Tutorial 8 Summary

RESPONSIBILTY ACCOUNTING INVESTMENT CENTERS AND PERFORMANCE EVALUATION

Goal Congruence
(For details on Goal Congruence refer lecture notes slide 4)
Goal congruence means a meshing of objectives, in which the managers throughout an organization strive to achieve goals that are consistent with the goals set by top management. Goal congruence is important for organizational success because managers often are unaware of the effects of their decisions on the organization's other subunits. Also, it is natural for people to be more concerned with the performance of their own subunit than with the effectiveness of the entire organization. In order for the organization to be effective, it is important that everyone in it be striving for the same ultimate objectives. A responsibility-accounting system fosters goal congruence by establishing the performance criteria by which each manager will be evaluated. Development of performance measures and standards for those measures can help to ensure that managers are striving toward goals that support the organization's overall objectives

Responsibility Accounting
What are the useful measurement tools:1. 2. 3. 4. Revenue Centers Revenue standards,.. Cost Centers Costs standards,.. Profit Centers Contribution Income Statements,.. Investment Centers ROI, RI, EVA.( others such as IRR or returns multiples over the investment horizon or Enterprise Value / market value of Equity)

Each of these centers have accountability or responsibility to costs, revenue, profit , capital invested of the subunits.

Investment Centre - Return on Investment (ROI) Formula

Income before interest and taxes (EBIT)

Net operating income ROI = Average operating assets

Cash, accounts receivable, inventory, plant and equipment, and other productive assets.
The operating asset base used in the formula is typically computed as the average operating assets {(beginning assets + ending assets)

2}

Different measures of Invested Capital

a. Average operating/productive assets: All assets held for operating purposes. Excludes assets that are not in service, such as construction in progress, investment in another company, etc. a. Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including non-operating assets. c. Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of shortterm credit to finance operations.

Implications of use of Cost or NBV

The use of cost or gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. Also, the usual methods of computing depreciation, such as straight-line or declining-balance methods, are arbitrary. As a result, some managers prefer not to allow these depreciation charges to affect ROI or residual-income calculations.

Breaking down the formula for ROI

ROI = Net operating income (EBIT) Average operating assets

Sales Margin =

Net operating income Sales

A. Turnover =

Sales Average operating assets

ROI = Sales Margin Asset Turnover

DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI, namely sales margin and asset turnover. Sales Margin is computed as shown in the next slide & is improved by increasing sales or reducing operating expenses. The lower the operating expenses per dollar of sales, the higher the sales margin earned. Asset Turnover is computed as shown. It incorporates a crucial area of a managers responsibility the investment in operating assets. Excessive funds tied up in operating assets depress asset turnover and lower ROI

3 Primary ways in Improving ROI ROI = Sales Margin Asset Turnover

Reduce Expenses Increase Sales

ROI =

Sales - Operating expenses Sales

Sales Average operating assets

Reduce Assets
* Refer to lecture notes slides 26 to 33 on the various scenarios

Average Operating Asset/ invested capital as used in ROI

Two situations 1. Investing in new project or new plant & purchasing new machinery or purchasing another company : It refers to the capital outlay or purchase price of the investment. 2. Existing operation: This refers to operating assets i.e. the average net operating asset, or In the case of expansion its the fresh capital to be injected for expansion, be it borrowed funds or self funding.
Average net operating asset is sum of beg. bal. & ending bal. 2
(Note: F.A is taken at NBV and if there is a scrap value for the F.A. its necessary to less the scrap value from the new cost of FA to compute the depreciation. For our purpose depreciation is assumed on a straight line basis.) EBIT Earnings before interest and tax EBITDA Earnings before interest, tax and depreciation , amortization

Residual Income as an investment centers performance measurement

Residual income measures net operating income earned less the minimum required return* on average operating assets.

* Sometimes called imputed interest or notional interest or minimum cost of capital. Net Average Minimum Residual = operating operating required rate of income income assets return

This computation differs from ROI.

ROI measures net operating income earned relative to the investment in average operating assets.

Calculating Residual Income

Example of the calculation of residual income: Suppose an investment center's profit is $100,000; invested capital is $800,000 & the imputed interest rate is 12% : Residual income = $100,000 ($800,000 X12%) = $4,000 The imputed interest rate is used in calculating residual income, but it is not used in computing ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital. Sometimes this notional interest is called cost of capital.

Motivation and Residual Income

Residual income encourages managers to make profitable investments that would be rejected by managers using ROI. It motivates managers to pursue investments where the ROI associated with those investments that exceeds the companys minimum required return but is less than the ROI being earned by the managers. Ideally wherever possible in such situations it is desirable to evaluate them together.

