Chapter 19

Slide 19.
Control Systems and Performance Measurement
Chapter 19
Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Pearson Education Limited 2012
Slide 19.3
Learning Objectives L i Obj i
Provide examples of financial and nonnonfinancial measures of performance Design an accounting-based performance accountingmeasure Understand the return on i U d d h investment (ROI) method of profitability analysis
Slide 19.4
Learning Objectives (Continued) L i Obj i (C i d)
Describe the residual-income (RI) measure residualDescribe the economic value added (EVA) method Distinguish between current-cost and currenthistorical-cost asset measurement methods historical hi i lh d
Slide 19.5
Learning Objectives (Continued) L i Obj i (C i d)
Recognise the role of salaries and incentives in compensation arrangements 8 Describe the management accountant s role accountants in designing incentive systems 9 Describe the incentive problems arising ib h i i bl ii when employees perform multiple tasks 10 Describe the four levers of control and understand their effects
Slide 19.6
Learning Objective 1 L i Obj ti
Provide examples of financial and nonnon-financial measures of performance
Slide 19.8
Financial and Non-Financial NonPerformance Measures ( f (Continued) i d)
Some organisations present financial and nonnon-financial performance measures for their subunits in a single report the balanced g p scorecard. scorecard. Most scorecards include: Profitability measures CustomerCustomer-satisfaction measures
Slide 19.9
Financial and Non-Financial NonPerformance Measures ( f (Continued) i d)
Internal measures of efficiency, quality and time Innovation measures measures. Some performance measures have a long-run longtime horizon. i h i Other measures have a short-run time horizon. short-
Slide 19.10
Learning Objective 2 L i Obj i
Design an accounting-based accountingperformance measure
Slide 19.11
AccountingAccounting-Based Performance Measure f
Designing an accounting-based performance accountingmeasure requires six steps: Choose performance measures that align with top managements financial goal(s). Choose the time horizon of each performance Ch h i h i f h f measure in Step 1. Choose a definition for each performance measure in Step 1. 1
Slide 19.12
AccountingAccounting-Based Performance Measure (C i d) (Continued)
Choose a measurement alternative for each performance measure in Step 1. Choose a target level of performance. performance Choose the timing of feedback.
Slide 19.13
Ye Olde Brewery owns three small hotels at airports in London, Manchester and g Birmingham. At present, Ye Olde Brewery does not allocate the total long-term debt of the company to the longthree separate hotels.
Slide 19.14
London Hotel: Current assets: LongLong-term assets: Total assets: Current liabilities:
350,000 550,000 550 000 900,000 50,000
Slide 19.15
London Hotel: Revenues Variable costs Fixed costs Operating profit
1,100,000 297,000 297 000 637,000 166,000 166 000
Slide 19.16
Manchester Hotel: Current assets: LongLong-term assets: Total assets: Current liabilities:
400,000 600,000 600 000 1,000,000 150,000
Slide 19.17
Manchester Hotel: Revenues Variable costs Fixed costs Operating profit
1,200,000 310,000 310 000 650,000 240,000 240 000
Slide 19.18
Birmingham Hotel: Current assets: LongLong-term assets: Total assets: Current liabilities:
600,000 5,000,000 5 000 000 5,600,000 300,000
Slide 19.19
Birmingham Hotel: Revenues Variable costs Fixed costs Operating profit
3,200,000 882,000 882 000 1,166,000 1,152,000 1 152 000
Slide 19.20
Ye Olde Brewery: Total current assets longg Total long-term assets Total assets Total current liabilities LongLong-term debt Stockholders Stockholders equity Total liabilities and equity
1,350,000 6,150,000 , , 7,500,000 500,000 500 000 4,800,000 2,200,000 2 200 000 7,500,000
Slide 19.21
Which hotel is the most successful? London Hotel with an operating profit of 166,000, 166 000 Manchester Hotel with 240,000, or Birmingham Hotel with 1,152,000? It appears that the Birmingham Hotel is the most successful.
Slide 19.22
A major weakness of comparing operating profits alone is ignoring differences in the size of the investments in each hotel. Investment refers to the resources or assets used to generate profit profit.
Slide 19.23
Three approaches include investment in the performance measure: Return on investment (ROI) Residual income (RI) Economic value added (EVA). A fourth approach measures return on sales (ROS).
Slide 19.24
Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment.
Return on investment (ROI) = Income Investment
Slide 19.25
Some companies use operating profit for the numerator. Other companies use net profit profit. Some companies use total assets in the denominator. d i Others use total assets minus current liabilities.
Slide 19.26
The return on investment (ROI) is also called the accounting rate of return. The ROI can be compared with the rate of return on opportunities elsewhere, inside and outside the company. company
Slide 19.27
What is the ROI for each hotel? London Hotel: , p g profit 166,000 Operating p 900,000 Total assets = 18% Manchester Hotel: 240,000 1,000,000 240 000 1 000 000 = 24% Birmingham H t l 1 152 000 5,600,000 Bi i h Hotel: 1,152,000 5 600 000 = 21%
Slide 19.28
Learning Objective 3 L i Obj ti
Understand the return on investment (ROI) method of profitability analysis
Slide 19.29
ROI M h d Method
The ROI method of profitability analysis recognises that there are two basic ingredients p g in profit making: Using assets to generate more revenue Increasing income per unit (e.g. , ) of i i i ( ) f revenue.
Slide 19.30
ROI M h d (C i d) Method (Continued)
Investment turnover = Revenues Investment
Return on sales = Profit Revenues
ROI = Investment turnover Return on sales

