Chapter 22 Chapter 22

Control: Control: The Management Control The Management Control

EnvironmentEnvironment

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Management ControlManagement Control

This chapter addresses the control This chapter addresses the control process and the use of accounting process and the use of accounting information in that process.information in that process.

The activity “strategy formulation” The activity “strategy formulation” develops strategies to attain an develops strategies to attain an organization’s goals.organization’s goals.

Strategies change whenever a new Strategies change whenever a new opportunity or a new threat is perceived.opportunity or a new threat is perceived.

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Management Control ProcessManagement Control Process

Process by which managers influence Process by which managers influence members of the organization to implement members of the organization to implement the organization’s strategies efficiently and the organization’s strategies efficiently and effectively.effectively.

Takes goals and strategies as given. Takes goals and strategies as given. Seeks to assure that the strategies are Seeks to assure that the strategies are

implemented.implemented. Includes planning.Includes planning.

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Two Parts of PlanningTwo Parts of Planning

A statement of objectives.A statement of objectives.

Resources required to achieve those Resources required to achieve those objectives.objectives.

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Goals and ObjectivesGoals and Objectives

Terms often used interchangeably. Terms often used interchangeably. Goals = broad, usually non-quantitative, Goals = broad, usually non-quantitative,

long run plans relating to the organization long run plans relating to the organization as a whole.as a whole.

Objectives = more specific, often Objectives = more specific, often quantitative, shorter run plans for quantitative, shorter run plans for individual responsibility centers.individual responsibility centers.

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The EnvironmentThe Environment

Four facets of the management control Four facets of the management control environment:environment: Nature of organizations.Nature of organizations. Rules, guidelines and procedures that govern Rules, guidelines and procedures that govern

the actions of the organization’s members.the actions of the organization’s members. The organization’s culture.The organization’s culture. External environment.External environment.

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The Nature of OrganizationsThe Nature of Organizations

Organization: a group of human beings Organization: a group of human beings who work together for one or more who work together for one or more purposes.purposes.

Managers or the management: Leaders Managers or the management: Leaders who perform important tasks.who perform important tasks.

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Tasks of ManagementTasks of Management Determining goals.Determining goals. Determining objectives to achieve the goals.Determining objectives to achieve the goals. Communicating goals and objectives.Communicating goals and objectives. Determining tasks to be performed to achieve Determining tasks to be performed to achieve

objectives.objectives. Coordination.Coordination. Matching individuals to tasks.Matching individuals to tasks. Motivating.Motivating. Observing/monitoring employee performance.Observing/monitoring employee performance. Taking corrective action as needed.Taking corrective action as needed.

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Organization Hierarchy.Organization Hierarchy.

= Layers of management with authority running from top = Layers of management with authority running from top to bottom.to bottom.

Optimal number of subordinates: (10?)Optimal number of subordinates: (10?) Organization chart.Organization chart. Line units Line units their activities are associated with achieving their activities are associated with achieving

the objectives of the organization. (They produce and the objectives of the organization. (They produce and market goods or services.)market goods or services.)

Staff units Staff units exist to provide support services to other exist to provide support services to other units and to the chief executive officer (CEO).units and to the chief executive officer (CEO).

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Rules, Guidelines, and Rules, Guidelines, and ProceduresProcedures

Influence the way members behave.Influence the way members behave.

Written, or verbal; formal, or informal.Written, or verbal; formal, or informal.

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CultureCulture

Norms of behavior determined by:Norms of behavior determined by: Tradition.Tradition. External influences.External influences. Attitudes of senior management and the Attitudes of senior management and the

board of directors (BOD).board of directors (BOD).

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External EnvironmentExternal Environment

Everything outside of the organization Everything outside of the organization itself.itself.

E.g., customers, suppliers, competitors, E.g., customers, suppliers, competitors, regulatory agencies.regulatory agencies.

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Responsibility AccountingResponsibility Accounting

Involves a continuous flow of information Involves a continuous flow of information that corresponds to the continuous flow of that corresponds to the continuous flow of inputs into, and outputs from, an inputs into, and outputs from, an organization’s responsibility centers. organization’s responsibility centers.

Usage of various resources are measured Usage of various resources are measured directly in or converted to a monetary directly in or converted to a monetary measure.measure.

Focuses on responsibility centers.Focuses on responsibility centers.

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Full Cost AccountingFull Cost Accounting

Focuses on goods and services. Focuses on goods and services.

Responsibility accounting is a different Responsibility accounting is a different ways of slicing the same pie.ways of slicing the same pie.

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Responsibility CentersResponsibility Centers

Commonly perform work related to several Commonly perform work related to several products.products.

