Chapter 8 Controlling

Advanced Organizer

Chapter Objective Describe some of the important elements for establishing financial controls Explain balance sheets, income statements, ratios. Explain different non-financial control systems

Definition of “Controlling” “compelling events to conform to plans” -- Goetz “Control techniques and actions are intended to insure, as far as possible, that the organization does what management wants it to do.”

Steps in the Control Process 2. Measuring Actual Performance 1. Establish Standards 4. Corrective Action 3. Comparing Performance with Standards Planning Controlling

Steps in the Control Process Establish Standards Technical: Quality, Quantity, MTBF Market: Sales, ROI, Earning Expectation Planning: Objectives, Schedules, Budgets, Policies Safety: OSHA EEO Historical

Steps in the Control Process Establish Standards—by Benchmarking Internal Benchmarking: productivity External Benchmarking Financial Ratios Performance Metrics Best Practices Critical Success Factors Target Pricing Balanced Scorecard: new products, new projects, patents, new partners, new customers, new technology

Steps in the Control Process Measuring Actual Performance Data collection and analysis Time study, work sampling, performance rating Comparing Performance with Standards Establish limits of tolerance Note variations (deviation within limits) and exceptions (deviation outside limits) Provide recognition and warning

Steps in the Control Process Corrective Action Short-term: Consultants, temporary workers Long-term: Training, modifying procedures and policies

Closed-Loop vs. Open-Loop Control Closed-loop control (also known as automatic or cybernetic control) monitors and manages a process by means of a self-regulating system.  Open-loop control (or non-cybernetic control) requires an external monitoring system and/or an external agent to complete the control loop.

Timing of Control Feed-back control Screening or concurrent control Feed-forward (or preliminary or steering) control

Timing of Control Feedback Control (Output) Measures system output and variance with predetermined standard Adjusts system to maintain variance within a specified range

Timing of Control Screening Control (Concurrent) Control applied concurrently with effort being controlled

Timing of Control Feed-forward Control (Steering or Preliminary) Attempts to predict the impact of current actions/events Current decisions are refined to facilitate goal attainment

Characteristics of Effective Control Efficient Timely Flexible Understandable Tailored Highlight deviations Lead to corrective action

Types of Control Financial Human Resource Social

Financial Controls Financial statements provide the basic information for the control of cash and credit, which are essential to the survival of a company. The balance sheet The income statement The cash flow statement

Balance Sheet Total Assets = Total Liability + Owner’s Equity Balance sheet shows the firm's financial position at a particular instant in time (a financial "snapshot.“) Total Assets = Total Liability + Owner’s Equity

Balance Sheet Assets are what the company "owns" Current assets (assets that can be converted into cash within a year) Fixed assets (property, plant, and equipment at original cost, less the cumulative depreciation of plant and equipment [but not land] and depletion of natural resources since they were purchased) Tangibles and Intangibles

Balance Sheet Liabilities are what the firm "owes" Net worth or Equity Current liabilities (must be paid within a year) Long-term debt Net worth or Equity Original investment (what was paid in for common and preferred stock) Retained earnings (the cumulative profits over the years after dividends are paid).

TABLE 8-1 Balance Sheet, Sterling Chemicals, Inc., December 31, 2005 Assets Current assets Cash $150,000 Securities (at cost) 100,000 $250,000 Accounts receivable 400,000 Inventories (at lower of cost or market) Raw materials and supplies 200,000 Work in progress 180,000 Finished goods 300,000 680,000 Prepaid expenses 30,000 Total current assets 1,360,000 Property, plant, and equipment 4,500,000 Less accumulated depreciation 2,400,000 Net property, plant, and equipment 2,100,000 Total Assets $3,460,000

TABLE 8-1 Balance Sheet, Sterling Chemicals, Inc., December 31, 2005 Liabilities and Stockholders' Equity Current liabilities Accounts payable $100,000 Installments due within 1 year 30,000 Federal income and other taxes 250,000 Other accrued liabilities 120,000 Total current liabilities 500,000 Long-term debt 1,000,000 Total Liabilities $1,500,000 Stockholders' equity Capital stock 500,000 Retained earnings 1,460,000 1,960,000 Total liabilities and equity $3,460,000

Income Statement Income statement (also called a profit and loss or revenue and expense statement) shows the financial performance of the firm over a period of time (usually three months or a year).

