Chapter 12

Performance Evaluation in
Decentralized Firms

+ Ethics
 Lecture outline
• Costs and benefits of decentralization
• General principles of performance measurement
• Performance measurement in:
 cost centers
 profit centers
 investment centers

+Ethics
 Decentralization: Benefits and Costs
Many firms are decentralized:
major decisions are delegated to lower-level managers

• Benefits of decentralization
 lower-level managers have better information in their area than
senior managers => well-informed decisions
 lower-level managers have more expertise and experience in their
area than senior managers => better decisions
• Costs of decentralization
 managers might pursue their personal goals instead of doing what
is best for the firm => bad decisions for the firm
=> need to measure and evaluate manager’s performance
to mitigate these costs

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 Performance Measurement: General Idea
Why do we measure managers’ performance and
reward or punish them based on performance?
Want to give managers incentives to…

make sufficient effort make the right kind of effort

(work hard vs slacking off) (pursue firm’s goals vs pet projects)

To create the right incentives:

• evaluate managers based on their controllable performance (i.e., effort),
not factors outside of their control
• use performance measures that provide information about manager’s effort

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 Types of Responsibility Centers
To evaluate the manager of a given business unit:
(1) What exactly is the manager responsible for?
(2) What performance measures best reflect the manager’s controllable
performance given his/her responsibilities?

Three types of responsibility centers within a firm:

• Cost center: manager is responsible for costs only
 e.g., production plant, HR department, accounting department
Evaluate the manager based on costs: meeting cost targets in the short
term, sustained cost reduction in the long term
• Profit center: manager is responsible for costs and revenue (=> profit)
 e.g., a Walmart store
Evaluate the manager based on profit: meeting profit targets in the short
term, sustained profit increases in the long term
• Investment center: manager is responsible for costs, revenue, and
investments
 e.g., Chevrolet or Cadillac within GM; the firm as a whole
Evaluate the manager based on investment performance (next few slides)
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 Performance Measures for Investment
Centers

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 Measure 1: Return on Investment (ROI)
ROI = Profit / Investment
annual profit per $1 of investment, where
investment = level of operating assets

Compute ROI for each division

Profit Investment
Division A $18,000 $100,000 ROI =
$160,00
Division B $1,000,000 ROI =
0

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 DuPont Method: Decomposing ROI
We can rewrite ROI as

ROI = profit = profit × sales

investment sales investment
= profit margin × asset turnover

where
profit margin = profit/sales
profit per $ of sales
* “profit margin” here is different from that in Ch 9,10
asset turnover = sales/investment
sales per $ of operating assets

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 DuPont Method: Decomposing ROI
=profit/assets

Sales Profit Total ROI Profit Asset

Assets margin turnover
Tiffany $1,707 $319 $1,924 16.6% 18.7% 0.89
Walgreen’s $28,681 $1,624 $9,879 16.4% 5.7% 2.9
All numbers are in millions of $.
Source: Rajiv Banker’s SCPM lecture notes
=sales/assets
=profit/sales

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 Exercise: DuPont Method
Which company likely has higher profit margin?
Higher asset turnover? Why?

Profit Margin Asset turnover

 HIGH  LOW  HIGH  LOW

 HIGH  LOW  HIGH  LOW

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 Measure 2: Residual Income (RI)
Residual Income (RI) = the amount that the investment
generates above the required rate of return
RI = Profit – (Required rate of return * Investment)

Compute RI for each division.

Profit Investment
Division A $18,000 $100,000

Division B $160,000 $1,000,000

Required rate of return is 10%.

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 Measure 3: Economic Value Added (EVA)
EVA is a refined version of RI.

EVA = NOPAT – WACC  (invested capital – current liabilities)

NOPAT = net operating profit after taxes

[ = (1−tax rate)*net operating profit before taxes ]

WACC = weighted average cost of capital:

• A firm can raise capital through equity (sell shares) or debt (sell
bonds or borrow from a bank). WACC measures the average cost
of capital for the firm’s mix of equity and debt.

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 Exercise: Computing EVA
Invested capital (total assets) $10,000
Current liabilities $1,000
Operating profit before taxes $2,000

The tax rate is 30%. The WACC is 10% a year. Compute EVA.

