1 Introduction We will discuss the investment base. The investment base is types of asset that may...

1

Introduction

We will discuss the investment base. The investment base is types of

asset that may be employed in an

investment center.

We will discuss the investment base. The investment base is types of

asset that may be employed in an

investment center.

We also discuss two methods

of relating profit to the investment

base :1. ROI2. EVA

2

Structure of the Analysis

The purposes of measuring assets employed are :

1.1. To provide information that To provide information that is useful in making sound is useful in making sound decisions about assets decisions about assets employed and to motivate employed and to motivate managers to make these managers to make these sound decisions that are in sound decisions that are in the best interests of the the best interests of the company.company.

2.2. To measure the To measure the performance of the performance of the business unit as an business unit as an economic entity.economic entity.

The purposes of measuring assets employed are :

1.1. To provide information that To provide information that is useful in making sound is useful in making sound decisions about assets decisions about assets employed and to motivate employed and to motivate managers to make these managers to make these sound decisions that are in sound decisions that are in the best interests of the the best interests of the company.company.

2.2. To measure the To measure the performance of the performance of the business unit as an business unit as an economic entity.economic entity.

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In general business unit managers have two

performance objectives : 1.1. They should generate profits from They should generate profits from

the resources at their disposal.the resources at their disposal.2.2. They should invest in additional They should invest in additional

resources only when the investment resources only when the investment will produce an adequate return.will produce an adequate return.

The purpose of relating profits to The purpose of relating profits to investments is to motivate business investments is to motivate business unit managers to accomplish these unit managers to accomplish these objectives.objectives.

In general business unit managers have two

performance objectives : 1.1. They should generate profits from They should generate profits from

the resources at their disposal.the resources at their disposal.2.2. They should invest in additional They should invest in additional

resources only when the investment resources only when the investment will produce an adequate return.will produce an adequate return.

The purpose of relating profits to The purpose of relating profits to investments is to motivate business investments is to motivate business unit managers to accomplish these unit managers to accomplish these objectives.objectives.

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The two ways of relating profits to asset employed

are : 1.1. Return on Investment (ROI)Return on Investment (ROI)ROI is a ratio. The numerator is income, ROI is a ratio. The numerator is income,

as reported on the income as reported on the income statement. The denominator is statement. The denominator is assets employedassets employed

2. Economic Value Added (EVA)2. Economic Value Added (EVA)EVA is a dollar amount, rather than a EVA is a dollar amount, rather than a

ratio. It is found by subtracting a ratio. It is found by subtracting a capital charge from the net operating capital charge from the net operating profit. This capital charge is found profit. This capital charge is found multiplying the amount of assets multiplying the amount of assets employed by a rate. employed by a rate.

The two ways of relating profits to asset employed

are : 1.1. Return on Investment (ROI)Return on Investment (ROI)ROI is a ratio. The numerator is income, ROI is a ratio. The numerator is income,

as reported on the income as reported on the income statement. The denominator is statement. The denominator is assets employedassets employed

2. Economic Value Added (EVA)2. Economic Value Added (EVA)EVA is a dollar amount, rather than a EVA is a dollar amount, rather than a

ratio. It is found by subtracting a ratio. It is found by subtracting a capital charge from the net operating capital charge from the net operating profit. This capital charge is found profit. This capital charge is found multiplying the amount of assets multiplying the amount of assets employed by a rate. employed by a rate.

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Structure of the AnalysisBalance Sheet

_ ($ 000s) _Current Assets Current LiabilitiesCash $ 50 Account payable $ 90Receivables $ 150 Other current $ 110Inventory $ 200Total current assets $ 400 Total current liabilities $ 200Fixed assetsCost $ 600 Depreciation $ 300 Corporate Equity $ 500Book value $ 300Total Assets $ 700 Total Equities $ 700

_ Income Statement _Revenue $ 1,000Expense, except depreciation $ 850Depreciation $ 50Income before taxes $ 100Capital charge ($ 500 * 10 %) $ 50Economic Value Added (EVA) $ 50Return On Investment (ROI) $ 100/$ 500 : 20 %

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EVA is conceptually superior to ROI.Nevertheless, it is clear from the surveys that ROI is more widely used in a business rather than EVA.

EVA is conceptually superior to ROI.Nevertheless, it is clear from the surveys that ROI is more widely used in a business rather than EVA.

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Measuring Assets Employed

In deciding what investment base to use to evaluate investment center managers, headquarters asks two questions :

1.1. What practices will induce What practices will induce business unit managers to business unit managers to use their assets most use their assets most efficiently and to acquire the efficiently and to acquire the proper amount and kind of proper amount and kind of new assets ?.new assets ?.

2.2. What practices best measure What practices best measure the performance of the unit the performance of the unit as an economic entity ?. as an economic entity ?.

In deciding what investment base to use to evaluate investment center managers, headquarters asks two questions :

1.1. What practices will induce What practices will induce business unit managers to business unit managers to use their assets most use their assets most efficiently and to acquire the efficiently and to acquire the proper amount and kind of proper amount and kind of new assets ?.new assets ?.