TABLE 8-2 Income Statement Sterling Chemicals, Inc., December 31, 2005 Gross sales $3,200,000 Less returns and allowances 150,000 Net sales $3,050,000 Less expenses and costs of goods sold Cost of goods sold 2,000,000 Depreciation and depletion 250,000 Selling expenses 100,000 General and admin. expenses 200,000 2,550,000 Operating profit 500,000 Plus interest and other income 60,000 Gross income 560,000

Gross income 560,000 Less interest expense 20,000 TABLE 8-2 Income Statement Sterling Chemicals, Inc., December 31, 2005 Gross income 560,000 Less interest expense 20,000 Income before taxes 540,000 Provision for income taxes 260,000 Net income 280,000 Retained earnings January 1, 2005 1,500,000 1,780,000 Dividends paid 320,000 Retained earnings December 31, 2005 1,460,000

Cash Flow Statement Cash flow statement (or sources and uses of funds statement) shows where funds come from (net profit plus depreciation, increased debt, sale of stock, sale of assets) and what they are used for (plant and equipment, debt reduction, stock repurchase, and dividends).

Cash Flow Statement (Income Statement) Operating Costs Payments to suppliers, Employees, and others Operating Revenue Interest Payments to Debt Holders Int. on Debt Depr. Taxable Income After-tax Cash Flow Net Income Income Tax Div. RE

Cash Flow Statement RE Depr. Sources: Uses: Disposal of New Debt/ Properties New Debt/ Capital Depr. RE Sources: Uses: Increase in Working Capital Working Capital = Current Assets – Current Lib. Others Repayment of debt & equity Capital Expenditures

A L  + +  S U Cash Flow Statement The letters labeling the boxes stand for Uses, Sources, Assets, and Liabilities (broadly defined). The pluses (minuses) indicate increases (decreases) in assets or liabilities.  + S +  U

Ratio Analysis Financial ratios are ratios of two financial numbers taken from the balance sheet and/or the income statement. compared with average values for the industry the firm is in to evaluate relative financial health, and compared with earlier values from the same firm to evaluate trends.

Liquidity Ratios Liquidity ratios measure the ability to meet short-term obligations.

Leverage Ratios Leverage ratios identify the relative importance of stockholders and outside creditors as a source of the enterprise's capital.

Activity Ratios Activity ratios (also known as operating ratios) show how effectively the firm is using its resources.

Profitability Ratios Profitability ratios describe the organization's profit.

Budgets Financial budgets describe where the firm intends to get its cash for the coming period and how it intends to use it. Cash budgets Capital expenditure budgets Balance sheet budget

Responsibility Centers Expense or cost centers (expense budget) Revenue center (revenue budget) Profit centers (profit budget)

Budgeting Process Top-down approach Bottom-up approach Combination

Cost Accounting Allocating cost among products   Product A Product B Total Production 4,000 1,000 5,000 Direct Labor $40,000 $10,000 $50,000 Overhead $5,000 Set-up Cost $8,000 Total Cost $63,000 Unit Cost $4,000 $1,000 $4,000 $4,000 $48,000 $15,000 $12 $15

Audits of Financial Data Audits are investigations of an organization's activities to verify their correctness and identify any need for improvement. accounting and financial systems and records internal or external.

Nonfinancial Controls Human Resource Controls To assure that human and organizational performance conform to expectations. Performance appraisal (individual) Management audit (group) (Figure 8-2) Human resource accounting (group) Social controls.

Nonfinancial Controls Human Resource Controls Productivity Low Skills High Skills Amount of Supervision

Non-financial Controls Social Controls Standards Comparison with outcomes Corrective action

Non-financial Controls Effectiveness of research activities Systems for release of drawing release Inventory control Quality control Project control