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Capacity/product costs
o Practical Capacity
 Level of capacity that reduces theoretical capacity by considering
unavoidable operating interruptions (maintenance, holidays, etc.)
o Theoretical Capacity
 Level of capacity based on producing at full efficiency all the time
o Cost of Unused Capacity
 In the short run, capacity costs are fixed
 Actual capacity used/needed rarely matches available capacity
 Accounting in the presence of excess capacity can lead to incorrect
profitability signals
 Happens when you assign excess capacity costs to current
products
 Generally, occurs when demand is changing (growing or declining
companies)
 UCC = FC x (1 – Actual used/practical capacity)
o Two rules to remember about capacity
 Charge the cost of unused capacity to those who demand it
 Do not charge the cost of excess capacity to customers
Customer lifetime value
o To better understand how valuable a customer is, firms focus on these customer
related strategies
 Cost to acquire a customer
 Profit the customer generates for the firm
 Retention rate (how long the customer is likely to continue the
relationship with the firm)
o Issues?
 Can be difficult to calculate
 Depends on a number of different factors that may differ based upon
product, how customer was acquired, etc.
 The input to the calculation assumes that these values do not change
over time
Performance measures
o Goals
 To motivate managers to exert a high level of effort to achieve the goals
set by top management (bonuses)
 To provide the incentive for managers, acting autonomously, to make
decisions consistent with the goals set by top management
 To develop fairly the rewards earned by managers for their effort and
skill and the effectiveness of their decision-making
o ROI= accounting income/ investment
 Popular for two reasons:
 Blends all the ingredients of profitability (revenues, costs, and
investment) into a single percentage
 May be compared to other ROIs both inside and outside the firm
Underlying Factors
 (Income/sales revenue) * (Sales revenue/invested capital)
 Or return on sales * investment turnover
 Sales margin* capital turnover
 Improving ROI
 Increase sales margin
o Increase sales price or cut expenses
 Increase capital turnover
o Increase sales price or decrease total investment
 Advantages and limitations
 Advantages
o Easily understood by managers
o Comparable to interest rates and the rates of return on
alternative investments
o Widely used and reported in the business press
 Limitations
o Goal congruency issues: incentive for high ROI units to
invest in projects with ROI higher than the minimum rate
of return but lower than the unit’s current ROI
o Residual Income= income- (RRR*Investment)
 RRR= Required rate of return (discount rate, cost of capital)
 RRR * investment= imputed cost of the investment
 Imputed costs are costs recognized in some situations, but not in
the financial accounting records
o EVA =(After-tax operating income – [WACC*(Assets-current liabilities)]
 Specific type of residual income calculation that has recently gained
popularity
 A business unit’s income after taxes and after deducting the cost of
capital (also called economic profit)
 Generally include unrecorded intangibles in assets such as R&D or
Advertising and gross up income for these items
 WACC= after-tax average cost of all long-term funds in use
 = [(After-tax cost of debt capital *market value of debt)+(cost of
equity capital*market value of equity)]/(Market value of debt+
market value of equity)
o Advantages & Limitations of Residual Income
 Advantages
 Supports incentives to accept all projects with ROI > minimum
rate of return
 Can use the minimum rate of return to adjust for differences in
risk
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Can use a different minimum rate of return for different types of
assets
Limitations
 Favors large units
 Not as intuitive as ROI
 May be difficult to obtain a minimum rate of return at the subunit
level
Balanced scorecard
o Financial
 Financial goals
 Evaluates the profitability of the strategy
 Uses the most objective measures in the scorecard
 The other three perspectives eventually feed back into this dimension
o Customer
 What customers do we want to serve and how do we win and retain
them?
 Identifies targeted customer and market segments and measures the
company’s success in these segments
o Internal
 How can we excel at our internal business processes? What processes are
critical to providing value to our customers?
 Focuses in internal operations that create value for customers that, in
turn, furthers the financial perspective by increasing shareholder value
o Learning & Growth
 How can we continue to learn and create?
 Identifies the capabilities the organization must excel at to achieve
superior internal processes that create value for customers and
shareholders
o Sustainability
 The fifth perspective for many organizations
 The balancing of short-term and long-term goals in all three
dimensions of the company’s performance-economic, social, and
environmental
 Environmental reports use environmental performance indicators (EPIS)
to measure sustainability. These indicators are in three areas:
 Operational (measure stresses to the environment/regulatory
compliance issues)
 Management (try to reduce environmental effects)
 Environmental condition (measure environmental quality)
o Common Balanced Scorecard Measures
 Financial Perspective
 Income measures: operating income, gross margin percentage
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Revenue and cost measures: revenue growth, revenues from new
products, cost reductions in key areas
 Income and investment measures: Economic value added, return
on investment
 Customer perspective
 Market share, customer satisfaction, customer-retention
percentage, time taken to fulfill customers’ requests, number of
customer complaints
 Internal-Business-Process Perspective
 Innovation Process: Operating capabilities, number of new
products or services, new- product development times, and
number of new patents
 Operations Process: Yield, defect rates, time taken to deliver
product to customers, percentage of on-time deliveries, average
time taken to respond to orders, setup time, manufacturing
downtime
 Postsales Service Process: Time taken to replace or repair
defective products, hours of customer training for using the
product
 Learning- and- Growth Perspective
 Employee measures: Employee education and skill levels,
employee-satisfaction ratings, employee turnover rates,
percentage of employee suggestions implemented, percentage of
compensation based on individual and team incentives
 Technology measures: information system availability, percentage
of processes with advanced controls
o Features of a Good Balanced Scorecard
 Must motivate managers to take actions that eventually result in
improvements in financial performance
 Tells the story of a firm’s strategy, articulating a sequence of cause- andeffect relationships
 Must have commitment and leadership from top management and
communicate the strategy to all members of the organization
 Translate the strategy into a coherent and linked set of understandable
and measurable operational targets, identifying only the most critical
ones
o Implementation Pitfalls
 Managers should not assume the cause- and-effect linkages are precisethey are merely hypotheses
 Managers should not seek improvements across all of the measures all of
the time
 Managers should not use only objective measures: subjective measures
are important as well
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Managers should not use too many measures