2.2. What practices best measure What practices best measure the performance of the unit the performance of the unit as an economic entity ?. as an economic entity ?.

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1. Cash• Many companies use Many companies use

a formula to a formula to calculate the cash to calculate the cash to be included in the be included in the investment baseinvestment base

• Some companies Some companies omit cash from the omit cash from the investment base. investment base. These companies These companies reason that the reason that the amount of cash amount of cash approximates the approximates the current liabilities.current liabilities.

1. Cash• Many companies use Many companies use

a formula to a formula to calculate the cash to calculate the cash to be included in the be included in the investment baseinvestment base

• Some companies Some companies omit cash from the omit cash from the investment base. investment base. These companies These companies reason that the reason that the amount of cash amount of cash approximates the approximates the current liabilities.current liabilities.

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2. Receivables• Business unit managers can Business unit managers can

influence the level of influence the level of receivables indirectly, by their receivables indirectly, by their ability to generate sales, and ability to generate sales, and directly, by establishing credit directly, by establishing credit terms and approving individual terms and approving individual credit accounts.credit accounts.

• The usual practice is to include The usual practice is to include receivables at the book receivables at the book amount, which is the selling amount, which is the selling price less an allowance for bad price less an allowance for bad debtsdebts

2. Receivables• Business unit managers can Business unit managers can

influence the level of influence the level of receivables indirectly, by their receivables indirectly, by their ability to generate sales, and ability to generate sales, and directly, by establishing credit directly, by establishing credit terms and approving individual terms and approving individual credit accounts.credit accounts.

• The usual practice is to include The usual practice is to include receivables at the book receivables at the book amount, which is the selling amount, which is the selling price less an allowance for bad price less an allowance for bad debtsdebts

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3. Inventories• Inventories Inventories

ordinarily are ordinarily are treated in a manner treated in a manner similar to similar to receivables – that receivables – that is, they are often is, they are often recorded at end of recorded at end of period amounts period amounts even though intra even though intra period averages period averages would be preferable would be preferable conceptuallyconceptually

3. Inventories• Inventories Inventories

ordinarily are ordinarily are treated in a manner treated in a manner similar to similar to receivables – that receivables – that is, they are often is, they are often recorded at end of recorded at end of period amounts period amounts even though intra even though intra period averages period averages would be preferable would be preferable conceptuallyconceptually

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4. Working Capital in General

• At one extreme, companies At one extreme, companies include all current assets in include all current assets in the investments base with no the investments base with no offset for any current offset for any current liabilities.liabilities.

• At the other extreme, all At the other extreme, all current liabilities may be current liabilities may be deducted from current deducted from current assets.assets.

4. Working Capital in General

• At one extreme, companies At one extreme, companies include all current assets in include all current assets in the investments base with no the investments base with no offset for any current offset for any current liabilities.liabilities.

• At the other extreme, all At the other extreme, all current liabilities may be current liabilities may be deducted from current deducted from current assets.assets.

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5. Property, Plant and Equipment

• If depreciable assets are included in If depreciable assets are included in the investment base at net book value, the investment base at net book value, business unit profitability is misstated.business unit profitability is misstated.

• The fluctuation in EVA and ROI from The fluctuation in EVA and ROI from year to year can be avoided by year to year can be avoided by including depreciable assets in the including depreciable assets in the investment base at gross book value investment base at gross book value rather than at net book value.rather than at net book value.

• If depreciation is determined by the If depreciation is determined by the annuity, rather than the straight line annuity, rather than the straight line method, the business unit profitability method, the business unit profitability calculation will show the correct EVA calculation will show the correct EVA and ROI. and ROI.

5. Property, Plant and Equipment

• If depreciable assets are included in If depreciable assets are included in the investment base at net book value, the investment base at net book value, business unit profitability is misstated.business unit profitability is misstated.

• The fluctuation in EVA and ROI from The fluctuation in EVA and ROI from year to year can be avoided by year to year can be avoided by including depreciable assets in the including depreciable assets in the investment base at gross book value investment base at gross book value rather than at net book value.rather than at net book value.

• If depreciation is determined by the If depreciation is determined by the annuity, rather than the straight line annuity, rather than the straight line method, the business unit profitability method, the business unit profitability calculation will show the correct EVA calculation will show the correct EVA and ROI. and ROI.

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6. Leased Assets• The business unit The business unit

managers are induce to managers are induce to lease, rather than own, lease, rather than own, assets whenever the assets whenever the interest charge that is interest charge that is built into the rental cost built into the rental cost is less than the capital is less than the capital charge that is applied to charge that is applied to the business unit’s the business unit’s investment base, investment base, because it would because it would increase EVA.increase EVA.

6. Leased Assets• The business unit The business unit

managers are induce to managers are induce to lease, rather than own, lease, rather than own, assets whenever the assets whenever the interest charge that is interest charge that is built into the rental cost built into the rental cost is less than the capital is less than the capital charge that is applied to charge that is applied to the business unit’s the business unit’s investment base, investment base, because it would because it would increase EVA.increase EVA.

