Download Situational Influences on Management Control Systems

Management Control Systems
Chapter 11: Accounting Performance Measures and
Their Effects
mevrouw prof. dr J.P. Bahlmann
2 juni 2004
Wim Van der Stede
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
Accounting profits or returns ...

Timeliness
—measured in short time periods.

Precision
—accounting rules (FASB).

Objectivity
—independent auditors.

Congruence
» In for-profit firms, accounting profits or returns are relatively
congruent with the true firm goal of maximizing shareholder value.
» Positive correlations between accounting profits and changes in
stock prices.

Understandable

Inexpensive
—financial reporting requirements.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Limitations ...

Accounting income does not reflect economic
income perfectly, because accounting measures:
– Are transactions oriented;
– Are dependent on the choice of measurement method;
– Are conservatively biased;
– Ignore intangibles;
– Ignore the cost of investments in working capital;
– Ignore the cost of equity capital;
– Ignore risk;
– Focus on the past.
The change in the value of the entity
over a given period, where “value” is
obtained by discounting future cash flows.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Myopia ...

Investment myopia
– Reduce or postpone investments that promise
payoffs in future measurement periods.
– cf., accounting number’s conservative bias.

Operational myopia
– e.g., destroying goodwill with customers,
suppliers, employees, or the society at large.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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ROI performance measures ...

Return on Investment
» ROI is a ratio of the accounting profits earned by the
business unit divided by the investment assigned to it;
» ROI = profits ÷ investment base.

Residual Income
» RI is a dollar amount obtained by subtracting a
capital charge from the reported accounting profits;
» RI = profits - capital charge.

ROI is the most commonly used measure
» ROI is easy to calculate, easy to understand,
and meaningful in an absolute sense.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Labels ...




Return on investment (ROI)
Return on equity (ROE)
Return on capital employed (ROCE)
Return on net assets (RONA)
» The profit measure in the numerator can be a fully
allocated after-tax profit measure —or, a before-tax
operating income measure.
» The denominator can include all the line-items of assets
and liabilities, including allocations of assets and liabilities
not directly controlled by the division manager —or, it can
include only controllable assets which include receivables
and inventories at a minimum.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Problems caused by ROI-measures ...

Numerator ...
» Accounting profits, hence, ...
» ROI contains all problems associated with these profit measures.

Denominator ...
» How to measure the fixed assets portion?

Suboptimization ...
» ROI-measures can lead division managers to make decisions
that improve division ROI even though the decisions are not in
the corporation's best interest.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Example ...
RI
ROI
SBU
A
B
C
D
E
Cash Receivables Inventories Fixed Assets
$ 10
20
15
5
10
SBU
Profit
A
B
C
D
E
$ 24.0
14.4
10.5
3.8
(1.8)
$ 20
20
40
10
5
$ 30
30
40
20
10
$ 2.4
2.8
3.8
1.4
1.0
4%
Profit
ROI
$ 120
120
105
75
35
$ 24.0
14.4
10.5
3.8
(1.8)
20 %
12
10
5
(6)
$ 60
50
10
40
10
Cur. Assets Req. Earn. Fixed Assets
$ 60
70
95
35
25
Total Invest.
Required Earn.
Res. Income
$ 6.0
5.0
1.0
4.0
1.0
$ 15.6
6.6
5.7
(1.6)
(3.8)
$ 60
50
10
40
10
10%
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Suboptimization ...
– ROI provides different incentives for investments
across business units
» SBU-manager will not invest if ...
Corporate
Cost of
Capital
» SBU-manager will invest if ...
Corporate
Cost of
Capital
<
IRR
of
Project
>
IRR
of
Project
<
Business
Unit
ROI
>
Business
Unit
ROI
» Hence, if corporate cost of capital is 10%.,
– IRR of project is 11%, then A and B are unlikely to invest;
– IRR of project is 9%, then D and E are still likely to invest.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Suboptimization ...
Assume
Worthwhile !
Corporate cost of capital = 10%
Investment of $10 to earn $1,1 per year
DOES NOT INVEST
INVEST
INVEST
Base situation
Unit A
Unit C
Unit D
Profit Before tax
Investment base
ROI
$ 24
$ 120
20 %
$ 10.5
$ 105
10 %
$ 3.8
$ 75
5%
New situation
New situation
New situation
New situation
Profit before tax
Investment
ROI
$ 25.1
$ 130
19.30 %
$ 11.6
$ 115
10.08 %
$ 4.9
$ 85
5,76%
“WRONG”
“RIGHT”
“RIGHT”
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Suboptimization ...
Assume
Not worthwhile !
Corporate cost of capital = 15%
Investment of $10 to earn $1,1 per year
DOES NOT INVEST
INVEST
INVEST
Base situation
Unit A
Unit C
Unit D
Profit Before tax
Investment base
ROI
$ 24
$ 120
20 %
$ 10.5
$ 105
10 %
$ 3.8
$ 75
5%
New situation
New situation
New situation
New situation
Profit before tax
Investment
ROI
$ 25.1
$ 130
19.30 %
$ 11.6
$ 115
10.08 %
$ 4.9
$ 85
5,76%
“RIGHT”
“WRONG”
“WRONG”
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Suboptimization ...

