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CHAPTER 8 The Management Process PLAN ∇ Translate the organization’s mission and vision into operational objectives from multiple stakeholders’ perspectives. ∇ Select performance measures for objectives. ∇ Establish targets for each performance objective. PERFORM ∇ Balance the needs of all stakeholders when making decisions. I f managers want satisfactory results, they must understand the cause-and-effect relationships between their actions and their organization’s overall performance. By measuring and tracking the relationships that they are responsible for, managers can improve performance and thereby add value for all of their organization’s stakeholders. In this chapter, we describe the role of the balanced scorecard, responsibility accounting, and economic value added as they relate to performance management and evaluation. We also point out how managers can use a wide range of financial and nonfinancial data to manage and evaluate performance more effectively. ∇ Improve performance by tracking causal relationships among objectives, measures, and targets. Performance Management and Evaluation EVALUATE ∇ Compare financial and nonfinancial results with performance targets. ∇ Analyze results and take corrective actions. LEARNING OBJECTIVES LO1 Define a performance management and evaluation system, and describe how the balanced scorecard aligns performance with organizational goals. (pp. 302–305) LO2 Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation. (pp. 305–309) LO3 Prepare performance reports for cost centers using flexible COMMUNICATE ∇ Prepare reports of interest to stakeholder groups. budgets and for profit centers using variable costing. (pp. 310–313) Managers use multiple evaluation metrics to analyze and manage performance. LO4 Prepare performance reports for investment centers using the traditional measures of return on investment and residual income and the newer measure of economic value added. (pp. 313–319) LO5 Explain how properly linked performance incentives and measures add value for all stakeholders in performance management and evaluation. (pp. 319–322) 300 DECISION POINT  A MANAGER’S FOCUS  How do managers at Vail Resorts link performance measures and set performance targets to achieve performance objectives?  How do they use the PEAKS system and its integrated database to improve performance management and evaluation? VAIL RESORTS Vail Resorts includes five vacation spots: Vail, Breckenridge, Keystone, Heavenly, and Beaver Creek. To help guests enjoy all the activities that these places offer, Vail Resorts instituted its PEAKS system. PEAKS is an all-in-one card that guests at the five resort areas can use to pay for lift tickets, skiing and snowboarding lessons, equipment rentals, dining, and more. Guests like the PEAKS system’s convenience and its program for earning points toward free or reduced-rate lift tickets, dining, and lodging. After enrolling, members receive a picture identification card with radio frequency technology that is scanned each time they ride the ski lifts, attend ski school, or charge purchases, meals, or lodging.1 Managers at Vail Resorts like the PEAKS system because it enables them to collect huge amounts of information—both financial and nonfinancial—in a simple way and because the data have so many uses. New data are entered in the system each time a guest’s card is scanned. Those data then become part of an integrated management information system that managers use to measure and evaluate the performance of their resorts in many ways. 301 302 CHAPTER 8 Performance Management and Evaluation Performance Measurement LO1 Define a performance management and evaluation system, and describe how the balanced scorecard aligns performance with organizational goals. Study Note What a manager measures for example, quality—is not the same as the actual measures used to monitor performance— for example, the number of defective units per hour. A performance management and evaluation system is a set of procedures that account for and report on both financial and nonfinancial performance so that a company can identify how well it is doing, where it is going, and what improvements will make it more profitable. What to Measure, How to Measure Performance measurement is the use of quantitative tools to gauge an organization’s performance in relation to a specific goal or an expected outcome. For performance measurement to succeed, managers must be able to distinguish between what is being measured and the actual measures used to monitor performance. For iinstance, product or service quality is not a performance measure. It is part of a management strategy: Management wants to produce the highest-quality prodm uct or service possible, given the resources available. Product or service quality u tthus is what management wants to measure. To measure product or service quality, managers must collaborate with other managers to develop a group of measures, such as the balanced scorecard, that m will identify changes in product or service quality and help employees determine w what needs to be done to improve quality. w Other Measurement Issues O Each organization must develop a set of performance measures that is appropriate to its situation. In addition to answering the basic questions of what to measure and how to measure, management must consider a variety of other issues, including the following:  What performance measures can be used?  How can managers monitor the level of product or service quality?  How can managers monitor production and other business processes to identify areas that need improvement?  How can managers measure customer satisfaction?  How can managers monitor financial performance?  Are there other stakeholders to whom a manager is accountable?  What performance measures do government entities impose on the company?  