Lecture 11: Performance Evaluation in

Decentralized Organizations
In this module, we are going to discuss the principles behind performance
evaluation in decentralized organizations. We will discuss concepts such as
decentralization, controllability, informativeness, responsibility centers and transfer
pricing. These are issues that are connected to exercising managerial control in the
long term and therefore can be considered as the core elements of a typical
management control system.
Decentralization is essentially the delegation of decision-making rights. The
essence of decentralization is the freedom for managers at lower levels of the
organization to make decisions. In other words, the managers in a decentralized
organization will have minimum constraints and maximum freedom to make
decisions. So if youre comparing two organizations and if in one organization you
find that these decision-making rights have been delegated to relatively lower level
of the organization you would say that this organization is more decentralized.
Generally speaking, decentralization is desirable. But at the same time
decentralization has both benefits and costs. Lets first look at the benefits.
Decentralization creates greater managerial responsiveness to local needs. Timely
information is crucial for managers to make good decisions. Compared to the top
level managers, lower level managers are generally better informed about their
customers, competitors, et cetera. So, decentralization enables more agile, nimble
managerial response to rapidly changing market conditions. Decentralization leads
to gains from quick decision-making because decentralization speeds up decisionmaking process and therefore it can create or contribute a competitive advantage
over a centralized organization. Decentralization encourages management
development learning, giving managers more responsibility; it promotes the
development of an experienced pool of management talent. Its a pool that you can
draw for higher level of management positions, whenever a need arises. This paves
way for continuity of leadership. Finally, lower level managers are highly motivated
when they can exercise greater individual initiative. It empowers the employees
and contributes to higher level of job satisfaction. Now, let us look at the potential
costs of decentralization. Firstly, decentralization may lead to sub-optimal decisionmaking since the divergence between individual and organizational goals triggers
improper decision. Why? A decentralized manager is likely to have a very narrow
view of the organization and may not understand the big picture. His personal
goals are probably very different from the overall organizational goals and this
typically leads to dysfunctional or incongruent decisions. Decentralization may lead
to duplication of activities. For example, there may be a duplication of staff
functions like accounting, human resources, and management information systems.
Decentralization typically increases cost of gathering information and coordinating

decisions. The cost of coordination increases with the size of the organization and
the complexity of managerial tasks.
Organizations are typically composed of subunits. For example, the firm
might be organized into functional areas such as marketing, manufacturing, and
distribution departments. Some organizations might be divided into subunits along
the lines of products or geographic areas or services offered. Responsibility
accounting is the process of recognizing subunits within the organization, assigning
decision rights to managers of those subunits and evaluating the performance of
those managers. These subunits of the organization are called responsibility
centers. The managers of these responsibility centers have different decision rights
and are held responsible for different results and therefore are evaluated by
different performance measures. Generally speaking, there are five different types
of responsibility centers: Cost center, discretionary cost center, revenue center,
profit center and investment center.
A cost center is an organizational subunit, whose manager is held responsible
for the costs incurred in that center. Usually cost centers have well-defined
relationship between inputs and outputs. For example, a manufacturing division has
a well-defined input output relationship and therefore is suitable to be treated as a
cost center. A discretionary cost center is a subunit of an organization whose
manager is held responsible for costs incurred. A discretionary cost center differs
from a cost center by the fact that it has no well-defined input-output relationship.
For example, a R&D center can be a discretionary cost center. The manager of a
revenue center is held responsible for the revenue attributed to the subunit. For
example, the reservation department of an airline company and the sales
department of a manufacturing company could be treated as revenue centers. The
manager of a profit center is held responsible for overall profits generated by the
responsibility center. Since profit is equal to revenue minus costs, the profit center
manager is essentially being held accountable for both revenues and costs of the
subunit. An example of a profit center is an individual store of a retail chain such as
Sears. An investment center is one where the manager has the decision rights over
costs, revenue and the assets deployed in the responsibility center. For example, a
large division within organizations such as GE or Proctor and Gamble can be treated
as an investment center.
You probably have heard the famous clich that you get only what you
measure. So it is very important to measure the right things. The controllability
principle has long been used as a basis for managerial performance evaluation.
Controllability principle expresses the idea that managers should be held
responsible for the costs or revenues or profits over which they have decision
making authority. This principle is quite appealing and it seems like the correct
thing to do. However, today the controllability principle has largely been replaced
by the informativeness principle. According to the informativeness criterion, a
performance measure is said to be informative if it provides information about what

a manager did or failed to do. In other words, an informative performance measure

