CONTROL SYSTEMS AND

PERFORMANCE EVALUATION

• Management Control
• Responsibility Centers
• Perfomance Evaluation
− Return on Investment

− Economic Value Added
− Residual Income

• Transfer Pricing
 MANAGEMENT CONTROL
Procedures, tools, performance measures, and systems
that guide and motivate employees to achieve
organizational objectives.

QUALITIES OF CONTROL SYSTEMS

 Accurate
 Timely
 Consistent
 Flexible

Control Systems and Performance Reporting 2

 CONTROL OF DECENTRALIZED
ORGANIZATIONS

The control process has five steps:

•Planning
•Implementing
•Monitoring
•Evaluating
• Correcting

Control Systems and Performance Reporting 3

 RESPONSIBILITY CENTERS

Responsibility center – organizational unit in which a

manager is accountable for a performance measurement.

• Cost center – manager is

responsible for controlling costs

• Revenue center – manager is

responsible for producing revenues

• Profit center –
manager is responsible for controlling
costs and producing revenues

• Investment center – manager is

responsible for profits and level of
investment

Control Systems and Performance Reporting 4

 RESPONSIBILITY CENTERS
Measuring Performance

Basis of responsibility centers is the controllability principle:

Managers should only be responsible

for results they can control.

Manager Performance
Controls Comparison
Cost Center Costs Budgeted Costs

Revenue Center Revenue Expected

Revenue
Profit Center Costs and Expected Profits
Revenue
Investment Costs, Revenue, Return on
Center and Investment Investment

Control Systems and Performance Reporting 5

 PERFORMANCE EVALUATION
Return on Investment

Return on Operating Income

=
Investment Investment

Return on Operating Income __Sales___

= X
Investment Sales Investment

Return on Profit Asset

= X
Investment Margin Turnover

Return on
= Efficiency X Productivity
Investment

Three ways to improve return on investment:

• Increase sales
• Reduce expenses
• Decrease investment

History
• Devised by F. Donaldson Brown at duPont Chemical
• duPont bought 23% ownership in General Motors
• GM was highly decentralized,
• formula was utilized to account individual divisions

Control Systems and Performance Reporting 6

 PERFORMANCE EVALUATION
Breaking Down Return on Investment
(DuPont Decomposition)

Return on
Investment

Efficienc Productivit

Operatin Sales Sales Total

g Income Investment

Sales Costs Working Permane

Capital nt

Manufa Selling Gen Cash Accts Inven

c-turing and Rec -

Control Systems and Performance Reporting 7

 PERFORMANCE EVALUATION
DuPont Analysis

Evaluating Efficiency How well are expenses controlled?

First Stage
Profit Operating Income
=
Margin Sales

Second Stage
Expenses as a Percent of Sales:
• Material Expenses / Sales
• Labor Expenses / Sales
• Overhead Expenses / Sales
• Selling Expenses / Sales
• Administrative Expenses / Sales

Evaluating Productivity How well are assets used?

First Stage
Asset Sales
=
Turnover Investment

Second Stage
Sales as a Percent of Individual Assets:
This is the receivable
• Sales / Cash turnover ratio.
• Sales / Account Receivable
• Sales / Inventory
• Sales / Property, Plant, and Equipment This is the fixed
asset turnover ratio.

Control Systems and Performance Reporting 8

 PERFORMANCE EVALUATION
Problems with Return on Investment

1. What is the proper denominator?

denominator
• Net Book Value?

• Historical Cost? ROI =

• Net Realizable Value?

2. ROI ignores other success factors such as quality,

quality
service,
service and goodwill.
goodwill

3. ROI sometimes rejects sound investments.

investments
Example:
Example
Current Divisional ROI = 15%
Corporate Expected Rate of Return = 10%.
The division is investigating a project that is expected to
return 12%.

POSITION DECISION REASONING

Company Accept 12% exceeds the expected
corporate rate
Division Reject 12% reduces the divisional
return of 15%

Control Systems and Performance Reporting 9

 PERFORMANCE EVALUATION
Economic Value Added
(Modification of the Traditional Residual Income)

Economic value added is income less the economic cost

of the investment used to generate the income.

