Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Control: The Management Control Environment 22

22-2 Management Control Addresses control process and use of accounting information in that process. Strategy formulation develops strategies to attain an organization’s goals. Strategies change whenever a new opportunity or a new threat is perceived.

22-3 Management Control Process Process by which managers influence members of an organization to implement strategies efficiently and effectively. Takes goals and strategies as given. Seeks to assure that strategies are implemented. Includes planning.

22-4 Two Parts of Plans A statement of objectives. Resources required to achieve objectives.

22-5 Goals and Objectives Terms often used interchangeably. Goals = broad, usually non-quantitative, long run plans relating to organization as a whole. Objectives = more specific, often quantitative, shorter run plans for individual responsibility centers.

22-6 The Environment Four facets of management control environment: –Nature of organizations. –Rules, guidelines and procedures governing actions of organization’s members. –Organization’s culture. –External environment.

22-7 The Nature of Organizations Organization: a group of human beings who work together for one or more purposes. Managers or management: Leaders who perform important tasks.

22-8 Tasks of Management Determining goals. Determining objectives to achieve goals. Communicating goals and objectives. Determining tasks to be performed to achieve objectives. Coordination. Matching individuals to tasks. Motivating. Observing/monitoring employee performance. Taking corrective action as needed.

22-9 Organization hierarchy. = Layers of management with authority running from top to bottom. Optimal number of subordinates: (10) Organization chart. –Line units  activities directly associated with achieving objectives of organization. (Produce and market goods or services.) –Staff units  provide support services to other units and to chief executive officer (CEO).

22-10 Rules, Guidelines, and Procedures Influence the way members behave. Written, or verbal; formal, or informal.

22-11 Culture Norms of behavior determined by: –Tradition. –External influences. –Attitudes of senior management and board of directors (BOD).

22-12 External Environment Everything outside of organization. –Customers –Suppliers –Competitors –Regulatory agencies.

22-13 Responsibility Accounting Continuous flow of information corresponds to continuous flow of inputs into, and outputs from, an organization’s responsibility centers. Usage of various resources are measured directly in or converted to a monetary measure. Focuses on responsibility centers.

22-14 Full Cost Accounting Focuses on goods and services. Responsibility accounting is a different way of slicing the same pie.

22-15 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). Costs have three different dimensions.

22-16 Dimensions of Costs Responsibility center. Where was cost incurred? Product dimension. For what output was cost incurred? Cost element dimension. What type of resource was used?

22-17 Effectiveness and Efficiency Effectiveness = how well responsibility center does its job. Efficiency = amount of output per unit of input. –Lower cost is more efficient.

22-18 Limitations of Actual Costs Compared to Standard Not an accurate measure of efficiency for at least 2 reasons: –Recorded costs are not precisely accurate measures of resources consumed. –Standard are at best only approximate measures of what resource consumption ideally should have been in prevailing circumstances.

22-19 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.

22-20 Revenue Center Responsible for outputs of center as measured in monetary terms (revenues). Not responsible for costs of goods or services that center sells. e.g. sales organization. Responsible for selling expenses (e.g. travel, advertising, point-of-purchase displays, sales office salaries, rent).

22-21 Expense centers Responsible for expenses (i.e. costs) incurred but does not measure its outputs in terms of revenues. e.g. production departments, staff units such as accounting.

22-22 Standard or Engineered Cost Center Expense center for which many of its cost elements have standard costs established. Differences between standard costs and actual costs are variances. e.g. production cost centers, fast food restaurants, and blood testing laboratories.

22-23 Discretionary Expense Center Also called managed cost center. Difficult to measure output in monetary terms. Production support and corporate staff. e.g. human resources, accounting, R&D.

22-24 Profit Centers Performance measured as difference between revenues and expenses. e.g. independent division of a company, factory that sells output to marketing division.

22-25 Advantage of Profit Center Encourages managers to act as if they are running their own business.

22-26 Considerations for Profit Centers Extra record keeping. Only useful if manager influences both revenues, and costs. Not a profit center, if senior management requires service performed by other responsibility center at no charge, e.g. internal audit. If output is homogeneous (e.g. tons) no advantage to monetary measure of revenue. Multiple profit centers create spirit of competition.

22-27 Transfer Prices Price at which goods or services are sold between responsibility centers within a company. Revenue for selling center and cost for receiving center. 2 general types: –Market based price. –Cost based price.

22-28 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.

22-29 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.

22-30 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 consolidated company.

22-31 Investment center Responsible for use of assets as well as profits. Expected to earn a satisfactory return on assets employed in responsibility center.

22-32 Measures of Performance Return on investment = Profit/Investment Residual income = Pre-interest profit – (Capital charge * investment)

22-33 Residual Income Residual income = economic value added = EVA = Income before interest less a capital charge. Capital charge is calculated by applying a rate to the investment center’s assets or net assets.

22-34 Advantage of Residual Income over ROI Makes economic objective clear: –Earn rate of return greater than cost of invested capital. Encourages managers to make: – Investments whose return is greater than the capital cost rate. –Divest when return is less than cost of capital.

22-35 Advantage of ROI over residual income ROI measures are ratios that can be used to compare investment centers of different sizes. Residual income is an internal number that is not reported to shareholders and other outsiders.

22-36 Investment Center Issues Asset allocation among centers. How to value assets (e.g. historical cost or replacement cost). Most companies control investments in fixed assets using capital investment (i.e. capital budgeting) procedures addressed in Chapter 27. Managers focus day-to-day efforts on managing current assets, particularly inventories and receivables.

22-37 Non-monetary measures Non-monetary as well as monetary objectives. e.g. quality of goods or services, customer satisfaction. Management by objectives (MBO) and Balanced Scorecards in Chapter 24.

Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. End of Chapter 22 22