Residual income makes performance targets uniform, and divisions
will invest if IRR of project is greater than the capital charge (which
could be set equal to the corporate cost of capital).
• Capital charge for fixed assets is 10%;
• Investment of $10 to earn $1,1 per year.
Base situation
Unit A
Unit C
Unit D
Profit Before tax
Investment base
RI
$ 24
$ 120
$ 15.6
$ 10.5
$ 105
$ 5.7
$ 3.8
$ 75
($ 1.6)
New situation
New situation
New situation
New situation
Profit before tax
Investment
RI
$ 25.1
$ 130
$ 15.7
$ 11.6
$ 115
$ 5.8
$ 4.9
$ 85
($ 1.5)
(=25.1-2.4-7)
(=11.6-3.8-2)
(=4.9-1.4-5)
INVEST
INVEST
INVEST
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Miscellaneous ...

Residual Income (RI) allows to use different interest
charges for different types of assets
» e.g., fixed assets - longer term / higher risk - higher charge.

Return on equity (ROE)-measures induce managers
to use debt financing
» This is not the case with RI if the capital charge is equal to the
corporate cost of capital (i.e., weighted average of debt + equity).

ROI-measures create incentives for managers to lease assets
» This is also true for RI if the interest charge that is built into the
rental cost is less than the capital charge applied to the business
unit's investment base.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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The fixed assets portion ...

Net Book Value
» Both ROI and RI get better merely to passage of time.
» Both ROI and RI are usually overstated if the business
unit includes a relatively large number of older assets.
» Example

Invest $100; Cash flow $27 per year; Depreciation $20 (5 years)
Yr
NBV
Incremental
Income
1
2
3
4
5
100
80
60
40
20
7
7
7
7
7
(=27-20)
Capital
Charge
RI
ROI
10
8
6
4
2
-3
-1
1
3
5
7%
9%
12%
18%
35%
10 %
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Misleading performance signals ...

SBU-managers are encouraged to retain assets beyond their
optimal life and not to invest in new assets.

Corporate managers are induced to over-allocate resources
to business units with older assets.

Combined with the suboptimization issues discussed above,
manager of units with older assets, and, hence, a higher ROI,
are likely to be more reluctant to invest in "desirable" projects
with an IRR higher than the corporate cost of capital.

Gross Book Value (GBV)?
» However, in periods of inflation, old assets valued at GBV are
still expressed at lower values than new assets, so ROI is still
overstated.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Economic Value Added (EVA) ...

Modified after-tax operating profit
– (total capital x weighted average cost of capital)

Similar to RI (=profit–capital charge), except for the
modifications (164 in total, as suggested by Stern
Stewart & Co)
» e.g., Capitalization and subsequent amortization of intangible
investments (e.g., in R&D, employee training, etc.);
Adding LIFO-reserves to correct for undervalued inventories;
etc.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Management Control Systems
Chapter 12: Financial Results Control
Remedies to the Myopia Problem
mevrouw prof. dr J.P. Bahlmann
2 juni 2004
Wim Van der Stede
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
Recall that ...

Accounting income does not reflect economic
income perfectly, because accounting measures:
– Are transactions oriented;
– Are dependent on the choice of measurement method;
– Are conservatively biased;
– Ignore intangibles;
– Ignore the cost of investments in working capital;
– Ignore the cost of equity capital;
– Ignore risk;
– Focus on the past.
The change in the value of the entity
over a given period, where “value” is
obtained by discounting future cash flows.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Myopia ...

Investment myopia
– Reduce or postpone investments that promise
payoffs in future measurement periods.
– cf., Accounting number’s conservative bias.

Operational myopia
– e.g., destroying goodwill with customers,
suppliers, employees, or the society at large.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Overcoming myopia …

Measure changes in economic income directly
» Measurement precision and objectivity of future cash flows?

