Performance Management

Courage Hodey
 LEARNING OBJECTIVES
1. Discuss performance measurement and state the issues that affect
management’s ability to measure performance.
2. Define responsibility accounting and describe the role
responsibility centers play in performance management and
evaluation.
3. Prepare performance reports for the various types of
responsibility centers, including reports based on the flexible
budget for cost centers and variable costing for profit centers.
4. Use the traditional performance measures of return on
investment and residual income to evaluate investment centers.
5. Use economic value added to evaluate investment centers.

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 LEARNING OBJECTIVES
6. Explain how transfer pricing affect performance measurement.
7. Explain the key features of a good performance management
system.
8. Describe how the balanced scorecard aligns performance with
organizational goals and explain the balanced scorecard’s role
in the management cycle.
9. Explain how properly linked performance incentives and
measures add value for all stakeholders in performance
management and evaluation.

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 Performance Measurement

OBJECTIVE 1
Discuss performance measurement and state the
issues that affect management’s ability to
measure performance.

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What to Measure, How to Measure

Performance measurement is the use of

quantitative tools to gauge an
organization’s performance in relation
to a specific goal or expected outcome.
Product or service quality is NOT a
measure; it is what management wants
to measure. Quantifiable measures
must be developed to measure quality.

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 Other Measurement Issues
What performance measures can be used?
How can managers monitor the level of quality?
How can managers monitor processes to identify
areas that need improvement?
How can managers measure customer satisfaction?
How can managers monitor financial performance?
Are there other stakeholders?
What performance measures do governments
impose?
How can a manager measure the effect on the
environment?

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 Discussion

Q. How does a company measure the

quality of its products and services?

A.
It develops quantitative measures
which indicate whether quality
objectives are being achieved.

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 Responsibility Accounting

OBJECTIVE 2
Define responsibility accounting and
describe the role responsibility
centers play in performance
management and evaluation.

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 Responsibility Accounting
Responsibility accounting classifies data by
areas of responsibility and reports on only
the revenues, costs and resources that the
assigned manager can control.
A responsibility center is an organizational
unit whose manager is responsible for a
portion of the organization’s resources and
its activities.

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 Types of Responsibility Centers

Cost Centers – the manager is accountable only for

controllable costs.
Discretionary Cost Centers – the manager is accountable
only for costs; the relationship between
resources and products or services produced
is not well defined. Administrative or
support functions are often discretionary
cost centers.
Revenue Centers – the manager is accountable primarily
for controllable revenue generated.

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 Types of Responsibility Centers
(continued…)

Profit Centers – the manager is

accountable for revenues, costs and the
resulting operating income.

Investment Centers – the manager is

accountable for profit generation and can
make decisions about resources used.

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 Organizational Structure and
Performance Management
An organization chart shows the hierarchy
of responsibility for the purpose of
management control.
Performance reporting by responsibility
level traces the source of a cost, revenue or
resource to the manager who controls it
enabling his or her performance to be
evaluated.

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 Discussion
Q. Name the types of responsibility centers?

A. 1. Cost Centers
2. Discretionary Cost Centers
3. Revenue Centers
4. Profit Centers
5. Investment Centers

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 Performance Evaluation

OBJECTIVE 3
Prepare performance reports for the
various types of responsibility
centers, including reports based on
the flexible budget for cost centers
and variable costing for profit
centers.

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Evaluating Cost Center Performance
• Use flexible budgets to identify variances between
actual and expected costs.

Evaluating Profit Center Performance

• Compare actual results to budgeted income
statement.
• Use variable costing (contribution method) income
statements to focus on cost variability and the profit
center’s contribution to operating income.
• Only show controllable costs.
• Show other, nonfinancial performance measures.

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 Discussion

Q. What type of Income Statement should be

used to evaluate profit centers?

A. Variable Costing Income Statement

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Evaluating Investment Center
Performance

OBJECTIVE 4
Use the traditional performance
measures of return on investment
and residual income to evaluate
investment centers.

