1. Management Accounting:
A Road of Discovery
A Road of Discovery

2. Management Accounting:
A Road of Discovery
James T. Mackey
Michael F. Thomas
Presentations by:
Roderick S. Barclay
Texas A&M University - Commerce
James T. Mackey
California State University - Sacramento
© 2000 South-Western College Publishing

3. Chapter 8 Will our people do this?
Motivation and control through accounting information

4. Key Learning Objectives
1. Describe the motivational relationship between planning, control, and evaluation.
2. Discuss the evolution from clan control to accounting control and accounting’s control hierarchy.
3. Explain three motivational problems with using accounting information in performance evaluation.
4. Prepare a segmented income statement and explain its usefulness in evaluating segments and managers.
5. Compute ROI and residual income, and explain their motivational implications.
As with Chapter 7, this is a chapter with more to say that we can normally cover with introductory students in one week. Ou opinion is that each instructor will focus on what they feel are the critical issues. For example, the segment reporting issues need not be covered if you wish to focus on ROI, RI and EVA. With only one week to present the material, only stronger students can cover the entire material in a satisfactory manner. For our normal students, after covering segment reporting issues and ROI, we can only superficially cover the ROI vs. RI debate. We do make sure to explain EVA as a ‘value’ dominant measure rather that a GAAP dominated measure.
6. Summarize five ethical concerns with management’s use of accounting control measures.
7. [Appendix A] Demonstrate how service department and common cost allocations can support cost control.

5. Part I
The Meaning of Control

6. Control Means: Getting people to do what you want. Or
Getting people to always act to maintain or improve company value.
Getting people to always act according to established rules or procedures.
For management purposes we wish to make managers make ‘good decisions and exercise good judgment’.
Good judgment requires motivation and direction.
We often use Exhibit 8-2, p. 272, to present an overview of the objectives of this lecture.

7. A Personal Example
Is your grade in this course a good performance measure to control your behavior?
If the objective of a college education is to create long-term value, does increasing your GPA reflect an increase in your long-term value?
Does the calculation and components of the grade direct you to do long-term value adding actions?
If the grade is used to evaluate your performance, do you have sufficient control over the factors that determine your grade?
Do you have control over the activities for which you are held responsible?
Pair/Share: If we wish to expand this discussion, we use these questions for pair/share. However, if pressed for time, we answer the questions ourselves.
The answer is — probably not perfectly is the grade as a performance measure ‘good enough for the purpose at hand’.
Suppose you want to do a graduate degree, is the GPA sufficient? Usually your GPA alone will not get you accepted. An MBA program, for example, may require multiple measures line the GPA, a special GMAT examination, references, and your job experience.
Multiple measure improve the fit, but even these measures are rarely complete. When examining performance measures you must ‘know your business’ to detect when problems are happening.

8. The Motivational Cycle
Goal Congruence
(employees do what we want)
Responsibility Based on Controllability
(employees given the power to decide)
Reward System
(offer adequate rewards)
Exhibit 8-2, p. 264.
Performance Measures
(measure the right things, the right way)

9. About The Control Environment
Planning often requires guesswork from employees about costs versus revenues.
Management prefers hard data for evaluation.
Employee participation and their beliefs about legitimacy are necessary.
Management needs to encourage building in a cushion or slack.
Remember ‘What gets measured gets done’.
Understand the conflict between better decisions or better control.

10. Part II
Many Types of Controls

11. How Much Accounting Control Do We Need?
Primary
(accounting system measures the outputs from the black box)
Bureaucratic rules (decentralized)
Shared
(frequent direct observation or accounting system when direct observation is not practical
Bureaucratic rules (centralized)
Secondary
(primary source is external — police ticket)
Market control
(informal, infrequent direct observation is primary source of control)
Clan control
Role of accounting information in control
Control System
This is extracted from Exhibit 8-3, p The columns entitled “The contract” and ‘Source of Motivation’ were omitted. The were not omitted because they are unimportant, just because they would not fit. The instructor should review those columns and add as a verbal supplement to this slide.
For your information, the missing information is repeated below.
Control system “The contract” Source of motivation
Clan control Be home before it is too late. Shared values
Market control Be home before curfew. External (the police)
Bureaucratic rules I’ll pick you up at 8:00 Compliance with parental authority
(centralized)
Bureaucratic rules Be home by 8:00 Good judgment
(decentralized)

12. Types of Controls Control can be achieved through any combination of:
Clan Control — We have the same values or culture.
Bureaucratic Control — We follow the same rules.
Accounting Control — We follow management by the numbers.
Market Control — We follow what the market values most.
Most companies use a mix of controls subject to the costs and benefits of their situation (and the corporate culture).
For clan and bureaucratic control ‘value’ tends to be subjective and determined by managers in the group.
As we approach accounting and marketing control, value is determined by the market and through accounting systems.
We believe this pair/share questions is an important way for students to understand the concept.
Pair/Share: For this university or college, give an example of a market control, a clan control, etc. Phrase the question like: What actions by this institution are influenced by market prices? What actions by this institution are influenced by clan control (common values)?

