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Ch 11 Financial Control.docx

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BU247 Lecture 20-21 Chapter 11 – Financial Control  Financial control: use of measures based on financial info to assess organization & mgmt. performance. The focus can be a product, product line, department, division, or entire organization.  Financial control provides a counterpoint to the BSC view, which links financial results to their presumed drivers. In for-profit organizations, financial control looks at the drivers of profit such as the organization’s ability to use its assets effectively. In not-for-profit organizations, financial control looks at ability to use its resources in the most effective way to accomplish its service objectives.  Financial control summarizes the financial results of operations& compares them to planned results.  BSC = quantify strategy and drive strategy down through organization’s hierarchy. The BSC’s cause- and-effect structure reflects mgmt.’s assessment of what drives success in achieving organizational objectives. In for-profit organizations, success is measured by generating good financial returns to capital suppliers, using metrics such as return on investment, earnings per share, etc.  Because external stakeholders rely on financial measures to assess an organization’s potential, organizations use financial measures to assess performance and target areas for improvement.  Variance analysis is one of the oldest and most widely used forms of financial control.  When managers apply financial control tools to evaluate organization units, the resulting info is usually used internally and is not distributed to outsiders.  Internal financial control: supports decentralizing of decision-making info in large organizations. Outside analysts developed financial control tools to assess various aspects of performance. MOTIVATION FOR DECENTRALIZATION  Decentralization: process of delegating decision-making authority to frontline decision makers.  Decentralization evolved because as organizations grew, it become more difficult: 1) For a central decision maker to make all decisions. 2) To gather& transmit info about organization’s environment for evaluation  Decentralization was a natural development reflecting the need for large organizations to respond more quickly and effectively to important changes in their environment.  early 1900s.  Centralization is best suited to organizations that are well adapted to stable environments  power, gas, and telephone utilities, companies such as couriers, fast-food operations, financial institutions  A stable environment means: no major info differences between the corporate headquarters and employees who were responsible for dealing with customers or running the operations, and no changes in the environment that required the organization to adapt.  In such organizations, product line consisted mostly of commodity products for which the most important attributes were price and quality. When price is critical, so is cost control.  To accomplish this, organizations often develop standard operating procedures to ensure that 1) They’re using efficient technologies and practices to promote low cost &consistent quality 2) There are no deviations from the preferred way of doing things.  In response to increasing competitive pressures and the opening of former monopoly markets to competition, many organizations must be able to adapt quickly  Amount of decentralization reflects trust in its employees, employees’ level of skill and training, the increased risk from delegating decision making, and the employees’ ability to make the right choices.  control moves from task control—where people are told what to do—to results control—where people are told to use their skills, knowledge, and creativity to achieve organization objectives.  Benefits of Decentralization o lower-level managers gain experience in decision making o top management freed to concentrate on strategy o decision-making authority leads to job satisfaction 1 |N A T P A R K K E K E K E BU247 Lecture 20-21 o lower-level decisions often based on better info; can respond quickly to customers  Disadvantages of Decentralization o May be a lack of coordination among autonomous mgrs. o lower level mgrs. may make decisions without seeing the big picture o lower level mgrs. objectives may not be those of the organization o may be difficult to spread innovative ideas in the organization RESPONSIBILITY CENTRES AND EVALUATING UNIT PERFORMANCE  Responsibility center: organization unit for which a manager is held accountable.  Ex: a hotel in a chain of hotels, a work station in a production line that makes computer control units  Like a small business; manager is asked to run that small business to achieve the objectives of the larger organization. The manager and supervisor establish goals for the responsibility center.  Goals provide focus and should be specific and measurable. They should promote LT interests of the larger organization and coordination of each center’s activities with efforts of all the others. Coordinating responsibility centres  For an organization to be successful, the activities of its responsibility units must be coordinated.  The need for coordination explains the interest that organizations have in enterprise resource planning systems that focus on linking the organization with its suppliers and customers.  Mail and package couriers, such as Federal Express, establish local stations or collection points (called terminals) from which they dispatch trucks to pick up and deliver shipments. Shipments that are bound for other terminals are sent to the FedEx hub in Tennessee, where they are sorted and redirected. The formula for success in the courier business is simple and has two key elements: 1) meeting the service commitment to the customer, politely, on time, and without damage 2) controlling costs  ensure that all pieces of the system work together effectively and achieve the 2 critical elements  Suppose each terminal = a responsibility center. How should the company measure performance? 