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Return on Investment (ROI)
Traditionally the most common performance measure

ROI

= Operating Income
Average Assets Invested

= Operating Income x Sales

Sales Average Assets Invested

= Profit Margin x Asset Turnover

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Other Measures used in conjunction
with ROI include:
Revenues
Costs
Operating Income
Revenue growth
Market share
% changes in ROI

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 Residual Income
The operating income earned above a minimum
desired return on invested assets.

Residual Income = Operating Income – (Desired ROI x Average Assets Invested)

Residual income eliminates the possibility of missed

income opportunities that exist if ROI is used as a
performance measure. BUT residual income does not
provide a meaningful comparison between
investment centers of a different size because residual
income shows absolute dollars not a percentage.
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 Discussion

Q. What measure of investment center

performance is best used to compare
managers of different size investment
centers?

A.
ROI, because it provides a ratio.
Residual income provides an absolute
dollar amount.

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 Economic Value Added (EVA)

OBJECTIVE 5
Use economic value added to evaluate
investment centers.

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Economic Value Added – the shareholder wealth
created by an investment center.

Cost of Capital – the minimum desired rate of

return on an investment.

EVA = After Tax Operating Income

– [Cost of Capital x (Total Assets – Current Liabilities)]

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 Economic Value Added

Compare EVAs from previous periods,

target EVAs, and EVAs from other
investment centers.
Affected by decisions on pricing, sales
volume, taxes, cost of capital, etc.

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27
 Discussion
Q. Why should multiple performance
measures be used to evaluate investment
center performance?

A.
Because any one performance measure
tends to emphasize only one particular
aspect of performance.

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 Evaluating Transfer Pricing

OBJECTIVE 6
Explain how transfer pricing affect
performance measurement.

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 Evaluating Transfer Pricing
Transfer prices are almost inevitably needed
whenever a business is divided into more than one
department or division.
The transfer price negotiated between the divisions,
or imposed by head office, can have a profound, but
perhaps arbitrary, effect on the reported
performance and subsequent decisions made.

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 Evaluating Transfer Pricing Example
Division A Division B
GHS GHS
Transfer in price - 50
Own cost 30 20
Divisional mark up 20 20
Transfer out/final sale price 50 90

Each division makes a profit of $20/unit, and it should

be easy to see that the company (or group) will make a
profit of $40/unit. You can calculate this either by
simply adding the two divisional profits together ($20
+ $20 = $40) or subtracting both own costs from final
revenue ($90 – $30 – $20 = $40) 31
Evaluating Transfer Pricing Example
For every GHS 1 increase in the transfer price,
Division A will make GHS 1 more profit, and
Division B will make GHS 1 less. Mathematically,
the group will make the same profit, but these
changing profits can result in each division making
different decisions, and as a result of those
decisions, group profits might be affected.
Transfer pricing consideration is to help appreciate
the knock-on effects that different transfer prices
and different profits might have on the divisions.
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 Transfer Pricing Effects and Rule
Performance evaluation
Performance-related pay and motivation
Make/abandon/buy-in decisions
Investment appraisal
Taxation and profit remittance
The economic transfer price rule is as follows:
Minimum (fixed by transferring division)
Transfer price ≥ marginal cost of transfer-out division
Maximum (fixed by receiving division)
Transfer price ≤ net marginal revenue of transfer-in division
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Key Features of Good PMS
Objective 7
Explain the key features of a good
performance management system

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 Key Features of Good PMS
Clear Goal Alignment: The system aligns individual goals with the organization’s
overarching objectives, creating a sense of purpose and direction among employees.
Continuous Feedback Loops: Regular feedback fosters ongoing communication between
employees and managers, enabling timely adjustments and improving performance.
Performance Metrics and KPIs: The system integrates measurable metrics and Key
Performance Indicators (KPIs), providing insights into employee progress and contributing
to data-driven decisions.
Development Opportunities: The system identifies skill gaps and offers targeted training
and development opportunities, nurturing employees’ professional growth.
Fair and Transparent Evaluation: Transparency in evaluations builds trust and equity.
Transparent, unbiased evaluations enhance motivation and foster a sense of fairness.