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EVA vs ROI

Most companies employing Most companies employing investment centers evaluate investment centers evaluate business units on the basis of ROI business units on the basis of ROI rather than EVA.rather than EVA.

There are three apparent benefits on There are three apparent benefits on ROI measure :ROI measure :

• It is a comprehensive measure in that It is a comprehensive measure in that anything that affects financial statements anything that affects financial statements is reflected in this ratiois reflected in this ratio

• ROI is simple to calculate, easy to ROI is simple to calculate, easy to understand, and meaningful in absolute understand, and meaningful in absolute sensesense

• ROI is a common denominator that may be ROI is a common denominator that may be applied to any organizational unit applied to any organizational unit responsible for profitability, regardless of responsible for profitability, regardless of size or type of business.size or type of business.

Most companies employing Most companies employing investment centers evaluate investment centers evaluate business units on the basis of ROI business units on the basis of ROI rather than EVA.rather than EVA.

There are three apparent benefits on There are three apparent benefits on ROI measure :ROI measure :

• It is a comprehensive measure in that It is a comprehensive measure in that anything that affects financial statements anything that affects financial statements is reflected in this ratiois reflected in this ratio

• ROI is simple to calculate, easy to ROI is simple to calculate, easy to understand, and meaningful in absolute understand, and meaningful in absolute sensesense

• ROI is a common denominator that may be ROI is a common denominator that may be applied to any organizational unit applied to any organizational unit responsible for profitability, regardless of responsible for profitability, regardless of size or type of business.size or type of business.

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EVA vs ROI

The EVA approach has some inherent The EVA approach has some inherent advantages. There are four compelling advantages. There are four compelling reasons to use EVA over ROI :reasons to use EVA over ROI :

• With EVA all business units have the same With EVA all business units have the same profit objective for comparable investments.profit objective for comparable investments.

• Decisions that increase a center’s ROI may Decisions that increase a center’s ROI may decrease its overall profits. If an investment decrease its overall profits. If an investment center’s performance is measured by EVA, center’s performance is measured by EVA, investments that produce a profit in excess investments that produce a profit in excess of the cost of capital will increase EVA and of the cost of capital will increase EVA and therefore be economically attractive to the therefore be economically attractive to the manager.manager.

• Different interest rate may be used for Different interest rate may be used for different types of assets.different types of assets.

• In contrast to ROI, EVA has a stronger In contrast to ROI, EVA has a stronger positive correlation with changes in a positive correlation with changes in a company’s market value. company’s market value.

The EVA approach has some inherent The EVA approach has some inherent advantages. There are four compelling advantages. There are four compelling reasons to use EVA over ROI :reasons to use EVA over ROI :

• With EVA all business units have the same With EVA all business units have the same profit objective for comparable investments.profit objective for comparable investments.

• Decisions that increase a center’s ROI may Decisions that increase a center’s ROI may decrease its overall profits. If an investment decrease its overall profits. If an investment center’s performance is measured by EVA, center’s performance is measured by EVA, investments that produce a profit in excess investments that produce a profit in excess of the cost of capital will increase EVA and of the cost of capital will increase EVA and therefore be economically attractive to the therefore be economically attractive to the manager.manager.

• Different interest rate may be used for Different interest rate may be used for different types of assets.different types of assets.

• In contrast to ROI, EVA has a stronger In contrast to ROI, EVA has a stronger positive correlation with changes in a positive correlation with changes in a company’s market value. company’s market value.

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EVA vs ROI

EVA = Net profit – Capital chargeEVA = Net profit – Capital chargeWhere (1) :Where (1) :

Capital charge = Cost of capital x Capital Capital charge = Cost of capital x Capital employedemployed

Another way to calculate EVA (2):Another way to calculate EVA (2):EVA = Capital employed (ROI – Cost of EVA = Capital employed (ROI – Cost of

capital)capital)

EVA = Net profit – Capital chargeEVA = Net profit – Capital chargeWhere (1) :Where (1) :

Capital charge = Cost of capital x Capital Capital charge = Cost of capital x Capital employedemployed

Another way to calculate EVA (2):Another way to calculate EVA (2):EVA = Capital employed (ROI – Cost of EVA = Capital employed (ROI – Cost of

capital)capital)

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EVA vs ROI

The following actions can increase EVA :The following actions can increase EVA :• Increase in ROI through business process Increase in ROI through business process

reengineering and productivity gains, reengineering and productivity gains, without increasing the asset base.without increasing the asset base.

• Divestment of assets, products and/or Divestment of assets, products and/or businesses whose ROI is less than the businesses whose ROI is less than the cost of capitalcost of capital

• Aggressive new investments in assets, Aggressive new investments in assets, products, and/or businesses whose ROI products, and/or businesses whose ROI exceeds the cost of capitalexceeds the cost of capital

• Increase in sales, profit margins or Increase in sales, profit margins or capital efficiency or decrease in in cost of capital efficiency or decrease in in cost of capital percentage without affecting the capital percentage without affecting the other variables in equation (2) other variables in equation (2)

The following actions can increase EVA :The following actions can increase EVA :• Increase in ROI through business process Increase in ROI through business process

reengineering and productivity gains, reengineering and productivity gains, without increasing the asset base.without increasing the asset base.