The Balanced Scorecard

Management translates its strategy into performance measures that employees understand and influence.
Financial Customers

Performance measures
Internal business processes Learning and growth

The Balanced Scorecard: From Strategy to Performance Measures

Performance Measures Financial Has our financial performance improved? Customer Do customers recognize that we are delivering more value? Internal Business Processes Have we improved key business processes so that we can deliver more value to customers? Learning and Growth Are we maintaining our ability to change and improve? What are our financial goals? What customers do we want to serve and how are we going to win and retain them? What internal biz processes are critical to providing value to customers?

Vision and Strategy

The Balanced Scorecard: Non-financial Measures

The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons:

Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are leading indicators of future financial performance.

Top managers are ordinarily responsible for financial performance measures not lower level managers. Non-financial measures are more likely to be understood and controlled by lower level managers.

The Balanced Scorecard Jaguar Example

Results
If number of cars sold and contribution per car increase, profits increase. Profit
financial

Profits Increase Contribution Increases Cars Sold Increases

Contribution per car Number of cars sold

customer

Customer satisfaction with options

Strategies
Increase Options Increase Skills Number of options available

Internal biz processes

Time to install option

Time Decreases

Employee skills in installing options

Learning and Growth

Jaguar example
Jaguar offers distinctive, richly furnished luxury automobiles to wealthy individuals who prize individualized products such as leather seats, interior and exterior color combinations, and wooden dashboard. We can see that the performance measures used are closely linked to the companys vision. Dealership performance was measured throughout the year against a balanced scorecard including sales versus objective, customer satisfaction and product knowledge. Jaguar is concerned about quality, which is why one of their performance measures is measuring how well the employees skills in installing options. Jaguars management stresses the availability of options, and the time taken to install such options; this is an internal business Process measure. This performance measure would ensure the satisfaction of customers which in turn would increase sales. From the above we can see that Jaguars choice of performance measures in its balanced scorecard is complete and consistent with the organizations objectives.

Another case example of use of Balanced Scorecard at all levels of the organisation
Another example is the Philips Electronics Medical Devices Systems, North America, Philips created 4 critical success factors (CSF) to align indicators that measure markets, operations and laboratories with business success. Philips has also seen that the scorecard promotes the sharing of best practices and creates a worldwide communication system where employees can share success practices, product fixes, project knowledge, interests, and pitfalls. This communication prevents employees from repeating fellow employees mistakes, saving time and money.

Non-financial measures
Non-financial information is useful in measuring investment-center performance because it gives top management insight into the summary financial measures such as ROI or residual income. By keeping track of important non-financial data, top level managers often can see a problem developing before it becomes a serious problem. For example, if a manufacturer's rate of defective products has been increasing over some period of time, management can observe this phenomenon and take steps to improve product quality before serious damage is done to customer relations.

Measuring Operational Performance

Whilst variances pick up the financial performance measures, today many organizations use a variety of non-financial& operational measures as well:

Raw Material and Scrap control e.g. Quality of raw mat., vendors
qualification, % of scrap to RM; % of rework; waste management. (JIT inventory system, etc)

Inventory control e.g. Inventory T/O, average duration of inventory hold Machine performance and Product quality e.g. down time,
frequency of repairs & maintenance, use of Theory of Constraints, product warranty claims, rejects and reworks %.

Production and Delivery Mfg or throughput

and delivery cycle times, % of orders filled on time, wait time, move time, setup time, etc.( impact of Mar 2011 Japan tsunami, JIT production.) employee.

Productivity Finished Goods produced per employee, defects count per Innovation and learning - effective % sales from new products vs
competitors, benefits from process improvements.

Gains Sharing Plans an incentive system where any cost or productivity

gains are shared with those who helped to achieve those improvements.

Manufacturing Cycle Efficiency(MCE)

A)Throughput / Manufacturing Cycle time B) Wait time C) Delivery cycle time

C=A+B Process time is usually the only valueadded time, where MCE = Value-add time Mfg Cycle time

Tutorial 9 Segment Reporting & Transfer Pricing Group K15, & K17
Team 1 = Qn 1 & 6, Problem 13-24, A-8 Team 2 = Qn 3, Problem 13A-5 Team 3 = Qn 4, Supple. Qn Team 4 = Qn 2 & 5, Problem 13-27, A-7

Group K 16
Teams 3 = Qn 1 & 6, Problem 12-24, A-8 Teams 1,2, 4, 5 = Qn 2 to 5 respectively