Week 3 - Decentralisation, Responsibility Centres & Performance Evaluation Systems; ROI, RI and EVA

Define an Investment Base (Investment Centres)

The sum of assets employed in an investment centre

What are Profit and Investment Centres?

The two most far-reaching forms of formal decentralisation

Define Responsibility Accounting

Used to measure the performance of people and departments to foster goal congruence

Define Decentralisation

the dispersion or distribution of functions and powers

What are the disadvantages of using Market Measures such as Share Price in Divisional Performance Evaluation?

- Many factors affect share price expect from employee effort - Very volatile measures - Unavailable for private firms Firms therefore utilise readily available accounting measures

What are the Conditions for Delegating Responsibility?

- The manager should have access to the relevant information needed for making such a decision - There should be some way to measure the effectiveness of the trade-offs the manager has made - Establishing control = performance measurement systems

What are the advantages of Profit Centres?

- The quality of decisions may improve - Provide training ground for general management - Profit consciousness is enhanced

What are the key considerations of management control systems at the corporate and business unit level?

1. Measures used at the corporate and business unit level typically differ 2. Financial measures are mainly used at the corporate level 3. Operational or non-financial measures are used at lower levels, e.g. quality, lead times, volumes sold

What are the 2 primary methods of relating profit to the investment base?

1. ROI: Earnings before interest expenses and taxes/assets employed 2. RI: Earnings before interest expenses and taxes - (Cost of capital *assets employed)

Define Responsibility Centres

A subunit in an organisation whose manger is held accountable for specified financial results

How can ROI be improved?

- Increase sales prices - decrease expenses - lower invested capital

What are the disadvantages with Profit Centres?

- Loss of control - Lack of competent general managers - Too much emphasis on short-run profitability

What are the advantages of Decentralisation?

1. Allows organisations to respond more quickly to events 2. Frees top management from day-to-day operating activities 3. Uses specialised knowledge and skills of managers

What are the disadvantages of ROI

1. If ROI < mean ROI managers will reject these projects: - net income does not include value increases - accounting net income is conservative - total assets exclude intangible assets 2. Leads to underinvestment: - By providing incentives to managers to reject profitable projects 3. ROI measures provide incentives to keep old assets in the books 4. ROI measures lead to misleading performance signals = makes firms with old assets exhibit superior performance 5. Riskier projects if managers performance based on increasing ROI 6. Horizon problems - managers with short term horizons more likely to chose projects that increase ROI in the short run.

Define Divisional Performance Evaluation

Mainly based on the accounting measures of performance: - ROI, ROA, RONA, ROE, ROCE An alternative would be to use market measures: - Share Price

Define Investment Centre

Profit is compared with the assets employed in earning it

Define Profit Centre

Responsibility centre's financial performance is measured in terms of profit

What are Performance Reports?

Show the budgeted and actual amounts, and the variances between these amounts, of key financial results appropriate for the type of responsibility center