• Divestment of assets, products and/or Divestment of assets, products and/or businesses whose ROI is less than the businesses whose ROI is less than the cost of capitalcost of capital

• Aggressive new investments in assets, Aggressive new investments in assets, products, and/or businesses whose ROI products, and/or businesses whose ROI exceeds the cost of capitalexceeds the cost of capital

• Increase in sales, profit margins or Increase in sales, profit margins or capital efficiency or decrease in in cost of capital efficiency or decrease in in cost of capital percentage without affecting the capital percentage without affecting the other variables in equation (2) other variables in equation (2)

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Introduction

This discussion focuses on financial

performance measures

This discussion focuses on financial

performance measures

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Calculating Variances

• Most companies make a monthly Most companies make a monthly analysis of the differences between analysis of the differences between actual and budgeted revenues and actual and budgeted revenues and expenses for each business unit and expenses for each business unit and for the whole organization.for the whole organization.

• A more thorough analysis identifies A more thorough analysis identifies the causes of the variances and the the causes of the variances and the organization unit responsible. organization unit responsible.

• Effective systems identify variances Effective systems identify variances down to the lowest level of down to the lowest level of managementmanagement

• Therefore, it is possible to identify Therefore, it is possible to identify each variance with with the each variance with with the individual manager who is individual manager who is responsible for it. responsible for it.

• Most companies make a monthly Most companies make a monthly analysis of the differences between analysis of the differences between actual and budgeted revenues and actual and budgeted revenues and expenses for each business unit and expenses for each business unit and for the whole organization.for the whole organization.

• A more thorough analysis identifies A more thorough analysis identifies the causes of the variances and the the causes of the variances and the organization unit responsible. organization unit responsible.

• Effective systems identify variances Effective systems identify variances down to the lowest level of down to the lowest level of managementmanagement

• Therefore, it is possible to identify Therefore, it is possible to identify each variance with with the each variance with with the individual manager who is individual manager who is responsible for it. responsible for it.

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The analytical framework use to conduct variance analysis incorporates the following ideas :

• Identify the key causal Identify the key causal factors that affects profitsfactors that affects profits

• Break down the overall Break down the overall profit variances by these profit variances by these key causal factorskey causal factors

• Focus on the profit impact Focus on the profit impact of variation in each causal of variation in each causal factorsfactors

The analytical framework use to conduct variance analysis incorporates the following ideas :

• Identify the key causal Identify the key causal factors that affects profitsfactors that affects profits

• Break down the overall Break down the overall profit variances by these profit variances by these key causal factorskey causal factors

• Focus on the profit impact Focus on the profit impact of variation in each causal of variation in each causal factorsfactors

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• Try to calculate the specific, Try to calculate the specific, separable impact of each causal separable impact of each causal factor by varying only that factor factor by varying only that factor while holding all other factors while holding all other factors constantconstant

• Add complexity sequentially, one Add complexity sequentially, one layer at a time, beginning at a very layer at a time, beginning at a very basic “commonsense” level (“peel basic “commonsense” level (“peel the onion”).the onion”).

• Stop the process when the added Stop the process when the added complexity at a newly created level complexity at a newly created level is not justified by added useful is not justified by added useful insights into the casual factors insights into the casual factors underlying the overall profit underlying the overall profit variance variance

• Try to calculate the specific, Try to calculate the specific, separable impact of each causal separable impact of each causal factor by varying only that factor factor by varying only that factor while holding all other factors while holding all other factors constantconstant

• Add complexity sequentially, one Add complexity sequentially, one layer at a time, beginning at a very layer at a time, beginning at a very basic “commonsense” level (“peel basic “commonsense” level (“peel the onion”).the onion”).

• Stop the process when the added Stop the process when the added complexity at a newly created level complexity at a newly created level is not justified by added useful is not justified by added useful insights into the casual factors insights into the casual factors underlying the overall profit underlying the overall profit variance variance

22


Revenue Variances• The calculation is made for The calculation is made for

each product line, and the each product line, and the product line results are then product line results are then aggregated to calculate the aggregated to calculate the total variance.total variance.

Revenue Variances• The calculation is made for The calculation is made for

each product line, and the each product line, and the product line results are then product line results are then aggregated to calculate the aggregated to calculate the total variance.total variance.

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Variations in Practice

Time Period of the Comparison

• Some companies use Some companies use performance for the year to performance for the year to date as the basis for date as the basis for comparison. For period ended comparison. For period ended June 30, they would use June 30, they would use budgeted and actual amounts budgeted and actual amounts for the six months ending on for the six months ending on June, rather than the amounts June, rather than the amounts for June.for June.

• A comparison for the year to A comparison for the year to date is not as much influenced date is not as much influenced by temporary aberrations that by temporary aberrations that may be peculiar to the current may be peculiar to the current month.month.

Time Period of the Comparison

• Some companies use Some companies use performance for the year to performance for the year to date as the basis for date as the basis for comparison. For period ended comparison. For period ended June 30, they would use June 30, they would use budgeted and actual amounts budgeted and actual amounts for the six months ending on for the six months ending on June, rather than the amounts June, rather than the amounts for June.for June.