Inputs to a responsibility center are called Inputs to a responsibility center are called cost elements or line items (on a cost elements or line items (on a department cost report).department cost report).

Costs have three different dimensions:Costs have three different dimensions:

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Dimensions of CostsDimensions of Costs

Responsibility center. Where was cost Responsibility center. Where was cost incurred?incurred?

Product dimension. For what output was Product dimension. For what output was the cost incurred?the cost incurred?

Cost element dimension. What type of Cost element dimension. What type of resource was used?resource was used?

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Effectiveness and EfficiencyEffectiveness and Efficiency

Effectiveness = how well the responsibility Effectiveness = how well the responsibility center does its job.center does its job.

Efficiency = the amount of output per unit Efficiency = the amount of output per unit of input.of input.

Lower cost is more efficient.Lower cost is more efficient.

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Limitations of Actual Costs Limitations of Actual Costs Compared to StandardCompared to Standard

Not an accurate measure of efficiency for Not an accurate measure of efficiency for at least 2 reasons:at least 2 reasons: Recorded costs are not precisely accurate Recorded costs are not precisely accurate

measures of resources consumed.measures of resources consumed. Standard are at best only approximate Standard are at best only approximate

measures of what resource consumption measures of what resource consumption ideally should have been in the circumstances ideally should have been in the circumstances prevailing.prevailing.

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Types of Responsibility CentersTypes of Responsibility Centers

Important business goal: earn a satisfactory Important business goal: earn a satisfactory return on investment:return on investment:

ROI = (Revenues - Expenses) / InvestmentROI = (Revenues - Expenses) / Investment Leads to 4 types of responsibility centers:Leads to 4 types of responsibility centers:

Revenue centers.Revenue centers. Expense centers.Expense centers. Profit centers.Profit centers. Investment centers.Investment centers.

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Revenue CenterRevenue Center

Responsible for outputs of center as measured Responsible for outputs of center as measured in monetary terms (revenues). in monetary terms (revenues).

Not responsible for the costs of goods or Not responsible for the costs of goods or services that the center sells.services that the center sells.

E.g., sales organization.E.g., sales organization. Also responsible for selling expenses (e.g., Also responsible for selling expenses (e.g.,

travel, advertising, point-of-purchase displays, travel, advertising, point-of-purchase displays, sales office salaries, rent).sales office salaries, rent).

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Expense CentersExpense Centers

Responsible for expenses (i.e., the costs) Responsible for expenses (i.e., the costs) incurred but does not measure its outputs incurred but does not measure its outputs in terms of revenues.in terms of revenues.

E.g., production departments, staff units E.g., production departments, staff units such as accounting.such as accounting.

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Standard or Engineered Cost Standard or Engineered Cost Center Center

Expense center for which many of its cost Expense center for which many of its cost elements have standard costs established.elements have standard costs established.

Differences between standard costs and Differences between standard costs and actual costs are variances.actual costs are variances.

E.g., production cost centers, fast food E.g., production cost centers, fast food restaurants, and blood testing laboratories.restaurants, and blood testing laboratories.

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Discretionary Expense CenterDiscretionary Expense Center

Also called managed cost center.Also called managed cost center.

Difficult to measure output in monetary Difficult to measure output in monetary terms.terms.

Production support and corporate staff.Production support and corporate staff.

E.g., human resources, accounting, R&D.E.g., human resources, accounting, R&D.

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Profit CentersProfit Centers

Performance measured as difference Performance measured as difference between revenues and expenses.between revenues and expenses.

E.g., independent division of a company, E.g., independent division of a company, factory that sells its output to the factory that sells its output to the marketing division.marketing division.

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Advantage of Profit CenterAdvantage of Profit Center

Encourages managers to act as if they are Encourages managers to act as if they are running their own business.running their own business.

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Criteria for Profit CenterCriteria for Profit Center

Involves extra record keeping.Involves extra record keeping. Only useful if manager influences both revenues, Only useful if manager influences both revenues,

and costs.and costs. If senior management requires service performed If senior management requires service performed

by other responsibility center at no charge, then not by other responsibility center at no charge, then not a profit center, e.g., internal audit.a profit center, e.g., internal audit.

If output is homogeneous (e.g., tons) no advantage If output is homogeneous (e.g., tons) no advantage to monetary measure of revenue.to monetary measure of revenue.

Multiple profit centers creates spirit of competition. Multiple profit centers creates spirit of competition.

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Transfer PricesTransfer Prices

Price at which goods or services are sold Price at which goods or services are sold between responsibility centers within a between responsibility centers within a company.company.

Revenue for selling center and cost for the Revenue for selling center and cost for the receiving center.receiving center.

