Transcript Chapter 22 – Control: The Management Control Environment

Control:
The Management Control
Environment
Management Control Process
Process by which managers influence
members of the organization to
implement the organization’s strategies
efficiently and effectively.
Seeks to assure that the strategies are
implemented.
Focuses on responsibility centers
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Full Cost Accounting
Focuses on goods and services.
Responsibility accounting is a different
ways of slicing the same pie.
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Responsibility Centers
Commonly perform work related to
several products.
Inputs to a responsibility center are
called cost elements or line items (on a
department cost report).
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Types of Responsibility
Centers
Important business goal: earn a satisfactory
return on investment:
ROI = (Revenues - Expenses) / Investment
Leads to 4 types of responsibility centers:
Revenue centers.
Expense centers.
Profit centers.
Investment centers.
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Revenue Center
Responsible for outputs of center as
measured in monetary terms (revenues).
Not responsible for the costs of goods or
services that the center sells.
E.g., sales organization.
Also responsible for selling expenses (e.g.,
travel, advertising, point-of-purchase displays,
sales office salaries, rent).
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Expense Centers
Responsible for expenses (i.e., the
costs) incurred but does not measure
its outputs in terms of revenues.
E.g., production departments, staff
units such as accounting.
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Profit Centers
Performance measured as difference
between revenues and expenses.
E.g., independent division of a
company, factory that sells its output to
the marketing division.
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Advantage of Profit Center
Encourages managers to act as if they
are running their own business.
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Criteria for Profit Center
Only useful if manager influences both revenues,
and costs.
If senior management requires service performed
by other responsibility center at no charge, than not
a profit center, e.g., internal audit.
If output is homogeneous (e.g., tons) no advantage
to monetary measure of revenue.
Multiple profit centers creates spirit of competition.
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Golub Company
How should corporate spending be
allocated?
Should one division’s performance
impact another division’s costs?
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Watson Company
More allocated costs
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Investment Center
Responsible for use of assets as well as
profits.
Expected to earn a satisfactory return
on assets employed in the responsibility
center.
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Measures of Performance
Return on investment = Profit/Investment
Return on assets = (net income) / (total
assets).
Residual income = Pre-interest profit –
(Capital charge * investment)
EVA is a form of residual income
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What is EVA?
Economic Value Added
EE VE AYE, not a women’s name!
One of a number of shareholder value
metrics.
CFROI, SVA, EP, …
Shareholder value is the goal.
Not inconsistent with stakeholder theory!
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Which firm is better?
Firm A
Firm B
Invested Capital
$1000
$5000
Net income
$200
$750
ROI
20%
15%
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Case 1
Cost of Capital
A
B
$1000
$5000
ROI
20%
15%
Net Income
$200
$750
Capital Charge
$175
$875
Invested Capital
Residual Income
17.5%
$25 $(125)
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Case 1
Opportunity costs matter!
In this case it is the foregone profit of
investing elsewhere at 17.5%
$175 for A
$875 for B
Residual income considers this cost explicitly
while traditional GAAP earnings does not.
Only A exceeds the opportunity cost of capital
and therefore is the only “good” investment.
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Question?
Why not just go with the higher return
on investment? Won’t that lead to the
correct decision just as residual income
does?
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Case 2
Cost of Capital
A
B
$1000
$5000
ROI
20%
15%
Net Income
$200
$750
Capital Charge
$120
$600
$80
$150
Invested Capital
Residual Income
12%
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Case 2
With a 12% opportunity cost of capital
both investments exceed this hurdle
and have positive residual income.
But residual income is higher for B even
though B has a lower (15% versus
20%) return. What is going on?
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Case 2
Think in terms of an extreme example:
How excited would you be to earn 1000%
on your investment if you could only invest
$1? Would you rather earn a smaller
return, say 20%, on a much larger
investment?
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ROI Problems
Feed the Dogs
Starve the Stars
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Summary (1 of 2)
GAAP earnings can lead to investing in and
retaining projects that fail to cover their full
cost of capital, especially if they are internally
financed.
Case 1 – Investment B has positive earnings yet is
a bad investment.
ROIC can lead to starving the stars
(underinvestment) and feeding the dogs
(overinvestment).
Case 2 – Investment A has the higher ROIC but is
not the better investment.
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Summary (2 of 2)
Residual income is able in incorporate both
the magnitude of the return and the
magnitude of the investment in its
calculation. Unlike simple return metrics it
also incorporates the opportunity cost of
capital.
The decision rule is simple. Choose the
investment with the highest residual income
given your opportunity cost of capital.
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Advantage of Residual Income
over ROI
Encourages managers make all
investments whose return is greater
than the capital cost rate.
