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CMN 201 (1)
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sm16.doc

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Communication
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CMN 201
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Tsogbadral Galaabaatar

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Chapter 16: Performance Evaluation and Compensation 169 Chapter 16 Performance Evaluation and Compensation LEARNING OBJECTIVES Chapter 16 addresses the following objectives: LO1 Discuss how decision-making responsibility and authority are related to performance evaluation. LO2 Explain how responsibility centres are used to measure, monitor, and motivate performance. LO3 Calculate return on investment, residual income and economic value added and explain how each is used to measure, monitor and motivate performance. LO4 Discuss how compensation is used to motivate performance. These learning objectives (LO1 through LO4) are cross-referenced in the textbook to individual exercises and problems. © 2012 John Wiley and Sons Canada, Ltd. 170 Cost Management QUESTIONS 16.1 ROI is calculated by dividing operating income by average assets, or income/assets. It can be decomposed as follows: ROI = sales/assets x income/sales. 16.2 ROI can be increased by cutting costs or reducing assets. Cost cutting can improve short- term results but harm long-term results if discretionary expenditures such as advertising and research and development are cut. Similarly, reducing investment in new projects could improve ROI in the short term, but harm the organization in the long term. 16.3 Residual income = operating income – (required rate of return * average operating assets). Many organizations have a minimum return that is expected on operations and new investments, this is their required rate of return. 16.4 The size of investment affects residual income less than ROI because it is used only to value the dollar amount of expected return, not as a denominator. Residual income is therefore less influenced than ROI by changes in investment, but it is still subject to the same disadvantages as ROI that affect the operating income – such as cost cutting to discretionary expenditures. 16.5 General knowledge is usually easy to transfer throughout an organization. Specific knowledge is more detailed and is therefore more costly to transfer throughout an organization. General knowledge is needed in the food and beverage manufacturing, in clothing manufacture, and in restaurants and bars, among others. Specific knowledge is important to software companies, bio-tech organizations, and healthcare organizations, among others. 16.6 If general knowledge is required for success within an organization, a centralized form is usually best because knowledge can easily be transferred to headquarters where decision making can be done from the perspective of the overall organization. If specific knowledge is required, it is costly to transfer to headquarters, so a decentralized form is usually best because the decision-making authority lies with the people with specific knowledge to make the best decision. 16.7 EVA is very similar to residual income because both subtract from operating income some measure of interest times investment. EVA is different than residual income because many adjustments are made to all parts of the calculation. For example, after tax operating income is usually used in EVA, whereas before tax operating income is usually used in RI. The assets are also adjusted under EVA, for example long-term leases are usually capitalized. There are over 160 possible adjustments that can be made to RI under EVA. 16.8 The four responsibility centre descriptions and objectives follow. Cost Centres: In cost centres, managers are held responsible only for the costs under their control. Some cost centres provide support services that are relatively easy to monitor because their outputs are measurable. Cost centres are also used for subunits that © 2012 John Wiley and Sons Canada, Ltd. Chapter 16: Performance Evaluation and Compensation 171 produce goods or services that eventually will be sold by others. Managers in these cost centres are responsible for producing their goods or services