Chapter 8, Performance Management and Evaluation 1
Chapter 8
Review of Learning Objectives
LO1 Describe how the balanced scorecard aligns performance with organizational goals.
The balanced scorecard is a framework that links the perspectives of an organization’s four basic stakeholder groups—financial, learning and growth, internal business processes, and customers—with its mission and vision, performance measures, strategic and tactical plans, and resources. Ideally, managers should see how their actions help to achieve organizational goals and understand how their compensation is linked to their actions. The balanced scorecard assumes that an organization will get what it measures.
LO2 Discuss performance measurement, and identify the issues that affect management’s ability to measure performance.
An effective performance measurement system accounts for and reports on both financial and nonfinancial performance so that an organization can ascertain how well it is doing, where it is going, and what improvements will make it more profitable. Each organization must develop a unique set of performance measures that are appropriate to its specific situation. Besides answering basic questions about what to measure and how to measure, management must consider a variety of other issues. Managers must collaborate to develop a group of measures, such as the balanced scorecard, that will help them determine how to improve performance.
LO3 Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation.
Responsibility accounting 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. There are five types of responsibility centers: cost, discretionary cost, revenue, profit, and investment. Performance reporting by responsibility center allows the source of a cost, revenue, or resource to be traced to the manager who controls it and thus makes it easier to evaluate a manager’s performance.
LO4 Prepare performance reports for cost centers using flexible budgets and for profit centers using variable costing.
Performance reports contain information about the costs, revenues, and resources that individual managers can control. The content and format of a performance report depend on the nature of the responsibility center. 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 is a summary of anticipated costs for a range of activity levels. It provides forecasted cost data that can be adjusted for changes in the level of output. A flexible budget is derived by multiplying actual unit output by predetermined standard unit costs for each cost item in the report. As you will learn in another chapter, the resulting variances between actual costs and the flexible budget can be examined further by using standard costing to compute specific variances for direct materials, direct labor, and overhead. A profit center’s performance is usually evaluated by comparing its actual income statement results to its budgeted income statement. When variable costing is used, the profit center manager’s controllable costs are classified as variable or fixed. The resulting performance report takes the form of a contribution income statement instead of a traditional income statement. The variable costing income statement is useful because it focuses on cost variability and the profit center’s contribution to operating income.
LO5 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.
Traditionally, the most common performance measure has been return on investment (ROI). The basic formula is ROI = Operating Income Assets Invested. Return on investment can also be examined in terms of profit margin and asset turnover. In this case, ROI = Profit Margin Asset Turnover, where Profit Margin = Operating Income Sales and Asset Turnover = Sales Assets Invested. Residual income (RI) is the operating income that an investment center earns above a minimum desired return on invested assets. It is expressed as a dollar amount: Residual Income = Operating Income (Desired ROI Assets Invested). It is the amount of profit left after subtracting a predetermined desired income target for an investment. Today, businesses are increasingly using the shareholder wealth created by an investment center, or economic value added (EVA), as a performance measure. The calculation of economic value added can be quite complex because it is a composite of many cause-and-effect relationships and interdependent financial elements. Basically, the concept of economic value added is similar to that of residual income. EVA = After-Tax Operating Income Cost of Capital in Dollars. A manager can improve the economic value of an investment center by increasing sales, decreasing costs, decreasing assets, or lowering the cost of capital.
LO6 Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation.
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 tying appropriate compensation incentives to the achievement of those targets. Common types of incentive compensation are cash bonuses, awards, profit-sharing plans, and stock programs. Each organization’s unique circumstances will determine the correct mix of measures and compensation incentives for that organization. If management values the perspectives of all of its stakeholder groups, its performance management and evaluation system will balance and benefit all interests.