2 general types of transfer prices:2 general types of transfer prices: Market based price.Market based price. Cost based price.Cost based price.

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Market-based Transfer PricesMarket-based Transfer Prices

Based on price for same product between Based on price for same product between independent parties, i.e., a market price independent parties, i.e., a market price or, equivalently, an arm’s length price.or, equivalently, an arm’s length price. Adjusted for quantifiable differences such as Adjusted for quantifiable differences such as

credit costs.credit costs. Where available is widely used.Where available is widely used. Frequently not available.Frequently not available.

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Cost-Based Transfer PricesCost-Based Transfer Prices

When no reliable market price is available.When no reliable market price is available.

Cost plus a mark-up.Cost plus a mark-up.

If based on actual cost, little incentive to If based on actual cost, little incentive to reduce costs.reduce costs.

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Transfer Pricing IssuesTransfer Pricing Issues

Negotiated by responsibility centers or Negotiated by responsibility centers or set/arbitrated by top management.set/arbitrated by top management.

Should manager have freedom to use Should manager have freedom to use alternative source?alternative source?

Sub-optimization: maximize profits for a Sub-optimization: maximize profits for a responsibility center may not maximize responsibility center may not maximize profit for the consolidated company.profit for the consolidated company.

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Investment CenterInvestment Center

Responsible for use of assets as well as Responsible for use of assets as well as profits.profits.

Expected to earn a satisfactory return on Expected to earn a satisfactory return on assets employed in the responsibility assets employed in the responsibility center.center.

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Measures of PerformanceMeasures of Performance

Return on investment = Profit/InvestmentReturn on investment = Profit/Investment

Return on assets = (net income) / (total Return on assets = (net income) / (total assets).assets). Split between ROS and Asset TurnoverSplit between ROS and Asset Turnover

Residual income = Pre-interest profit – Residual income = Pre-interest profit – (Capital charge * investment)(Capital charge * investment)

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Residual IncomeResidual Income

Residual income = Income before taxes Residual income = Income before taxes less a capital charge.less a capital charge.

Capital charge is calculated by applying a Capital charge is calculated by applying a rate to the investment center’s assets or rate to the investment center’s assets or net assets.net assets.

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Advantage of Residual Income Advantage of Residual Income over ROIover ROI

Encourages managers to make all Encourages managers to make all investments whose return is greater than investments whose return is greater than the capital cost rate.the capital cost rate.

ExampleExample

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Advantage of ROI Over Advantage of ROI Over Residual Income:Residual Income:

ROI measures are ratios that can be used ROI measures are ratios that can be used to compare investment centers of different to compare investment centers of different sizes.sizes.

Residual income is an internal number that Residual income is an internal number that is not reported to shareholders and other is not reported to shareholders and other outsiders.outsiders.

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EVA - overviewEVA - overview EVA is simply annual operating profit after-tax--minus a special charge for EVA is simply annual operating profit after-tax--minus a special charge for

the cost of capital. That charge corrects a glaring loophole in standard the cost of capital. That charge corrects a glaring loophole in standard accounting. In financial statements, companies pay nothing for equity accounting. In financial statements, companies pay nothing for equity capital. It looks like free money. But equity is really very expensive. To raise capital. It looks like free money. But equity is really very expensive. To raise money from investors, companies must return at least as much as money from investors, companies must return at least as much as shareholders could earn from a basket of stocks with the same risk--say, shareholders could earn from a basket of stocks with the same risk--say, 12% a year. That's the cost of equity capital. If the company doesn't earn at 12% a year. That's the cost of equity capital. If the company doesn't earn at least its capital cost (blended to include the cost of debt), it can't keep least its capital cost (blended to include the cost of debt), it can't keep attracting new investment. attracting new investment.

Far from being new, EVA, in effect, is one of the long- standing pillars of Far from being new, EVA, in effect, is one of the long- standing pillars of finance theory: Until a company posts a profit greater than its cost of capital, finance theory: Until a company posts a profit greater than its cost of capital, it's not making money for shareholders, no matter how good accounting it's not making money for shareholders, no matter how good accounting earnings look. earnings look.