Control investments with preaction reviews
» Operating expenses
» Today businesses
Financial results controls
—
—
Developmental expenses
Tomorrow businesses
Combination of nonfinancial
performance indicators
and action controls
» Distinction between operating and developmental
expenses?
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Overcoming myopia …

Improve accounting profit measures
» Adjust depreciable lives of fixed assets, adopt
current value depreciation, charge depreciation
for older assets;
» Capitalize expenditures related to long term
investments;
» Recognize profits more quickly;
» Impute a cost of equity on income statement;
» Put leases on the balance sheet; …
» Cost of developing performance reports for
control purposes?
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Overcoming myopia …

Extend the measurement horizon
» Measurement congruence:
 The
longer the period of measurement, the
higher the correlation between accounting
income and economic income.
» Long-term incentive plans,
but higher cost of rewards?
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Overcoming myopia …

Reduce pressure for short-term profit
– Reduce the weighting placed on the annual profit
target and emphasize other, longer-term performance
indicators, such as market share and technical breakthroughs.
» Risks associated with discretionary performance
evaluations?
– Make the short-term profit targets easier to achieve.
» Some slack is created to fund longer-term projects;
» But, motivational effects of easy targets?
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Overcoming myopia …

Measure a set of drivers of future financial
performance.
– Also use non-financial performance measures.
» Managers should not have to choose between
financial and operational measures.
– Balanced scorecard
» The BSC includes financial measures that tell the
results of actions already taken;
» It complements the financial measures with operational
measures on customer satisfaction, internal processes,
and the firm’s innovation and improvement activities.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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The Balanced Scorecard ...
Financial Perspective
How do we look to
our shareholders?
Customer Perspective
How do we look to
our customers?
Vision
Strategy
Business Processes
What business
processes are the
value drivers?
Organization Learning
Are we able to sustain
innovation, change and
improvement
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Customer perspective ...

Time / quality / performance & service / cost

Measures?
– Percent of shipments that arrived on time;
– Equipment up-time percentage;
– Mean time response to a service call;
– Rankings against competitors on efforts
to improve quality, delivery time, and price
performance;
– Percentage delivery schedule disruptions;
– Percentage incorrect deliveries; etc.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Internal business perspective ...

Customer-based measures must be translated into
measures of what the company must do internally
to meet its customers’ expectations.

Measures?
– Cycle time;
– Defect rates;
– Productivity;
– Percentage scrap, waste;
– etc.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Innovation and learning perspective ...

Targets for success keep changing ...

Measures?
– Percent of sales from new products;
– Rates of improvement for:
»
»
»
»
On-time delivery;
Cycle times;
Defect rates;
Yield; etc.
– etc.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Financial perspective ...

The extent to which the company’s strategy,
implementation and execution are contributing
to the bottom-line.

Measures?
– EPS, EVA, ROE, RI, CF;
– Operating income by division;
– etc.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Thus ...

A method for the organization to systematically
consider what it should do to develop an …
– … internally consistent + comprehensive
system of planning and control.

The BSC brings together, in a single measurement
report, many of the seemingly disparate elements
of a company’s competitive agenda.

The BSC guards against suboptimization; i.e.,
– It should prevent that improvement in one
area comes at the expense of another.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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What does a BSC-approach really do …

It forces clear specification of strategic objectives
and appropriate measures in four areas: financial,
customer, internal business, and learning/innovation.

It helps managers understand the causal linkages
from high-level financial and strategic objectives to
operational measures.

It helps managers understand critical success factors
and helps them move toward the development of
measures of value drivers throughout the firm.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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What does a BSC-approach really do …

It provides a method of balancing short-term and
long-term concerns by directing attention both to
short-term financial indicators and leading indicators
of forthcoming performance (“performance drivers”).

The BSC can be used to balance any competing
concerns (e.g., productivity vs. employee morale).

The BSC helps top management communicate
its strategic vision throughout the firm.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Limitations of the BSC-approach …

It is not the final story: performance measurement
 performance management
– e.g., measuring customer satisfaction doesn’t tell
anyone how to improve it.

When multiple measures are used, there is a
danger that some measures are really not value
drivers (i.e., there is no link between the measure
and financial success).
– e.g., some customers are not willing to pay for
improved quality, and improved quality is costly.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Limitations of the BSC-approach …

Choices of measures get confounded with
measurement difficulties.
– e.g., Few would argue that customer satisfaction
leads to repeat sales, and hence, shareholder value.
But can customer satisfaction be measured accurately?

It does not solve the problem of setting good goals.
– How can the goals be made equally and optimally
challenging across the organization and over time?
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Limitations of the BSC-approach …

When multiple measures are used, managers face
the problem of how to weight them.

Link with incentive systems?

The system may lag reality. Can the BSC keep up?
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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In sum ...

The BSC is future-oriented.

It is perhaps particularly useful if an organization
is undergoing significant change or if management
wants to shift the strategic focus.

It is a costly process, but with these demands for
change on an organization, its benefits may
outweigh the costs.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Bottom-line measures vs. BSC ...

Bottom-line measures:
– Are like a “compass” leading managers in the
desired direction;
– Allow managers greater autonomy.
» The managers can decide what intermediate
measures to focus on to achieve the desired
result.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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Bottom-line measures vs. BSC ...

Baskets of measures:
– Are like a “roadmap” that provides guidance to
managers as to how to achieve the desired end;
– If done well, can provide a linked cascading of
measures from the top of the organization to the
bottom. They show everybody how their efforts
contribute to the overall goal;
– Can be restrictive;
– Likely to become obsolete as conditions change.
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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