How can a manager measure the company’s effect on the environment? FOCUS ON BUSINESS PRACTICE “Old” Doesn’t Mean “Out of Date” The tableau de bord, or “dashboard,” was developed by French engineers around 1900 as a concise performance measurement system that helped managers understand the cause-and-effect relationships between their decisions and the resulting performance. The indicators, both financial and nonfinancial, allowed managers at all levels to monitor their progress in terms of the mission and objectives of their unit and of their company overall. Like a set of nested Russian dolls, each unit’s key success factors and key performance indicators were integrated with those of other units. The dashboard continues to encourage a performance measurement system that focuses on and supports an organization’s strategic plan.2 Performance Measurement 303 Organizational Goals and the Balanced Scorecard The balanced scorecard, developed by Robert S. Kaplan and David R Norton, is a framework that links the perspectives of an organization’s four basic stakeholder groups—financial (investors), learning and growth (employees), internal business processes, and customers—with the organization’s mission and vision, performance measures, strategic and tactical plans, and resources. To succeed, an organization must add value for all groups in both the short and the long term. Thus, an organization will determine each group’s objectives and translate them into performance measures that have specific, quantifiable performance targets. Ideally, managers should be able to see how their actions contribute to the achievement of organizational goals and understand how their compensation is related to their actions. The balanced scorecard assumes that an organization will get only what it measures. The Balanced Scorecard and Management To illustrate how managers use the balanced scorecard, we will refer to Vail Resorts’ PEAKS system, which we described in the Decision Point. Planning During the planning stage, the balanced scorecard provides a framework that enables managers to translate their organization’s vision and strategy into operational terms. Managers evaluate the company’s vision from the perspective of each stakeholder group and seek to answer one key question for each group:  Financial (investors): To achieve our organization’s vision, how should we appear to our shareholders?  Learning and growth (employees): To achieve our organization’s vision, how should we sustain our ability to improve and change?  Internal business processes: To succeed, in which business processes must our organization excel?  Customers: To achieve our organization’s vision, how should we appeal to our customers? Study Note The alignment of an organization’s strategy with all the perspectives of the balanced scorecard results in performance objectives that benefit all stakeholders. These key questions align the organization’s strategy from all perspectives. The T answers to the questions result in performance objectives that are mutually beneficial to all stakeholders. Once the organization’s objectives are set, managers can select performance measures and set performance targets to translate the objectives into an p action plan. For example, if Vail Resorts’ collective vision and strategy is to please guests, its managers might establish the following overall objectives: Perspective Objective Financial (investors) Increase guests’ spending at the resort. Learning and growth (employees) Continually cross-train employees in each other’s duties to sustain premium-quality service for guests. Internal business processes Leverage market position by introducing and improving innovative marketing and technology-driven advances that clearly benefit guests. Customers Create new premium-price experiences and facilities for vacations in all seasons. These overall objectives are then translated into specific performance objectives and measures for specific managers. Figure 8-1 summarizes how Vail 304 CHAPTER 8 Performance Management and Evaluation FIGURE 8-1 Sample Balanced Scorecard of Linked Objectives, Performance Measures, and Targets Financial (Investors’) Perspective Objective Increase guest vacation spending Performance Measure Annual percentage growth in lift-ticket sales Target Increase number of lift tickets sold by at least 10% per year Customer Perspective Objective Premium price experiences for a welldeserved vacation Performance Measure PEAKS points earned Internal Business Processes Perspective Objective Target Increase PEAKS points earned by at least 10% per year Leverage market position by innovative marketing and technology PLEASING GUESTS Performance Measure Ski-lift cycle time Target Decrease average ski-lift cycle time by 10% per year Learning and Growth (Employees’) Perspective Objective Staff well known for quality service Performance Measure Number of tasks in which employees are crosstrained Target Each employee crosstrained in at least five tasks Source: Adapted from Robert S. Kaplan and David P. Norton, “Using the Balanced Scorecard as a Strategic Management System,” Harvard Business Review, January–February 1996. Resort’s managers might link their organization’s vision and strategy to objectives, then link the objectives to logical performance measures, and, finally, set performance targets for a ski lift manager. As a result, a ski lift manager will have a variety of performance measures that balance the perspectives and needs of all stakeholders. Performing Managers use the mutually agreed-upon strategic and tactical objectives for the entire organization as the basis for decision making within their individual areas of responsibility. This practice ensures that they consider the needs of all stakeholder groups and shows how measuring and managing performance for some stakeholder groups can lead to improved performance for another stakeholder group. Specifically, improving the performance of indicators like internal business processes and learning and growth will create improvements for customers, which in turn will result in improved financial performance. For example, when making decisions about available ski lift capacity, the ski lift manager at Vail Resorts will balance such factors as lift ticket sales, snow conditions, equipment reliability, trained staff availability, and length of wait for ski lifts. When managers understand the causal and linked relationship between their actions and their company’s overall performance, they can see new ways to be more effective. For example, a ski lift manager may hypothesize that