13. Centralized vs. Decentralized Controls
Centralized management — Higher level corporate management makes more decisions.
Decentralized management — Managers at lower levels make more decisions.
If accounting measures accurately measure value, then centralized ‘Management by the Numbers’ is more efficient.
Pair/Share: We like to use a corner garage as an example because students have probably taken a car there. We simply ask them to give an example of some decisions appropriate for the garage manager when the garage is a cost center, a profit center, or an investment center.

14. Responsibility Centers used in Accounting Control Systems
Cost center
Profit center
Investment center
Its budget covers only the costs incurred. Cost center activities create costs such as in a production department. Cost variances have been the primary accounting control measure.
Its budget includes revenues and costs. Profit centers normally are product lines or sales territories. A profit center’s activities create revenues and incur costs. Sales and cost variances have been the primary accounting control measures.
Its budget involves investment and profit activities. Its activities involve asset purchases that are used to generate profits, (e.g., divisions or companies). Primary accounting measures include sales and cost variances, and expression of profit in relation to investment, (e.g., ROI, residual income, and economic value added).
Exhibit 8-4, p. 266.
If accounting numbers accurately measure value, then centralized ‘management by the numbers’ is more efficient.

15. Limitations for ‘Management by the Numbers’ or Accounting Control
Does the accounting measure reflect company value?
Does the accounting measure reflect the results of activities which the managers are responsible for and which they can control?
Do the accounting measures direct managers to actions that improve value?
This is a very critical part of this chapter. It sets up the continuous improvement management issues in the second half of the text. Unlike the traditional scientific management systems we have been discussing, the goal for continuous improvement is not stability but change. (Change has to be managed and controlled or it will fail.) Our current objectives should be moving targets. Performance measures are a critical part of the control process. In each of the following chapters, we will introduce performance measures to monitor continuous improvement. Performance measures are more important for continuouws improvement, because of the need to focus the company on the current priorities for improvement. The directing, or decision influncing, characteristic of performance measures become an important issue. Our goal in this chapter is to insure that measures meet value, directing, and controllability criteria.
Now we echo back to the discussion at the beginning of class to explain the need for multiple measures and how each measure needs to compliment the other.
This is the discussion on the multiple measures used to evaluate students for graduate courses or outside employment.
Pair/Share: Explain how the grade you receive in this course is correlated with your long-term value.
Pair/Share: How many of the activities that influence your grade in this course do you control?
Pair/Share: Does the GPA suggest behaviors necessary to score highly and create value or are additional rules or procedures needed to support it? Doe the grade as a performance measure stand alone?
This leads to ideas of incomplete and complementary measures by referring back to the earlier example about the multiple measures used to evaluate candidates for graduate school or a job.
The issue is that GIVEN THE COMBINATION OF CLAN, MARKET, AND RULES , ARE THE ACCOUNTING PERFORMANCE MEASURES GOOD ENOUGH FOR CURRENT NEEDS?

16. Segmented Income Statements
Part III
Segmented Income Statements

17. Segment Profitability Statement
Sales
- Variable product expenses
= Contribution margin from product sales
- Controllable fixed costs
= Segment contribution margin
- Common (allocated) costs
= Segment profit margin

18. Evaluation of Managers and Divisions
These reports are designed to identify the costs and revenues influenced or controlled by manager’s activities and those due to a business segment.
Review and analyze Exhibit 8-5, p. 273.
Note that this is a full cost report where the segments must equal the company total.
Hidden in these numbers are:
The costs controllable by the segment manager.
The costs not controllable by the segment manager but only existing for this segment.
Common fixed costs allocated to the segment but not related to segment activity.
We present this exhibit as an example of a typical GAAP driven full-cost statement. The key is to demonstrate the weaknesses of this statement when asking evaluative questions like:
How much money will we make, or how much will our profits increase with the sale of one more unit?
What will happen to our overall company profits if we eliminate one segment?
What has been the controllable contribution to overall company profits for each segment manager?
Or, what is the best basis for setting performance bonuses for segment managers?

