1

STRATERGIC MANAGEMENT ACCOUNTING

APC 309
UNIVERSITY OF SUNDERLAND

CONTENTS
NO

PAGE

1. Importance of performance measures

2. Return on Investment

4-5

3. Limitation of ROI

4. Economic value added

7-8

5. EVA Limitations

6. Limitations of Performance measures

10

7. Balance Scorecard

11

8. Conclusion

12

Importance of Performance Measurement

Performance measure is one of the measures which used to measure the

performance of the management process in a division or investment
centre. Its include the both objective and subjective assessments of the
both individual and divisional performance. Performance measurement is
effective way of ensuring the division is placed the organization strategy
successfully. In order to monitor the organization goals and objectives are
in well place within the division this measure will use by the organization.
Performance measure consists of financial and non financial information
(Drury, C 2005).Return on Investment(ROI) and Economic value
added(EVA),Residual Income are few tools which used to measure the
performance of the division. But on this report we have discussed ROI and
EVA as a performance measure of the divisions or investment centre.

Return on Investments (ROI)

ROI is one of the most important profitability ratios. Its used to evaluate
the efficiency of an investment to compare the efficiency of a number of
different investments.ROI is similar measure to ROCE but this mainly used
to appraise the investment decisions of an division or investment
centre.ROI expressed the divisional profit as a percentage of the assets
employed in the division or investment (Drury, C 2005) ROI calculate as
follows

ROI= NET PROFIT *100

NET INVESTMENT
ROI provide rational for the future decision relates to the investments and
acquisitions. It helps to management to choose which investment option
need to be followed and which should be ignored.eg:
Division

Profit

1m

2m

Investment

4m

20m

ROI

25%

10%

When we compare the results between above example division y profit is

exceeding the division x. But when we compare the return getting form
investment its clearly division x due to the fact that ROI has 25% when
compared to Division Y 10%. This is one of the major advantages
associate with ROI. Also it provide summary of past firms investment
which capital invested. These information help to managers to decide
their future investment. According to the Kaplan and Atkinson despite
the fact that lack of measurement of ex-post returns on capital, there is a
little help for accurate estimates of future cash flows during the capital
budgeting process. Measuring the returns of capital invested help

managers to draw their attention to the impact of levels of working capital

on the ROI in particular with stocks and debts (Drury, C 2005). This can
lead to the decision making that are optimal for division and sub optimal
for corporate organization. Further advantage of ROI is its can be used as
common denominator for comparing returns of other businesses such as
other divisions, competitors and other dissimilar business.

Limitations of Return on investment

Despite the advantages of ROI there are some major drawbacks for the
ROI such as dysfunctional decision making. Eg:

Division

Investment

20m

20m

Return from the investment

4m

2.6m

ROI

20%

13%

Current ROI

25%

9%

Cost of capital

15%

In this situation division a manager will reject the investment due to the
fact that investment ROI is lower than the Current Division ROI. Because if
manager A accept the investment could harm his bonus for division
performance. But accepting the investment division A could lead to
success as the company cost of capital is lower than the investment
return.
Another important limitation of ROI is some investment indicates low or
negative figures in the short term but it increase in the long term. But
divisional managers tempt to reject the investment on the lower returns
on the short term.
Divisional mangers could manipulate the profit and capital employed in
order to improve the results of ROI to get the bonus payments.

Also different accounting policy such as depreciation policy could have

adverse effect on the comparison.
Use of ROI is not helping company shareholder wealth maximisation as
divisions accept the higher ROI figures which good for divisions.

Economic Value Added (EVA)

In an organization primary objective is maximisation of shareholders
wealth. So successful performance measure evaluate the how the
company perform to achieve its objects. Most of the organization used
profit based measured as their primary measure of financial performance.
But there are two main problems relating to the profit which is

Profit ignores the cost of capital

Profits are calculated according to the accounting standard which is
not truly reflecting the wealth that has been created and it could
manipulate by accountants.