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 Key Features of Good PMS
Recognition and Rewards: The system acknowledges exceptional performance, motivating
employees and reinforcing the value of their contributions.
Employee-Centric Approach: A system tailored to employees’ strengths and needs drives
engagement and encourages their active participation.
Regular Performance Check-Ins: Scheduled interactions allow for continuous dialogue
between employees and managers, ensuring alignment and understanding.
Performance Analytics: Data-driven insights offer a comprehensive view of employee
performance, aiding in identifying trends and areas for improvement.
Adaptability and Evolution: A dynamic system adapts to changing business environments,
remaining relevant and aligned with organizational strategies.

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 The Balanced Scorecard
OBJECTIVE 8
Describe how the balanced scorecard aligns
performance with organizational goals and explain
the balanced scorecard’s role in the management cycle

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 The Balanced Scorecard
A framework that links the perspectives of an
organization’s 4 stakeholder groups:
Financial (investors)
Learning and growth (employees)
Internal business processes (management)
Customers
with the organization’s:
Mission and vision
Performance measures
Strategic plan
Resources

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 The Balanced Scorecard

To succeed, an organization must

add value for all stakeholders.
Determine each group’s objectives.
Translate their objectives into
performance measures that have
specific, quantifiable performance
targets.

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The Balanced Scorecard and the
Management Cycle
Planning
Example: Strategy is to achieve customer satisfaction
Perspective Objectives Performance Measures

Financial (investors) Revenue growth % growth in sales

dollars

Learning and growth Trained employees Number of trained

(employees) employees, employee
turnover
Internal business Reliable products, short Number and cost of
processes delivery cycles breakdowns, repair
costs, mean time
between order and
delivery
Customers Customer loyalty Number of repeat
customers, $ purchases
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 The Balanced Scorecard and the
Management Cycle
Executing
• Use agreed-upon strategic objectives as a basis for
decision-making.
Reviewing
• Review financial and nonfinancial results frequently.
• Compare objectives with actual results.
• Determine if measures or objectives need revision.
Reporting
• Prepare reports which show performance measures
for each stakeholder group.

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 Discussion

Q. Who are the stakeholders in an

organization?

A. 1. Investors
2. Employees
3. Management (Internal business
processes)
4. Customers

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Behaviourial Aspects of Performance
Management Systems

OBJECTIVE 9
Explain how properly linked performance
incentives and measures add value for all
stakeholders in performance management
and evaluation.

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Linking Goals, Objectives, Measures
and Performance Targets
The links should be causal:

Goal → Objective → Measure → Performance

Target
To be a friend To reduce the Number of To recycle at
of the company’s products least 10% of
environment environmental recycled products sold
risk

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 Performance-Based Pay

Responsibility center managers are

more likely to achieve their
performance targets if their pay
depends on it.
Cash bonuses, awards, profit-sharing
and stock options are forms of
incentive compensation.

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 The Coordination of Goals
Incentive plans to coordinate goals
must consider:
When to give rewards?
Who shall be rewarded?
How should the reward be computed?
Does the incentive plan address the interest of
all stakeholders?
Performance Management and Evaluation
systems should balance and benefit all
stakeholders.
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 Discussion
Q. What does “an organization will get what
it measures” mean?

A.
If performance measures (and incentives)
are based on specific objectives, managers
will be motivated to achieve the objectives
that are being measured.

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 OK, LET’S REVIEW . . .

1. Discuss performance measurement and state

the issues that affect management’s ability to
measure performance.
2. Define responsibility accounting and describe
the role responsibility centers play in
performance management and evaluation.
3. Prepare performance reports for the various
types of responsibility centers, including
reports based on the flexible budget for cost
centers and variable costing for profit centers.
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CONTINUING OUR REVIEW . . .

4. Use the traditional performance measures of

return on investment and residual income to
evaluate investment centers.
5. Use economic value added to evaluate
investment centers.
6. Explain how transfer pricing affect
performance measurement.

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 AND FINALLY . . .
7. Explain the key features of a good performance
management system.
8. Describe how the balanced scorecard aligns
performance with organizational goals and explain the
balanced scorecard’s role in the management cycle.
9. Explain how properly linked performance incentives
and measures add value for all stakeholders in
performance management and evaluation.

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