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

Full Cost Accounting Focuses on goods and services. Responsibility accounting is a different ways of slicing the same pie.

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).

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.

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).

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.

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.

Advantage of Profit Center Encourages managers to act as if they are running their own business.

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.

Golub Company How should corporate spending be allocated? Should one division’s performance impact another division’s costs?

Watson Company More allocated costs

Investment Center Responsible for use of assets as well as profits. Expected to earn a satisfactory return on assets employed in the responsibility center.

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

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!

Which firm is better? Firm A Firm B Invested Capital $1000 $5000 Net income $200 $750 ROI 20% 15%

Case 1 Cost of Capital 17.5% A B Invested Capital $1000 $5000 ROI 20% 15% Net Income $200 $750 Capital Charge $175 $875 Residual Income $25 $(125)

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.

Question? Why not just go with the higher return on investment? Won’t that lead to the correct decision just as residual income does?

Case 2 Cost of Capital 12% A B Invested Capital $1000 $5000 ROI 20% 15% Net Income $200 $750 Capital Charge $120 $600 Residual Income $80 $150

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?

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?

ROI Problems Feed the Dogs Starve the Stars

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.

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.

Advantage of Residual Income over ROI Encourages managers make all investments whose return is greater than the capital cost rate.

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.

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.

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.

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.

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.

Some Practice Problems with Transfer Prices C. Can Company Urban Services, Inc.

Some General Incentive Plan Examples Tarrell Company Concord Publications

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

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.

Limitation of Zero-base Review Time consuming and upsetting to normal functioning. Cannot be effectively conducted every year.

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?

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.

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.

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).

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.

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.

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.

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.

Cash Budget Revenues and expenses from the operating budget translated into cash inflows and outflows for cash planning.

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.

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.

Practice Problem Example 7.5 from Schaum’s Outlines

Cash vs Accrual Budgets Medieval Adventures