Slide 19.31
Assume that top management at Ye Olde Brewery adopts a 30% target ROI for the Manchester Hotel. How can this return be attained? Present situation: Revenues Total assets , 00,000 ,000,000 . 0 = 1,200,000 1,000,000 = 1.20 Operating profit Revenues 240,000 1,200,000 0.20 = 240 000 1 200 000 = 0 20 1.20 0.20 = 24%
Slide 19.32
Alternative A: Decrease assets, keeping revenues and operating profit per of revenue constant. Revenues Total assets 1,200,000 800 000 1.50 = 1 200 000 800,000 = 1 50 1.50 0.20 = 30%
Slide 19.33
Alternative B: Increase revenues, keeping assets and operating profit per of revenues d i fi f constant. Revenues Total assets , , , , = 1,500,000 1,000,000 = 1.50 Operating profit Revenues 300,000 1 500 000 0 20 = 300 000 1,500,000 = 0.20 1.50 0.20 = 30%
Slide 19.34
Alternative C: Decrease costs to increase operating profit per of revenues, keeping revenues and assets constant. Revenues Total assets , , , , = 1,200,000 1,000,000 = 1.20 Operating profit Revenues 300,000 1,200,000 0 25 = 300 000 1 200 000 = 0.25 1.20 0.25 = 30%
Slide 19.35
Describe the residual-income residual(RI) measure
Slide 19.36
Residual I R id l Income
Residual income (RI) is an accounting measure of profit minus a required monetary unit (e.g. , ) return on an accounting ( g ) g measure of investment. Residual profit (RI) = Income (Required rate of return Investment)
Slide 19.37
Residual I R id l Income (Continued) (C i d)
Assume that Ye Olde Brewerys required rate of return is 12%. What is the residual income from each hotel? London Hotel: Total assets l 900,000 12% = 108,000 Operating profit 166,000 108,000 = Residual income 58,000
Slide 19.38
Manchester Hotel: Total assets 1,000,000 12% = 120,000 p gp , , Operating profit 240,000 120,000 = Residual income 120,000 Birmingham Hotel: Total assets 5,600,000 12% = 672,000 Operating profit 1,152,000 672,000 = Residual income 480,000
Slide 19.39
The objective of maximising ROI may induce managers of highly profitable divisions to j p j , p reject projects that, from the viewpoint of the organisation as a whole, should be accepted. Goal congruence is more likely to be promoted by using residual income rather than ROI.
Slide 19.40
Describe the economic value added (EVA) method
Slide 19.41
EVA M h d Method
Economic value added (EVA) is a specific type of residual profit calculation that has recently attracted considerable attention. y Economic value added (EVA) = After-tax operating profit Afterf i fi [Weighted[Weighted-average cost of capital (Total assets Current liabilities)]
Slide 19.42
EVA M h d (C i d) Method (Continued)
Total assets minus current liabilities can also be computed as: LongLong-term assets + Current assets Current liabilities, or LongLong-term assets + Working capital ki i l
Slide 19.43
Economic value added (EVA) substitutes the f ll i specific numbers in the RI h following ifi b i h calculations: Income equal to after-tax operating profit afterA required rate of return equal to the weightedweighted-average cost of capital Investment equal to total assets minus I t t lt t t l t i current liabilities.
Slide 19.44
Assume that Ye Olde Brewery has two sources of long-term f d f longl funds: LongLong-term debt with a market value and book g value of 4,800,000 issued at an interest rate of 10% Equity capital that also has a market value of 4,800,000 and a book value of 2,200,000 4 800 000 2 200 000 Tax rate is 30%.
Slide 19.45
What is the after-tax cost of capital? after0.10 (1 Tax rate) = 0.07, or 7% The cost of equity capital is the opportunity cost to investors for not investing their capital in another investment that is similar in risk to Ye Olde Brewery. Assume th t Ye Old B A that Y Olde Brewerys cost of t f equity capital is 14%.
Slide 19.46
What is the weighted-average cost of capital weighted(WACC)? WACC = [(7% Market value of debt) + (14% Market value of equity)] (Market value of debt + Market value of equity) WACC = [(0.07 4,800,000) + (0.14 4,800,000)] 9,600,000 , , WACC = 336,000 + 672,000 9,600,000 WACC = 0 105 or 10.5% 0.105 10 5%
Slide 19.47
What is the after-tax operating profit for aftereach hotel? London Hotel: Operating profit 166,000 0.7 = 116,200 Manchester Hotel: Operating profit 240,000 0.7 = 168,000 Birmingham H t l Bi i h Hotel: Operating profit 1,152,000 0.7 = 806,400
