Accounting: The Language of Business - Vol. 1 (Part 145)

Without market prices for capital goods, accounting is not possible. You don't know if you are making money or losing money, saving resources or wasting them, doing the right thing or not doing the right thing.

Llewellyn Rockwell

Performance Evaluation for Decentralized Operations (Part D)

by

Charles Lamson

Residual Income

An additional measure of evaluating divisional performance---residual income---is useful in overcoming some of the disadvantages associated with the rate of return on investment. Residual income is the excess of income from operations over a minimum acceptable income from operations, as illustrated below.

The minimum acceptable income from operations is normally computed by multiplying a minimum rate of return by the amount of divisional assets. The minimum rate is set by top management, based on such factors as the cost of financing the business operations. To illustrate, assume that DataLink Inc. has established 10% as the minimum acceptable rate of return on divisional assets. The residual incomes for the three divisions are as follows:

The  Northern Division has more residual income than the other divisions, even though it has the least amount of income from operations. This is because the assets on which to earn a minimum acceptable rate of return are less for the Northern Division than for the other divisions.

The major advantage of residual income as a performance measure is that it considers both the minimum acceptable rate of return and the total amount of the income from operations earned by each division. Residual income encourages division managers to maximize income from operations in excess of the minimum. This provides an incentive to accept any project that is expected to have a rate of return in excess of the minimum. Thus, the residual income number supports both divisional and overall company objectives.

The Balanced Scorecard

The balanced scorecard was developed by R.S. Kaplan and D.P. Norton and explained in The Balanced Scorecard: Translating Strategy into Action (Cambridge. Harvard Business School press Kerala 1996).

In addition to financial divisional performance measures, many companies are also relying on nonfinancial divisional measures. One popular evaluation approach is the balanced scorecard. The balanced scorecard is a set of financial and nonfinancial measures that reflect multiple performance dimensions of a business. A common balanced scorecard design measures performance in the innovation and learning, customer, internal, and financial dimensions of a business. These four areas can be diagrammed as shown in Exhibit 7.

EXHIBIT 7 The Balanced Scorecard

The innovation and learning perspective measures the amount of innovation in an organization. For example, a drug company, such as Merck, would measure the number of drugs in its FDA (Food and Drug Administration) approval pipeline, the amount of research and development (R&D) spending per period, and the length of time it takes to turn ideas into marketable products. Managing the performance of its R&D processes is critical to Merck's longer-term prospects and thus would be an additional performance perspective beyond the financial numbers. The customer perspective would measure customer satisfaction, loyalty, and perceptions. For example, amazon.com measures the number of repeat visitors to its website as a measure of customer loyalty. Amazon.com needs repeat business because the costs to acquire a new customer are very high. The internal process perspective measures the effectiveness and efficiency of internal business processes. For example, an automobile manufacturer measures quality by the average warranty claims per automobile, measures efficiency by the average labor hours per automobile, and measures the average time to assemble each automobile. The financial perspective measures the economic performance of the responsibility center. All companies will use financial measures. The measures most commonly used are income from operations as a percent of sales and rate of return on investment.

The balanced scorecard is designed to reveal the underlying nonfinancial drivers, or causes, of financial performance. For example, if a business improves customer satisfaction, this will likely lead to improved financial performance. In addition, the balanced scorecard helps managers consider trade-offs between short and long-term performance. For example, additional investment and research and development (R&D) would penalize the short-term financial perspective, because R&D is an expense that reduces income from operations. However, the Innovation perspective would measure additional R&D expenditures favorably, Because current R&D expenditures will lead to future profits from new products. The balanced scorecard will motivate the manager to invest in new R&D, even though it is recognized as a current period expense. A survey by Bain & Co., a consulting firm, indicated that 62% of large companies use the balanced scorecard (Bain & Co., "Management Tools 2003."). Thus, the balanced scorecard is gaining acceptance because of its ability to reveal the underlying causes of financial performance, while helping managers consider the short and long-term implications of their decisions. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 964-966*

end