NOPAT =

EVA =

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 ROI, RI, and EVA can be dangerous

ROI, RI and EVA are short-term measures – they ignore the

long-term consequences of today’s decisions

E.g., if you cut R&D to zero, will you…

• improve ROI, RI, and EVA in the short term?  YES  NO
• kill the firm in the long term?  YES  NO

Many firms complement ROI, RI, and EVA with long-term

performance measures
 e.g., market share, customer satisfaction – more on this in Ch 13

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 Additional Exercises

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 Exercise: Responsibility Centers
Classify the following business units as a cost center, a profit
center, or an investment center.

cost profit investment

center? center? center?
a Starbucks coffee shop   
an independently owned coffee shop   
accounting department at Walmart   
Lexus division of Toyota   
a GM car assembly plant   
HR department at Bank of America   
market research department at GM   

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 Exercise: Computing ROI and RI
Fiat Auto Group owns Chrysler and Ferrari. The required rate of return (cost
of capital) is 10% a year.
profit investment
($ million) ($ million)
Chrysler 3,000 20,000
Ferrari 500 2,000

1. Compute ROI
Chrysler =
Ferrari =

2. Compute RI
Chrysler =
Ferrari =

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 Exercise: DuPont method
company A company B
profit margin
(=profit/sales) 3% 12%

asset turnover
(=sales/assets) 3.2 0.8

1. Compute ROI
ROI for A =
ROI for B =

2. One of these companies is Apple and the other one is Dell.

Apple is  A?  B? Why?
Dell is  A?  B? Why?

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 Exercise: Computing EVA
Invested capital (total assets) $50,000
Current liabilities $10,000
Operating profit before taxes $20,000

The tax rate is 40%. The WACC (weighted average cost of capital) is 10% a
year. Compute EVA.

NOPAT =

EVA =

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 Exercise: Short-Term vs Long-Term
Consequences
You run a major consumer goods company. The company
spends $5 billion a year on advertising. The consumers are well
aware of the company’s products. Your bonus depends on the
short-term financial performance of the company. Therefore, you
decided to cut advertising to zero to reduce costs and increase
profits.
What are the likely consequences of this decision?
1. Will it improve financial performance (ROI, RI, and EVA) and
increase your bonus in the short term?  YES  NO
2. Will it kill the company (or at least cause massive damage) in
the long term?  YES  NO

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 Ethics in Business

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 Why ethics?
• In this course, we emphasize profit maximization: make the
choice that yields the highest CM, profit, NPV, etc
• BUT many profit-maximizing choices are also
highly illegal (e.g., bribing government officials, collusion)
or
legal but questionable (next few slides)
=> do NOT take profit-maximization too literally
 aka, corporate social responsibility (CSR)

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 A simple Cost-Benefit analysis
You are about to launch a new product X. You expect to sell 11 million units.
You have discovered a minor design flaw that will affect less than 0.01% of
your customers (i.e., 99.99% of customers will never notice the problem).
• You can fix the problem through a simple redesign. However, this will
increase the production costs by $11 per unit, or $121 million in total.
• If you do not fix the problem, some of your customers will be unhappy. You
will have to compensate them at a total cost of $47.5 million.
Assume that this choice does not affect revenue and all other costs.

Fix the Do not fix the

problem problem
Revenue no effect no effect
Relevant costs $121 million $47.5 million
Other costs no effect no effect
Should you fix the problem?  YES  NO
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 Add some details…
• “product X” = Ford Pinto

• “Minor design flaw” = deadly fires in rear-end collisions

 Easy to fix (just redesign the fuel tank) at a cost of $11 per vehicle.

• Compensating unhappy clients = settling the lawsuits:

 180 burn deaths, $200,000 each
 180 serious burn injuries, $67,000 each
 2,100 burned-out vehicles, $700 each

• Ford was aware of the problem before Pinto went into

production. The cost-benefit analysis is from Ford’s internal
memos.
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 What should we do?
Fix the Let them
fuel tanks burn…
Revenue no effect no effect
Relevant costs $121 million $47.5 million
Other costs no effect no effect
Non-financial considerations
Burn deaths – 180
Burn injuries – 180
Burned cars – 2,100
1. You are the CEO of Ford. What do you want to do?
 Fix the fuel tanks?  Let them burn?

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Btw, Ford did nothing. No one went to jail for this.
 (continued) What should we do?
Fix the Let them
fuel tanks burn…
Revenue no effect no effect
Relevant costs $121 million 47.5 million
Other costs no effect no effect
Non-financial considerations
Burn deaths – 180
Burn injuries – 180
Burned cars – 2,100
2. You are a mid-level executive at Ford. Your bosses did
nothing. What do you want to do?

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 Ethics question on the final
• One “ethics” question
• Do the “right thing”, i.e., fix the fuel tanks,
do not sell plutonium on eBay, etc.

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