Economic Value Added (EVATM) was developed by the US consulting firm

Stern Stewart & co, and it has expanded among the well-known
companies such as Coca Cola, Seimens. Etc. EVA was developed to
overcome above two difficulties which face by organizations.EVA
performance measure based on the operating income after taxes and the
investment in assets required to generate that income and the cost of the
investment in assets. (WACC).EVA main objective is produce overall
financial measure which encourage senior managers to focus on the
delivery of shareholder value. EVA is pound amount if the amount is
positive figure means company has earned after tax operating income
than the cost of assets employed to generate that income. On the other
hand negative figure indicate that company consuming capital compared
to generating wealth so company goals is to have positive and increasing
EVA. Its calculate as follows.

EVA = conventional divisional profits + accounting adjustments cost of capital charge on divisional
Or
EVA = Net operating profit after tax (Total capital employed X
weighted average cost of capital)

Economic value Added strengths

EVA has overcome the ROI primary limitation which is mangers make
decisions while ignoring the company as whole to get the performance
bonus. Such as investment which has 12% return and divisional manager
ignore this due to the divisional ROI which is 15%.But Company as whole
cost of capital is 10% and if they followed that investment could get good
profitability and it could lead to shareholder wealth maximisations. EVA
can overcome that situation by using EVA instead of ROI using company
cost of capital as whole to choose investment over 10%.Apart from the
goal congruence EVA can eliminate the distortions in the GAAP to focus
decision on real economic results. EVA is more practical concept than the
ROI which is highly complex and hard to understand.EVA provide better
assessment of decision compared to ROI as which affect Income
statement and balance sheet or tradeoffs between each through the use
of the capital budgetary targets. Also it overcomes the dysfunctional
decision making.

EVA Limitations
Despite the advantages over ROI, this measure have some limitation as
well.EVA is required numerous adjustments to profit and capital employed
figures.EVA doesnt provide comparison between division EVA is an
absolute measure.EVA mainly based on the historical data and
shareholders interest in future performance.EVA doesnt control for size
differences across divisions. Larger division tend to have higher amount of
EVA and smaller Divisions have lower amount of EVA.EVA is based on the
computed number that relies on financial accounting methods of revenue
realization and expense recognition. So this could be lead managers to
manipulate those numbers to get good performance.EVA clearly focuses
on the immediate results which could stop investing on innovative product
or process technologies.EVA do not consider the nonfinancial facts which
is employee satisfaction, market competition, products quality. These
factors are crucial when making effective decisions.

10

Limitations of Financial Performances

Financial performance measurements are generally short term oriented
and it leads managers to become short term oriented. So this may ignore
the positive investments which has initial adverse on the division
performance and higher payoff later period or in the long run.
Financial performance measures consider as lagging indicators (Eccles
and Pyburn, 1992) by time lag between action and results. Which mean
outcomes of the management action after some time and its too late to
alter the decisions.

11

Balance scorecard (BSC)

BSC was introduced by Kaplan and Norton (1992) to overcome the
shortcoming of EVA and ROI and control which fails to provide signals to
changes in the company economic value as an organization makes
substantial investments ore depletes past investments in intangible
assets. These manly consisted four different perspectives which is
customers, internal business processes, and learning and growth.BSC can
use for following reasons,

Improving organizational performance by measuring what matters

to the company.
Increase focus on strategy and results
Align organisation strategy with divisions workers on a day to day

basis
Focus on drivers key to future performance.
Prioritise projects and investments.

BSC approach to performance measurement offer several advantages

such as

It measures the division performance in a variety of ways, rather

than relying on one figure.

In these measures managers are not able to distort the performance

measure.
BSC take long perspective of business performance.
Four areas should lead to the long term success of the company.