efficiently. In discretionary cost centres (marketing, research and development, for example), the output is not easily measurable in dollars or activities. Cost centres are found in for-profit, not-for-profit, and government organizations. Cost centre managers are expected either to minimize costs for a certain level of output or to maximize output for a certain level of cost. Revenue Centres: In revenue centres, managers are held responsible for the revenues under their control. Revenue centres frequently sell products from manufacturing subunits. Managers are expected to maximize revenues. Profit Centres: Managers in profit centres are held responsible for both revenues and costs under their control. Profits centres produce and sell goods or services, and may include one or several cost centres. Profit centre managers are responsible for decisions about inputs, product mix, pricing, and volume of goods or services produced. The objective of profit centres is to maximize profits. Investment Centres: Managers of investment centres are held responsible for the revenues, costs, and investments under their control. Investments include any assets related to the investment centre, such as fixed assets, inventory, intangible assets, and accounts receivable. Investment centres resemble profit centres, where profitability is related to the assets used to generate the profits. The objective of investment centres is to maximize the return on investments made by the organization. This means the most profitable projects must be identified and selected for investment. 16.9 Advantages of decentralization for this company: Because expansion is into other countries, decision making will be timelier and probably more appropriate because local managers understand the local markets. The need to communicate detailed information up and down the organization will be reduced. The people making the decisions have the most knowledge and expertise. Disadvantagesof decentralization for this company: The decision makers may have objectives that are different from the overall company’s objectives. Decisions need to be coordinated among all of the divisions to reduce non-optimal behavior such as duplication of products or services. Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker. 16.10 The span of control is the scope of operations over which an individual has decision- making authority. Manager with a wide span of control, such as CEOS, have extensive authority. Individuals with a narrow span of control, such as bank tellers, have very little authority. 16.11 Residual income is EBIT less ROI * Total Assets. The EBIT budget variance is the sum of sales, COGS, and operating expenses budget variances. On the ROI side the budget variance is the sum of accounts receivable, inventory, other current assets, and long-term asset budget variances. Analysing these variance do determine the effect price, © 2012 John Wiley and Sons Canada, Ltd. 172 Cost Management efficiency, and volume variance along with collection problems and asset management problems, will provide insight into understanding the residual income variance. © 2012 John Wiley and Sons Canada, Ltd. Chapter 16: Performance Evaluation and Compensation 173 MULTIPLE CHOICE 16.12 Why is residual income a better measure for performance evaluation of an investment centre manager than return on investment? a) The problems associated with measuring the asset base are eliminated. b) Desirable investment decisions will not be neglected by high-return divisions. c) Only the gross book value of assets needs to be calculated. d) Returns do not increase as assets are depreciated. e) The arguments over the implicit cost of interest are eliminated. Ans: B 16.13 Robert Motoz is the manager of Division B of a large manufacturing company. Division B purchases all of its direct materials from Division A at a negotiated transfer price. Division B manufactures a product and sells this product on the market. Robert Motoz makes all production efficiency decisions for the division, including replacing and upgrading manufacturing equipment. The above represents which of the following types of responsibility centre? a) Cost centre. b) Revenue centre. c) Profit centre. d) Investment centre. e) Discretionary centre. Ans: D 16.14 ZIL Inc. operates two divisions, which are treated as investment centres. Data for eachdivision for Year 4 are as follows (in ’000s): Division A Division B Net income $50,000 $95,000 Total assets $300,000 $650,000 © 2012 John Wiley and Sons Canada, Ltd. 174 Cost Management The company’s required rate of return is 12%. The president wishes to evaluate the performance of these divisions and is not sure whether to use return on investment (ROI) or residual income (RI) as the performance measure. Which division performed better based on the ROI and RI performance measures? a) Division A, because its ROI and RI are higher than those of Division B. b) Division A, because its RI is higher than that of Division B. c) Division B, because its ROI is higher than that of Division A. d) Division B, because its ROI and RI are higher than those of Division A. e) None of the above. Ans: E Division A ROI is $50,000 / $300,000 = 16.67%; Division A RI is $50,000 – ($300,000 * 12%) = $14,000 Division B ROI is $95,000/ $650,000 = 14.62% Division B RI is $95,000 – ($650,000 * 12%) = $17,000 16.15 A small company in Vancouver sold $788,000 worth of its products last year. Net income represents 24% of sales. Net operating profit after tax (NOPAT) and total capital are, respectively, $240,000 and $520,000. The weighted average cost of capital and the required cost of capital were, respectively, 15% and 12%. What is EVA? a) $111,120 b) $126,720 c) $162,000 d) $177,600 Ans: C EVA = After-tax operating income - [WACC * (Total assets - Current liabilities)] EVA = $240,000 – [15% * ($520,000)] = $162,000 16.16 Which of the following best describes the responsibility of an investment centre manager? a) Evaluating alternative capital investments the organization must make. b) Achieving a certain target revenue within the manager’s organizational segment. c) Achieving a certain target profit within the manager’s organizational segment. d) Maximizing segment revenues given a predetermined expenses limit. e) Maximizing segment profit while making efficient use of the segment’s investment in capital assets. Ans: E © 2012 John Wiley and Sons Canada, Ltd. Chapter 16: Performance Evaluation and Compensation 175 EXERCISES 16.17 Responsibility Centres, ROI, RI – ZIL Inc. Division B performed better, because its ROI and RI are higher than those of Division A. ROI Division A = $65,000/$400,000 = 16.3% ROI Division B = $140,000/$850,000 = 16.5% RI Division A = $65,000 - ($400,000 * .15) = $5,000 RI Division B = $140,000 - ($850,000 * .15) = $12,500 Division B has a higher ROI and RI. 16.18 ROI, Required Rate of Return – An Investor Net operating income (OI) is $200,000 ($1.2 million – $1 million). A residual income (RI) of $2,000 implies that the return in dollars is net OI – RI = $198,000. The minimum required rate of return is $198,000 / $900,000 = 22%. 16.19 Responsibility Centres, ROI, RI – Spring Bulbs ROI Division T = $85,000/$255,000 = 33.3% ROI Division I = $210,000/$840,000 = 25.0% Division T performed better based on ROI. RI Division T = $85,000 - ($255,000 * .12) = $54,400 RI Division I = $210,000 - ($840,000 * .12) = $109,200 Division I performed better based on RI. 16.20 Responsibility Centres, Performance Measures - Brother’s Coffee Cart Business A. Each cart is a profit centre because the employees who operate the carts buy baked goods and other items and are responsible for selling them—i.e., they are responsible for both costs and revenues. B. My brother could use measures that focus on revenues, costs, or profit. Here are some possible measures: total revenue, revenue per hour, revenue growth, cost of goods sold as a percent of revenue, supplies cost as a percent of revenue, and profit margin percent (operating profit divided by revenue). © 2012 John Wiley and Sons Canada, Ltd. 176 Cost Management C. Number or percentage of return customers is very important because a small cart cannot survive without regular customers. Customer satisfaction is also important. Cleanliness of the cart could be an issue. Students may think of other factors. 