company was more concerned with long-term positioning, it would drop the $igh-7nd uits division due to a higher savings in the long run.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-26 Risk Aversion; Strategy (20 min
?ohn6s decision about scheduling the special order involves the conflict of three key factors+ the need for maintenance, the delay of currently scheduled jobs, and the value of the new customer in terms of current contribution to profits as well as the later contribution to profits from future sales to the special order customer. *isk is an important aspect of the problem because of the risk of the e!uipment failure and its conse!uences, plus the uncertainty about the delay for currently scheduled jobs, irrespective of whether the e!uipment fails. )ecause of risk aversion 1we e'pect ?ohn to be risk averse2, ?ohn will be motivated to reject the special order since it adds risk. $owever, from the perspective of the entire firm, it is desirable to accept the special order for its current and future contributions. %he best way to handle issues such as this is to address the risk aversion issue directly. %his can be done by making sure that ?ohn6s performance evaluation includes a reward for accepting the special order, and that any scheduling difficulties or additional costs due to the special order will not be charged directly to him, but against the contribution of the special order. In this way, ?ohn6s interests are more in line with those of the entire firm.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-27 Resear!" an# $eve%o&ment: Risk Aversion an# 'erorman!e )eas*rement (20 min
0. *isk aversion, the tendency to avoid actions with uncertain outcomes 1even with good probability of success2, is a common trait among managers. %his leads fre!uently to a choice of a short-term gain that may conflict with a long-term benefit. In the case of *@<, when economic times are hard, very often the risk aversion and the shortterm thinking take over and *@< is reduced. # recent Business Week article 1cited below2 notes this trend among ilicon Aalley venture capitalists. %he article notes that the solution to risk aversion can be to rely on the least risk-averse entity around, the federal government. %he article notes that there are discussions of federal ta' breaks to encourage increased spending in *@<. #lso, the #merica ompetes #ct, passed by ongress in 3>>5 but not funded, was intended to increase funding for research and development at universities and in corporations, as well as improvements in science education. hile managing risk aversion may mean relying in part on e'ternal sources of funding, it can also be accomplished by a strong emphasis on the importance of innovation and its role in future competitiveness. ometimes this means that BchampionsC of research within firms will play an important role in increasing the funding of research. %he Business Week article notes that some ilicon Aalley entrepreneurs have taken money out of their own pockets to fund research. )udgeting and controlling activities such as *@< is difficult. Donetheless some control must be e'ercised. %he firm should attempt to track the costs and progress of individual projects. Periodically the projects should be evaluated by the personnel doing the research, by other scientists, and by operating managers8 the goals is to assess the progress and commercial 19-' Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
potential of the project. %hese evaluations should form the basis for setting priorities on e'isting projects. &or new projects the firm might use a proposal system. *esearchers would prepare a short proposal outlining planned research and its e'pected benefits. # committee of scientists and operating personnel could then set priorities for the various projects. &or control of overall spending, the company(s approach of comparing its
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-27 (!ontin*e# -1
spending with the spending of competitors seems reasonable. #n alternative approach, used by $ewlett-Packard6s P division is to increase *@< spending for products that can most benefit. %o determine how to target *@< effort, $-P uses a measure called B*@< productivity,C which is the ratio of *@< spending on a product line to the gross margin of the product line. /sing this approach, products with higher gross margin are allocated a higher portion of *@< e'penditures. %he idea is that products with higher gross margins, such as high-end laptops, are more likely to compete on differentiation, and investments in innovation will be rewarded by increased customer demand. In contrast, products with low gross margins, the cost leaders, re!uire a focus on cost reduction rather than innovation. 1ee also 7'ercise 09-4E, BManaging the *esearch and