1) Measure efficiency in each terminal. It may measure the number of parcels picked up, sorted, or delivered per route, per employee, per vehicle, per hour, or per shift. To focus on efficiency and customer satisfaction, it may count only shipments that meet customer requirements 2) How well the pieces fit together. The company should measure how much each group contributes to the organization’s ability to meet its commitments to customers. The following are the two important elements of terminal–hub interaction for a courier: A. The proportion of the time that the terminal meets its deadlines=percent correct measure B. When terminals are required to sort shipments, the # of shipments sorted to the wrong destination or that travel by the wrong mode (percent defect measure). 3) Company must assess its service to the customer at a more detailed level. For example, measure: A. # Of complaints (or % of shipments with complaints) the terminal group receives B. The average time taken by the operations group to respond to complaints C. # of complaints of poor service received by the company’s customer service line D. Customer satisfaction  In general, controlling the activities of responsibility centers requires measuring the nonfinancial elements of performance (quality and service) that create financial results in the long run.  Properly chosen nonfinancial measures anticipate and explain financial results.  Focusing on nonfinancial measures of performance such as innovation and employee morale motivates managers to avoid sacrificing long-run performance for short-run performance gains. 2 |N A T P A R K K E K E K E BU247 Lecture 20-21  Be careful to use financial results as aggregate measures of performance and rely on nonfinancial results to identify the causes or drivers of the financial results. Responsibility Centres and Financial Control  Financial control provides a summary measure of how well operations control systems are working.  When organizations use a single index to provide a broad assessment of operations, they use a financial number, such as cost, profit, etc. because these are the measures that shareholders use  The accounting report prepared for a responsibility center should reflect the degree to which the responsibility center manager controls revenue, cost, profit, or return on investment.  For accounting summaries, accountants classify responsibility centers into one of these: 1. Cost centers: employees control costs but do not control revenues or investment levels  virtually every processing group in service operations or in manufacturing operations o Evaluate the performance of cost center employees by comparing the center’s actual costs with budgeted cost levels for the amount and type of work done. Therefore, cost standards and variances figure prominently in cost center reports. o Process of setting standards and interpreting variances has behavioral effects on employees, particularly relating to misrepresenting performance potential and performance results. o Other Cost Control Approaches: when mix of products and production levels is constant, you can compare current cost levels with previous periods to promote continuous cost improvement. Inter-period cost comparisons can be misleading when the production mix/level is changing. o Addressing Other Issues in Cost Center Control: many organizations make the mistake of evaluating a cost center solely on its ability to control and reduce costs. Quality, response time, and employee motivation are other critical measures used to assess cost center performance. 2. Revenue centers: members control revenues but do not control the manufacturing /acquisition cost of the product /service, or the level of investment made in the center.  Ex: restaurant in a chain o Evaluates the center based on revenues. Most revenue centers incur sales and marketing costs and have varying degrees of control over those costs. So deduct the center’s traceable costs (salaries, ad costs, selling costs) from its sales revenue to compute the center’s net revenue o Critics argue that basing performance evaluation on revenues can create undesirable consequences. Ex: sales staff rewarded solely on sales may offer excessive customized services. o In general, focusing only on revenues causes members to increase their use of activities that create costs to promote higher revenue levels. o Some control price, the mix of stock on hand, and promotional activities. Then, revenue measures most of the value-added activities & suggest how well their activities were carried out 3. Profit centers: managers and other employees control both the revenues and costs o Like an independent business, except that senior mgmt. (not the responsibility center manager) controls the level of investment in the center.  if the manager of one outlet in a chain has responsibility for pricing, product selection, purchasing, and promotion but not for the level of investment in the store, the outlet meets the conditions to be evaluated as a profit center o Most individual units of chain operations are treated as profit centers. It is doubtful, however, that a unit of a corporate-owned fast-food restaurant (Burger King), or a corporate-owned hotel (Holiday Inn) meets conditions to be treated as a profit center because the head office makes most purchasing, operating, pricing, and promotional decisions. o However, these units are large so costs can vary because of differences in controlling labor costs, food waste, and the schedule for the facility’s hours. Revenues also can shift significantly, depending on mgmt. Thus, although they do not seem to be candidates to be treated as profit centers, local discretion often affects revenues and costs enough so that they can be. 3 |N A T P A R K K E K E K E BU247 Lecture 20-21 o Many companies evaluate units as profit centers even though the corporate office controls many facets of their operations. The profit reported by these units is a broad index of performance that reflects both corporate and local decisions. If unit performance is poor, it may reflect 1) an unfavorable condition that no one in the organization can control 2) poor corporate decisions 3) poor local decisions o For these reasons, organizations should not rely only on profit center financial results for performance evaluations. Instead, detailed performance evaluations should include quality, material use (yield), labor use (yield), and service measures that the local units can control. 