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Transfer Prices
Price at which goods or services are
sold between responsibility centers
within a company.
Revenue for selling center and cost for
the receiving center.
2 general types of transfer prices:
Market based price.
Cost based price.
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Market-based Transfer Prices
Based on price for same product
between independent parties, i.e., a
market price or, equivalently, an arm’s
length price.
Adjusted for quantifiable differences such
as credit costs.
Where available is widely used.
Frequently not available.
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Cost-Based Transfer Prices
When no reliable market price is
available.
Cost plus a mark-up.
If based on actual cost, little incentive
to reduce costs.
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Transfer Pricing Issues
Negotiated by responsibility centers or
set/arbitrated by top management.
Should manager have freedom to use
alternative source?
Sub-optimization: maximize profits for a
responsibility center may not maximize profit
for the consolidated company.
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Goal Congruence
Organizational goals are goals of top
management and board of directors.
Participants act in their own self interest.
Management control system should be
designed so that incentives/goals of
participants are consistent with the goals of
the organization.
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Some Practice Problems with
Transfer Prices
C. Can Company
Urban Services, Inc.
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Some General Incentive Plan
Examples
Tarrell Company
Concord Publications
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Budgeting
Strategic planning looks forward several
years.
Budgeting focuses on next year.
Budget = a plan expressed in quantitative,
usually monetary, terms that covers a
specified period of time usually one year.
Budget is developed as a result of
negotiations between managers of
responsibility centers and their managers
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Zero-based Review
(Zero-based Budgeting)
A systematic way of analyzing ongoing
programs.
Cost estimates are built up from scratch or zero.
Contrasts with taking the current level of costs
as the starting point as is customarily done in
the budgeting process (i.e., an incremental
approach).
May overcome complacency.
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Limitation of Zero-base
Review
Time consuming and upsetting to
normal functioning.
Cannot be effectively conducted every
year.
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Raises Basic Questions
Questions of a product line or other
activity:
Should this activity be performed at all?
Is too much or too little being done?
Should it be done internally or outside the
firm?
Is there a better way of obtaining the
desired results?
How much should it cost?
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Budget Uses: 1 of 2
Aid in coordinating short run plans.
Essentially a refinement of strategic
plans.
A device for communicating plans.
A way of motivating managers.
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Budget Uses: 2 of 2
A benchmark for controlling ongoing activities.
Actual compared to budget provides a “red flag.”
Directs attention where needed.
A basis for evaluating performance of
responsibility centers and their managers.
A means of educating managers about detailed
workings of their responsibility centers, and
interrelationships with other centers.
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Multiple Use Complications
Planning and control
Budget preparation is a complicated process.
Managers may introduce bias.
Negotiation helps to eliminate bias (also helps
in achieving each of the above uses).
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Negotiation Between
Managers and Superiors
Crucial to usefulness of budget.
Most effective when budget is tight but
attainable.
Slack:
Difference between potential output and actual
output.
A certain amount is desirable otherwise too
much pressure on employees.
Challenge is to keep slack to a reasonable level.
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Setting Guidelines
Major program decisions are not made
through the budget process.
Budget process helps implement
broader planning decisions on programs
previously approved.
Guidelines may include: assumptions
about economic conditions, expected %
of pay increase, allowable promotions.
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The Master Budget
Complete budget package.
3 principal parts, with budgeted balance sheet
Operating budget = Revenues, expenses, and
changes in inventory and other working capital items
for the coming year.
Cash budget = anticipated sources and uses of cash
in the coming year.
Capital expenditure budget = planned changes in
property, plant and equipment.
Budgeted balance sheet is derived from other
budgets.
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Operating Budget
Identical in format to the actual financial statements.
Budget committee consisting of member of top
management prepares guidelines.
Generally, line positions make the significant decisions.
Budgets are usually prepared once a year, covering the
next fiscal year, and are broken down by month.
Some companies preparing a rolling 12-month budget in
which every three months, the quarter just completed is
dropped and three additional months are added on.
OB is a control device used to compare to actual.
Variances are identified.
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Cash Budget
Revenues and expenses from the
operating budget translated into cash
inflows and outflows for cash planning.
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The Capital Expenditure
Budget
List of investments that management
plans to make in long-term (= fixed =
property, plant, and equipment) assets
in the coming year.
Usually separated from preparation of
operating budget.
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Flexible (Variable) Budgets
Shows planned behavior of costs at various
volume levels.
Usually expressed in terms of a cost-volume
relationship
Costs at one particular level, budgeted or
planned level, are used in the operating budget.
Usually same level used for setting standard
costs.
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Practice Problem
Example 7.5 from Schaum’s Outlines
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Cash vs Accrual Budgets
Medieval Adventures
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