ources+ teve $amm, BIs ilicon Aalley ;osing Its MagicF+ # *oad %rip &inds *isk #version, hort-term %hinking, and # &ew )old Ideas,C Business Week , ?anuary 03, 3>>G, pp. 3G-448 liff 7dwards, B$ow $P Hot the ow )ack,C Business Week , >9, pp. E>-E0.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-39 +inan!ia% Re&orting an# S, 'erorman!e (20 min
0. %he business unit information prepared for public 1e'ternal2 financial reporting purposes may not be appropriate for the evaluation of business unit management performance because+ an allocation of common costs incurred for the benefit of more than one business unit must be included for public reporting purposes, in e'ternal financial reports, common costs are often allocated on an arbitrary 1non-causal2 basis . the business units identified for public reporting purposes may not coincide with actual managerial responsibilities. # business unit may have different operating responsibilities in practice than that described in the financial report. &or e'ample, for simplicity the annual report may group operations into geographical-based categories 1foreign versus domestic8 western states versus Midwest, etc. 2, when instead unit managers are given responsibility for product lines including all areas in which the product is sold. If business unit leaders6 performance is evaluated on the basis of the information in the annual financial report, unit managers may become frustrated and dissatisfied because they would be held responsible for an earnings figure that includes the arbitrary allocation of common costs and costs traceable to but not controllable by them. %his type of performance evaluation is unfair to managers and does little to motivate them. #s a result of this dissatisfaction, the best managers may seek employment elsewhere. •
•
•
•
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-39 (!ontin*e# -1
3. %he company should consider establishing profit centers for its business units. %he contribution income statement should be used to evaluate amentech Inc.6s business unit managers. %he contribution income statement is the best measure of performance because it distinguishes both+ a2 traceable and nontraceable costs, and b2 controllable and uncontrollable costs 1some costs might be traceable to a unit, but not controllable in the short term, as for e'ample the cost of facilities.2 %he determination of whether noncontrollable costs should be charged to division is a comple' issue. &or e'ample, the managers in this case are choosing a higher cost insurance coverage in order to maintain some local fle'ibility. If insurance costs are not charged to the unit managers, there is no incentive for them to choose a cost-saving insurance plan. In this case, the desired incentive might be achieved by allocating the cost of insurance 1for e'ample, on the basis of headcount, number of claims, or some measure that is related to the use of insurance2, thereby providing the incentive for the managers to get together and choose a cost-saving join policy. Many times it can be advantageous to compare the managers6 performance to a budget, where the budget is determined with an e'plicit consideration of conditions in the industry for that unit. %his way managers are not rewarded or penali"ed for favorable or unfavorable conditions within the market place that are beyond their control. #lso, the company should consider using the balanced scorecard, in order to include in the performance measurement all of the critical success factors that managers should attend to in order to align their performance with the company6s strategic goals. 4. /sing the ) and the contribution income statement should help amentech Inc. bring its managers6 decision making more in line with overall corporate strategy. It will specifically help control the lack of motivation and cooperation that is commonplace in amentech Inc.6s current operations. 19-9 Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
18-54 /entra%iation vs $e!entra%iation; ,anking (30 min
0. %he following advantages are attributed to a decentrali"ed organi"ational structure+ •
•
•
•
%he manager making the decisions is closer to the situation and can make better and faster decisions. %op management has more time for strategic decisions and longrange planning because operational decisions are made at lower levels. Hreater freedom and responsibility provide greater opportunity for individual development, innovation, and creative decisions. 7'cellent training in decision-making is provided for lower level managers resulting in a pool of trained managerial talent.
3. %he following disadvantages of a decentrali"ed structure and their effect on *D) are as follows. •
%here is an increased risk of loss of control. *D) does not have sufficient control over its individual banks as evidenced by the uni!ue BpackagedC accounts, inter-bank competition, and conflicting advertising.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-54 (!ontin*e# -1 •
•
•
%here is less information flow to top levels. %he individual banks sometimes failed to notify the e'ecutive office of their plans and programs.
