1
Introduction
We also discuss two
methods of
relating profit to
the investment
base :
1. ROI
2. EVA
We will discuss the
investment base. The
investment base is
types of asset that
may be employed in
an investment center.
2
Structure of the Analysis
The purposes of measuring
assets employed are :
1. To provide information that is
useful in making sound decisions
about assets employed and to
motivate managers to make
these sound decisions that are in
the best interests of the
company.
2. To measure the performance of
the business unit as an economic
entity.
3
Structure of the Analysis
In general business unit managers
have two performance objectives :
1. They should generate profits from the
resources at their disposal.
2. They should invest in additional resources
only when the investment will produce an
adequate return.
The purpose of relating profits to investments is
to motivate business unit managers to
accomplish these objectives.
4
Structure of the Analysis
The two ways of relating profits to
asset employed are :
1. Return on Investment (ROI)
ROI is a ratio. The numerator is income, as
reported on the income statement. The
denominator is assets employed
2. Economic Value Added (EVA)
EVA is a dollar amount, rather than a ratio. It is
found by subtracting a capital charge from
the net operating profit. This capital charge
is found multiplying the amount of assets
employed by a rate.
5
Structure of the Analysis
Balance Sheet
($ 000s)
Current Liabilities
50 Account payable
150 Other current
200
400 Total current liabilities
_
Current Assets
Cash
$
Receivables
$
Inventory
$
Total current assets $
Fixed assets
Cost
$ 600
Depreciation
$ 300
Book value
$ 300
Total Assets
$ 700
_
$ 90
$ 110
$ 200
Corporate Equity
$ 500
Total Equities
$ 700
_
Income Statement
_
Revenue
$ 1,000
Expense, except depreciation
$ 850
Depreciation
$
50
Income before taxes
$ 100
Capital charge ($ 500 * 10 %)
$
50
Economic Value Added (EVA)
$
50
Return On Investment (ROI) $ 100/$ 500 :
20 %
6
Structure of the Analysis
EVA is conceptually
superior to ROI.
Nevertheless, it is
clear from the surveys
that ROI is more
widely used in a
business rather than
EVA.
7
Measuring Assets Employed
In deciding what investment base
to use to evaluate investment
center managers, headquarters
asks two questions :
1. What practices will induce business
unit managers to use their assets
most efficiently and to acquire the
proper amount and kind of new
assets ?.
2. What practices best measure the
performance of the unit as an
economic entity ?.
8
Measuring Assets Employed
1. Cash
• Many companies use a
formula to calculate the
cash to be included in the
investment base
• Some companies omit
cash from the investment
base. These companies
reason that the amount
of cash approximates the
current liabilities.
9
Measuring Assets Employed
2. Receivables
• Business unit managers can influence
the level of receivables indirectly, by
their ability to generate sales, and
directly, by establishing credit terms
and approving individual credit
accounts.
• The usual practice is to include
receivables at the book amount,
which is the selling price less an
allowance for bad debts
10
Measuring Assets Employed
3. Inventories
• Inventories ordinarily
are treated in a manner
similar to receivables –
that is, they are often
recorded at end of
period amounts even
though intra period
averages would be
preferable conceptually
11
Measuring Assets Employed
4. Working Capital in General
• At one extreme, companies include
all current assets in the
investments base with no offset for
any current liabilities.
• At the other extreme, all current
liabilities may be deducted from
current assets.
12
Measuring Assets Employed
5. Property, Plant and Equipment
• If depreciable assets are included in the
investment base at net book value, business
unit profitability is misstated.
• The fluctuation in EVA and ROI from year to
year can be avoided by including depreciable
assets in the investment base at gross book
value rather than at net book value.
• If depreciation is determined by the annuity,
rather than the straight line method, the
business unit profitability calculation will show
the correct EVA and ROI.
13
Measuring Assets Employed
6. Leased Assets
• The business unit managers
are induce to lease, rather
than own, assets whenever
the interest charge that is
built into the rental cost is
less than the capital charge
that is applied to the
business unit’s investment
base, because it would
increase EVA.