conveys some information about the action or the lack of it on the managers part.
The basic idea behind the design of modern performance measurement systems
design is to employ informative performance measures in performance
evaluation. You may want to remember that not all informative measures are
controllable. A CEO does not control the stock market performance. Yet the CEO is
evaluated based on stock price performance. By the same token, not all
controllable measures are necessarily informative. An ideal performance measure
should align the goals of the organization with the personal goals of the individual
being evaluated. Unless it is easy to measure, too much effort or cost will be
expended in just the measurement aspects which may divert the attention of the
managers from the task at hand. In addition, a good performance measure should
be easy to understand and communicate. Unless the person being evaluated
understands the linkage between his or her actions and the performance measure,
the employee cant be motivated. Finally, the chosen performance measure should
be very informative about the managers actions or the state of the organizational
subunit that is being evaluated.
Cost centers or managers managing cost centers are usually evaluated based
on input measures. The manager of cost centers must meet the target of budgeted
costs while achieving the budget output. If the actual output is different than the
budgeted output, then the manager must meet the flexible budget for the costs
given the actual output. In other words, cost variances which are obtained by
comparing the actual costs to the flexible budgeted costs will be the typical
evaluation measures. However, evaluating cost center managers based on the
budgeted cost benchmark is typically a short term evaluation scheme. In the long
run, cost center managers should improve efficiency by continuously improving the
processes. To achieve long-term reductions in cost, firms use techniques such as
benchmarking and kaizen principle. Benchmarking is a process of comparing the
effectiveness and efficiency of various activities and business processes in a firm
against the best practices in the industry. Keep in mind that the best practices are
not controllable by managers being evaluated. Still such a comparison is useful
performance measure since this measure is informative about how the managers
are performing compared to their industry peers. Kaizen is a Japanese word
meaning improvement and the kaizen philosophy aims to continuously improve
activities and processes and eliminate waste. Kaizen motivates managers to
achieve permanent cost reduction.
Now, let us discuss the broad principles behind evaluation of profit center
managers. Since a profit center manager controls both inputs and outputs, a profit
center manager should be evaluated based on a measure that depends both on
inputs and outputs of the profit center. In most organizations, the profit centers are
formed along product lines. For example, Microsoft can have a profit center for a
division that develops and maintains Microsoft office products. Some organizations

have a more complex structure of responsibility centers. It is possible to form

responsibility centers following a matrix structure. Profit centers may be formed
both along the product lines as well as geographic regions. Using the same revenue
and cost numbers, one can calculate profits for the product segments as well as
regional segments. While the product managers are evaluated based on product
profit margins, the regional managers are evaluated based on region profit margins.
In general, firms evaluate profit center managers based on profit before nontraceable fixed costs. In other words, you need to evaluate a profit center manager
based on profit before taxes for the profit center computed as contribution margin
for the profit center minus the traceable fixed costs to the profit center. Just like
how cost center managers are evaluated, it is possible to evaluate the profit center
managers in two dimensions. The short term evaluation measure for profit center
managers is obviously the budgeted profits. The flexible budget variance is a
convenient measure to evaluate the profit center mangers. The long term
evaluation measure can be growth in profits. In this measure, the benchmark is
profits from the last period. We can have a yet another benchmark to evaluate
profit center managers. In addition to benchmarks such as budgeted profit, last
year profit, we can also have the average industry profit as an additional
benchmark. This concept is called relative performance evaluation. By using such
a benchmark, we are filtering out the uncontrollable risk in the profit performance
measure that can be attributed to factors outside the control of the profit center
manager. For example, macro economic conditions or conditions specific to a
particular industry can affect the profits. These issues are beyond the control of the
profit center managers. Since these common business conditions affect all the
managers in an industry in a similar manner, by taking the average industry profit
as a benchmark, we are shielding a profit center manager from these uncontrollable
factors. Note that a given profit center manager has no control over the industry
average profits. In the same way, a profit center manager has no control over the
macro economic conditions affecting the profitability of the profit center. Yet, we
can use the industry profits, which is not a controllable performance measure for a
profit center manager, to evaluate a profit center manager so that to filter out the
impact of macro economic conditions that are outside the control of a given profit
center manager. So far, we have discussed only the financial performance
measures in evaluating a responsibility center manager. While the financial
measures are the most commonly used measures, firms have begun to supplement
these measures with non-financial performance measures such as customer
satisfaction or quality and productivity measures. The main reason for this trend is
the fact that the non-financial measures are often leading indicators of financial
measures. Therefore, stressing nonfinancial measures promotes future profitability
and provides incentives to the managers to take the necessary steps to ensure that
future profits are healthy.
Investment center managers must be evaluated based on everything that
they control. So the performance measure used to evaluate them must be based on