19. Assigning Costs by ‘Ability to Bear’ or Sales Revenue
Common costs are costs necessary for the company to exist but cannot be related to a particular segment.
Since full costing says all our costs must be recovered, the common costs are assigned to each segment by their relative sales activity. Remember, this isn’t GAAP and will vary in practice.
Review Exhibit 8-5, p. 273 again.
If we sell one more standard home, why will the increase in net income exceed $8,552? Why not?
If the standard home line is dropped, will the reduction in total net income be $855,167? Why not?
All of these questions can become Pair/Share questions or the instructor can merely answer the questions as part of the lecture.
They are included on the next slide in slightly different form.
1. If we sell one more standard home, why will the increase in net income exceed $8,552? Why not?
The issue is that we know profits are going to increase more that $8,552, but by how much?
2. If the standard home line is dropped, will the reduction in total net income be $855,167? Why not?
The answer is no. It will be worse since the common costs will not go away.
The issue we mention is that the questions asked previously become more frequent. In chapter 7, we developed techniques for infrequent decisions. Now we introduce customized reports that support specific decision needs. This is an important cost versus benefits story about investing in better information systems. The investment in better information systems can only be justified by the increase in company value from using the new systems.

20. Segment Margin Statements
Common costs are not assigned to segments or product lines.
Common fixed costs are taken out of the overhead costs.
Review and analyze Exhibit 8-8, p. 280.
If one more standard house were sold, how would the total company profit change?
If the company dropped the standard home line, how would the total company profit change?
Now we like to evaluate the appropriateness of the segment report for motivating managers to make value-creating decisions.
Pair/Share: If the segment margin increases, will the value of the company as a whole also increase?
Pair/Share: Does the segment statement direct managers to do things that increase the segment margin and, therefore, overall company value? For example, reducing costs while holding revenues constant, etc…
The answers should indicate that the segment statement is better at providing the information to answer these questions than the GAAP statements.

21. Controllable Segment Margin Statements
For evaluation and motivation, fixed costs not controllable by the segment managers should not be part of the bonus system.
Review and analyze Exhibit 8-9, p. 281.
If a manager’s performance and bonus are based on the controllable segment margin, explain how managers can increase their bonus and company value at the same time.
Assume you are the manager of the standard homes segment, what actions does this statement suggest you can take to both improve your bonus and increase company value?
Again, to evaluate the appropriateness of this segment report for motivating managers to make value creating decisions, try the following questions again.
Pair/Share: If the controllable segment margin increases, will the value of the company also increase?
Pair/Share: Does the controllable segment statement direct managers to do things that increase the segment margin and, therefore, overall company value? For example reducing costs while holding revenues constant etc..
Again the answers should indicate that the segment statement is better at these tasks than the GAAP statements.

22. Limitations of Segment Reports
Common costs are difficult to allocate based upon cause and effect.
Segments often influence each other’s performance.
All accounting measures ae subject to errors and may be estimates.
If dropping the Custom Division also reduced the sales of the Standard homes division by 10%, what would be the decrease in the total Net Income? Refer back to Exhibit 8-8, p. 280.
Usually to get any accuracy at all requires a significant investment in more detailed cost allocation systems. We will cover ABC in the next chapter.
A lot of easy examples come to mind for the second issue. The introduction of the marginally profitable 240Z sports car to enhance sales of other Nissan product lines. To illustrate, we use a story about department stores that keep the sports department at the back of the store. Thus husbands buying equipment to start the fishing season have to walk past the perfume counter. Interestingly, sales for the beginning of fishing season increased perfume sales as well. They found that many husbands/boy friends made sure they had gifts for their ladies as well as fishing tackle.
10% reduction in Standard Home contribution margin = $200,000
Lost segment margin from Custom homes = $185,000
total decrease for the company = $385,000

23. Measures of Relative Profitability
Part IV
Measures of Relative Profitability
Profitability in terms of the money invested is measured by various profit and invested capital calculations.

24. Return on Investment (ROI)
Sales / Investment
Sales Turnover =
Profit / Sales
Sales Margin =
Sales Margin x Sales Turnover
ROI =
Profit / Investment
Return on Investment =
The Sales Margin measures the relative profit on each sales dollar. Increasing the sales margin by increasing the profit on sales will improve the ROI.
The Sales Turnover ratio examines how efficiently the investment in assets is used to generate sales. Increasing sales while maintaining the same level of investment or decreasing the level of investment will increase the ROI.
In practice there is considerable variation in the items that are included in each category depending on the firm’s objectives.
Now we move from cost and profit centers into investment center analysis. We try not to encourage memorizing formulas and ratios in a rote way. We encourage students to play with the names of the ratios to make the formulas clear to them. They need to tap into their embedded knowledge. The Return on Investment is simply the return (or profit) on the investments made. Sales Margin is the profit on sales. The Sales Turnover is the number of times sales cover the cash invested, etc. Students should be encouraged to develop definitions that are meaningful to them while still learning the required formula.
Pair/Share: What additional ways to create value are suggested when we add these ratios to the existing segment statements?

