STRATEGIC BUSINESS ANALYSIS

Learning Module:
Performance Evalua�on (Responsibility Accoun�ng)

� Learning Objec�ves

Upon successful comple�on of this module, students will be able to:

1. Explain the purpose of performance evalua�on and the "Controllability Principle" that underlies
responsibility accoun�ng.

2. Define and Differen�ate the four types of responsibility centers (Cost, Revenue, Profit, and Investment)
and provide examples of appropriate performance measures for each.

3. Calculate Return on Investment (ROI) using both the standard formula and the DuPont formula (breaking
it down into Profit Margin and Asset Turnover).

4. Calculate Residual Income (RI) and explain how it differs from ROI.

5. Cri�cally Evaluate the use of ROI and RI for performance evalua�on, specifically by explaining the "goal
incongruence" problem associated with ROI and how RI helps to mi�gate it.

6. Calculate Economic Value Added (EVA)

PART 1: THE "WHY" — STRATEGY, ALIGNMENT, AND MOTIVATION

In any large organiza�on, top-level management sets a broad strategy (e.g., "We want to be the top high-quality
airline"). But how do they ensure a-thousands of employees—from baggage handlers to pilots to marke�ng
managers—make daily decisions that support that strategy?

This is the role of performance evalua�on. It is the formal process of:

1. Communica�ng the strategy to all parts of the business.

2. Measuring whether different parts of the business are helping achieve that strategy.

3. Mo�va�ng managers and employees to make decisions that align with the strategy (o�en by linking
bonuses, promo�ons, or recogni�on to these measures).

Two of the most powerful tools to accomplish this are Responsibility Accoun�ng and the Balanced Scorecard.

PART 2: RESPONSIBILITY ACCOUNTING — WHO IS ACCOUNTABLE FOR WHAT?

Responsibility Accoun�ng is a management control system where performance is evaluated by tracking costs and
revenues to the specific individuals (managers) or organiza�onal units (centers) who are responsible for controlling
them.

The primary objec�ves are:

• Performance Evalua�on: To provide a fair and effec�ve way to measure the performance of managers and
their respec�ve centers.

• Control: To empower managers with informa�on they can use to monitor and control the costs and
revenues within their authority.

• Mo�va�on: To mo�vate managers to achieve their center's goals, which should ideally align with the
overall goals of the company (this is called goal congruence).

• Planning: To facilitate a "botom-up" budge�ng process, where managers responsible for costs and
revenues are directly involved in se�ng their own budgets.
STRATEGIC BUSINESS ANALYSIS

The core idea is the Controllability Principle:

Managers should only be evaluated on the costs, revenues, or assets that they can personally control or
significantly influence.

It would be unfair (and demo�va�ng) to penalize a factory manager for high raw material costs if the corporate
purchasing department is the only one with the authority to nego�ate prices.

CONTROLLABLE VS. NON CONTROLLABLE COSTS

Why is this dis�nc�on crucial in Responsibility Accoun�ng?

• Controllable Cost: A cost that a specific manager can significantly influence or change within a given
period.

o Example: The manager of a store can control employee over�me hours, the amount of supplies
ordered, and local adver�sing.

• Non-Controllable Cost: A cost that a manager cannot influence. These are o�en allocated to the center
by corporate headquarters.

o Example: The store manager's own salary (set by their boss), the store's share of the CEO's salary,
or the monthly rent for the building (which was set by a long-term lease signed by corporate).

Why it's Crucial: The core principle of responsibility accoun�ng is fairness. Managers should only be evaluated on
the results they can actually control. Holding a manager accountable for non-controllable costs is demo�va�ng
and leads to an inaccurate and unfair assessment of their performance

TYPES OF ORGANIZATIONAL STRUCTURES:

• Centraliza�on: An organiza�onal structure where top management retains the authority to make most or
all key decisions.

• Decentraliza�on: An organiza�onal structure where decision-making authority is delegated to lower-level

managers (e.g., the managers of responsibility centers).

Responsibility accoun�ng systems are the primary tool for managing a decentralized organiza�on.

Benefits of Decentraliza�on:

• Faster Decisions: Local managers can respond more quickly to local customer needs and market changes
without wai�ng for approval from headquarters.

• Beter Informa�on: Lower-level managers o�en have more detailed, on-the-ground informa�on about
their specific opera�ons, leading to beter decisions.

• Manager Training & Mo�va�on: Gran�ng authority empowers and mo�vates managers. It also serves as
an excellent training ground for future top execu�ves.

• Frees Top Management: It allows senior execu�ves to delegate daily opera�onal problems and focus on
long-term strategy and overall company goals.