4. %he change appears to be risky. *D) has built a successful business on the basis of local bank autonomy, allowing the local bank e'ecutives to develop products and services that fit the needs of their local customers. ;ocal managers should be in the best position to determine how to improve customer satisfaction. %he reduction of local autonomy will also likely have a negative impact on the motivation of the local managers and on the effectiveness of *D)6s management incentive plans. %he concerns about duplication of effort and loss of control are valid concerns, and it may be that for the bank to successfully implement new strategic initiatives, more top level control will be necessary. &or e'ample, if the firm wants to appeal to the type of customer that needs higher-level services of the type that would re!uire coordination from a centrali"ed office, or if the customers are large businesses that will need to deal with many of *D)6s local banks in a coordinated manner, then a greater emphasis on centrali"ation would be advisable.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
09-:: )alanced corecard8 trategic )usiness /nits8 7thics 1> min2
0. %he new 7O made the correct decision because the increased contribution of sales from lighting fi'tures upscale and electronic timing devices more than made up for the increased selling costs and the lost sales in the mid-range unit. %his is due largely to the fact that the mid-range units had relatively low margins in comparison to those in the upscale unit and the timing devices unit. 3. a. %he benefits that an organi"ation reali"es from business unit reporting include the following+ •
•
Improved evaluation of profit contributions of divisions, plants, product lines, and sales territories because of the separation of traceable and nontraceable costs and the separation of controllable and non-controllable costs. )etter consideration of decisions such as eliminating unprofitable business units, providing special attention to problem business units, and allocating capital to the most promising business units.
b. )usiness unit reporting on a variable cost basis not only focuses on costs that vary with production and sales but also re!uires the segregation of fi'ed costs between traceable fi'ed costs 1i.e., those directly assignable to the business unit2 and common fi'ed costs. %raceable fi'ed costs can also be further distinguished as controllable or not. ontrollable fi'ed costs could be discontinued if the business unit were to be discontinued. %hus, variable costing allows management to focus on the profit contribution of decisions or actions. /nder full costing the allocation of fi'ed manufacturing costs to inventory and cost of goods sold can introduce a bias into the calculation of profit, since profit under full costing is affected by changes in inventory levels.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-55 (!ontin*e# -1
4. %he current approach of allocating common fi'ed e'penses on the basis of units produced is unfavorable to the 7lectronic %iming . P should either keep the budgeted allocation or e'clude the allocation of common costs in the evaluation of unit managers. .%he actions contemplated by the ;ighting &i'tures
/)'/
7ach member has a responsibility to+ 0. Maintain an appropriate level of professional e'pertise by continually developing knowledge and skills. 3. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 4. Provide decision support information and recommendations that are accurate, clear, concise, and timely. 19-1% Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
18-55 (!ontin*e# -2
. *ecogni"e and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. /+$A
7ach member has a responsibility to+ 0. Keep information confidential e'cept when disclosure is authori"ed or legally re!uired. 3. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates6 activities to ensure compliance. 4. *efrain from using confidential information for unethical or illegal advantage. R
7ach member has a responsibility to+ 0. Mitigate actual conflicts of interest. *egularly communicate with business associates to avoid apparent conflicts of interest. #dvise all parties of any potential conflicts. 3. *efrain from engaging in any conduct that would prejudice carrying out duties ethically. 4. #bstain from engaging in or supporting any activity that might discredit the profession.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-55 (!ontin*e# -3
/R$,
7ach member has a responsibility to+ 0. ommunicate information fairly and objectively. 3.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-55 (!ontin*e# -4
ince customer service is critical, the balanced scorecard should begin with the customer perspective. %he learning and innovation perspective might be left for last or omitted because of the firm6s approach in this area, while the financial and operations perspectives should get a second and third ranking of importance. ome suggested measures in each perspectives follow. 7ach measure should be determined for each business unit, and when practical, for each product line and sales region. ustomer Perspective Dumber of new customers this period Dumber of customers lost this period Dumber of complaints ustomer satisfaction, as measured by reports from sales reps and by direct report from customers #verage lead time #dvertising e'penditures &inancial Perspective ontribution margin ontrollable margin ontribution by P ales growth hange in stock price elected financial ratios+ the current ratio, gross margin percentage, etc. Operations Perspective ycle time ;evel of work-in-process inventory Plant efficiency, by work unit
