Consider our equipment-replacement example in light of the five-step sequence in Exhibit 12-1:
Every step depicted in the flow chart lead to the next corresponding step with feedback at each step. The details of the flow chart are as follows:
Step 1 is to identify the problem and uncertainties.
Step 2 is to obtain information.
Step 3 is to make predictions about the future.
Step 4 is to make decisions by choosing among alternatives.
Step 5 is to implement the decision, evaluate performance, and learn.
The decision model (Step 4), which is presented in Exhibits 12-11 and 12-12, dictates replacing the machine rather than keeping it. In the real world, however, would the manager replace the machine? An important factor is the manager’s perception of whether the decision model is consistent with how the company will judge his or her performance after the decision is implemented (the performance-evaluation model in Step 5).
From the perspective of their own careers, managers tend to favor the alternative that makes their performance look better. In our earlier examples, the decision model and the performance-evaluation model were consistent. If, however, the performance-evaluation model conflicts with the decision model, the performance-evaluation model often prevails in influencing managers’ decisions. The following table compares Toledo’s accrual accounting income for the first year and the second year when the manager decides to keep the machine versus when the manager decides to replace the machine.
The table depicts revenues, operating costs, and operating income or loss for the first and second year, whether keeping or replacing the machine. The details of the table are as follows:
1. Revenues
2. Operating costs, cash-operating costs:
3. Operating costs, depreciation:
4. Operating costs, loss on disposal:
5. Total operating costs:
6. Operating income or loss:
Total accrual accounting income for the 2 years together is $120,000 higher if the machine is replaced, as in Exhibit 12-11. But if the promotion or bonus of the manager at Toledo hinges on his or her first year’s operating-income performance under accrual accounting, the manager would be very tempted to keep the old machine. Why? Because the accrual accounting model for measuring performance will show a first-year operating income of $100,000 if the old machine is kept versus an operating loss of $20,000 if the machine is replaced. Even though top management’s goals encompass the 2-year period (consistent with the decision model), the manager will focus on first-year results if top management evaluates his or her performance on the basis of short-run measures such as the first-year’s operating income.
It is often difficult to resolve the conflict between the decision model and the performance-evaluation model. In theory, resolving the difficulty seems obvious: Senior managers should design models that are consistent. Consider our replacement example. Year-by-year effects on operating income of replacement can be budgeted for the 2-year planning horizon. The lower-level manager then would be evaluated on the expectation that the first year would be poor and the next year would be much better. Doing this for every decision, however, makes the performance-evaluation model very cumbersome. As a result of these practical difficulties, accounting systems rarely track each decision separately. Performance evaluation focuses on responsibility centers for a specific period, not on projects or individual items of equipment over their useful lives. Thus, the effects of many different decisions are combined in a single performance report and evaluation measure, say operating income. Lower-level managers make decisions to maximize operating income, and top management—through the reporting system—is rarely aware of particular desirable alternatives that lower-level managers did not choose because of conflicts between the decision and performance-evaluation models.
Consider another conflict between the decision model and the performance-evaluation model. Suppose a manager buys a particular machine only to discover shortly afterward that he or she could have purchased a better machine instead. The decision model may suggest replacing the machine that was just bought with the better machine, but will the manager do so? Probably not. Why? Because replacing the machine so soon after its purchase will reflect badly on the manager’s capabilities and performance. If the manager’s bosses have no knowledge of the better machine, the manager may prefer to keep the recently purchased machine rather than alert them to the better machine.
Many managers consider it unethical to take actions that make their own performance look good when these actions are not in the best interests of the firm. But critics believe that it was precisely these kinds of behaviors that contributed to the global financial crisis in 2008. To discourage such behaviors, managers develop codes of conduct, emphasize values, and build cultures that focus on doing the right things. Chapter 24 discusses performance-evaluation models, ethics, and ways to reduce conflict between the decision model and the performance-evaluation model in more detail.