ORGANIZATIONAL CHART

An organiza�onal chart is a diagram that visually represents the formal structure of a company. It shows the chain
of command, the lines of authority, and how different departments and divisions are related (i.e., who reports to
whom).
STRATEGIC BUSINESS ANALYSIS

Rela�onship: The responsibility accoun�ng system is built directly on the organiza�onal chart. Each "box" on the
chart (represen�ng a manager, department, or division) is defined as a responsibility center. The repor�ng lines on
the chart dictate how the financial reports (responsibility reports) "roll up" from the lowest levels to the top,
summarizing performance at each managerial level.

RESPONSIBILITY CENTERS

A Responsibility Center is any part of an organiza�on where a manager has authority over and is held accountable
for a specific set of financial results.

The four main types are:

1. Cost Center: A center where the manager is responsible only for costs.

o What is it? A department or unit where the manager has control over costs, but not over revenues
or investment decisions.

o Goal: To minimize costs while maintaining a specified level of quality or output.

o Examples:

1. A factory produc�on department (controls labor, materials, and overhead).

2. An IT help desk (controls staffing and support costs).

3. The accoun�ng department (controls salaries and supplies for its own department).

o How We Evaluate Them: By comparing actual costs to budgeted costs. This is classic variance
analysis. We ask, "Did you control your costs as expected?"

o Performance Measure: Cost control. This is measured by comparing actual costs to budgeted
costs and analyzing the resul�ng cost variances. Efficiency metrics (e.g., cost per unit) are also
used.

2. Revenue Center: A center where the manager is responsible only for genera�ng revenues.

o What is it? A unit where the manager is only responsible for genera�ng revenue. They typically
don't set prices or control the costs of the products they sell.

o Goal: To maximize revenue.

o Examples:

1. A regional sales team (given a price list and a product, their job is to sell as much as
possible).

2. A university's fundraising office.

o How We Evaluate Them: By comparing actual revenues to budgeted revenues or sales quotas.

o Performance Measure: Revenue genera�on. This is measured by comparing actual revenues to

budgeted revenues or sales quotas.

3. Profit Center: A center where the manager is responsible for both revenues and costs (and therefore,
profit).

o What is it? A unit where the manager has control over both revenues and costs.

o Goal: To maximize the center's profit.

o Examples:

1. A single Starbucks store (the manager controls revenues by driving sales and costs like
labor and inventory waste).

2. A product line at a large company (e.g., the "Xbox" division at Microso�).

STRATEGIC BUSINESS ANALYSIS

o How We Evaluate Them: By comparing actual profit to budgeted profit. This uses a profit center
income statement, o�en focusing on Contribu�on Margin or Segment Margin

o Performance Measure: Profitability. This is measured by comparing actual profit (revenues minus
controllable costs) to budgeted profit. The key metric is o�en the controllable margin.

4. Investment Center: A center where the manager is responsible for revenues, costs, and the assets
(investment) used to generate that profit.

o What is it? This is the highest level. The manager controls revenues, costs, AND the assets (the
"investment") used to generate those profits. They have the authority to make large capital-
expenditure decisions, like buying new machinery or opening a new factory.

o Goal: To maximize the return on the assets invested in the center.

o Examples:

1. A major subsidiary (e.g., "PepsiCo North America").

2. An en�re regional division (e.g., "General Electric's Avia�on division").

o How We Evaluate Them: We need more than just profit. We need to know how efficiently they
used the company's money to generate that profit

o Performance Measure: Return on investment. This is measured using ra�os like Return on
Investment (ROI), or dollar-based measures like Residual Income (RI) and Economic Value Added
(EVA).

PART 3: THE "HOW" — MEASURING INVESTMENT CENTER PERFORMANCE

This is where the financial calcula�ons become cri�cal. Let's analyze two common methods.

A. METRIC 1: RETURN ON INVESTMENT (ROI)

ROI is a percentage that shows how much opera�ng profit was earned for every dollar of assets invested.

ROI = Opera�ng Income/Average Opera�ng Assets

• Opera�ng Income: This is before interest and taxes (EBIT), as the divisional manager o�en doesn't
control these.

• Average Opera�ng Assets: (Beginning Assets + Ending Assets) / 2. We use an average because
profit is earned over time.

A Deeper Look: The DuPont Formula

Managers can increase ROI in two ways, shown by spli�ng the formula:

• Profit Margin: How much profit you keep from each sales dollar. You can increase this by cu�ng
costs or raising prices.

• Asset Turnover: How efficiently you use your assets to generate sales. You can increase this by
increasing sales with the same assets or by ge�ng rid of idle assets.