18-59 'erorman!e )eas*rement; ,a%an!e# S!ore!ar#; os&ita% (20 min
0. %he number of perspectives was likely reduced to further refine the focus of the scorecard and the performance measurement system. %oo many perspectives and critical success factors could reduce the desired 19-16 Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
emphasis on key measures. %he two perspectives, !uality and process improvement, were combined in 3>>0, for this reason. )oth of these perspectives were related to performance in meeting patients6 e'pectations through improved operations, and the combination of the two provide greater focus on operational improvement. %he remaining four perspectives could be related to the conventional balanced scorecard in the following way+
Perspectives in the )$$ and onventional )alanced corecard+
,S S!ore!ar# (2001
,a%an!e# S!ore!ar#
Organi"ational $ealth
;earning and Innovation
Process and Luality Improvement
Operational Performance
Aolume and Market hare Hrowth
ustomer
&inancial $ealth
&inancial
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-59 (!ontin*e# -1
0. %he &s used by )$$ in the 3>>> ) include the following+ Organi"ational percentage of employee development plans in $ealth place, number of employee survey action plans, job vacancy rates, turnover rates Process Improvement
operating room turnaround time, number of physicians using online hospital clinical information systems
Luality Improvement
patient satisfaction survey scores, patient safety measures, score on onnecticut !uality award, measurable progress to implementing a minimally invasive surgery program
Aolume and Market hare Hrowth
medical volume, surgical volume, urgent care visits, primary care visits, home care visits
&inancial $ealth
measured growth in group purchasing, measured growth in funding, managed care price increases, cost per discharge
4. %he scorecard perspectives appear to be correctly aligned with the mission statement which has goals for improvement in terms of patient care, physician satisfaction, and overall staff satisfaction. %he perspectives of process and !uality improvement should support the satisfaction of patients, while the focus on the organi"ational health perspective should help support physician and staff satisfaction. $owever, it appears that the critical success factor measures are not as clearly targeted. &or e'ample, none of the critical success factors noted in the article directly address physician satisfaction. Physician satisfaction could be directly measured by survey or indirectly, by tenure, turnover, salary and benefits, and related measures. 19-1) Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
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Chapter 19 - Strategic Performance Measurement—Investment Centers
18-59 (!ontin*e# -2
. %he strategy map is likely to follow the se!uence of perspectives provided in the article. Organi"ation $ealth, as the foundation of the strategy map, supports Process Improvement, which in turn supports Luality Improvement, which in turn supports Aolume and Market hare Hrowth, which finally supports &inancial *esults
:. It is unlikely that a profit center approach alone would be able to capture the breadth of goals that )$$ has. In this case, because of the breadth of its mission and goals, )$$ has chosen the use of multiple measures, in the form of a balanced scorecard.
ource+ B?ourney to >:,C by #ndra Humbus, )ridget ;yons, and >3, pp. E-:>.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-1 Investment centers are commonly used when there are a number of business units
to be compared, andor when top management intends to evaluate the economic performance of the business unit relative to alternative investments. )y definition, managers of these business units e'ercise control over revenues, costs, and the level of investment in the business unit. %he profit per dollar invested 1usually called the BreturnC2 can be compared to the rate of return for alternative investments other types of business units or other investment possibilities. ommonly, the rate of return is determined by taking the ratio of the amount of profit divided by the amount invested in the business unit
19-2
*eturn on investment 1*OI2 is the ratio of some measure of BprofitC to some measure of Binvested capitalC for the business unit.
19-3
%he primary measurement issues for *OI are+ 0. %he effect of accounting policies, which affect the determination of Bincome.C 3. Other measurement issues for income, which include the handling of nonrecurring items in the income statement, differences in the effect of income ta'es across units, differential effect of foreign currency e'change, and the effect of cost allocation when two or more units share a facility or cost. 4. Measuring investment+ which assets to includeF . Measuring investment+ whether and how to allocate the cost of shared assets.
19-4
%he primary advantages of using return on investment 1*OI2 as a performance indicator are+ 0. It is intuitive and easily understood. 3. It provides a useful basis for comparison among )/s. 4. It is widely used. %he primary limitations of return on investment 1*OI2 as a performance indicator are+ 0. It has an e'cessive short-term focus. 3. Investment planning uses discounted cash flow 1<&2 analysis 1hapter 032, while managers are evaluated on *OI. 4. It contains a disincentive for new investment by the most profitable units.