16.21 RI, ROI and EVA - Brannard Company A. Residual income = operating income – (rate of return x average assets) = ($2,000,000 - $1,200,000 - $200,000) – (15% x $3,000,000) = $600,000 - $450,000 = $150,000 B. ROI = operating income / average investment = $600,000/$3,000,000 = 20% C. EVA = adjusted after-tax income – [weighted average cost of capital x (adjusted total assets – current liabilities)] = [$600,000 x (1-0.36)] – [12% x ($3,000,000 - $200,000)] = $384,000 - $336,000 = $48,000 16.22 RI, ROI, and EVA – Coburg Company A. Residual income = operating income – (rate of return x average assets) = ($5,000,000 - $3,000,000 - $500,000) – (15% x $7,500,000) = $1,500,000 - $1,125,000 = $375,000 B. ROI = operating income / average investment = $1,500,000/$7,500,000 = 20% C. EVA = adjusted after-tax income – [weighted average cost of capital x (adjusted total assets – current liabilities)] = [$1,500,000 x (1-0.32)] – [12% x ($7,500,000 - $500,000)] = $1,020,000 - $840,000 = $180,000 © 2012 John Wiley and Sons Canada, Ltd. Chapter 16: Performance Evaluation and Compensation 177 16.23 ROI, RI, Breakeven Point, Contribution Margin - Oslo Company [Note: Part C of this problem requires knowledge of breakeven analysis from Chapter 3.] A. Before calculating ROI, it is first necessary to calculate income: Sales (300,000 * $2) $600,000 Variable costs (450,000) Fixed costs (90,000) Income $ 60,000 ROI = $60,000/[($500,000 + $700,000)/2] = 10% B. Residual income: Income $ 60,000 Minimum return [($500,000 + $700,000)/2 x 0.15] (90,000) Residual income $(30,000) C. Variable cost per unit: $450,000/300,000 = $1.50 Breakeven number of units: Breakeven units = Fixed costs/ CM per unit CM per unit = $2.00 - $1.50 = $0.50 BE units = $90,000 / $.50 BE units = 180,000 units D. Sales $600,000 Variable costs 450,000 Contribution margin $150,000 16.24 EVA for Segments - Fulcrum Company Segment A EVA = after-tax income – WACC*(assets – current liabilities) = [€8,000,000*(1-0.30)] – [10%*(€32,000,000 + €8,000,000 – €4,000,000)] = €5,600,000 – €3,600,000 = €2,000,000 Segment B EVA = [€4,000,000*(1-0.30)] – [10%*(€30,000,000)] = = €2,800,000 – €3,000,000 = (€200,000) Segment C EVA = [€6,000,000*(1-0.30)] – [10%*€21,000,000] = €4,200,000 – €2,100,000 = €2,100,000 © 2012 John Wiley and Sons Canada, Ltd. 178 Cost Management Segment C has the highest EVA: 16.25 EVA for Segments – Pyramid Company Segment A EVA = after-tax income – WACC*(assets – current liabilities) = [£2,000,000*(1-0.25)] – [8%*(£2,000,000 + £8,000,000 – £1,000,000)] = £1,500,000 – £720,000 = £780,000 Segment B EVA = [£1,000,000*(1-0.25)] – [8%*(£1,500,000 + £6,500,000 – £500,000)]= = £750,000 – £600,000 = £150,000 Segment C EVA = [£3,000,000*(1-0.25)] – [8%*(£4,000,000 + £8,000,000 – £1,500,000)]] = £2,250,000 – £840,000 = £1,410,000 Segment C has the highest EVA. 16.26 Residual Income, Solve for Unknown – A Business Use the residual income formula to solve for the unknown, and assume that “investment” is approximately equal to average assets: RI = Operating income – (Required return * Average operating assets) $(10,000) = $50,000 – (Required return * $400,000) $(10,000)+ (Required return * $400,000) = $50,000 (Required return * $400,000) = $50,000 + $10,000 (Required return * $400,000) = $60,000 Required return = $60,000/ $400,000 Required return = $15% 16.27 ROI, Solve for Unknowns Unit 1 Unit 2 Unit 3 Income $10,000 $50,000 (D) $75,000 (G) Investment $50,000 (A) $250,000 (E) $300,000 Sales $150,000 (B) $500,000 $500,000 (H) Return on Investment 20% 20% (F) 25% Return on Sales 6.67% (C) 10% 15% Investment turnover 3.0 times 2.0 times 1.67 times (I) © 2012 John Wiley and Sons Canada, Ltd. Chapter 16: Performance Evaluation and Compensation 179 All answers are calculated using the ROI formula and DuPont Analysis formulas, assuming that “income” is equal to operating income and that “investment” is equal to total assets: ROI = Operating income / Total assets = Investment turnover × Return on sales = Sales/Total assets × Operating income/Sales Calculations in order of solving the unknowns: A. ROI = Income/ Investment therefore Investment = Income / ROI = $10,000 * 20% = $50,000 C. ROI = Investment turnover * Return on Sales therefore Return on sales = ROI/ Investment turnover = 20%/ 3.0 = 6.67% B. Return on sales = Income / Sales therefore Sales = Income / Return on sales = $10,000/6.67% = $150,000 D. Return on sales = Income / Sales therefore Income = Return on sales * Sales = 10% * $500,000 = $50,000 F. ROI = Investment turnover * Return on sales = 2.0 * 10% = 20% E. ROI = Income/ Investment therefore Investment = Income / ROI =$50,000 / 20% = $250,000 G. ROI = Income/ Investment therefore Income = ROI * Investment = 25% * $300,000 = $75,000 H. Return on sales = Income / Sales therefore Sales = Income / Return on sales = $75,000 / 15% = $500,000 I. ROI = Investment turnover * Return on sales therefore Investment turnover = ROI / return on sales = 25% / 15% = 1.67 times 16.28 ROI, Solve for Unknowns Unit 1 Unit 2 Unit 3 Income $20,000(A) $10,000 $15,000 Investment $60,000 $50,000 (D) $60,000 (G) Sales $200,000 $150,000 (E) $300,000 (H) Return on Investment 33.33% 20% 25% Return on Sales 10%(B) 6.67% (F) 5.0% (I) Investment turnover 3.33 times (C) 3.0 times 5.0 times © 2012 John Wiley and Sons Canada, Ltd. 180 Cost Management All answers are calculated using the ROI formula and DuPont Analysis formulas, assuming that “income” is equal to operating income and that “investment” is equal to total assets: ROI = Operating income / Total assets = Income / Investment = Investment turnover × Return on sales = Sales/Total assets × Operating income/Sales Calculations in order of solving: A. ROI = Income / Investment therefore Income = ROI * Investment = $60,000 * 33.33% = $20,000 rounded B. Return on sales = Income / Sales = $20,000 / $200,000 = 10% C. ROI = Investment turnover * Return on sales therefore Investment turnover = ROI / return on sales = 33.33% / 10% = 3.33 D. ROI = Income/ Investment therefore Investment = Income / ROI = $10,000 /20% = $50,000 F. ROI = Investment turnover * Return on Sales therefore Return on sales = ROI/ Investment turnover = 20%/ 3.0 = 6.67% E. Return on sales = Income / Sales therefore Sales = Income / Return on sales = $10,000/6.67% = $150,000 I. ROI = Investment turnover * Return on sales therefore Return on sales = ROI / Investment turnover = 25% / 5.0 = 5% H. Return on sales = Income / Sales therefore Sales = Income / Return on sales = $15,000/5.0% = $300,000 G. ROI = Income / Investment therefore Investment = Income / ROI = $15,000 / 25% = $60,000 16.29 Span of Control, General and Specific Knowledge, Performance Measures - Barnett’s A. In a high end boutique store, salespeople need specific knowledge about the tastes of their clients and also knowledge about styles that are most flattering for each client’s figure. Clients expect to receive phone calls when new items arrive at the store that would be stylish for them. The salespeople might also have general knowledge about fashion trends that could affect decisions such as which items to purchase. However, this type of general knowledge is probably centralized. B. An advantage of giving salespeople authority to resolve customer problems is that the salespeople have specific knowledge about each customer and probably have a better © 2012 John Wiley and Sons Canada, Ltd. Chapter 16: Performance Evaluation and Compensation 181 understanding of how to satisfy the customer. The disadvantage is that the salesperson may allow the customer to take advantage of the situation, costing the store more money than is necessary to resolve the issue. C. In most retail stores, salespeople have narrow spans of control. They cannot set prices, cannot resolve problems, and cannot set their own schedules, although they may be able to negotiate schedules with co-workers. However, the information provided about Barnett’s suggests that the salespeople have at least a moderate span of control because they are allowed to resolve customer problems including the return or exchange of merchandise and to hold merchandise for individual customers (which might cause lost sales). D. 1. Total store sales would encourage the employees to work as a team to increase sales both within and across the men’s and women’s departments. For example, a salesperson is the women’s department might encourage a female customer to purchase clothing in the store for her husband. This measure would also discourage salespeople from setting aside clothing for a particular customer unless they are confident that doing so would increase overall sales. On the other hand, this measure might encourage free riding by salespeople who are no
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