Slide 19.48
What is the investment? London Hotel: Total assets 900,000 Current liabilities 50,000 = 850,000 50 000 850 000 Manchester Hotel: Total assets 1,000,000 Current li bili i 150,000 = 850,000 liabilities Birmingham Hotel: Total assets 5,600,000 Current liabilities 300,000 = 5,300,000
Slide 19.49
What is the weighted-average cost of capital weightedtimes the investment for each hotel? i h i f h h l? London Hotel: 850,000 10.5% = 89,250 Manchester Hotel: 850,000 10.5% = 89,250 Birmingham Hotel: 5,300,000 10 5% = 5 300 000 10.5% 556,500
Slide 19.50
What is the economic value added?
London Hotel: 116,200 89,250 = 26,950
Manchester Hotel: 168,000 89,250 78,750 M h t H t l 168 000 89 250 = 78 750
Birmingham Hotel: 806,400 556,500 = 249,900
The EVA charges managers for the cost of their investments in long-term assets and working capital longcapital.
Slide 19.51
What can managers do to improve their EVA? Earn more after-tax operating profit with the aftersame capital. capital Use less capital to earn the same after-tax afteroperating profit. i fi Invest capital in high-return projects. high-
Slide 19.52
Return on Sales R S l
The income-to-revenue (sales) ratio, or return on income-tosales (ROS) ratio, is a frequently-used financial frequentlyperformance measure. What is the ROS for each hotel? London Hotel: 166,000 1,100,000 = 15% Manchester Hotel: 240,000 1,200,000 = 20% Birmingham H t l 1 152 000 3,200,000 Bi i h Hotel: 1,152,000 3 200 000 = 36%
Slide 19.53
Comparing Performance C i P f
RI EVA 58,000 26,950 , 78,750 , 120,000 480,000 249,900 ROS 15% 20% 36%
Hotel ROI London 18% Manc. 24% Bham 21%
Slide 19.54
Comparing Performance (Continued) C i P f (C i d)
Methods Ranking M th d R ki Hotel ROI RI EVA London 3 3 3 Manchr 1 Manch r 2 2 Bham 2 1 1
ROS 3 2 1
Slide 19.56
Distinguish between current-cost currentand historical-cost asset historicalmeasurement methods
Slide 19.57
Choosing h Time H i Ch i the Ti Horizon
The second step in designing accounting-based accountingperformance measures is choosing the time horizon of each performance measure. The ROI, RI, EVA and ROS calculations represent the results of a single time period, a year in the example of Ye Olde Brewery. Many companies evaluate subunits on the basis of y p ROI, RI, EVA and ROS over multiple years.
Slide 19.58
Choosing the Time Horizon (Continued) (C i d)
What are some of the reasons for evaluating subunits over a multi-year time horizon? multiManagers could take actions that cause short-run shortincreases in the measures used but are in conflict with the long-run interests of the organisation. longBenefits of actions taken in the current period may not show up in short-run performance measurements. p shortp
Slide 19.59
Choosing Al Ch i Alternative Definitions i D fi i i
The third step in designing accounting-based accountingperformance measures is choosing a definition for each performance measure. p Definitions include the following: Total assets available i l d all assets, l l bl includes ll regardless of their particular purpose.
Slide 19.60
Choosing Alternative Definitions (Continued) (C i d)
Total assets employed includes total assets available minus the sum of idle assets and p p assets purchased for future expansion. Total assets employed minus current liabilities excludes that portion of total assets employed that are financed by short-term shortcreditors.
Slide 19.61
Choosing Alternative Definitions (Continued) (C i d)
Stockholders equity using this definition in the Ye Olde Brewery example requires allocation of the long-term liabilities to the g longthree hotels, which would then be deducted from the total assets of each hotel. hotel
Slide 19.62
Choosing M Ch i Measurement Alternatives Al i
The fourth step in designing accountingaccountingbased performance measures is choosing a measurement alternative for each performance p measure. The current cost of an asset is the cost now t t of purchasing an identical asset to the one currently held.
Slide 19.63
Choosing Measurement Alternatives (Continued) Al i (C i d)
A drawback of using current costs is that obtaining current-cost estimates for some currentassets can be difficult. HistoricalHistorical-cost asset measurement methods generally consider the net book value of the asset.