19-5
e can enhance the *OI measure6s usefulness by making it the product of two ratios+ *OI N 1Profit ales2 1ales #ssets2 19-21
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Chapter 19 - Strategic Performance Measurement—Investment Centers
*OI N *eturn on ales #sset %urnover *OI N *O #% *eturn on sales 1*O2 is the firm6s profit per sales dollar and it measures the unit manager6s ability to control e'penses and increase revenues to improve profitability. &or divisions 1investment centers2, BprofitC is usually interpreted as Boperating profit.C &or the company as a whole, BprofitC can be defined as Bnet income.C #sset turnover, the amount of sales achieved per dollar of investment, measures the manager6s ability to manage both sales and assets, that is, to produce increased sales from a given level of investment in assets. %ogether, the two components of *OI tell a more complete story of the manager6s performance and enhance top management6s ability to evaluate and compare the different units. 19-6
%he key advantage of residual income 1*I2 is that it deals effectively with the limitation of *OI+ *OI has a disincentive for the managers of the most profitable units to make new investments. ith residual income, no matter how profitable the unit, there is still an incentive for new profitable investment. In contrast, a key limitation is that since *I is not a percentage, it suffers the same problem of using the amount of investment-center profit in that it is not useful for comparing units of significantly different si"es. It favors larger units that would be e'pected to have larger residual incomes, even with relatively poor performance. Moreover, relatively small changes in the desired minimum rate of return can dramatically affect *I for different-si"ed units. #nd, in contrast to *OI, some managers do not find *I to be as intuitive and as easily understood.
19-7
7conomic value added 17A#Q is a profitability measure that appro'imates the Beconomic earningsC of an investment center. Operationally, we define 7A#Q as business unit6s income after-ta' cash earnings and after deducting an imputed charge of the level of invested capital in the business unit. On the surface, *I and 7A#Q look confusingly similar. %here is a major difference, however. *esidual income 1*I2 is calculated entirely using reported accounting data, for income and for assets 1level of invested capital2. #s such, the resulting measure of profitability suffers from all of the limitations associated with historical-based accounting statements. )y contrast, 7A#Q attempts to appro'imate economic, rather than accounting, earnings and level of invested capital. %hus, *I and 7A#Q are similar in form but are strikingly different in terms of measurement. %hus, the overall objective of 7A#Q is to provide an estimate of the value added to 1or destroyed by2 each strategic investment unit during a given period. #s such, 7A#Q is one approach to what we call BAalue-)ased Management.C
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-8
%he three most widely accepted methods are+ 102 the comparable uncontrolled price method, 132 the resale price method, and 142 the cost-plus method. %he comparable controlled price method establishes an arm6s length price by using the sales prices of similar products made by unrelated firms. %he resale price method is based on determining an appropriate markup, where the markup is based on gross profits of unrelated firms selling similar products. %he cost-plus method determines the transfer price based on the seller6s costs, plus a gross profit percentage determined from comparison of sales of the seller to unrelated parties, or sales of unrelated parties to other unrelated parties.
19-9
%he Barm6s-lengthC standard says that transfer prices should be set so they reflect the price that would have been set by unrelated parties acting independently. It is used to set transfer prices on global business such that the countries affected will accept the cost and revenue information for ta' and customs purposes.
19-10 Expropriation happens when a foreign government takes ownership and control of assets the domestic investor has invested in that country. hen there is a significant risk of e'propriation, the domestic firm can take appropriate actions such as limiting new investment, developing improved relationships with the foreign government, and setting the transfer price such that funds are removed from the foreign country as !uickly as possible.