EVA is changing not only how managers run companies, but the way Wall EVA is changing not only how managers run companies, but the way Wall Street prices them. In the past three years, Credit Suisse First Boston and Street prices them. In the past three years, Credit Suisse First Boston and Goldman Sachs have instructed their analysts to de-emphasize measures Goldman Sachs have instructed their analysts to de-emphasize measures like earnings per share and return on equity in favor of EVAlike earnings per share and return on equity in favor of EVA

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EVA Calculations - Part 1EVA Calculations - Part 1 To figure a company's or operation's economic value added, you must know two To figure a company's or operation's economic value added, you must know two

things: the true cost of capital and how much capital is tied up. Here's a short guide to things: the true cost of capital and how much capital is tied up. Here's a short guide to get you on your way. Most companies pay for two kinds of capital, borrowed and get you on your way. Most companies pay for two kinds of capital, borrowed and equity. It's easy to figure the cost of your borrowed capital--it's simply the interest rate equity. It's easy to figure the cost of your borrowed capital--it's simply the interest rate your banks and bondholders charge. But equity capital, the money stockholders your banks and bondholders charge. But equity capital, the money stockholders provide, is tricky. Although you don't have to write a check for it, don't think it's free. provide, is tricky. Although you don't have to write a check for it, don't think it's free. The true cost is what your shareholders could be earning elsewhere. The true cost is what your shareholders could be earning elsewhere.

To get that figure, you need to know that shareholders generally earn about six To get that figure, you need to know that shareholders generally earn about six percentage points more on stocks than on government bonds. With long-term percentage points more on stocks than on government bonds. With long-term treasury rates around 7.5%, your cost of equity would be about 13.5%--more if you're treasury rates around 7.5%, your cost of equity would be about 13.5%--more if you're in a riskier than average industry. Assuming you use debt as well as equity capital, in a riskier than average industry. Assuming you use debt as well as equity capital, the overall cost is the weighted average of the two. the overall cost is the weighted average of the two.

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EVA Calculations - Part 2EVA Calculations - Part 2 Now you need to figure out how much capital is tied up in your Now you need to figure out how much capital is tied up in your

business. That includes buildings, machines, and computers. business. That includes buildings, machines, and computers. But there's more. What about investments in R&D or training? But there's more. What about investments in R&D or training? Those are meant to pay off over the long haul, but accounting Those are meant to pay off over the long haul, but accounting rules say you have to write them off all at once. Forget the rules say you have to write them off all at once. Forget the accounting rules. Treat them as capital, and give them a useful accounting rules. Treat them as capital, and give them a useful life. If, say, you're spending $20 million developing new life. If, say, you're spending $20 million developing new products this year, add that to your capital base, and add it back products this year, add that to your capital base, and add it back to operating profits. If you expect the product to have a five-year to operating profits. If you expect the product to have a five-year life cycle, deduct $4 million a year from capital--and operating life cycle, deduct $4 million a year from capital--and operating profits--in each of the next five years. profits--in each of the next five years.

Now get out your calculator. Multiply your total capital by your Now get out your calculator. Multiply your total capital by your weighted average cost of capital. Compare that figure with your weighted average cost of capital. Compare that figure with your after-tax operating earnings. If they are greater than your cost of after-tax operating earnings. If they are greater than your cost of capital, have a cigar. You've got a positive EVA, which means capital, have a cigar. You've got a positive EVA, which means you're creating wealth for your shareholders.you're creating wealth for your shareholders.

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EVA - SummaryEVA - Summary EVA is powerful and widely applicable because in the end it doesn't EVA is powerful and widely applicable because in the end it doesn't

prescribe doing anything. If it tried, it would inevitably run aground in certain prescribe doing anything. If it tried, it would inevitably run aground in certain unforeseen situations. Instead it is a method of seeing and understanding unforeseen situations. Instead it is a method of seeing and understanding what is really happening to the performance of a business. Using it, many what is really happening to the performance of a business. Using it, many managers and investors see important facts for the first time. And in managers and investors see important facts for the first time. And in general, they validate EVA's basic premise: If you understand what's really general, they validate EVA's basic premise: If you understand what's really happening, you'll know what to do. happening, you'll know what to do.

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Investment Center IssuesInvestment Center Issues Asset allocation between centers.Asset allocation between centers.

How to value assets (e.g., historical cost or How to value assets (e.g., historical cost or replacement cost).replacement cost).

Most companies control investments in fixed Most companies control investments in fixed assets using capital investment (i.e., capital assets using capital investment (i.e., capital budgeting) procedures addressed in Chapter 27.budgeting) procedures addressed in Chapter 27.

Managers focus their day-to-day efforts on Managers focus their day-to-day efforts on managing current assets, particularly inventories managing current assets, particularly inventories and receivables.and receivables.

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Non-monetary MeasuresNon-monetary Measures

Non-monetary as well as monetary Non-monetary as well as monetary objectives.objectives.

E.g., Quality of goods or services, E.g., Quality of goods or services, customer satisfaction.customer satisfaction.

Management by objectives (MBO) and Management by objectives (MBO) and Balanced Scorecards in Chapter 24.Balanced Scorecards in Chapter 24.