Slide 19.64
Book value = Original cost Accumulated depreciation The proponents of using net book value as an investment base maintain that it is less confusing. confusing
Slide 19.65
The fifth step in designing accounting-based accountingperformance measures is choosing a target level of performance. p HistoricalHistorical-cost measures are often inadequate for measuring economic returns on new investments and sometimes create disincentives for expansion.
Slide 19.66
Despite these problems, historical-cost ROIs historicalcan be used to evaluate current performance by establishing target ROIs. y g g The alternative of comparing actual results to target performance is frequently overlooked. overlooked
Slide 19.67
The sixth step in designing accounting-based accountingperformance measures is choosing the timing of feedback. Timing of feedback depends largely on how critical the information is for the success of the organisation specific level of management involved ifi l l f ti l d sophistication of the organisation.
Slide 19.69
Recognise the role of salaries and incentives in compensation arrangements
Slide 19.70
The B i TradeTh Basic Trade-Off T d
Performance evaluation often affects managers and employees rewards. Compensation arrangements run the range from a flat salary with no direct performanceperformancebased incentive to rewards based only on performance.
Slide 19.71
The B i TradeTh Basic Trade-Off (Continued) T d (C i d)
Managers may face risks because factors beyond their control may also affect p performance. Owners choose a mix of salary and incentive compensation to trade off the incentive benefit against the cost of imposing risk.
Slide 19.72
The B i TradeTh Basic Trade-Off (Continued) T d (C i d)
Most often, a managers total compensation includes some combination of salary and a p performanceperformance-based incentive.
Slide 19.73
Describe the management accountants role in designing g g incentive systems
Slide 19.75
Benchmarks B h k
Owners can use benchmarks to evaluate performance. Benchmarks representing best practice may be available inside or outside the organisation.
Slide 19.76
Measuring M i
Obtaining performance measures that are more sensitive to employee performance is p g g critical for implementing strong incentives. Many practices in management accounting, such as the design of responsibility centres and the establishment of financial and nonnonfinancial measures, have as their goal better p performance evaluation.
Slide 19.78
Describe the incentive problems arising when employees p g p y perform multiple tasks
Slide 19.79
Multiple k M l i l tasks
Baura Motors is a well-respected garage in wellWembley, London. The management wants their mechanics to focus on two elements of repair quantity and quality they not only want to maintain the speed at which repairs are done but also maintain high levels of quality to maintain customer satisfaction levels.
Slide 19.80
Multiple k (C i d) M l i l tasks (Continued)
What are the options open to the management of Baura motors?
They can drop the standard piece rate system that is in place, and give mechanics a salary promotions and bonuses can then be worked out on a quality and throughput basis basis. Management can use customer satisfaction surveys as the basis for their bonus decisions. Management can employ independent staff as quality managers and monitor whether repairs q y g p are being done to a high standard.
Slide 19.81
Multiple k (C i d) M l i l tasks (Continued)
The key element is to measure both aspects of an employees job (quality and quantity) and to balance the incentives so that both aspects are properly emphasised.
Slide 19.82
Describe the four levers of control and understand their effects
Slide 19.83
The four levers of control are: Diagnostic (measures that help diagnose i i ( h h l di whether a company is performing to expectations) Boundary systems (these describe standards of behaviour and codes of conduct) Belief systems (these articulate the mission, purpose and core values of a company) Interactive control systems (these help managers to focus organisational attention and learning on key strategic issues).
Slide 19.84
End of Chapter 19 p