EVA = Income – Cost of Capital

Cost of Capital is the required payments to providers of

capital:
You must first
Capital Provider Capital Cost pay back those

Lenders Interest that make

operations
Stockholders Dividends possible.

Interpretation:
Interpretation Shareholders receive added value when
the return from the capital employed in the business
operations is greater than the cost of that capital

Control Systems and Performance Reporting 10

 PERFORMANCE EVALUATION
Economic Value Added

Adjustments to EVA

In reality, EVA is a bit more complex:

Often Income is adjusted for “conservative nature of

GAAP.” For example:
• Research and Development expenses are capitalized.
• Advertising expense is capitalized.
• The increase in the allowance for bad debt is added to
income.
• The increase in the LIFO reserve is added to income.
• Effect of the change in deferred taxes is netted from income.
• Operating leases are assumed to be capital leases.

Capital is reduced by “non interest bearing current

liabilities” such as:
• Customer advances
• Accounts payable
• Accrued liabilities


EVA is trademarked by Stern Stewart & Co.

Control Systems and Performance Reporting 11

 PERFORMANCE EVALUATION
Economic Value Added
EVA Example

Perón Corporation has net income of $12 million. The

company uses $90 million of capital, funded primarily by
8% bonds. What is Perón’s EVA?

EVA = Income – Cost of Capital

EVA = $12 million – ($90 million * 8%)
EVA = $4.8 million

Control Systems and Performance Reporting 12

 PERFORMANCE EVALUATION
EVA of New Investments

Economic Value Added can be utilized to evaluate new

investments:

Cost of Capital = 10%

Expected Rate of Return for Project = 12%
Cost of the Project = $100,000

Project EVA = Expected Income – Cost of Capital

Project EVA = ($100,000 * .12) – ($100,000 * .10)
Project EVA = $100,000 * (.12 - .10)
Project EVA = $100,000 * .02
Project EVA = $2,000
ACCEPT if
Expected Income >

Control Systems and Performance Reporting 13

 PERFORMANCE EVALUATION
Advantages of Economic Value Added

• Encourages managers to think like owners

• Easily understood
• Closely tied to market value of stock
• Focuses on long term

Control Systems and Performance Reporting 14

 PERFORMANCE EVALUATION
Residual Income

Residual income differs from EVA in the calculation of the

subtrahend (the item subtracted from the minuend):

Comparison:
Comparison
Residual Income = Net Income – (Investment * Expected Rate of Return)
EVA = Net Income – Cost of Capital

Example:
Example
A project employing $200,000 of capital is expected to yield
$25,000 in income. The expected rate of return is 10%.

Investment $200,000
Required ROI 10%
Minimum $20,000
Expected Profit $25,000
Residual Income $5,000
The project would be accepted because it yields residual income.

Remember:
Remember EVA uses the dollar cost of capital (interest and
dividends) in the subtrahend. EVA differs from RI:
• EVA asks whether we are exceeding our capital
maintenance costs.
• Residual Income asks whether we are exceeding
investment expectations.

Control Systems and Performance Reporting 15

 Return on Investment versus
Residual Income

Expected ROI for the company = 20%

Currently in the division:

Income = $30,000
Investment = $100,000

ROI = $30,000 / $100,000 = 30%

Proposed:
Proposed A project is proposed that requires an investment of
$30,000 and pays $7,500.

New income = $30,000 + $7,500 = $37,500

New investment = $100,000 + $30,000 = $130,000

New ROI = $37,500 / $130,000 = 28.8%

It is within the best interest of the company to accept this project

(28.8% > 20%). However, acceptance would reduce divisional
ROI (because (28.8% < 30%). ROI
suggests
rejection
When the project is evaluated using Residual Income of the
proposal.
Without With
Project Project
Investment $100,000 $130,000
Required ROI 20% 20%
Minimum $20,000 $26,000 RI
suggests
Profit $30,000 $37,500 acceptanc
Residual Income $10,000 $11,500 e of the
proposal.