12

Conclusion
There are many arguments which suggest ROI and EVA motivate
managers to focus on the short terms of the divisions. But they possess
the traits of long term. Main limitation with ROI and EVA they only depend
on the financial information which they measure the profitability in the
short term. But both performance measures ignore the non financial
factors such as

employee satisfaction, quality of products and

services.etc. But BSC has overcome this limitation by including the non
financial information to evaluate the performance. Divisional performance
measures should be based on the combination of financial and non
financial measures in order to maximise shareholders wealth.

13

CONTENTS

PAGE NO

1. Marginal Costing

14-17

2. Absorption Costing

18-20

3. Activity based Costing

21-23

4. Conclusion

24

5. References

25

6. Appendice

26

14

Marginal Costing/Variable costing

Marginal costing is accounting system in which variable cost charged to
the cost unit and fixed costs of the period are written off in full against
aggregate contribution (CIMA).Marginal costing components doesnt
include fixed cost. Marginal costing enables management to take
necessary arrangements to the decision and understand the cost
structure. The marginal production cost of an item is equal to sum of
direct material cost. Direct labour, direct expenses and variable
production overhead. Basically when production volume and sales
increase total variable cost will rise proportionately. Although fixed cost
remain unchanged in a time period. Contribution concept is vital in
marginal costing and it calculate as follows,
Sales Revenue

***

15

Less variable cost of product

(***)

Contribution

****

Contribution which earned from specific products or group of products is

added so as to calculate the total contribution. Fixed cost is paid form this
total contribution and then part of the total contribution which remains
becomes profit of the business as whole.
Marginal costing statement
Sales revenue

****

(-)Variable cost of production

(***)

Contribution

***

(-) Fixed cost

(**)

Total profit

**

Advantages of Marginal Costing

Provide useful data for decision making process.
Very effective tool of profit planning.
Under this technique problems which arise from the computations of
accurate such as fixed factory overhead rate can be avoided as it
charged against contribution.
Closing inventory valued at variable cost and it help to avoid the
carrying fixed cost of one period to the next period through closing
inventories.
Under marginal product variable cost per unit is constant from
period to period within short span of time, Pricing decision can
easily be taken by the management

16

Limitation of Marginal costing

Marginal cost assumes that semi variable cost can be divided in to

two parts such as fixed and variable elements and it is difficult task
to do it in practical.
It excludes the fixed cost and some time it could be lead to wrong
conclusions.
With development of the technology and application of automation
of the industry fixed cost have substantial impact on the production
cost and marginal cost is failed to reflect on the impact on the fixed
cost as they give great importance to the variable cost.
Marginal costing does not provide parameter for cost control and it
can achieved better with help of standard costing and budgetary
control rather than relying on this costing.
Inventory valuation is not helpful in case of abnormal loss and such
valuation is not accepted under the view point of income tax
authorities and auditors.

17

Managerial Decision making Situation

Determination of optimum price is very important for a company as they

want to make profit from each unit of product or service. In marginal
costing fixed cost will not be change at any production level. Marginal
costing variable cost is changing is the only way to getting optimum price
where company can achieve expected profit. APPENDIX 1
Choose of good product mix also one of the important decisions for
organization. Some time company produce more than one product and in
such a situation company has to calculate their each products contribution
margin or gross profit margin. The product which gives higher contribution
margin will choose to go ahead. Also company can check contribution by
producing different quantity of other products. Increasing quantity
producing maximum contribution, it will be equilibrium point and
production of units at that quaintly will be benefit to the company.

18

Absorb costing/full costing

Absorption costing system which treats all cost of production as product
costs, ignoring the fact that fixed or variable. Cost of product unit under
absorption costing consists of direct materials, direct labour, and both
variable and fixed overhead. Under the absorption costing fixed cost are
allocated to each product unit along with the variable manufacturing cost.
Under the absorption cost manufacturing overhead which has been
applied to products. Under the absorption costing overhead is applied
based on the predetermined overhead allocation rate. Overhead is over
absorbed when the amount allocated to a product or cost is higher than
the actual amount of overhead. On the other side when actual amount of
allocation is higher than the allocation and its called under absorbed.