Example:

The "Appliance" division has 1,000,000 in opera�ng income, 10,000,000 in sales, and 5,000,000 in average
assets.
STRATEGIC BUSINESS ANALYSIS

• ROI = 1,000,000 / 5,000,000 = 20%

• Profit Margin = 1,000,000 / 10,000,000 = 10%

• Asset Turnover = 10,000,000 / 5,000,000 = 2

• Check: 10% (Margin) * 2 (Turnover) = 20% (ROI)

Cri�cal Viewpoint: The Problem with ROI

ROI is popular, but it can lead to bad decisions (known as sub-op�miza�on).

• Scenario: The Appliance division manager (with a 20% ROI) is offered a new project. The project
requires a 100,000 investment and will generate 15,000 in opera�ng income.

• Project's ROI: 15,000 / 100,000 = 15%

• Company's View: The company's minimum required return for new projects is only 12%. This 15%
project is good for the company.

• Manager's View: If the manager accepts this 15% project, it will be "averaged in" with their
exis�ng 20% performance, pulling down their division's overall ROI. To protect their bonus (which
is based on achieving the highest possible ROI), the manager rejects the good project.

B. METRIC 2: RESIDUAL INCOME (RI)

Residual Income is an absolute dollar amount, not a percentage. It measures the opera�ng profit earned
above the company's minimum required return on assets.

RI = Operating Income} - (Minimum Required Return x Average Operating Assets)

• Minimum Required Return: Also called the "hurdle rate." This is set by the company (e.g., 12%).

Example (Same Data):

The Appliance division (assets = 5,000,000, op. income = 1,000,000) and the company's minimum
return is 12%.

• Required Return = 12% * 5,000,000 = 600,000

• Residual Income = 1,000,000 (Opera�ng Income) - 600,000 (Required Return) = 400,000

Cri�cal Viewpoint: How RI Solves the ROI Problem

Let's re-evaluate that same project using RI.

• Scenario: The 15% project (15k income on 100k investment).

• Project's RI:

o Required Return = 12% * 100,000 = $12,000

o Project RI = 15,000 (Project Income) - 12,000 (Required Return) = +3,000

• Manager's View: Taking this project adds 3,000 to the division's total Residual Income. The
manager is mo�vated to accept the good project.

• Conclusion: RI beter aligns the manager's goals with the company's goals. Its main weakness is
that it's harder to compare divisions of different sizes (a large division will almost always have a
larger RI than a small one).

C. METRIC 3: ECONOMIC VALUE ADDED

STRATEGIC BUSINESS ANALYSIS

Economic Value Added (EVA) is a specific, o�en trademarked, version of the residual income concept. It
measures the true economic profit of a business by comparing its a�er-tax opera�ng profit to the total
cost of the capital required to generate that profit.

While standard Residual Income (RI) is flexible for internal use, EVA is more formal. Its goal is to align
management's decisions with maximizing shareholder value by making managers accountable for all
capital costs, including equity.

The two key differences from our simpler RI calcula�on are:

1. Profit is A�er-Tax: It uses After-Tax Operating Income.
2. Capital Cost is Specific: It uses the Weighted Average Cost of Capital (WACC) as the minimum
required return and applies it to Total Capital Employed.

EVA = After-Tax Operating Income- (WACC x Total Capital Employed)

• A�er-Tax Opera�ng Income: = Opera�ng Income (1 - Tax Rate)
• Total Capital Employed: = Total Assets - Non-Interest-Bearing Current Liabili�es (This is o�en
similar to Long-Term Debt + Shareholders' Equity).
• WACC (Weighted Average Cost of Capital): This is the blended cost of all the capital the company
uses (both debt and equity). It's the "true" hurdle rate for the company.

Example:
The Appliance division has 1,000,000 in opera�ng income. The company's tax rate is 25%, its WACC is 10%,
and the division's total capital employed is 7,000,000.
1. A�er-Tax Opera�ng Income = 1,000,000 x (1 - 0.25) = 750,000
2. Capital Charge = 10% (WACC) x 7,000,000 (Capital) = 700,000
3. EVA = 750,000 - 700,000 = 50,000
Interpretation: The division created 50,000 in true economic value above and beyond the cost of
all the capital it used. A posi�ve EVA is good; a nega�ve EVA means the division is destroying
shareholder value.

PRACTICAL APPLICATION & CHALLENGES

Common costs (also called service department costs) are costs from central departments like IT, HR, or Legal, which
support mul�ple responsibility centers. These costs cannot be directly traced to one center. The process of
alloca�on involves:

1. Iden�fying the total cost of the service department (e.g., the total cost of the IT department).

2. Choosing an alloca�on base (or "cost driver") that best reflects how the other centers use that service
(e.g., "number of computers" for IT costs, or "square footage" for building rent).

3. Dividing the total common cost by the total alloca�on base to get a rate.

4. Applying that rate to each center based on its usage of the base.

• Example: If the IT department costs 100,000 and there are 100 computers in the company, the rate is 1,000
per computer. A profit center with 20 computers would be allocated 20,000 of IT cost.