Control Systems and Performance Reporting 16

 PERFORMANCE CRITERIA
EXAMPLE
Originally established in 1885 and incorporated in 1921, today Nash Finch Company, headquartered in Minneapolis,
Minnesota, is the second largest publicly traded wholesale food distributor in the United States. Annual sales are
approximately $4.5 billion.

NASH-FINCH COMPANY
2000 STOCK INCENTIVE PLAN
(Amended and Restated Effective July 14, 2008)

The purpose of the Nash-Finch Company 2000 Stock Incentive Plan (the “Plan”) is to support the
maximization of long-term value creation for Nash-Finch Company (the “Company”) and its stockholders
by enabling the Company and its Subsidiaries to attract and retain persons of ability to perform services
for the Company and its Subsidiaries by providing an incentive to such individuals through equity
participation in the Company and by rewarding such individuals who contribute to the achievement by the
Company of its economic objectives. The Plan is hereby amended and restated in its entirety, effective as
of July 14, 2008.
2.16 “Performance Criteria” means the performance criteria that may be used by the Committee in
granting Performance Units or Restricted Stock Awards contingent upon achievement of performance
goals, consisting of specified levels of, or relating to:
(a) customer satisfaction as measured by a Company sponsored customer survey;
(b) employee engagement or employee relations as measured by a Company sponsored survey;
(c) employee safety; (d) employee diversity;
(e) financial performance as measured by
• net sales,
• operating income,
• income before income taxes,
• net income, net income per share (basic or diluted),
• earnings before interest, taxes depreciation and amortization (EBITDA) ,
• profitability as measured by return ratios (including return on assets, return on equity, return on
investment and return on sales),
• cash flows, market share,
• cost reduction goals,
• margins (including one or more of gross, operating and net income margins),
• stock price,
• total return to stockholders,
• economic value added,
• working capital and
• productivity improvements;
(f) retail store performance as determined by independent assessment; and (g) operational performance as
measured by on-time delivery, fill rate, selector accuracy, cost per case, sales per square foot, sales per
labor hour and other, similar, objective productivity measures.

Control Systems and Performance Reporting 17

 TRANSFER PRICING
Transfer pricing – a means of allocating jointly earned
revenue among responsibility centers

Allocaton Methods
Allocation method transfer is based on:
prices determined by an external
Market based
market
cost plus a specified markup (for
Cost Plus based
internal profit)
price negotiated between internal
Negotiated
supplier and buyer
price is determined by
Administered management

Control Systems and Performance Reporting 18

 TRANSFER PRICING
Method Advantages

Method Advantage Disadvantage

Market economically outside market may not
sound exist
Cost + easy to provides no incentive to
impleme the supplier to control
nt costs
Negotiated economically may reflect negotiating
sound skills rather than
economics
Administered easy to Does not provide
implement incentive to centers

Control Systems and Performance Reporting 19

 CASE: TRANSFER PRICING
Mega Corp.

M
ega Corp. negotiates a five-year contract with a major paper
products company to purchase office paper at a significant
discount. Mega set up an Office Supply Center in the
company for distributing office supplies to departments within the
company. The departments are billed for cost plus 10%
“handling”. The cost to departments is
typically 5% below a typical outside supplier.

The Legal Department of Mega can buy legal-

sized paper at $24 per box of ten reams from the
Office Supply Center. However, the purchaser for
the Legal Department noticed the same paper on sale for
$22 through a local office supply company. The purchase
promptly bought 100 boxes for $2,200 in an effort to “save Mega
some money”. [Savings = ($24 - $22) x 100 boxes = $200]

Mega’s Office Supply Center, upon hearing about the purchase,

sought to prevent the Legal Department from making further
purchases of this type. The Office Supply Center claimed they
would be “stuck” with an inordinate supply of “legal-sized” paper
in inventory that is typically not used by other departments. The
Office Supply Center will now be forced to warehouse this paper
for a much longer period of time.

Questions:
Questions Should the Legal Department be allowed to make
such purchases? What factors should be considered in this a
decision?

Control Systems and Performance Reporting 20