BUS105 Study Guide
Unit 9: Performance Evaluation
9a. Explain the advantages and disadvantages of decentralizing an organization
- What is meant by a decentralized organization?
- What are some advantages of having a decentralized organization?
- What are some disadvantages of having a decentralized organization?
- Why would the goals of managers of individual units sometimes conflict with the goals of the company as a whole?
In a decentralized organization, managers of each segment, or division, of the organization are tasked with decision-making and operational responsibilities for their particular division or segment. Decentralized organizations have the advantage of increased expertise for leaders of each division, as well as quicker decisions, better use of time at top management levels, and increased motivation of division managers.
However, there can also be disadvantages to having a decentralized organization. Disadvantages can include the duplication of services, such as support staff, conflicts amongst division managers, and division managers' goals being misaligned with company-wide goals. Finally, decentralized organizations can result in a loss of control at the top management level.
9b. Differentiate between the three types of responsibility centers commonly used to evaluate segments: cost centers, profit centers, and investment centers
- Why is it important to divide organizations into different responsibility centers?
- Why should a manager of a cost center not be evaluated at all based on sales?
- What is the difference in responsibility between a manager of a profit center and a manager of an investment center?
In a decentralized organization, divisions or segments of the organization are divided into three types of responsibility centers. A segment that is responsible for costs, but not revenue or investments in assets is known as a cost center. Most service departments, such as marketing and human resources, are cost centers. These segments are only responsible for costs, not generating revenues or providing a return on investment. Thus, managers of these departments are evaluated based on providing services while keeping costs low.
A segment that is responsible for costs and revenues (and profit), but not investments in assets, is called a profit center. An example of a profit center would be a retail store that is part of a larger company. A manager of a profit center would be responsible for revenues and costs, and the resulting profits but not for assets.
The third type of responsibility center is known as an investment center. This is a segment that is responsible for costs and revenues (and profit), as well investments in assets. Unlike the other managers in the organization, a manager of an investment center has control over asset investment decisions and is thus evaluated on those as well.
Review Maintaining Control over Decentralized Organizations, especially the part on the three types of responsibility centers.
9c. Calculate segmented net income and interpret the results to evaluate the performance of investment centers
- In a decentralized organization, how are the managers of each segment evaluated?
- What are the two weaknesses that are evident in using segmented net income as a way to evaluate segment managers?
- Why would segmented net income be a more accurate measure of [performance for a manager of a profit center than for a manager of an investment center?
Managers of investment centers are many times evaluated using segmented net income. This is simply the revenues for that particular segment minus the expenses of the segment. In this way, managers are evaluated against an expected segmented net income level and also against managers of other segments.
However, there are two weaknesses associated with this measure. First, it fails to consider the fact that larger segments will likely have higher revenues and thus higher net income. A way to get around this is to compare profit margins (net income ÷ sales) for each segment. This way the segments are being compared and scaled by their respective sales.
The second weakness lies in the fact that investment centers also have control over assets. Comparing net income ignores the use of assets in generating this net income and the managers efficiency in the use of the assets. This can be mitigated by making use of some efficiency ratios that include the use of assets such as return on investment.
9d. Calculate return on investment (ROI), residual income (RI), and extra value added (EVA) and interpret each to evaluate the performance investment centers
- What are three measures used to evaluate the performance of investment centers?
- What is the purpose of including assets in these performance measures?
- Why does the residual income method and the extra value added method make adjustments to net income for their measures?
Three common measures used to evaluate the performance of investment centers are return on investment (ROI), residual income (RI), and extra value added (EVA).
Return on investment is a measure that incorporates the use of assets. It is calculated as:
Return on investment = Operating income ÷ Average operating assets
Operating income is income produced from daily activities and excludes items such as taxes, interest, and unusual gains and losses. Average operating assets is the beginning balance plus ending balance of assets divided by two. ROI can be interpreted as showing how many dollars of operating income are generated for every dollar of assets invested in the segment.
Residual income (RI) is similar to ROI, but rather than using a ratio, it uses a dollar amount to evaluate performance. It is the segment's operating profit in excess of the segment's cost of acquiring capital to purchase operating assets. RI is calculated as follows:
Residual income = Operating income − (Percent cost of capital × Average operating assets)
Percent cost of capital is the company's percentage cost to obtain investment funds (often called capital). If an investment produces an operating profit higher than the division's cost of acquiring capital, managers evaluated with RI have an incentive to accept the investment. A manager's goal in such a situation is to increase the RI from period to period.
The third measure, economic value added (EVA) is calculated as:
Economic value added = Net operating profit after taxes adjusted − (Percent cost of capital × Average operating assets adjusted)
The calculation is very similar to RI, but certain adjustments are made to the financial information to better reflect the economic results of the division. First, operating profit is calculated net of income taxes. This is done by simply deducting income taxes from operating income. Second, adjustments are made to operating income and average operating assets. There are many different types of adjustments that can be made. Some of the more popular ones are capitalizing research and development costs, capitalizing advertising costs, and deducting non-interest-bearing current liabilities from average operating assets.
Unit 9 Vocabulary
This vocabulary list includes terms you will need to know to successfully complete the final exam.
- average operating assets
- cost center
- decentralized organization
- residual income (RI)
- extra value added (EVA)
- investment center
- operating income
- percent cost of capital
- profit center
- profit margins
- responsibility centers
- return on investment (ROI)
- segmented net income