4. Investment centers: managers/employees control revenues, costs, and investment o Like an independent business o Ex: senior mgmt. uses return on investment to evaluate each business unit and their subunits. Evaluating Responsibility Centres Using the Controllability Principle to Evaluate Responsibility Centers  The controllability principle: manager of a responsibility center should be assigned responsibility only for the revenues, costs, or investments responsibility center personnel control.  For example, the manager of a production line in a factory should be evaluated based on labor and machine hours used and not based on labor cost and machine cost because labor wage rates and machine costs were determined elsewhere in the organization.  Problem in applying the principle is that usually, many revenues &costs are jointly earned/incurred  Ex: operations of a fishing products company that is divided into 3 responsibility centers: harvesting, processing, and marketing and distribution. The harvesting group operates ships that go out to sea to catch fish. The plants process the fish into salable products. The marketing group sells products. o The activities that create the final product in this company are sequential& interdependent. The product must be of the right species, quality, and cost to be acceptable to the customer. o The performances of each of the 3 groups jointly determine the organization’s success. o Evaluating the individual performance of each group requires the firm to consider many facets of performance. Ex: evaluate harvesting’s operations by measuring its ability to do the following: 1. Catch the entire quota allowed. 2. Minimize the waste and damage done to the fish caught. 3. Minimize equipment failures. 4. Control the costs associated with operating the ships. o As part of performance evaluation, organization may prepare accounting summaries of the performance of the 3 groups to support some system of financial control. How do we account for interrelated organization centers as if they were individual businesses? 4 |N A T P A R K K E K E K E BU247 Lecture 20-21 o Costs of harvesting are easy to determine, but the harvesting revenues? Harvesting does not control sales/prices—its role is to catch the fish, maintain raw material, and meet the schedules o If the company evaluates harvesting as a cost center, what about indirect organization costs (such as corporate administration) that reflect overhead resources used by the cost center? o We could conclude that processing should be evaluated as a cost center, but what about the marketing and distribution group, which has the greatest impact on sales? The only costs controlled by marketing & distribution are marketing &distribution costs, which are <10% of total costs. The harvesting and processing group also determine the sales level. However, some do not agree that the controllability principle is the best way to view performance evaluation. Using Performance Measures to Influence versus Evaluate Decisions  Some people argue that controllability is not a valid criterion to use in selecting a performance measure. They suggest that the performance measure should influence decision-making behavior.  Ex: dairy faced the problem of developing performance standards in an environment of rising costs. Because the costs of raw materials were market determined, product managers argued that their evaluation should depend on ability to control the quantity of raw materials used (vs. cost)  The dairy’s senior management announced that it planned to evaluate managers on their ability to control total costs. The product managers discovered that one way to control costs was to make judicious use of LT fixed price acquisition contracts. These contracts soon led to declining raw materials costs. Moreover, the company could project product costs several quarters into the future, thereby achieving lower costs and stability in planning and product pricing.  Thus, managers, even when they cannot control costs entirely, can take steps to influence final product costs. When more costs or even revenues are included in performance measures, managers are more motivated to find actions that can influence incurred costs or generated revenues. Using Segment Margin Reports  When organizations treat responsibility centers as profit centers, problems occur; they concern identifying responsibility for the control of sales and costs.  Deciding how to assign the responsibility for jointly earned revenues and jointly incurred costs.  Despite the problems, the profit measure is so pervasive that organizations prefer to treat many of their organization units as profit centers. Because most organizations are integrated operations, the first problem that designers of profit center accounting systems must confront is handling the interactions among the various profit center units.  To address this issue, consider the activities at Earl’s, an automobile dealership organized into five responsibility centers: new car sales, used car sales, body shop, service department, and leasing. Each responsibility center has a manager responsible for the profit reported for that unit. The center managers report to Earl, using the quarterly reports format shown:  It illustrates a common form of the segment margin report for an organization that is divided into responsibility centers. One column is devoted to each profit center. 5 |N A T P A R K K E K E K E BU247 Lecture 20-21 1) The revenue attributed to each profit center is the first row. Variable costs are deducted from revenue to get contribution margin, which is the contribution made by operations to cover revenue center costs that are not proportional to volume (“Other costs”). Examples of these costs are equipment and buildings that the segment uses exclusively. 2) The segment’s fixed costs are deducted from its contribution margin to determine that unit’s segment margin, which is the performance measure for each center. The unit’s segment margin measures its controllable contribution to the organization’s profit and other indirect costs. 3) Allocated avoidable costs are admin costs (personnel-related costs and committed costs for facilit
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