19-41 Ret*rn on nvestment (R; Resi#*a% n!ome (R 1: minutes2
0. %he calculation of the unit contribution margin for *eigis teel >,>>> units were produced and sold during the year ended Dovember 4>, 3>0E is presented below. Reigis Steel Division
&erating Statement +or t"e ear n#e# ovem
ales *evenue ;ess Aariable osts ost of Hoods old elling 7'penses 1=3,5>> 10422 ontribution Margin
=4E,>>> =09,E5: G>>
0G,:5: =0E,3:
ontribution margin per unit N =0E,3: 0,:>> N =1095 3. alculations of selected performance measures for 3>0E for *eigis teel
Chapter 19 - Strategic Performance Measurement—Investment Centers
a. %he preta' return on average investment in operating assets employed is 1316>. calculated as follows+ *OI N Income from operations before ta'es average operating assets N =0>,E3:,>>> =9>,5:>,>>> N 1316> b. %he calculation of residual income 1*I2 on the basis of average operating assets employed is as follows+ *I N income from operations before ta'es R minimum re!uired return on average assets N =0>,E3:,>>> R 1=9>,5:>,>>> >.>G2 N =0>,E3:,>>> R =5,3E5,:>> N =3.357.500
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-41 1continued2
4. %he management of *eigis teel would be more likely to accept the contemplated capital ac!uisition if residual income 1*I2 were used as the performance measure because the investment would increase both the division6s residual income and management bonuses. /sing residual income 1*I2, management would accept all investments with a return higher than GS as these investments would all increase the dollar value of *I. hen using *OI as a performance measure, *egis6 management is likely to reject any investment that would lower the current overall *OI 104.0ES for 3>0E2, even though the return is higher than the re!uired minimum, as this would lower bonus rewards. . *eigis must be able to control all items related to profits and investment if it is to be evaluated fairly as an investment center using either *OI or residual income 1*I2 as a performance measure. *eigis must control all elements of the business e'cept the cost of invested capital, that being controlled by onsolidated Industries.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-42 /a%!*%ating Ret*rn on nvestment (R an# Resi#*a% n!ome (R; /omå Res*%ts 13: minutes2
0. a. *OI N Operating Income #verage #ssets N =3,>,>>> TU=0E,>>>,>>> V 1=0E,>>>,>>> 0.>E2W 3X N =3,>,>>> 11=0E,>>>,>>> V =0:,>G,4>2 32 N =3,>,>>> =0:,:5,05> N 1569> b. *I N Operating Income * 1#vg. #ssets Min. pre-ta' rate of return2 N =3,>,>>> * 1=0:,:5,05> >.0>2 N =3,>,>>> R =0,::,505 N =885.283 3. In this case residual income 1*I2 provides the desired incentive for local managers to make investments desired by top management.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-47 enera% ranser-'ri!ing R*%e; oa% /ongr*en!e 14>-> Minutes2
0. /sing the general guideline presented in the chapter, the minimum price at which the %ransmission , its incremental cost of manufacturing each standard
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-47 1ontinued2
transmission. %he #uto and =0,95: will depend on the bargaining strengths of the two divisions. %he negotiated transfer price has the following properties. a. #chieves goal congruenceF Zes, as described above. b. /seful for evaluating division performanceF Zes, because the transfer price is the result of direct negotiations between the two divisions. Of course, the transfer prices will be affected by the bargaining strengths of the two divisions. c. Motivating management effortF Zes, because once negotiated, the transfer price is independent of actual costs of the producing division. %hus, management of this division has every incentive to manage efficiently to improve profits. d. Preserves subunit autonomyF Zes, because the transfer price is based on direct negotiations between the two divisions and is not specified by head!uarters on the basis of some rule 1such as the producing division6s incremental costs2. . Deither method is perfect, but negotiated transfer pricing 1re!uirement 42 has more favorable properties than the cost-based transfer pricing 1re!uirement 32. )oth transfer-pricing methods achieve goal congruence, but negotiated transfer pricing facilitates the evaluation of divisional performance, motivates management effort, and preserves division autonomy, whereas the transfer price based on incremental cost does not achieve these objectives.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-48 ranser-'ri!ing )et"o#s 1:> minutes2
0. a. %he positive and negative motivational implications arising from employing a negotiated transfer price system for goods e'changed between divisions include the following+ 'ositive: •
•
)oth the buying and selling divisions have participated in the negotiations and are likely to believe they have agreed on the best deal possible. Degotiating and determining transfer prices will enhance the autonomyindependence of the divisions.