14
EVA vs ROI
 Most companies employing investment
centers evaluate business units on the basis
of ROI rather than EVA.
 There are three apparent benefits on ROI
measure :
•
•
•
It is a comprehensive measure in that anything that
affects financial statements is reflected in this ratio
ROI is simple to calculate, easy to understand, and
meaningful in absolute sense
ROI is a common denominator that may be applied
to any organizational unit responsible for
profitability, regardless of size or type of business.
15
EVA vs ROI
 The EVA approach has some inherent
advantages. There are four compelling reasons
to use EVA over ROI :
•
•
•
•
With EVA all business units have the same profit
objective for comparable investments.
Decisions that increase a center’s ROI may decrease its
overall profits. If an investment center’s performance
is measured by EVA, investments that produce a profit
in excess of the cost of capital will increase EVA and
therefore be economically attractive to the manager.
Different interest rate may be used for different types
of assets.
In contrast to ROI, EVA has a stronger positive
correlation with changes in a company’s market value.
16
EVA vs ROI
EVA = Net profit – Capital charge
Where (1) :
Capital charge = Cost of capital x Capital employed
Another way to calculate EVA (2):
EVA = Capital employed (ROI – Cost of capital)
17
EVA vs ROI
The following actions can increase EVA :
• Increase in ROI through business process
reengineering and productivity gains, without
increasing the asset base.
• Divestment of assets, products and/or businesses
whose ROI is less than the cost of capital
• Aggressive new investments in assets, products,
and/or businesses whose ROI exceeds the cost of
capital
• Increase in sales, profit margins or capital
efficiency or decrease in in cost of capital
percentage without affecting the other variables
in equation (2)
18
Introduction
This discussion focuses
on financial performance
measures
19
Calculating Variances
• Most companies make a monthly analysis of
the differences between actual and budgeted
revenues and expenses for each business unit
and for the whole organization.
• A more thorough analysis identifies the
causes of the variances and the organization
unit responsible.
• Effective systems identify variances down to
the lowest level of management
• Therefore, it is possible to identify each
variance with with the individual manager
who is responsible for it.
20
Calculating Variances
The analytical framework use
to conduct variance
analysis incorporates the
following ideas :
• Identify the key causal factors
that affects profits
• Break down the overall profit
variances by these key causal
factors
• Focus on the profit impact of
variation in each causal factors
21
Calculating Variances
• Try to calculate the specific, separable
impact of each causal factor by varying only
that factor while holding all other factors
constant
• Add complexity sequentially, one layer at a
time, beginning at a very basic
“commonsense” level (“peel the onion”).
• Stop the process when the added
complexity at a newly created level is not
justified by added useful insights into the
casual factors underlying the overall profit
variance
22
Calculating Variances
Revenue Variances
• The calculation is made for each
product line, and the product line
results are then aggregated to
calculate the total variance.
23
Variations in Practice
Time Period of the Comparison
• Some companies use performance for
the year to date as the basis for
comparison. For period ended June
30, they would use budgeted and
actual amounts for the six months
ending on June, rather than the
amounts for June.
• A comparison for the year to date is
not as much influenced by temporary
aberrations that may be peculiar to
the current month.
24
Variations in Practice
Focus on Gross Margin
• Gross margin = Selling prices – Manufacturing
cost
25
Variations in Practice
Focus on Gross Margin
• Evaluation
The formal standards used in the evaluation of
reports on actual activities are :
1. Predetermined standards
If carefully prepared and coordinated, these
are excellent standards
2. Historical standards
These are records of past actual performance.
Results for the current month may be
compared with the results for last month, or
with results for the same month a year ago.
3. External standards
26
Variations in Practice
Full Cost Systems
• If the company has a full cost system, both
variable and fixed overhead costs are
included in the inventory at the standard
cost per unit
• Variance = Budgeted fixed production cost
at the actual volume – Standard fixed
production costs at that volume
• The important point is that production
variances should be associated with
production volume, not sales volume
27
Variations in Practice
Amount of Detail
We analyzed revenue variances at several levels :
1. In total
2. By volume, mix and price
3. By analyzing the volume and mix variance
4. By industry volume and market share
At each of these levels, we analyzed the
variances by individual products. The process
of going from one level to another is often
referred to as “peeling the onion “.
