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Lecture

Lecture Notes 6

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Department
Accountancy
Course
AYB321
Professor
All Professors
Semester
Spring

Description
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: ‘...be 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
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