Class Notes (834,049)
Australia (1,844)
Accountancy (152)
AYB321 (10)
All (10)

Lecture Notes 6

5 Pages
Unlock Document

All Professors

AYB321 – STRATEGIC MANAGEMENT ACCOUNTING Lecture 6: Financial Measures of Performance Financial Control  Control = tools and methods used by organizations to keep on track toward achieving their objectives.  Typically involves: o Setting targets (planning) o Measuring actual performance o Comparing actual with target o Investigating variances; and o Taking remedial action where necessary.  Starts with aggregate measures of performance, then “drills down”.  History: Cost control o 1980s: Drivers of organizational costs  ABC to manage & predict costs. o 1990s: Drivers of revenue  BSC.  BSC requires a systematic consideration of how non-financial measures affect financial measures.  Non financial indicators drive financial results Familiar and leading lagging short term, but aggregate and direct  Financial measures are still the most widely used because they are an aggregate measure of performance, and a direct measure of the primary purpose of for-profit organizations. Measuring Divisional Performance  General Rule: The performance evaluation and reward systems should be consistent with the decision rights allocated to the sub-unit manager.  Each sub-unit can be characterised as one of five categories based on its decision rights: o Cost centres  Task: Produce some output.  Decision rights: Input mix (labour, materials, and outside services) used to produce the output.  Evaluation: Efficiency in applying these inputs to produce output. (Budgeted cost and output.)  Note: Quality must be easily observable and must be monitored. o Expense centres  Task: Support the business with advice, services. (Usually a corporate unit, e.g., Finance, HR.) Similar to a CC, but with output that is measured subjectively.  Decision rights: Input mix (labour and outside services) used to fulfil their role.  Evaluation: Often measured through benchmarking to other firms (eg, cost as a % of turnover). o Revenue centres  Task: Sell the firm’s output  Decision rights: Use of a small operating budget to maximise revenue.  Evaluation: Maximise sales for a given price (or quantity). o Profit centres and  Task: Run a specified part of the business profitably.  Decision rights: Input mix, selling prices, marketing techniques.  Evaluation: Profit (actual versus budget).  Two complications: o Which (if any) corporate overhead costs to allocate to business units o How to price transfers of goods and services between business units o Investment centres.  Task: Run a specified part of the business, earning an adequate return on investment.  Decision rights: Similar to profit centres but with additional decision rights for capital expenditures.  Evaluation: ROI, RI, EVA.  Two complications: o Which (if any) corporate overhead costs to allocate to business units o How to price transfers of goods and services between business units Financial Measures of Investment Centre Performance  The usual measure of the financial performance of a profit centre is……profit!  But an IC manager also has decision rights over the capital employed in earning that profit.  Therefore the measure must incorporate capital = profit earned per dollar of capital employed.  ROI, RI, EVA relate the amount of profit earned to the level of assets employed. Refer to lecture example Return on Investment (ROI) A historical perspective  19th century: Owner-entrepreneurs, single type of economic activity efficiently (eg, textile mill, railroad, steel company). o In the short-run, return on sales was adequate.  The DuPont Powder Company, formed in 1903 from several separate enterprises, had a new challenge: o To co-ordinate and allocate capital to the various manufacturing activities.  The founders of DuPont declared that there: ‘ no expenditures for additions to the earning equipment if the same amount of money could be applied to some better purpose in another branch of the company.’ (i.e., opportunity cost)  DuPont developed ROI. Measured by:  net earnings (after depreciation but before deduction of interest on long-term debt) divided by  net assets (total assets minus goodwill and other intangibles, current liabilities, and reserves for depreciation) Calculation  Simply put: ROI = profit / assets  ROI can be written as the product of two ratios ROI = profit X sales = PT sales assets  This enables further analysis of the ROI measure. Technical Shortcomings of ROI  Actions that increase divisional ROI can make the corporation worse off & conversely.  These perverse incentives happen whenever performance is measured by a percentage or a ratio.  Consider a division with assets of $90,000 and net income before taxes (NIBT) of $20,000  ROI = NIBT/Assets o = 20,000/90,000 o = 22.2% o Cost of capital for the division = 15%  Now suppose: o Cost of capital for the division = 15% o New investment opportunity: $15,000, yielding an annual profit improvement of $3,000/year Should the division invest? o Decision rule: If ROI > CoC  Invest o ROI = 3,000/15,000 = 20% (> the division’s cost of capital) Should the division invest? YES Will the division invest? NO  New ROI for the division: o = (20,000 + 3,000)/(90,000 + 15,000) o = 23,000/105,000 o = 0.219 o = 21.9% - less than the previous ROI  What does the firm want the manager to do? o Invest! (Accept all +ve NPV projects.)  What will the manager to do? o Not invest! (Reduces manager’s reported performance: 22.2% 21.9%)  Similar problem when comparing two divisions with different investment bases.  Assume a second division with assets of $50,000 and net income of $12,500: ROI = 25%  Appears that the second division is more profitable since ROI of 25% > 22.2% ROI of first division  Note – still a problem if current ROI < CoC  Assume: o Cost of capital for the division = 15% o Current ROI = 10%  In summary: Managers who wish to maximise ROI can either: o increase the numerator; or o decrease the denominator.  That’s fine, except for the perverse incentives described above.  These particular problems are overcome by Residual Income (RI). Residual Income (RI)  RI is calculated as follows: o Risk-adjusted cost of capital. o Multiplied by net investment base (assets) o Equals the
More Less

Related notes for AYB321

Log In


Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.