inputs, outputs and the invested capital in the investment center. Three possible
measures can be used to evaluate an investment center manager. The first
measure is Return on Investment measured as profit expressed as a percentage of
the invested capital. The numerator of this ratio should be measured based on
what the manager controls. Usually, we calculate profit of the center before taxes
and interest. Tax planning is usually done at the corporate headquarters and
therefore tax is not controllable by the divisional managers. Debt policy is also
centrally decided and therefore, we cant hold the divisional manager responsible
for interest expenses. The denominator of ROI should be assets over which the
manger exercises control. So we will exclude any financial asset such as
marketable securities from the divisional assets if these financial assets are
managed by corporate headquarters. Notice that while the numerator of ROI is a
flow measure (i.e. computed over a year) the denominator is a stock measure
(computed at a point of time). Therefore, we use the average operating assets in
the denominator estimated as the sum of beginning and ending operating assets of
the division divided by two. There are two alternative ways of measuring the
operating assets of an investment center. It can be based on accounting values or
economic values. We can measure the operating assets as net book value (i.e.
acquisition value minus accumulated depreciation) or gross book value (i.e.
acquisition value of the assets). Notice that older assets are heavily depreciated
and therefore, will generally provide a higher ROI. This may provide incentives to
managers not to replace older equipment in a timely manner. In spite of this
shortcoming, this is the most popularly used measure to evaluate profit center
managers. Using economic value of assets computed independent of accounting
values, while appealing, is difficult to implement. It is subjective and is often
tedious. The biggest advantage of ROI is that it is a size adjusted measure since
profits are expressed as a percentage of investment of the division. So ROI is
comparable across various investment centers whether big or small. The major
criticism of ROI is that it may provide incentives for the manager to underinvest or
overinvest in operating assets. Assume that a firm wants to invest in all projects
with profitability over 15%. Assume that an investment center manager, whose
current ROI is 25% has an opportunity to invest in a new project with an estimated
profitability of 20%. If the manager accepts the new project, his overall profitability
is going to decrease. So this manager has incentives not to invest in the new
project. This leads to less investment than the optimal investment. Consider
another investment center manager with a current profitability of 7% and a
potential investment opportunity with a projected profitability of 10%. Since the
new projects profitability is less than 15%, this project should not be accepted.
However, since the new projects ROI is more than the current ROI of 7%, the
divisional manager has an inventive to invest in this project. This leads to
overinvestment. Finally, ROI is often criticized as a measure that makes the
mangers to think about only in the short term. For example, replacing older
equipment may be better in the long run. However, purchasing the new equipment
will increase the operating assets and result in reduced ROI for the current period.

A manager who is worried about current ROI may delay replacement of equipment
beyond the optimal replacement time.
ROI can be decomposed as profit margin multiplied by asset turnover. Asset
turnover represents the revenue generating ability of operating assets. This form of
decomposition highlights the tradeoff between managerial decisions. A manager
can either improve the profit margin or the efficiency of asset utilization to improve
the profits. It depends on the strategy of the firm. For example, Walmart relies on
low cost strategy. It has thin profit margins relative to other competitors but makes
it up by having a higher asset turnover. We can write profit margin as one minus
operating expenses ratio. Again, this reflects the tradeoffs between managerial
decisions. A manager can hold the sales at the same level and try to cut down
operating expenses to improve profit margin. Or alternatively, a manger can incur
higher operating expenses and try to increase sales more than proportionately. This
will also improve profit margin.
The next measure we want to discuss is Residual Income. This measure is
computed as the profit for the investment center minus an imputed charge for the
operating assets of the division. Usually, firms set this imputed charge equal to or
close to the weighted average cost of capital for the firm. The biggest advantage of
RI over ROI is the fact that RI does not lead to under or over investment. For
example, assume a firm has a minimum profitable criterion of 15% for new projects
and the imputed charge for RI calculations is also 15%. Irrespective of current RI, a
manager faced with a new project will accept any project with ROI higher than 15%
and reject any project with ROI less than 15%. Unlike ROI, the current level of RI will
not influence a managers decision to accept or reject a new project. Notice that RI
is not size adjusted in the sense bigger divisions are likely to report bigger RI and
smaller divisions are likely to report smaller RI. Therefore, comparing the
performances of multiple divisions using RI is not possible. Also, the choice of the
imputed charge on investment (also called as required return in RI calculations) can
flip the profitability rankings of centers.
EVA or Economic Value Added is the last measure we are going to discuss in
evaluating an investment center manager. This is really a special form of residual
income. This is defined as Net Operating Profit After Taxes minus weighted average
cost of capital multiplied by invested capital in the investment center excluding the
current liabilities. EVA is a measure developed and promoted by a consulting
company, Stern Stewart & Company. It involves numerous adjustments to the
accounting numbers such as backing of R&D expenditure from operating profits and
capitalizing them. This is a time consuming method and requires considerable
effort. Finally, similar to a profit center manager, an investment center manager
also needs to be evaluated based on forward looking nonfinancial measures such as
market share, customer satisfaction and measures based on new products
introduced.