28
Variations in Practice
Engineered and Discretionary Costs
• A favorable variance in engineered costs is
usually an indication of good performance, that
is the lower the cost, the better the
performance
• By contrast, the performance of a
discretionary expense center is usually judged
to be satisfactory if actual expenses are about
equal to the budgeted amount, neither higher
or lower.
29
Limitations of Variance Analysis
1. Although it identifies where a variance
occurs, it does not tell why the variance
occurred or what is being done about it.
2. To decide whether a variance is significant
3. The performance reports become more
highly aggregated, offsetting variances
might mislead the reader.
Finally, the reports show only what was
happened. They do not show the future
effects of actions that manager has taken.
30
Limitations of Variance Analysis
Management Action
• There is one cardinal principle in
analyzing formal financial reports. The
monthly profit report should contain
no major surprises.
• One of the most important benefits of
formal reporting is that is provides the
desirable pressure on the subordinate
managers to take corrective actions on
their own initiative
• Profit reports are worthless unless
they lead to action
Performance Measurement
Systems
31
Framework for Designing Performance Measurement
Systems
What counts, get
measured
What gets
rewarded,
really
counts
STRATEGY
What gets done, gets
rewarded
What gets
measured,
gets done
Performance Measurement
Systems
Balance Scorecard
• The balance scorecard is an example of a
performance measurement system.
• The four perspective of balance scorecard :
1. Financial (eq. profit margin, ROA, cash flows)
2. Customer (eq. market share, customer
satisfaction index)
3. Internal business (eq. employee retention,
cycle time reduction)
4. Innovation and learning (eq. percentage of
sales from new products)
32
Performance Measurement
Systems
Balance Scorecard
In creating the balanced scorecard, executives
must choose a mix of measurements that :
1. Accurately reflect the critical factors that
will determine the success of the company’s
strategy
2. Show the relationships among the individual
measures in a cause and effect manner
3. Provide a broad based view of the current
status of the company
33
34
Performance Measurement Systems
Cause Effect Relationships Among Measures
Perspective
Measures
Innovation and
learning
perspective
Manufacturing
skills
Internal business
perspective
First pass yields
Order cycle time
Customer
perspective
Customer
Satisfaction survey
Financial
perspective
Sales revenue
growth
35
Interactive Control
• The primary role of management
control is to help execute strategies.
• The chosen strategy defines the
critical success factors which become
the local point for the design and
operation of control systems.
• In a rapidly changing and dynamic
environment, creating a learning
organization is essential to corporate
survival.
• The main objective of interactive
control is to facilitate the creation of
a learning organization
Interactive Control
Control System as a Strategy Implementation Tool
Chosen Strategy
Critical success
Factors
Design and operation
of management
control system
36
Interactive Control
Interactive Control
Today’s Management
Control System
Tomorrow’s
Strategy
37
38
Interactive Control
Interactive control has the following
characteristic :
• A subset of the management control information that
has a bearing on the strategic uncertainties facing the
business becomes the focal point
• Senior executives take such information seriously
• Managers at all levels of the organization focus
attention on the information produced by the system
• Superiors, subordinates and peers meet face to face to
interpret and discuss the implications of the
information for future strategic initiatives
• The face to face meetings take the form of debate and
challenge of the underlying data, assumption, and
appropriate actions.