• A comparison for the year to A comparison for the year to date is not as much influenced date is not as much influenced by temporary aberrations that by temporary aberrations that may be peculiar to the current may be peculiar to the current month.month.

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Focus on Gross Margin• Gross margin = Selling prices – Gross margin = Selling prices –

Manufacturing costManufacturing cost

Focus on Gross Margin• Gross margin = Selling prices – Gross margin = Selling prices –

Manufacturing costManufacturing cost

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Focus on Gross Margin• EvaluationEvaluationThe formal standards used in the The formal standards used in the

evaluation of reports on actual evaluation of reports on actual activities are :activities are :

1.1. Predetermined standardsPredetermined standards If carefully prepared and coordinated, If carefully prepared and coordinated,

these are excellent standardsthese are excellent standards2. Historical standards2. Historical standards These are records of past actual These are records of past actual

performance. Results for the current performance. Results for the current month may be compared with the month may be compared with the results for last month, or with results results for last month, or with results for the same month a year ago. for the same month a year ago.

3. External standards 3. External standards These are standards derived from the These are standards derived from the

performance of other responsibility performance of other responsibility centers or of other companies in the centers or of other companies in the same industry.same industry.

Focus on Gross Margin• EvaluationEvaluationThe formal standards used in the The formal standards used in the

evaluation of reports on actual evaluation of reports on actual activities are :activities are :

1.1. Predetermined standardsPredetermined standards If carefully prepared and coordinated, If carefully prepared and coordinated,

these are excellent standardsthese are excellent standards2. Historical standards2. Historical standards These are records of past actual These are records of past actual

performance. Results for the current performance. Results for the current month may be compared with the month may be compared with the results for last month, or with results results for last month, or with results for the same month a year ago. for the same month a year ago.

3. External standards 3. External standards These are standards derived from the These are standards derived from the

performance of other responsibility performance of other responsibility centers or of other companies in the centers or of other companies in the same industry.same industry.

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Full Cost Systems• If the company has a full cost If the company has a full cost

system, both variable and fixed system, both variable and fixed overhead costs are included in the overhead costs are included in the inventory at the standard cost per inventory at the standard cost per unitunit

• Variance = Budgeted fixed Variance = Budgeted fixed production cost at the actual production cost at the actual volume – Standard fixed production volume – Standard fixed production costs at that volume costs at that volume

• The important point is that The important point is that production variances should be production variances should be associated with associated with productionproduction volume, volume, not sales volume not sales volume

Full Cost Systems• If the company has a full cost If the company has a full cost

system, both variable and fixed system, both variable and fixed overhead costs are included in the overhead costs are included in the inventory at the standard cost per inventory at the standard cost per unitunit

• Variance = Budgeted fixed Variance = Budgeted fixed production cost at the actual production cost at the actual volume – Standard fixed production volume – Standard fixed production costs at that volume costs at that volume

• The important point is that The important point is that production variances should be production variances should be associated with associated with productionproduction volume, volume, not sales volume not sales volume

27


Amount of DetailWe analyzed revenue variances at We analyzed revenue variances at

several levels :several levels :1.1. In totalIn total2.2. By volume, mix and priceBy volume, mix and price3.3. By analyzing the volume and mix By analyzing the volume and mix

variance variance 4.4. By industry volume and market shareBy industry volume and market share

At each of these levels, we analyzed the At each of these levels, we analyzed the variances by individual products. The variances by individual products. The process of going from one level to process of going from one level to another is often referred to as another is often referred to as “peeling the onion “. “peeling the onion “.

Amount of DetailWe analyzed revenue variances at We analyzed revenue variances at

several levels :several levels :1.1. In totalIn total2.2. By volume, mix and priceBy volume, mix and price3.3. By analyzing the volume and mix By analyzing the volume and mix

variance variance 4.4. By industry volume and market shareBy industry volume and market share

At each of these levels, we analyzed the At each of these levels, we analyzed the variances by individual products. The variances by individual products. The process of going from one level to process of going from one level to another is often referred to as another is often referred to as “peeling the onion “. “peeling the onion “.

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Engineered and Discretionary Costs

• A favorable variance in engineered A favorable variance in engineered costs is usually an indication of good costs is usually an indication of good performance, that is the lower the performance, that is the lower the cost, the better the performancecost, the better the performance

• By contrast, the performance of a By contrast, the performance of a discretionary expense center is usually discretionary expense center is usually judged to be satisfactory if actual judged to be satisfactory if actual expenses are about equal to the expenses are about equal to the budgeted amount, neither higher or budgeted amount, neither higher or lower. lower.

Engineered and Discretionary Costs

• A favorable variance in engineered A favorable variance in engineered costs is usually an indication of good costs is usually an indication of good performance, that is the lower the performance, that is the lower the cost, the better the performancecost, the better the performance

• By contrast, the performance of a By contrast, the performance of a discretionary expense center is usually discretionary expense center is usually judged to be satisfactory if actual judged to be satisfactory if actual expenses are about equal to the expenses are about equal to the budgeted amount, neither higher or budgeted amount, neither higher or lower. lower.