Transfer price is the price at which goods or services are transferred within a
company from one division to another division. It is revenue item for the selling
division and a cost item for the buying division. From the overall perspective of the
firm, revenue for one division washes against cost for another division and therefore
transfer prices do not affect overall corporate profits. However, transfer prices do
affect the profits reported by individual divisions. There are two main reasons why
we have transfer prices. If different divisions are located in different tax
jurisdictions, then we need transfer prices to report taxable income. For example,
engines shipped from Japan to the plant of Honda should generate revenue for the
Japan division and costs to the U.S division. IRS authorities in the U.S and the tax
authorities in Japan are concerned about the price at which this transfer of goods is
recorded by Honda. Too high a transfer price will reduce taxable profit in U.S and
too low a price will reduce taxable profit in Japan. The second reason why we have
transfer prices is to promote internal efficiency and provide the right incentives to
managers managing responsibility centers.
We can have cost based transfer prices or market based transfer prices. Cost
based transfer prices may be based on either variable cost or full absorption cost.
The use of full absorption cost for setting transfer prices may provide the wrong
incentives especially if the selling division has spare capacity. For the buying
division, the transfer price is a variable cost. Notice that a transfer price based on
full absorption cost makes the manager of the buying division to treat the fixed
costs of the selling division as variable costs. This may lead to a variety of
suboptimal decisions. Market price is often promoted as the right transfer price.
This is especially true if the selling division has no spare capacity and the product
market conditions allow us to estimate the opportunity cost of transfer for the
selling division. If the selling division can either transfer the goods internally or sell
the goods in the external market, the opportunity cost of transfer equal the
difference between the market price and the variable costs for the selling division.
Negotiated transfer price is one where the mangers of the selling and buying
divisions discuss and decide on the transfer price. This may be a difficult solution to
achieve in practice.
From the selling division managers perspective, the minimum acceptable
transfer price is the variable cost of transfer plus the selling divisions opportunity
cost of transfer. As we saw before, the opportunity cost of transfer, if the selling
division is operating at capacity is its contribution margin from external sales. This
is because the selling division is potentially losing its contribution margin for every
unit of goods transferred internally. On the other hand, if the selling division is
operating with enough spare capacity, then it can meet the demand for internal
transfer from the spare capacity without affecting the sales to external market. In
this case, the opportunity cost of transfer is zero. So the minimum possible transfer
price is the variable costs for the selling division and sets the floor for the transfer
price. From the buying divisions perspective, the maximum price that it will be

willing to buy is the market price which is its opportunity cost of transfer. So this
represents the maximum possible transfer price. This implies that the feasible
transfer price lies in between TPmin and TPmax. If the product market is close to being
perfectly competitive, then the market price is the only feasible transfer price.
I can summarize the principles discussed in the last slide as a golden
rule that guides the principle of transfer pricing. We saw that, given that some
transfer took place within a firm, transfer price does not affect the overall corporate
profits since the transfer price is revenue for one division and cost for another
division. However, transfer price does affect whether transfer of goods takes place
or not. Transfer or goods internally is a good decision in some circumstances and
not a good decision in some other circumstances. So companywide profits will be
affected if wrong transfer pricing scheme led the managers to reach a sub-optimal
decision. The optimal transfer pricing scheme is one that allows the managers to
maximize their own divisional profits that also happen to maximize the overall
corporate profits. Ideal transfer price can be defined as the sum of two
components. The first component is the additional outlay cost incurred by the
selling unit because of the transfer. Typically this is the variable cost for the selling
division associated with transfer of goods. The second component is the
opportunity cost per unit of transfer. Usually this is zero if the selling division has
spare capacity and equal to contribution margin if the selling division has no spare
capacity.