Interactive Control
Control System as a Strategy Formation Tool
Strategic
Uncertainties
Use of a subset of
management control
information
interactively
New strategies
39
40
Service Organizations in General
Management control in
service industries is
somewhat different from
management control in
manufacturing companies
41
Service Organizations in General
Characteristics :
• Absence of inventory
buffer
• Difficulty in controlling
quality
• Labor intensive
• Multi unit organizations
42
Professional Service Organizations
Special
Characteristics :
a. Goals
b. Professionals
c. Output and Input
Measurement
d. Small Size
e. Marketing
43
Professional Service Organizations
Management Control Systems :
a. Pricing
b. Profit Centers and Transfer
Pricing
c. Strategic Planning and Budgeting
d. Control of Operations
e. Performance Measurement and
Appraisal
44
Financial Service Organizations
Financial service
organizations include
commercial bank and
thrift institutions,
insurance companies and
securities firms
45
Financial Service Organizations
Special Characteristics :
While the general principles and concepts of
management control systems apply, they need
to be adapted to the following special
characteristics of the financial services
industry :
a.
b.
c.
d.
Monetary Assets
Time Period for Transactions
Risk and Reward
Technology
46
Nonprofit Organizations
A nonprofit organization, as
defined in law, is an
organization that cannot
distribute assets or income to,
or for the benefit of, its
members, officers, or
directors.
This definition does not
prohibit an organization from
earnings a profit, it prohibits
only the distribution of
profits.
47
Corporate Strategy
Implications for Organization Structure
• Different corporate strategies imply different
organization structures and, in turn, different
controls
• The organization structure implications of
different corporate strategies are given on the
next slide
• At the “single industry” end, the company
tends to be functionally organized
• “Unrelated diversified” company
(conglomerate) is organized into relatively
autonomous business units
48
Corporate Strategy
Different Corporate Strategies : Organizational Structure
Implications
Single Industry Related Diversified Unrelated Diversified
Organizational structure Functional
Business units
Holding company
Industry familiarity of
corporate management
High
Functional background
Relevant
Of corporate management Operating
Decision making authority More centralized
Low
Mainly
Finance
More decentralized
Size of corporate staff
High
Low
Reliance on internal
promotions
High
Low
Use of lateral transfers
High
Low
Corporate culture
Strong
Weak
49
Corporate Strategy
Implications for Management Control
Different corporate strategies imply the
following differences in the context in which
control systems need to be designed :
• Corporate level managers may not have
significant knowledge of, or experience in the
activities of the company’s various business
units.
• Single industry and related diversified firms
possess corporatewide core competencies on
which the strategies of most of the business
units are based.
50
Corporate Strategy
Different Corporate Strategies : Management Control Implications
Single Industry Related Diversified Unrelated Diversified
Strategic Planning
Vertical cum
Vertical only
horizontal
Budgeting, Control
Low
High
Over Budget Formulation
Importance Attached
Low
High
to Meeting the Budget
Transfer Pricing
High
Sourcing Flexibility
Constrained
Incentive Compensation
Bonus Criteria
Financial/non
financial criteria
Bonus Determination
Approach
Bonus Basis
Primarily
subjective
Based both on business
& corporate performances
Low
Arm’s length market
pricing
Primarily financial
criteria
Primarily formula
based
Based on business
unit performance
51
Business Unit Strategy
Business Unit Mission : The BCG Model
Cash source
High
Low
Hold
Build
“ Star “
“ Question mark “
Harvest
Divest
“ Cash cow “
“ Dog “
High
Market
growth
rate
Low
High
Relative market share
High
Cash use
Low
Low
52
Business Unit Strategy
The BCG Model
• Build
This mission implies an objective of increased market share,
even at the expense of short term earnings and cash flow
• Hold
This strategic mission is geared to the protection of the
business unit’s market share and competitive position
• Harvest
This mission has the objective of maximizing short term
earnings and cash flow
• Divest
This mission indicates a decision to withdraw from the
business either through a process of slow liquidation or
outright sale
53
Corporate Strategy
Different Strategic Mission : Implications for Incentive
Compensation
Percent Compensation
as Bonus
Bonus Criteria
Build
Relatively
High
More emphasis
on non financial
criteria
Bonus Determination
Approach
More
subjective
Frequency of Bonus
Payment
Less
frequent
Hold
Harvest
Relatively
Low
More emphasis
on financial
criteria
More
formula based
More
frequent
54
Top Management Style
The management control
function in an
organization is influenced
by the style of senior
management