Performance Evaluation Part 1

Summary

This lecture on performance evaluation in management accounting covers the importance of performance measurement, the challenges posed by agency problems, and the concept of control within organizational structures. The presenter discusses the role of return on investment (ROI) and residual income as financial performance metrics, highlighting their advantages and disadvantages. The lecture ties these measures to net present value (NPV), explaining how they influence decision-making. Ultimately, the content emphasizes aligning individual goals with organizational objectives to ensure long-term growth and minimize conflicts between managers and shareholders.

Takeaways

• 😀 Performance management is crucial for aligning employee goals with company objectives to promote long-term growth and avoid short-term profit manipulation.
• 😀 Agency problems arise when managers act in their own interest instead of benefiting shareholders, leading to conflicts of interest.
• 😀 Incentives and threats, such as bonuses or job security, can help mitigate agency problems and align manager actions with shareholder interests.
• 😀 Control in performance evaluation depends on the company structure, whether functional or divisional, influencing what a manager can control.
• 😀 In a functional structure, managers are only evaluated based on their specific functional area, such as marketing, while in a divisional structure, they have more control over investments, profits, and costs.
• 😀 When evaluating managers in decentralized structures, performance should be based on what they control, not on the overall division's performance.
• 😀 Residual income and return on investment (ROI) are two financial measures for performance evaluation, helping assess profitability relative to investment.
• 😀 ROI is calculated as profit divided by investment, and it can be further broken down using the DuPont model to assess profit margin and asset turnover.
• 😀 Residual income accounts for controllable contributions minus the cost of capital, offering a more risk-sensitive measure of performance than ROI.
• 😀 While ROI is simple and relative, its main disadvantage is the potential for manipulation and ignoring risk factors, making it less reliable in some contexts.
• 😀 Residual income considers both income and investment but lacks comparability across divisions or companies due to its absolute nature, making it harder to benchmark performance.

Q & A

Why is performance management important in organizations?

Performance management is crucial because it ensures congruence between the goals of individual managers and the broader goals of the organization, promoting sustainable long-term growth. It also helps to address the agency problem, where managers may not always act in the best interest of shareholders.

What is the agency problem, and how does it affect performance management?

The agency problem arises when managers, as agents for shareholders, pursue their own interests instead of maximizing shareholder value. This misalignment can lead to decisions that are not in the best interest of the company, so performance management systems aim to mitigate this issue by aligning managerial incentives with shareholder goals.

How do organizational structures impact performance evaluation?

Organizational structures, such as functional and divisional, determine the scope of control for managers. In a functional structure, managers are evaluated based on their specific function, while in a divisional structure, managers have more autonomy, overseeing profits, costs, and investments for their division. Understanding the structure helps ensure managers are evaluated on areas within their control.

What is the difference between functional and divisional structures?

A functional structure is centralized and focuses on specific functions (e.g., marketing, finance), with managers evaluated solely on their own area. A divisional structure, on the other hand, decentralizes decision-making, with managers having control over a division’s profits, costs, and investments, enabling quicker decisions but increasing the risk of agency problems.

Why is it important to evaluate managers only on areas they control?

Evaluating managers only on the areas within their control ensures fairness and accuracy in performance assessment. It prevents managers from being penalized or rewarded for factors outside their influence, leading to more effective decision-making and motivation to align with organizational goals.

What are the key financial performance measures discussed in the video, and how do they differ?

The two key financial performance measures discussed are Return on Investment (ROI) and Residual Income (RI). ROI is a relative measure calculated as profit divided by investment, offering a percentage comparison across projects or divisions. RI, on the other hand, considers controllable contributions and the cost of capital, offering a risk-adjusted evaluation of profit relative to investment.

What is the advantage of using ROI in performance evaluation?

The primary advantage of ROI is its simplicity and ability to provide a percentage that makes it easy to compare across divisions or projects. It is a relative measure, which aids in decision-making by highlighting efficient use of investment.

What are the disadvantages of ROI as a performance measure?

The main disadvantages of ROI are that it ignores risk and can be easily manipulated. Managers might manipulate ROI by delaying investments or underreporting costs to artificially inflate ROI, potentially leading to suboptimal decisions.

How does Residual Income (RI) address the limitations of ROI?

Residual Income (RI) addresses the limitations of ROI by considering the cost of capital, thus adjusting for risk. It evaluates whether a division is generating profit above the required return on invested capital, making it a more effective tool for motivating managers to make decisions that create value for shareholders.

How should ROI and Residual Income (RI) be used together in performance evaluation?

ROI and Residual Income (RI) should be used together to get a comprehensive view of performance. ROI provides a quick, relative measure of efficiency, while RI accounts for the cost of capital and ensures that profit is created over and above the required returns. Using both allows for more informed and balanced decision-making.