shorter waiting lines for the ski lifts would improve customer satisfaction and lead to more visits to the ski lift. The manager could test this possible cause-and-effect relationship by measuring and tracking the length of ski lift waiting lines and the number of visits to the ski lift. If a causal relationship exists, the manager can improve the Responsibility Accounting 305 performance of the ski lift operation by doing everything possible to ensure that waiting lines are short because a quicker ride to the top will result in improved results for the operation and for other perspectives as well. Evaluating Managers compare performance objectives and targets with actual results to determine if the targets were met, what measures need to be changed, and what strategies or objectives need revision. For example, the ski lift manager at Vail Resorts would analyze the reasons for performance gaps and make recommendations to improve the performance of the ski lift area. Communicating A variety of reports enable managers to monitor and evaluate performance measures that add value for stakeholder groups. For example, the database makes it possible to prepare financial performance reports, customer PEAKS statements, internal business process reports for targeted performance measures and results, and performance appraisals of individual employees. The balanced scorecard adds dimension to the management process. Managers plan, perform, evaluate, and communicate the organization’s performance from multiple perspectives. By balancing the needs of all stakeholders, managers are more likely to achieve their objectives in both the short and the long term. STOP & APPLY Molly Sams wants to measure customer satisfaction within her sales region. Link an appropriate performance measure with each balanced scorecard perspective. Customer Satisfaction 1. Financial (investors) 2. Learning and growth (employees) 3. Internal business processes 4. Customers Possible Performance Measures a. Number of cross-trained staff b. Customer satisfaction rating c. Time lapse from order to delivery d. Dollar sales to repeat customers SOLUTION 1. d; 2. a; 3. c; 4. b Responsibility Accounting LO2 Define responsibility accounting, and describe the role that responsibility centers play in performance management and evaluation. As part of their performance management systems, many organizations assign resources to specific areas of responsibility and track how the managers of those areas use those resources. For example, Vail Resorts assigns resources to its Lodging, Dining, Retail and Rental, Ski School, and Real Estate divisions and holds the managers of those divisions responsible for generating revenue and managing costs. Within each division, other managers are assigned responsibility for such areas as Children and Adult Ski School, Snowboard School, or Private Lessons. All managers at all levels are then evaluated in terms of their ability to manage their areas of responsibility in keeping with the organization’s goals. To assist in performance management and evaluation, many organizations use responsibility accounting. Responsibility accounting is an information system that classifies data according to areas of responsibility and reports each area’s activities by including only the revenue, cost, and resource categories that the 306 CHAPTER 8 Performance Management and Evaluation assigned manager can control. A responsibility center is an organizational unit whose manager has been assigned the responsibility of managing a portion of the organization’s resources. The activities of a responsibility center dictate the extent of a manager’s responsibility. A report for a responsibility center should contain only the costs, revenues, and resources that the manager of that center can control. Such costs and revenues are called controllable costs and revenues because they are the result of a manager’s actions, influence, or decisions. A responsibility accounting system ensures that managers will not be held responsible for items that they cannot change. Types of Responsibility Centers There are five types of responsibility centers: (1) cost centers, (2) discretionary cost centers, (3) revenue centers, (4) profit centers, and (5) investment centers. The key characteristics of the five types of responsibility centers are summarized in Table 8-1. Cost Centers A responsibility center whose manager is accountable only for controllable costs that have well-defined relationships between the center’s resources and certain products or services is called a cost center. Manufacturing companies like Apple Computer use cost centers to manage assembly plants, where the relationship between the costs of resources (direct material, direct labor) and the resulting products is well defined. Service organizations use cost centers to manage activities in which resources are clearly linked with a service that is provided at no additional charge. For example, in nursing Research and development units, such as the one shown here, are a type of discretionary cost center in which a manager is accountable for costs only and the relationship between resources and products or services produced is not well defined. A common performance measure used to evaluate research and development activities is the number of patents obtained. Courtesy of Image Source/Getty Images. Responsibility Accounting TABLE 8-1 Types of Responsibility Centers Responsibility Center Cost center Discretionary cost center Revenue center Profit center Investment center Manager Accountable For Only controllable costs, where there are well-defined links between the costs of resources and the resulting products or services Only controllable costs; the links between the costs of resources and the resulting products or services are not well defined How Performance Is Measured Compare actual costs with flexible and master budget costs Analyze resulting variances Compare actual noncost-based measures with targets Determine compliance with preapproved budgeted spending limits Revenue generation Compare actual revenue with budgeted revenue Analyze resulting variances Compare actual Operating income resulting from variable costing controllable income statement revenues and costs with