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Limitations of Variance Analysis

1.1. Although it identifies where a Although it identifies where a variance occurs, it does not tell variance occurs, it does not tell whywhy the variance occurred or what the variance occurred or what is being done about it.is being done about it.

2.2. To decide whether a variance is To decide whether a variance is significantsignificant

3.3. The performance reports become The performance reports become more highly aggregated, offsetting more highly aggregated, offsetting variances might mislead the variances might mislead the reader.reader.

Finally, the reports show only what Finally, the reports show only what was happened. They do not show was happened. They do not show the future effects of actions that the future effects of actions that manager has taken. manager has taken.

1.1. Although it identifies where a Although it identifies where a variance occurs, it does not tell variance occurs, it does not tell whywhy the variance occurred or what the variance occurred or what is being done about it.is being done about it.

2.2. To decide whether a variance is To decide whether a variance is significantsignificant

3.3. The performance reports become The performance reports become more highly aggregated, offsetting more highly aggregated, offsetting variances might mislead the variances might mislead the reader.reader.

Finally, the reports show only what Finally, the reports show only what was happened. They do not show was happened. They do not show the future effects of actions that the future effects of actions that manager has taken. manager has taken.

30

Limitations of Variance Analysis

Management ActionManagement Action• There is one cardinal principle There is one cardinal principle

in analyzing formal financial in analyzing formal financial reports. The monthly profit reports. The monthly profit report should contain no major report should contain no major surprises.surprises.

• One of the most important One of the most important benefits of formal reporting is benefits of formal reporting is that is provides the desirable that is provides the desirable pressure on the subordinate pressure on the subordinate managers to take corrective managers to take corrective actions on their own initiativeactions on their own initiative

• Profit reports are worthless Profit reports are worthless unless they lead to actionunless they lead to action

Management ActionManagement Action• There is one cardinal principle There is one cardinal principle

in analyzing formal financial in analyzing formal financial reports. The monthly profit reports. The monthly profit report should contain no major report should contain no major surprises.surprises.

• One of the most important One of the most important benefits of formal reporting is benefits of formal reporting is that is provides the desirable that is provides the desirable pressure on the subordinate pressure on the subordinate managers to take corrective managers to take corrective actions on their own initiativeactions on their own initiative

• Profit reports are worthless Profit reports are worthless unless they lead to actionunless they lead to action

31Performance Measurement Systems

STRATEGYSTRATEGY

What counts, get measured

What gets

measured, gets done

What gets done, gets rewarded

What gets

rewarded, really counts

Framework for Designing Performance Measurement Systems


Balance Scorecard• The balance scorecard is an example

of a performance measurement system.

• The four perspective of balance scorecard :

1. Financial (eq. profit margin, ROA, cash flows)

2. Customer (eq. market share, customer satisfaction index)

3. Internal business (eq. employee retention, cycle time reduction)

4. Innovation and learning (eq. percentage of sales from new products)

Balance Scorecard• The balance scorecard is an example

of a performance measurement system.

• The four perspective of balance scorecard :

1. Financial (eq. profit margin, ROA, cash flows)

2. Customer (eq. market share, customer satisfaction index)

3. Internal business (eq. employee retention, cycle time reduction)

4. Innovation and learning (eq. percentage of sales from new products)


Balance Scorecard

In creating the balanced scorecard, executives must choose a mix of measurements that :

1. Accurately reflect the critical factors that will determine the success of the company’s strategy

2. Show the relationships among the individual measures in a cause and effect manner

3. Provide a broad based view of the current status of the company

Balance Scorecard

In creating the balanced scorecard, executives must choose a mix of measurements that :

1. Accurately reflect the critical factors that will determine the success of the company’s strategy

2. Show the relationships among the individual measures in a cause and effect manner

3. Provide a broad based view of the current status of the company

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Performance Measurement Systems

Customer Customer perspectiveperspective

Customer Customer perspectiveperspective

Internal business Internal business perspectiveperspective

Internal business Internal business perspectiveperspective

Innovation and learning

perspective

Innovation and learning

perspective

Cause Effect Relationships Among Measures

Manufacturing skills

Manufacturing skills

First pass yieldsOrder cycle timeFirst pass yieldsOrder cycle time

Financial perspectiveFinancial

perspective

Customer Customer Satisfaction Satisfaction

surveysurvey

Customer Customer Satisfaction Satisfaction

surveysurvey

Sales revenueSales revenuegrowthgrowth

Sales revenueSales revenuegrowthgrowth

Perspective Measures

35

Interactive Control

• The primary role of The primary role of management control is to help management control is to help execute strategies.execute strategies.

• The chosen strategy defines The chosen strategy defines the critical success factors the critical success factors which become the local point which become the local point for the design and operation of for the design and operation of control systems.control systems.

• In a rapidly changing and In a rapidly changing and dynamic environment, creating dynamic environment, creating a learning organization is a learning organization is essential to corporate survival.essential to corporate survival.