25. An Illustration $3,000,000 $10,000,000 Capital Invested $ 500,000
$ 500,000
$ 1,500,000
Operating income
1,000,000
500,000
8,000,000
Less:
Operating expenses
R & D
$2,000,000
Sales
Division B
Division A
For A: ROI = $1,500,000 / $10,000,000 = 15%
For B: ROI = $ 500,000 / $3,000,000 = 16.7%
For A: Sales Margin = $1,500,000 / $10,000,000 = 15%
For B: Sales Margin = $500,000 / $2,000,000 = 25%
For A: Turnover Ratio = $10,000,000 / $10,000,000 = 1.0
For B: Turnover Ratio = $2,000,000 / $3,000,000 = 0.67

26. Residual Income (RI) and The Cost of Capital (COC)
Part V
Residual Income (RI) and
The Cost of Capital (COC)

27. Definitions
The residual income measures the profits returned after a ‘Cost of Capital’ (COC) charge is recovered from the segment or division.
Residual income (RI) is simply the operating profit less the COC.
We use a formula in the text that stresses the relationship between ROI and RI, but for mathematically weaker students we simple show them the direct calculation and try not to confuse them by linking the mathematics in a formal way.

28. An Illustration
For Divisions A & B with a 12% COC, the Residual Income is:
A B
Operating Income $1,500,000 $500,000
Less:
12% x $10,000,000 $1,200,000
12% x $3,000, $360,000
Residual Income $ ,000 $140,000

29. Cost of Capital Employed:
This is the rate of return required by the company multiplied by the capital employed.
Arguments surround how this capital charge should be calculated.
Some authors suggest that it should reflect the unique risk for each segment. Riskier segments should have a higher COC, safer segments less.
Others argue that the cost of capital should reflect the value of alternative uses for the invested capital, or the firm’s cost of borrowing money.

30. ROI versus RI ROI measures the average return for dollars invested.
RI measures net excess (shortfall) over the cost of capital required.
ROI versus RI measures the return over the life of the product.
Review Exhibit 8-13, p. 289 for an illustration of a multi-year investment.
Exhibit 8-13 provides an illustration of ROI versus RI. A good pair/share question is to ask each pair to try and explain the exhibit
Pair/Share: Explain Exhibit 8-13 to your study partner. What is happening?

31. Accounting Performance Measures
Economic value added (EVA )
Residual income
Investment x (ROI – Cost of capital)
Return on investment (ROI)
(Segment profit ratio x Asset turnover ratio)
Exhibit 8-14, p. 292.
This illustrates how various accounting performance measures apply to the management hierarchy by implementing the ‘drilling down’ process.
Segment profit ratio
(Segment profit / Sales)
Asset turnover ratio
(Sales / Segment assets)
Sales variances
(price & volume)
Cost variances
(price & usage)
Cash budgets
(working capital)
Capital budgets
Implementation audits

32. Economic Value Added — EVA
The overall calculation is roughly the same as RI. However, the costs and revenues used may change from company to company.
The idea behind changes to the GAAP numbers is that they do not always reflect changes in value.
Adjustments are made to the accounting numbers so that changes in value are captured.
For each company any one of many adjustments can be made to better measure value. While the measurements are debated, EVA has become extremely popular as an organizational performance measure.

33. Adjustments to Reflect Economic Value
EVA theory states that research and development is an asset and contributes to future value. It is not a current expense for the EVA calculation. Thus, R&D expenses are subtracted from operating income to calculate the EVA for each division.
Division B is much riskier than Division A, therefore the COC for A is 10% and for B it is 15%.
Note: There is approximately 160 adjustments that are possible for us to make to GAAP based accounting numbers to truly illustrate the economic value of a company.

34. Divisions A and B Revisited
A B
Adjusted Operating Income
$1,500,000 + $500,000 $2,000,000
$ 500,000 + $500, $1,000,000
Less Adjusted COC
10% x $10,000, ,000,000
15% x $ 3,000, $ 450,000
EVA $1,000, $ 550,000
EVA gives up hardness to attempt to better measure value. Even when hard measures are used, the adjustments can change from company to company so full disclosure and understanding is necessary when EVA is applied for performance measurement purposes.

35. Do Our Accounting Systems Encourage Good Judgment?
Part V
Do Our Accounting Systems Encourage Good Judgment?

36. Non-Financial Measures of Value
Financial measures are ‘lag’ indicators of value.
Non-financial measures of value may predict value changes sooner than financial measures.
What Gets Measure Gets Done,
But If We Measure the Wrong things
The Wrong Things Will be Done
And
The Wrong things May be Done Very Well