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Slide 19.

Control Systems and Performance Measurement

Learning Objectives L i Obj i

Learning Objectives (Continued) L i Obj i (C i d)

Learning Objectives (Continued) L i Obj i (C i d)

Learning Objective 1 L i Obj ti

Provide examples of financial and nonnon-financial measures of performance

Financial and Non-Financial NonPerformance Measures ( f (Continued) i d)

Financial and Non-Financial NonPerformance Measures ( f (Continued) i d)

Learning Objective 2 L i Obj i

Design an accounting-based accountingperformance measure

AccountingAccounting-Based Performance Measure f

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

350,000 550,000 550 000 900,000 50,000

AccountingAccounting-Based Performance Measure (C i d) (Continued)

London Hotel: Revenues Variable costs Fixed costs Operating profit

1,100,000 297,000 297 000 637,000 166,000 166 000

AccountingAccounting-Based Performance Measure (C i d) (Continued)

400,000 600,000 600 000 1,000,000 150,000

AccountingAccounting-Based Performance Measure (C i d) (Continued)

Manchester Hotel: Revenues Variable costs Fixed costs Operating profit

1,200,000 310,000 310 000 650,000 240,000 240 000

AccountingAccounting-Based Performance Measure (C i d) (Continued)

600,000 5,000,000 5 000 000 5,600,000 300,000

AccountingAccounting-Based Performance Measure (C i d) (Continued)

Birmingham Hotel: Revenues Variable costs Fixed costs Operating profit

3,200,000 882,000 882 000 1,166,000 1,152,000 1 152 000

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

Return on investment (ROI) = Income Investment

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

AccountingAccounting-Based Performance Measure (C i d) (Continued)

Learning Objective 3 L i Obj ti

Understand the return on investment (ROI) method of profitability analysis

ROI M h d (C i d) Method (Continued)

Investment turnover = Revenues Investment

Return on sales = Profit Revenues

ROI = Investment turnover Return on sales

ROI M h d (C i d) Method (Continued)

ROI M h d (C i d) Method (Continued)

ROI M h d (C i d) Method (Continued)

ROI M h d (C i d) Method (Continued)

Learning Objective 4 L i Obj i

Describe the residual-income residual(RI) measure

Residual I R id l Income (Continued) (C i d)

Residual I R id l Income (Continued) (C i d)

Residual I R id l Income (Continued) (C i d)

Learning Objective 5 L i Obj i

Describe the economic value added (EVA) method

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)

EVA M h d (C i d) Method (Continued)