the budgeted income statement Controllable Return on revenues, costs, and investment the investment of Residual income resources to achieve Economic value organizational goals added 307 Examples Product: Manufacturing assembly plants Service: Food service for hospital patients Product or service: Administrative activities such as accounting, human resources, and research and development Product: Phone or e-commerce sales for pizza delivery Service: Reservation center on Internet Product or service: Local store of a national chain Product: A division of a multinational corporation Service: A national office of a multinational consulting firm homes and hospitals, there is a clear relationship between the costs of food and direct labor and the number of inpatient meals served. The performance of a cost center is usually evaluated by comparing an activity’s actual cost with its budgeted cost and analyzing the resulting variances. You will learn more about this performance evaluation process in the chapter on standard costing. Discretionary Cost Centers A responsibility center whose manager is accountable for costs only and in which the relationship between resources and the products or services produced is not well defined is called a discretionary cost center. Departments that perform administrative activities, such as accounting, human resources, and legal services, are typical examples of discretionary cost centers. These centers, like cost centers, have approved budgets that set spending limits. 308 CHAPTER 8 Performance Management and Evaluation Because the spending and use of resources in discretionary cost centers are not clearly linked to the production of a product or service, cost-based measures usually cannot be used to evaluate performance (although such centers are penalized if they exceed their approved budgets). For example, among the performance measures used to evaluate the research and development activities are the number of patents obtained and the number of cost-saving innovations that are developed. At service organizations, such as the United Way, a common measure of administrative activities is how low their costs are as a percentage of total contributions. Revenue Centers A responsibility center whose manager is accountable primarily for revenue and whose success is based on its ability to generate revenue is called a revenue center. Examples of revenue centers are Hertz’s national car reservation center and the clothing retailer Nordstrom’s ecommerce order department. A revenue center’s performance is usually evaluated by comparing its actual revenue with its budgeted revenue and analyzing the resulting variances. Performance measures at both manufacturing and service organizations may include sales dollars, number of customer sales, or sales revenue per minute. Profit Centers A responsibility center whose manager is accountable for both revenue and costs and for the resulting operating income is called a profit center. A good example is a local store of a national chain, such as Wal-Mart or Jiffy Lube. The performance of a profit center is usually evaluated by comparing the figures on its actual income statement with the figures on its master or flexible budget income statement. Investment Centers A responsibility center whose manager is accountable for profit generation and can also make significant decisions about the resources that the center uses is called an investment center. For example, the president of Harley-Davidson’s Buell subsidiary and the president of Brinker International’s Chili’s Grill and Bar can control revenues, costs, and the investment of assets to achieve organizational goals. The performance of these centers is evaluated using such measures as return on investment, residual income, and economic value added. These measures are used in all types of organizations, both manufacturing and nonmanufacturing, and are discussed later in this chapter. Organizational Structure and Performance Management Much can be learned about an organization by examining how its managers organize activities and resources. A company’s organizational structure formalizes its lines of managerial authority and control. An organization chart is a visual representation of an organization’s hierarchy of responsibility for the purposes of management control. Within an organization chart, the five types of responsibility centers are arranged by level of management authority and control. By examining a typical corporate organization chart, you can see how a responsibility accounting system works. Figure 8-2 shows part of the management structure for the Restaurant Division of a major hospitality corporation. Notice that the figure shows examples of all five types of responsibility centers. Responsibility Accounting 309 FIGURE 8-2 Partial Organization Chart of a Restaurant Division DIVISION PRESIDENT Consuelo Jorges (Investment Center) VICE PRESIDENT—RESTAURANTS VICE PRESIDENT—FOOD PRODUCTS Orlena Torres (Cost Center) Ruben Lopez (Profit Center) TRENTON RESTAURANT (Profit Center) OTHER RESTAURANTS (Profit Centers) CENTRAL KITCHEN (Cost Center) VICE PRESIDENT—ADMINISTRATION Manuel Segundo (Discretionary Cost Center) HUMAN RESOURCES (Discretionary Cost Center) DELIVERY SALES CENTER (Revenue Center) PHYSICAL RESOURCES (Discretionary Cost Center) FINANCIAL RESOURCES (Discretionary Cost Center) In a responsibility accounting system, the performance reports for each level of management are tailored to each manager’s individual needs for information. As information moves up the organizational chart, it is usually condensed. Performance reporting by responsibility level enables an organization to trace the source of a cost, revenue, or resource to the manager who controls it and to evaluate that manager’s performance accordingly. STOP & APPLY Identify the most appropriate type of responsibility center for each of the following organizational units: 1. A pizza store in a pizza chain 2. The ticket sales center of a major airline 3. The food service function at a nursing home 4. A subsidiary of a business conglomerate 5. The information technology area of a company SOLUTION 1. Profit center 2. Revenue center 3. Cost center 4. 5. Investment center Discretionary cost center