19

Advantages and Limitations of absorbing costing

Advantages
Absorbing cost treat fixed cost in the product cost and its help to
determining price of the product.
Absorption costing method will show most appropriate profit
calculation than the variable costing in a situation where production
is done to have sales in future such as seasonal production and
seasonal sales.
Absorption costing method is recognizing method which use for
preparing external reports and inventory valuation process.
It avoids the cost separation such as fixed and variable elements.
The allocation and apportionment of fixed factory overheads to cost
centres which makes manger more aware and responsible for cost
and services provided to others.
Absorption cost help to accrual and matching accounting concepts
which requires matching cost with revenue for particular accounting
period.

20

Limitations
Considering fixed manufacturing overhead as product cost which
increase the cost of output and it could be harmful for specially
offered price for product.
Under the absorption cost some current product cost can remove
from the income statement by produce as inventory and it could
lead to managers who evaluated on the ground of operating income
can improve temporarily profit by increasing production.
Absorption cost mainly depends on the total cost which include
variable and fixed is not useful for management in decision making
system.

Managerial decision making situations

Under the absorption costing allocates fixed overhead in to cost unit which
makes it appear as though additional unit produced add overhead cost, in
fact they are revenue opportunities.eg: Company makes 100 baseballs per
month for variable cost of4 and fixed overhead cost of 100 per month,
under the absorption costing it allocates 1 to each baseball for a total
cost of 5.If company sells another additional 10 baseballs at 4.5 each
under the absorption costing company make loss of .50 each. It s making
.50 each as it is not adding fixed cost by producing 10 more units they
only add variable cost. Due to the reason absorption costing is inadequate
for decision making process.

21

Inventory appear on the balance sheet as an asset but it doesnt appear

as an expenses or cost of goods sold. This is due to the fact that under the
absorption cost allocations of fixed overhead to the finished unit level.

Activity based costing

A new approach to costing called Activity based costing developed by
Harvards Robert Kaplan and Robin cooper and it assign staff and
overhead costs to products on the ground of how the products actually
consume or cause to those activities.ABC is basically methodology for
more suitable allocation of overheads to those items that actually use it.
ABC used mostly in complex environments where there are many types of
machinery, products and tangled process which are not easy to sort out.

The Activity based costing process

1. Identify costs: Identify the cost which we want to allocate.

22

2. Load Secondary cost pools: Create cost pools which cost incurred to
provide services to other parts of the company such as computer
services, administrative salaries...etc.
3. Load primary cost pools: Create cost pools for those cost which
aligned with the production more closely such as research and
development, advertising, procurement and distribution.
4. Measuring Activity Drivers: Use a data collection system to collect
information about activity drivers which are used to allocate the
secondary cost pools to primary cost pools, and primary cost pools
to cost objects. This is expensive process.
5. Allocate costs in secondary pools to primary pools: Use activity
drivers to apportion the cost in the secondary cost pools to primary
cost pools.
6. Charge cost to cost objects: Using activity driver to allocate the
contents of each primary pool to cost.
7. Formulate Reports: on this stage convert the results of ABC system
in to report mode for management use.

Advantages and Disadvantages

Advantages
ABA is useful for providing accurate cost per unit so as a result
improved pricing, sales strategy, performance management and
decision making.
Most importantly it recognizes that overhead cost is not all related
to the production and volume.
ABC applied to all overheads not just production overheads.
ABC is useful when use as service costing and product costing.
It provides much better insight view of what drives overhead costs.

23

Disadvantages
It is very hard to allocate all overhead cost to specific activities.
Implementing an ABC system is requires substantial resources and
time and once it implemented, it is costly to maintain.
It can easily misinterpret and must be used with care when making
decisions.
ABC is more complex to explain to the stakeholders of the costing
exercise.
Choice between activities and cost drivers might be inappropriate.