• The main objective of The main objective of interactive control is to interactive control is to facilitate the creation of a facilitate the creation of a learning organization learning organization

• The primary role of The primary role of management control is to help management control is to help execute strategies.execute strategies.

• The chosen strategy defines The chosen strategy defines the critical success factors the critical success factors which become the local point which become the local point for the design and operation of for the design and operation of control systems.control systems.

• In a rapidly changing and In a rapidly changing and dynamic environment, creating dynamic environment, creating a learning organization is a learning organization is essential to corporate survival.essential to corporate survival.

• The main objective of The main objective of interactive control is to interactive control is to facilitate the creation of a facilitate the creation of a learning organization learning organization

36

Interactive Control

Design and Design and operation of operation of management management

control systemcontrol system

Design and Design and operation of operation of management management

control systemcontrol system

Critical successCritical successFactorsFactors

Critical successCritical successFactorsFactors

Chosen StrategyChosen Strategy

Control System as a Strategy Implementation Tool

37

Interactive Control

Tomorrow’sTomorrow’sStrategyStrategy

Tomorrow’sTomorrow’sStrategyStrategy

Today’s ManagementControl System

Today’s ManagementControl System

Interactive Control

38

Interactive Control

Interactive control has the following Interactive control has the following characteristic :characteristic :

• A subset of the management control A subset of the management control information that has a bearing on the information that has a bearing on the strategic uncertainties facing the business strategic uncertainties facing the business becomes the focal pointbecomes the focal point

• Senior executives take such information Senior executives take such information seriouslyseriously

• Managers at all levels of the organization Managers at all levels of the organization focus attention on the information produced focus attention on the information produced by the systemby the system

• Superiors, subordinates and peers meet face Superiors, subordinates and peers meet face to face to interpret and discuss the to face to interpret and discuss the implications of the information for future implications of the information for future strategic initiativesstrategic initiatives

• The face to face meetings take the form of The face to face meetings take the form of debate and challenge of the underlying data, debate and challenge of the underlying data, assumption, and appropriate actions.assumption, and appropriate actions.

Interactive control has the following Interactive control has the following characteristic :characteristic :

• A subset of the management control A subset of the management control information that has a bearing on the information that has a bearing on the strategic uncertainties facing the business strategic uncertainties facing the business becomes the focal pointbecomes the focal point

• Senior executives take such information Senior executives take such information seriouslyseriously

• Managers at all levels of the organization Managers at all levels of the organization focus attention on the information produced focus attention on the information produced by the systemby the system

• Superiors, subordinates and peers meet face Superiors, subordinates and peers meet face to face to interpret and discuss the to face to interpret and discuss the implications of the information for future implications of the information for future strategic initiativesstrategic initiatives

• The face to face meetings take the form of The face to face meetings take the form of debate and challenge of the underlying data, debate and challenge of the underlying data, assumption, and appropriate actions.assumption, and appropriate actions.

39

Interactive Control

New strategiesNew strategiesNew strategiesNew strategies

Use of a subset of Use of a subset of management management

control control information information interactivelyinteractively

Use of a subset of Use of a subset of management management

control control information information interactivelyinteractively

Strategic Uncertainties

Strategic Uncertainties

Control System as a Strategy Formation Tool

40

Service Organizations in General

Management control in service industries is

somewhat different from management control in

manufacturing companies

Management control in service industries is

somewhat different from management control in

manufacturing companies

41

Service Organizations in General

Characteristics :Characteristics :• Absence of Absence of

inventory bufferinventory buffer• Difficulty in Difficulty in

controlling qualitycontrolling quality• Labor intensiveLabor intensive• Multi unit Multi unit

organizationsorganizations

Characteristics :Characteristics :• Absence of Absence of

inventory bufferinventory buffer• Difficulty in Difficulty in

controlling qualitycontrolling quality• Labor intensiveLabor intensive• Multi unit Multi unit

organizationsorganizations

42

Professional Service Organizations

Special Characteristics :

a. Goalsb. Professionalsc. Output and Input

Measurementd. Small Sizee. Marketing

Special Characteristics :

a. Goalsb. Professionalsc. Output and Input

Measurementd. Small Sizee. Marketing

43

Professional Service Organizations

Management Control Systems :

a.Pricingb.Profit Centers and

Transfer Pricingc.Strategic Planning and

Budgetingd.Control of Operationse.Performance Measurement

and Appraisal

Management Control Systems :

a.Pricingb.Profit Centers and

Transfer Pricingc.Strategic Planning and

Budgetingd.Control of Operationse.Performance Measurement

and Appraisal

44

Financial Service Organizations

Financial service organizations include commercial bank and

thrift institutions, insurance companies and

securities firms

Financial service organizations include commercial bank and

thrift institutions, insurance companies and

securities firms

45

Financial Service Organizations

Special Characteristics :While the general principles and concepts of management control systems apply, they need to be adapted to the following special characteristics of the financial services industry :

a. Monetary Assetsb. Time Period for Transactionsc. Risk and Rewardd. Technology

Special Characteristics :While the general principles and concepts of management control systems apply, they need to be adapted to the following special characteristics of the financial services industry :

a. Monetary Assetsb. Time Period for Transactionsc. Risk and Rewardd. Technology

46

Nonprofit Organizations

A nonprofit organization, as defined in law, is an organization that cannot distribute assets or income to, or for the benefit of, its members, officers, or directors. This definition does not prohibit an organization from earnings a profit, it prohibits only the distribution of profits.