egative: •
•
•
%he result of a negotiated transfer price between divisions may not be optimal for the firm as a whole and therefore will not be goal congruent. %he negotiating process may cause harsh feelings and conflicts between divisions. 1%he process is viewed as a B"ero-sumC game.2 %he negotiating process itself may be costly and time-consuming.
b. %he motivational problems that can arise from using actual full 1absorption2 manufacturing cost as a transfer price include the following. •
•
&ull-cost transfer pricing is not suitable for a decentrali"ed structure where the autonomous divisions are measured on profitability as the selling unit is unable to reali"e a profit. %his method can lead to decisions that are not goal congruent if the buying unit decides to buy outside at a price less than the full cost of the selling unit. If the selling unit is not operating at full capacity, it should reduce the transfer price to the market price if this would allow the recovery of variable costs plus a portion of the fi'ed costs. %his price reduction would optimi"e overall company performance. 19-29
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-48 1continued-02
3. %he motivational problems that could arise if Mylar orporation decides to change its transfer pricing policy to one that would apply uniformly to all divisions include the following+ •
•
•
# change in policy may be interpreted by the divisional managers as an attempt to decrease their freedom to make decisions and reduce their autonomy. %his perception could lead to reduced motivation. If managers lose control of transfer prices and thus, some control over profitability, they will be unwilling to accept the change to uniform prices. elling divisions will be motivated to sell outside if the transfer price is lower than market as this behavior is likely to increase profitability and bonuses.
4. %he likely behavior of both buying and selling divisional managers, for each of the following transfer pricing methods being considered by Mylar orporation, include the following+ a. tandard full manufacturing cost plus a markup. •
•
%he selling divisions will be motivated to control costs because any costs over standard cannot be passed on to the buying division and will reduce the profit of the selling division. %he buying divisions may be pleased with this transfer price. $owever, if the market price is lower and the buying divisions are forced to take the transfer price, the managers of the buying divisions will be unhappy.
b. Market selling price of the product being transferred. •
reates a fair and e!ual chance for the buying and selling divisions to make the most profit they can and should promote cost control, motivate divisional management, and optimi"e overall company performance. ince both parties are aware of the market price, there will be no distrust between the parties, and both should be willing to enter into the transaction. 19-%0
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-48 1continued-32
c. Outlay 1out-of-pocket2 costs incurred to the point of transfer plus opportunity cost per unit. •
•
%his method is the same as market price when there is an established market price and the seller is at full capacity. #t any level below full capacity, the transfer price is the outlay cost only 1as there is no opportunity cost2 which would appro'imate the variable costs of the good being transferred. )oth buyers and sellers should be willing to transfer under this method because the price is the best either party should be able to reali"e for the product under the circumstances. %his method should promote overall goal congruence between managers and the firm, should motivate managers, and should optimi"e overall company profits.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-49 ranser 'ri!ing; $e!ision )aking 14>-: minutes2
0. > units 1:>,>>> >.9>2. >> units, which will limit )6s outside sales to 45,:>> units, a loss in outside sales of 03,:>> units 1:>,>>> [ 45,:>>2. %he contribution for each type of sale by ;ess+ Aariable Marketing osts > ontribution Margin = 0:
Outside =04> 5> 9 = :3
>> units2+ %he best decision in the interest of >> units to >> N =45:,>>> &orgone contribution of not selling to outside consumers+ =:3 03,:>> N =E:>,>>> Det operating loss to ,>>> * =45:,>>> N =275.000 %he >>. #lso, the decision of >,>>> 1savings of =9> * =E> 3:,>>> units2, while the opportunity cost of lost sales is =E:>,>>> U1=04> * =592 03,:>>W for a net loss to the firm of =150.000 1=E:>,>>> * =:>>,>>>2. 19-%2 Copyright © 2016 McGraw-Hill Education. All rights rsr!d. "o rproduction or distri#ution without th prior writtn consnt o$ McGraw-Hill Education.