Decision Making Situations

Activity costs which is designed to track the cost of activities. It
helps to see if the activity cost is according with industry standards.
Also it may use for excellent feedback tool for measuring the
ongoing cost of specific services which help management to focus
on cost reduction.
Customer profitability which is help management to find the cost
incurred from individual customers such as product costs
,overhead ,unusual high customer service levels and product return
handling.ABC overcome these additional overhead costs by
choosing customer who actually earn company a reasonable profit
and it help to ignore the unprofitable customers. Also it may put
more effort on high earned customers to make larger profits.

24

Make or Buy decisions: ABC system shows comprehensive view of

every cost associated with manufacture product and then it will help
to identify which cost will be eliminated if item is outsourced versus
which cost remains.
Minimum price which is based on the market price for product and it
help marketing manager to know what the current cost of the
product in order to avoid selling products where company make
losses for product sales.ABC is provide details which overheads need
to be include in the minimum cost depending on situations.

Conclusions
Companies must evaluate their complexity of the operation and capital
consideration, nature of the competition before chose which system to
use. Company must adopt system where it will capture useful information
within their decision making system. Such as company which produce one
product would not need to use complex cost system as there all
overheads arise to support one product. On the other hand companies
which produce multiple products are complicated and they should use
complex cost system such as ABC.

25

References
Kaplan, R., Atkinson, A, 1998.Advanced Management Accounting.3rd Ed
Brinker, B. (Ed.). (1995). Handbook of Cost Management, Boston, MA:
Warren Gorham Lamont.
Campbell, R. (1995, January). Steeling time with ABC and TOC.
Management Accounting, 31-36.
Hansen, D., & Mowen, M. (1997). Cost management: Accounting and
control. Cincinnati, OH: Southwestern Publishing.
Hayes, R., & Abernathy, W. (1980, July-August). Managing our way to
economic decline. Harvard Business Review, 67-77.
Horngren, C., Foster, G., & Datar, S. (1997). Cost accounting: A managerial
emphasis. Upper Saddle River, NJ: Prentice Hall.
Johnson, T., & Kaplan, R. (1987). Relevance lost: The rise and fall of
management accounting. Boston, MA: Harvard Business School Press.

26

Kaplan, R., & Norton, D. (1992, January-February). The balanced scorecard

- Measures that drive performance. Harvard Business Review, 71-79.
McKinnon, S., & Bruns, W. (1993, January). What production managers
really want to know. Management Accounting, 29-35.
Morse, W., Davis, J., & Hartgraves, A. (1996). Management accounting: A
strategic approach. Cincinnati, OH: Southwestern Publishing.
Porter, M. (1985). Competitive advantage: Creating and sustaining
superior performance. NY: The Free Press.
Solomons, D. (1965). Divisional performance: Measurement and control.
Homewood, IL: Richard D. Irwin, Inc.
Stewart III, G. (1991). The quest for value: A guide for senior managers.
NY: Harper Collins Publishing.
Tully, S. (1993, September 20). The real key to creating wealth. Fortune,
38-50.

APPENDIX

1. Suppose a company wants to earn 15% net profit margin on 20,000 unit
sold. What price will company fix?
Following other information is give
suppose fixed cost which fixed = Rs. 180,000
suppose variable cost = Rs. 25

No. of units expected to sell = Fixed cost + desired profit /

contribution per unit
20000 = 180000 + 15% X ( 20000X S.P) / selling price - 25
20000 X ( S.P. - 25) = 180000+ 15% X( 20000 X S.P)
20000 S.P. - 500,000 = 180000 + 3000 S.P

27

20000 S.P - 3000 S.P = 180000 +500000

17000 S.P = 680000
S.P = 680000/17000 = 40
or
Expected Selling price = Rs. 40