A nonprofit organization, as defined in law, is an organization that cannot distribute assets or income to, or for the benefit of, its members, officers, or directors. This definition does not prohibit an organization from earnings a profit, it prohibits only the distribution of profits.

47

Corporate Strategy

Implications for Organization Structure

• Different corporate strategies imply different organization structures and, in turn, different controls

• The organization structure implications of different corporate strategies are given on the next slide

• At the “single industry” end, the company tends to be functionally organized

• “Unrelated diversified” company (conglomerate) is organized into relatively autonomous business units

Implications for Organization Structure

• Different corporate strategies imply different organization structures and, in turn, different controls

• The organization structure implications of different corporate strategies are given on the next slide

• At the “single industry” end, the company tends to be functionally organized

• “Unrelated diversified” company (conglomerate) is organized into relatively autonomous business units

48

Corporate StrategyDifferent Corporate Strategies : Organizational Structure

Implications Single Industry Related Diversified Unrelated

DiversifiedOrganizational structure Functional Business units Holding company

Industry familiarity of High Lowcorporate management

Functional background Relevant MainlyOf corporate management Operating Finance

Decision making authority More centralized More decentralized

Size of corporate staff High Low

Reliance on internal High Lowpromotions

Use of lateral transfers High Low

Corporate culture Strong Weak

49

Corporate Strategy

Implications for Management Control

Different corporate strategies imply the following differences in the context in which control systems need to be designed :

• Corporate level managers may not have significant knowledge of, or experience in the activities of the company’s various business units.

• Single industry and related diversified firms possess corporatewide core competencies on which the strategies of most of the business units are based.

Implications for Management Control

Different corporate strategies imply the following differences in the context in which control systems need to be designed :

• Corporate level managers may not have significant knowledge of, or experience in the activities of the company’s various business units.

• Single industry and related diversified firms possess corporatewide core competencies on which the strategies of most of the business units are based.

50

Corporate StrategyDifferent Corporate Strategies : Management Control Implications

Single Industry Related Diversified Unrelated Diversified

Strategic Planning Vertical cum Vertical only horizontal Budgeting, Control Low HighOver Budget FormulationImportance Attached Low Highto Meeting the Budget

Transfer Pricing High Low

Sourcing Flexibility Constrained Arm’s length market pricingIncentive Compensation Financial/non Primarily financial Bonus Criteria financial criteria criteria

Bonus Determination Primarily Primarily formulaApproach subjective based

Bonus Basis Based both on business Based on business & corporate performances unit performance

51

Business Unit Strategy

Hold

“ Star “

Build

“ Question mark “

Harvest

“ Cash cow “

Divest

“ Dog “

High

High

Low

High Low

Low

Low

High

Cash useMarket

growth rate

Business Unit Mission : The BCG ModelCash source

Relative market share

52

Business Unit Strategy

The BCG Model• BuildBuild This mission implies an objective of increased market share, This mission implies an objective of increased market share,

even at the expense of short term earnings and cash floweven at the expense of short term earnings and cash flow• HoldHold This strategic mission is geared to the protection of the This strategic mission is geared to the protection of the

business unit’s market share and competitive positionbusiness unit’s market share and competitive position• HarvestHarvest This mission has the objective of maximizing short term This mission has the objective of maximizing short term

earnings and cash flow earnings and cash flow • DivestDivest This mission indicates a decision to withdraw from the This mission indicates a decision to withdraw from the

business either through a process of slow liquidation or business either through a process of slow liquidation or outright saleoutright sale

The BCG Model• BuildBuild This mission implies an objective of increased market share, This mission implies an objective of increased market share,

even at the expense of short term earnings and cash floweven at the expense of short term earnings and cash flow• HoldHold This strategic mission is geared to the protection of the This strategic mission is geared to the protection of the

business unit’s market share and competitive positionbusiness unit’s market share and competitive position• HarvestHarvest This mission has the objective of maximizing short term This mission has the objective of maximizing short term

earnings and cash flow earnings and cash flow • DivestDivest This mission indicates a decision to withdraw from the This mission indicates a decision to withdraw from the

business either through a process of slow liquidation or business either through a process of slow liquidation or outright saleoutright sale

53

Corporate Strategy

Different Strategic Mission : Implications for Incentive Compensation

Build Hold HarvestPercent Compensation Relatively Relativelyas Bonus High Low

Bonus Criteria More emphasis More emphasis on non financial on financial criteria criteria

Bonus Determination More MoreApproach subjective formula based

Frequency of Bonus Less MorePayment frequent frequent

54

Top Management Style

The management control function in an

organization is influenced by the style of senior

management

The management control function in an

organization is influenced by the style of senior

management

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