Management Accounting:
A Road of Discovery
Management Accounting:
A Road of Discovery
James T. Mackey
Michael F. Thomas
Presentations by:
Roderick S. Barclay
Texas A&M University - Commerce
James T. Mackey
California State University - Sacramento
© 2000 South-Western College Publishing
Chapter 8
Will our people do this?
Motivation and control
through accounting
information
Key Learning Objectives
1. Describe the motivational
relationship between planning,
control, and evaluation.
3. Explain three motivational
problems with using
accounting information in
performance evaluation.
5. Compute ROI and residual
income, and explain their
motivational implications.
7. [Appendix A] Demonstrate how
service department and
common cost allocations can
support cost control.
2. Discuss the evolution from clan
control to accounting control
and accounting’s control
hierarchy.
4. Prepare a segmented income
statement and explain its
usefulness in evaluating
segments and managers.
6. Summarize five ethical
concerns with management’s
use of accounting control
measures.
Part I
The Meaning of Control
Control Means:

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Getting people to do what you want.
Or
Getting people to always act to maintain or improve
company value.
Or
Getting people to always act according to established
rules or procedures.
For management purposes we wish to make
managers make ‘good decisions and exercise good
judgment’.

Good judgment requires motivation and direction.
A Personal Example

Is your grade in this course a good performance
measure to control your behavior?
 If the objective of a college education is to create
long-term value, does increasing your GPA
reflect an increase in your long-term value?
 Does the calculation and components of the grade
direct you to do long-term value adding actions?
 If the grade is used to evaluate your performance,
do you have sufficient control over the factors
that determine your grade?
 Do you have control over the activities for which
you are held responsible?
The Motivational Cycle
Goal Congruence
(employees do what we
want)
Responsibility Based on
Controllability
(employees given the
power to decide)
Reward System
(offer adequate rewards)
Performance Measures
(measure the right things,
the right way)
About The Control Environment

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Planning often requires guesswork from employees
about costs versus revenues.
Management prefers hard data for evaluation.
Employee participation and their beliefs about
legitimacy are necessary.
Management needs to encourage building in a
cushion or slack.
Remember ‘What gets measured gets done’.
Understand the conflict between better decisions or
better control.
Part II
Many Types of Controls
How Much Accounting Control
Do We Need?
Control System
Role of accounting information in
control
Clan control
Secondary
(informal, infrequent direct observation is
primary source of control)
Market control
Secondary
(primary source is external — police ticket)
Bureaucratic rules
(centralized)
Shared
(frequent direct observation or accounting
system when direct observation is not
practical
Bureaucratic rules
(decentralized)
Primary
(accounting system measures the outputs
from the black box)
Types of Controls

Control can be achieved through any
combination of:

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Clan Control — We have the same values or
culture.
Bureaucratic Control — We follow the same rules.
Accounting Control — We follow management by
the numbers.
Market Control — We follow what the market
values most.
Most companies use a mix of controls subject
to the costs and benefits of their situation
(and the corporate culture).
Centralized vs. Decentralized Controls

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Centralized management — Higher level
corporate management makes more
decisions.
Decentralized management — Managers at
lower levels make more decisions.
If accounting measures accurately measure
value, then centralized ‘Management by the
Numbers’ is more efficient.
Responsibility Centers used in Accounting
Control Systems

Cost center
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Profit center
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Investment center

Its budget covers only the costs incurred. Cost
center activities create costs such as in a
production department. Cost variances have
been the primary accounting control measure.
Its budget includes revenues and costs. Profit
centers normally are product lines or sales
territories. A profit center’s activities create
revenues and incur costs. Sales and cost
variances have been the primary accounting
control measures.
Its budget involves investment and profit
activities. Its activities involve asset purchases
that are used to generate profits, (e.g.,
divisions or companies). Primary accounting
measures include sales and cost variances, and
expression of profit in relation to investment,
(e.g., ROI, residual income, and economic
value added).
Limitations for ‘Management by the
Numbers’ or Accounting Control

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Does the accounting measure reflect
company value?
Does the accounting measure reflect the
results of activities which the managers are
responsible for and which they can control?
Do the accounting measures direct
managers to actions that improve value?
Part III
Segmented Income Statements
Segment Profitability Statement
Sales
- Variable product expenses
= Contribution margin from product sales
- Controllable fixed costs
= Segment contribution margin
- Common (allocated) costs
= Segment profit margin
Evaluation of Managers and Divisions

