These lectures cover decentralization and evaluating performance of bsuiness unit such as cost centers, profit centers, investment centers, return on investment (ROI) and residual income and its cousin EVA.
Decentralization | Managerial Accounting
Return on investment ROI | Managerial Accounting
Residual income | Managerial Accounting
For purposes of evaluating performance, business units are classified as cost centers, profit centers, and investment centers. Cost and profit centers are commonly evaluated using standard cost and flexible budget variances as discussed in prior chapters. Investment centers are evaluated using the techniques discussed in this chapter.
Return on investment (ROI) and residual income and its cousin EVA are widely used to evaluate the performance of investment centers. ROI suffers from the underinvestment problem—managers are reluctant to invest in projects that would decrease their ROI but whose returns exceed the company’s required rate of return. The residual income and EVA approaches solve this problem by giving managers full credit for any returns in excess of the company’s required rate of return.
A balanced scorecard is an integrated system of performance measures designed to support an organization’s strategy. The various measures in a balanced scorecard should be linked on a plausible cause-and-effect basis from the very lowest level up through the organization’s ultimate objectives. The balanced scorecard is essentially a theory about how specific actions taken by various people in the organization will further the organization’s objectives. The theory should be viewed as tentative and subject to change if the actions do not in fact result in improvements in the organization’s financial and other goals. If the theory changes, then the performance measures on the balanced scorecard should also change. The balanced scorecard is a dynamic measurement system that evolves as an organization learns more about what works and what doesn’t work and refines its strategy accordingly.
Relative performance (or relative improvement) contracts essentially reward managers for how their business units perform relative to some appropriate benchmark performance, not a fixed bud- get target. For example, an operating unit or division might be evaluated on the basis of its return on investment (ROI) for a period relative to the market or to best-in-class performance. Some organizations benchmark actual performance to the top quartile of their peer group. This change in incentive, at least conceptually, avoids much of the dysfunctional consequences associated with traditional budgeting systems. Units and managers are motivated to achieve to their highest level because their compensation/reward is tied to how they performed relative to a prespecified (ex- ternal or internal) benchmark. In essence, this represents radical decentralization and significant reliance on self-regulation. Employees and operating managers in this model are vested with significant decision-making authority and are asked to use their own best judgment to achieve superior results, without being constrained by the plan embodied in a budget.