Why it's Controversial:

• Non-Controllable: The allocated cost is almost always non-controllable by the center manager. Managers
feel it is unfair to be held accountable for a cost they cannot influence.

• Arbitrary Base: The choice of alloca�on base can feel arbitrary and unfair. A manager might argue, "My
department has 20 computers, but we only call the help desk once a month, while the sales department
calls 20 �mes a day. Why are we paying the same rate?" This leads to disputes and "blame games."
STRATEGIC BUSINESS ANALYSIS

BEHAVIORAL ISSUES:

• Short-Term Focus: If managers are rewarded only on short-term profits or cost control, they may make
decisions that hurt the company in the long run. Example: Cu�ng the R&D budget, skipping essen�al
maintenance, or reducing employee training to meet this quarter's profit target.

• Conflicts Between Centers: It can create a "silo" mentality where managers focus only on their center's
success, even at the expense of another. This discourages coopera�on and teamwork.

• Budgetary Slack: To make targets easier to hit, managers may "pad" their budgets by inten�onally
underes�ma�ng revenues or overes�ma�ng costs. This makes the budget less accurate for planning.

• Sub-op�miza�on: As described earlier, managers may make decisions that are good for their center (e.g.,
rejec�ng a project with a 15% ROI) but bad for the company as a whole.

How to Mi�gate:

1. Beter Performance Metrics: Use Residual Income (RI) or EVA instead of just ROI or profit. This encourages
managers to make any profitable decision for the company.

2. Effec�ve Transfer Pricing: The system (discussed next) is the main way to fix this. A market-based transfer
price of $100 would make the Parts manager "indifferent" to selling internally or externally, and the
Assembly manager would see the true cost of the component.

3. Balanced Scorecard: Include non-financial metrics in the manager's evalua�on, such as "coopera�on with
other divisions" or "contribu�on to total company profit."

Module Summary:

• Responsibility Accoun�ng creates a fair system by evalua�ng managers only on what they can control
(Cost, Revenue, Profit, or Investment).

• ROI and RI are key tools for evalua�ng Investment Centers, but we must be aware of the "goal
incongruence" problem that ROI can create.

• EVA is a specific, trademarked version of Residual Income. It is designed to measure a center's true
economic profit by making more precise adjustments to accoun�ng data. By linking performance directly
to crea�ng value above the true cost of capital, EVA more effec�vely aligns manager decisions with
crea�ng long-term shareholder value.

� CHECKS FOR UNDERSTANDING

Use these ques�ons to test your comprehension of the module's key concepts.

Sec�on 1: Responsibility Accoun�ng

A. Iden�fy the Center: For each scenario below, iden�fy the most likely type of responsibility center (Cost,
Revenue, Profit, or Investment).

1. The manager of the "Kids' Shoes" department at a Nordstrom store. This manager has authority to make
inventory, staffing, and local marke�ng decisions but cannot approve capital spending for store remodels.
2. The corporate legal department of a large manufacturing company.
3. The European division of a mul�na�onal corpora�on. The divisional president has the authority to build
new factories, launch new product lines, and set pricing.
4. A telemarke�ng team that is responsible for booking new client appointments using a script and a
provided list of phone numbers.

B. The Controllability Principle (Short Answer): A plant manager's performance report shows a large, unfavorable
variance for the "Raw Materials Price." This manager is responsible for produc�on schedules and factory labor, but
STRATEGIC BUSINESS ANALYSIS

the company's central purchasing department nego�ates all raw material contracts. Based on the Controllability
Principle, why would it be inappropriate to hold the plant manager accountable for this variance?

C. Calcula�ng Performance (ROI, RI, EVA)

Use the following data for the "Op�cs Division" of a large tech company.

• Opera�ng Income: 3,000,000

• Sales: 20,000,000

• Average Opera�ng Assets: 15,000,000

• Total Capital Employed: 12,000,000

• Company Tax Rate: 30%

• Company Minimum Required Return (Hurdle Rate): 12%

• Company WACC: 10%

Calculate:

A. Return on Investment (ROI):

B. Profit Margin & Asset Turnover:

C. Residual Income (RI):

D. Economic Value Added (EVA):

D. Goal Incongruence (Scenario): The Op�cs Division (from Q3) has an ROI of 20% (3M / 15M). The division
manager is offered a new project that requires a 1,000,000 investment and is expected to generate 150,000 in
opera�ng income. The company's minimum required return is 12%.

• A. What is the new project's ROI?

• B. Will the manager be mo�vated to accept this project if their bonus is based on maximizing ROI? Why
or why not?

• C. Would the manager be mo�vated to accept this project if their bonus was based on maximizing Residual
Income? Show your work.