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These reports are designed to identify the costs and
revenues influenced or controlled by manager’s
activities and those due to a business segment.
Review and analyze Exhibit 8-5, p. 273.
Note that this is a full cost report where the
segments must equal the company total.
Hidden in these numbers are:
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The costs controllable by the segment manager.
The costs not controllable by the segment manager
but only existing for this segment.
Common fixed costs allocated to the segment but not
related to segment activity.
Assigning Costs by ‘Ability to Bear’ or
Sales Revenue
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Common costs are costs necessary for the
company to exist but cannot be related to a
particular segment.
Since full costing says all our costs must be
recovered, the common costs are assigned to each
segment by their relative sales activity. Remember,
this isn’t GAAP and will vary in practice.
Review Exhibit 8-5, p. 273 again.
If we sell one more standard home, why will the
increase in net income exceed $8,552? Why not?
If the standard home line is dropped, will the
reduction in total net income be $855,167? Why
not?
Segment Margin Statements
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Common costs are not assigned to segments or
product lines.
Common fixed costs are taken out of the overhead
costs.
Review and analyze Exhibit 8-8, p. 280.
If one more standard house were sold, how would
the total company profit change?
If the company dropped the standard home line,
how would the total company profit change?
Controllable Segment Margin Statements
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For evaluation and motivation, fixed costs not
controllable by the segment managers should not
be part of the bonus system.
Review and analyze Exhibit 8-9, p. 281.
If a manager’s performance and bonus are based
on the controllable segment margin, explain how
managers can increase their bonus and company
value at the same time.
Assume you are the manager of the standard
homes segment, what actions does this statement
suggest you can take to both improve your bonus
and increase company value?
Limitations of Segment Reports
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Common costs are difficult to allocate based upon
cause and effect.
Segments often influence each other’s performance.
All accounting measures ae subject to errors and may
be estimates.
If dropping the Custom Division also reduced the
sales of the Standard homes division by 10%, what
would be the decrease in the total Net Income? Refer
back to Exhibit 8-8, p. 280.
10% reduction in Standard Home contribution margin = $200,000
Lost segment margin from Custom homes
total decrease for the company
= $185,000
= $385,000
Part IV
Measures of Relative Profitability
Profitability in terms of the money invested is
measured by various profit and invested capital
calculations.
Return on Investment (ROI)
Return on Investment = Profit / Investment
ROI = Sales Margin x Sales Turnover
Sales Margin = Profit / Sales
Sales Turnover = Sales / Investment
•
The Sales Margin measures the relative profit on each sales dollar.
Increasing the sales margin by increasing the profit on sales will
improve the ROI.
•
The Sales Turnover ratio examines how efficiently the investment
in assets is used to generate sales. Increasing sales while
maintaining the same level of investment or decreasing the level
of investment will increase the ROI.
In practice there is considerable variation in the items that are
included in each category depending on the firm’s objectives.
An Illustration
Division A
Division B
$10,000,000
$2,000,000
8,000,000
500,000
1,000,000
500,000
Operating income
$ 1,500,000
$ 500,000
Capital Invested
$10,000,000
$3,000,000
Sales
Less:
Operating expenses
R&D
For A:
For B:
ROI = $1,500,000 / $10,000,000 = 15%
ROI = $ 500,000 / $3,000,000 = 16.7%
For A:
For B:
Sales Margin = $1,500,000 / $10,000,000 = 15%
Sales Margin = $500,000 / $2,000,000 = 25%
For A:
For B:
Turnover Ratio = $10,000,000 / $10,000,000 = 1.0
Turnover Ratio = $2,000,000 / $3,000,000 = 0.67
Part V
Residual Income (RI) and
The Cost of Capital (COC)
Definitions
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The residual income measures the profits
returned after a ‘Cost of Capital’ (COC)
charge is recovered from the segment or
division.
Residual income (RI) is simply the operating
profit less the COC.
An Illustration

For Divisions A & B with a 12% COC, the
Residual Income is:
A
$1,500,000
Operating Income
Less:
12% x $10,000,000 $1,200,000
12% x $3,000,000
Residual Income
$ 300,000
B
$500,000
$360,000
$140,000
Cost of Capital Employed:
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This is the rate of return required by the company
multiplied by the capital employed.
Arguments surround how this capital charge should
be calculated.
 Some authors suggest that it should reflect the
unique risk for each segment. Riskier segments
should have a higher COC, safer segments less.
 Others argue that the cost of capital should reflect
the value of alternative uses for the invested
capital, or the firm’s cost of borrowing money.
ROI versus RI
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ROI measures the average return for dollars
invested.
RI measures net excess (shortfall) over the
cost of capital required.
ROI versus RI measures the return over the
life of the product.
Review Exhibit 8-13, p. 289 for an illustration
of a multi-year investment.
Accounting Performance Measures
Economic value added (EVA )
Residual income
Investment x (ROI – Cost of capital)
Return on investment (ROI)
(Segment profit ratio x Asset turnover ratio)
Segment profit ratio
Asset turnover ratio
(Segment profit / Sales)
(Sales / Segment assets)
Sales variances
Cost variances
Cash budgets
Capital budgets
(price & volume)
(price & usage)
(working capital)
Implementation
audits
Economic Value Added — EVA
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The overall calculation is roughly the same as RI.
However, the costs and revenues used may change
from company to company.
The idea behind changes to the GAAP numbers is
that they do not always reflect changes in value.
Adjustments are made to the accounting numbers so
that changes in value are captured.
For each company any one of many adjustments can
be made to better measure value. While the
measurements are debated, EVA has become
extremely popular as an organizational performance
measure.
Adjustments to Reflect Economic Value
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EVA theory states that research and development is
an asset and contributes to future value. It is not a
current expense for the EVA calculation. Thus, R&D
expenses are subtracted from operating income to
calculate the EVA for each division.
Division B is much riskier than Division A, therefore
the COC for A is 10% and for B it is 15%.
Note: There is approximately 160 adjustments that
are possible for us to make to GAAP based
accounting numbers to truly illustrate the economic
value of a company.
Divisions A and B Revisited
A
B
Adjusted Operating Income
$1,500,000 + $500,000
$2,000,000
$ 500,000 + $500,000
$1,000,000
Less Adjusted COC
10% x $10,000,000
15% x $ 3,000,000
$ 450,000
EVA
1,000,000
$1,000,000
$ 550,000
Part V
Do Our Accounting Systems
Encourage Good Judgment?
Non-Financial Measures of Value
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Financial measures are ‘lag’ indicators of value.
Non-financial measures of value may predict value
changes sooner than financial measures.
What Gets Measure Gets Done,
But If We Measure the Wrong things
The Wrong Things Will be Done
And
The Wrong things May be Done Very Well