Performance Management
Variances and responsibility
Responsibility centers are cost, revenue, profit, and investment centers; each should be evaluated only on controllable items. Direct materials price variance = actual quantity purchased x (actual price - standard price). Direct materials quantity variance = standard price x (actual quantity used - standard quantity allowed). Labor rate and efficiency variances follow the same structure. The purchasing manager normally owns the price variance; the production manager owns the quantity and efficiency variances.
Investment center metrics
- ROI = operating income / average operating assets = margin x turnover.
- Residual income = operating income - (required rate of return x average operating assets).
- EVA = after-tax operating profit - (WACC x invested capital), with accounting adjustments.
Traps
A division manager judged on ROI may reject a project that earns more than the company's hurdle rate but less than the division's current ROI - the classic goal-congruence failure; residual income reduces this problem. Watch whether the question says average or ending assets, and whether income is before or after tax.
Balanced scorecard and transfer pricing
The balanced scorecard links four perspectives in a cause-and-effect chain: learning and growth, internal process, customer, and financial. Transfer pricing uses the general rule: the minimum (floor) is variable cost plus opportunity cost, the maximum (ceiling) is the market price. Idle capacity drops the opportunity cost to zero, so the floor becomes variable cost.
Worked example
Division operating income $180,000; average operating assets $900,000; required return 15%. ROI = 180,000 / 900,000 = 20%. Residual income = 180,000 - (0.15 x 900,000) = 180,000 - 135,000 = $45,000. If the division's ROI is the only criterion, a new project returning 17% would be rejected although it beats the 15% hurdle rate.