Chapter 19 - Strategic Performance Measurement—Investment Centers
19-49 1continued2
If Partial ales to ,>>> of total demand2 to outside consumers. %he remaining capacity 13>S, or 03,:>> units2 should be used to provide > units, the best transfer price should fall in the range of =60 1 would allocate all the profit on the manufacture of the e!uipment to would allocate all the profit to would be unacceptable to would be unacceptable to should be determined for these internal sales. %he important point from the firm6s view is that these 03,:>> parts should be purchased internally, since the internal cost of =E> is less than the e'ternal cost of =9>. It is up to the two divisions to determine the right price, but to fail to transfer the units would not be acceptable from the overall firm6s view.
P=$80
+,
/(' 5what di!ision A wants /60
+, 3s Capacity / 624'00
/1%0 /()
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-50 ranser 'ri!ing; Strategy 1: minutes2
0. %here are three options for the commercial division+ buy from the internal supplier 1the industrial division2, buy from #dmiral 7lectric, or buy from #dvanced Micro. %he analysis follows, from the perspective of &MI+ )uy inside from the industrial division+ ost to &MI 1assuming the Industrial >> =55:,>>> Plus+ lost contribution on Industrial : * =0::2 :,>>> 3:>,>>> =0,>3:,>>> =0,>3:,>>> :,>>> N =205 per unit )uy from #dmiral 7lectric+ ost to &MI is =30>. %he contribution on sales to #dmiral by the industrial division is ignored because these sales are not contingent on the commercial division6s decision. )uy from #dvanced Micro+ ost to &MI+ =3>> )est decision for &MI+ have the commercial division buy from #dvanced Micro, presuming the parts sold by #dvanced Micro and #dmiral 7lectric are of e!uivalent !uality and service. %he cost is the lowest, at =3>>. %he best transfer price, which would cause the buying division to autonomously make the correct decision, would be to use the selling division6s market price of =3>:. 3.
If the sales to #dmiral 7lectric by the industrial division were contingent on the commercial division6s decision, the relevant cost to &MI would be the price of =30> :,>>> units 1amount needed over the capacity of the industrial division2. %he net cost would then be the cost of =30> :,>>> N =0,>:>,>>> less the contribution from the sales to #dmiral 7lectric, E:> 1=G: * =E:2 N =0G,:>>, or =0,>4>,:>>, or =20610 &er *nit . %he correct transfer price would not change but would still be =205. as in part 0. 19-%&
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-50 1continued2
4. %he decision to have the commercial division buy outside to reduce overall costs is also consistent with a strategy of decreasing the reliance of the commercial division on products from the industrial division. If top management is unsure about the growth potential of the industrial division and has declined any new investments there, perhaps the future holds capacity reduction or divestment of the industrial division. On the other hand, it appears that the outside sales of the industrial division are currently !uite strong. %here is a good margin of =:> on its sales of part 34-E500 outside the company. Moreover, it appears that #dmiral 7lectric intends to continue to buy part 99-E0 from the industrial division, irrespective of the commercial division6s decision. %his is a positive statement about the !uality of the industrial division6s product and the !uality of its relationship with #dmiral. Perhaps top management should rethink its long-term strategy for the industrial division.
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Chapter 19 - Strategic Performance Measurement—Investment Centers
19-51 Strategy; Strategi! 'erorman!e )eas*rement; ranser 'ri!ing 1:> minutes2
0. %ransfer prices based on cost are not appropriate as a divisional performance measure, and among the reasons are because they+
•
•
provide little incentive for the selling division to control manufacturing costs as all costs incurred will be recovered often lead to suboptimal decisions for the company as a whole
3. /sing the market price as the transfer price the contribution margin for both the Mining 0E is as calculated below. A?a@ /onso%i#ate# /a%!*%ation o $ivisiona% /ontri<*tion )argin +or t"e ear n#e# )ay 31. 2016 Metals Division
elling Price ;ess+ Aariable costs
Mining
=0:>
03 0E 3 > =49 >>,>>> =15.200.000
E 3> 0> G> 3 >>,>>> =9.600.000
otes:
102 Aariable overhead N =43 5:S N =3 for mining division8 Aariable overhead N =3: >S N =0> for metals division 132 %he =: variable selling cost that the Mining
Chapter 19 - Strategic Performance Measurement—Investment Centers
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