Chapter 22

Control: The Management Control Environment

McGraw-Hill

2004 The McGraw-Hill Companies, Inc. All rights reserved.

Management Control
This

chapter addresses the control process and the use of accounting information in that process. The activity strategy formulation develops strategies to attain an organizations goals. Strategies change whenever a new opportunity or a new threat is perceived.
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Management Control Process

Process

by which managers influence members of the organization to implement the organizations strategies efficiently and effectively. Takes goals and strategies as given. Seeks to assure that the strategies are implemented. Includes planning.
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Two Parts of Planning

A

statement of objectives. required to achieve those

Resources

objectives.

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Goals and Objectives

Terms

often used interchangeably. Goals = broad, usually non-quantitative, long run plans relating to the organization as a whole. Objectives = more specific, often quantitative, shorter run plans for individual responsibility centers.

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The Environment
Four

facets of the management control environment:

Nature of organizations. Rules, guidelines and procedures that govern the actions of the organizations members. The organizations culture. External environment.

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The Nature of Organizations

Organization:

a group of human beings who work together for one or more purposes. or the management: Leaders who perform important tasks.

Managers

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Tasks of Management

Determining goals. Determining objectives to achieve the goals. Communicating goals and objectives. Determining tasks to be performed to achieve objectives. Coordination. Matching individuals to tasks. Motivating. Observing/monitoring employee performance. Taking corrective action as needed.
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Organization Hierarchy.

= Layers of management with authority running from top to bottom. Optimal number of subordinates: (10?) Organization chart. Line units their activities are associated with achieving the objectives of the organization. (They produce and market goods or services.) Staff units exist to provide support services to other units and to the chief executive officer (CEO).

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Rules, Guidelines, and Procedures

Influence
Written,

the way members behave.

or verbal; formal, or informal.

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Culture
Norms

of behavior determined by:

Tradition. External influences. Attitudes of senior management and the board of directors (BOD).

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External Environment
Everything

outside of the organization

itself.
E.g.,

customers, suppliers, competitors, regulatory agencies.

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Responsibility Accounting
Involves

a continuous flow of information that corresponds to the continuous flow of inputs into, and outputs from, an organizations responsibility centers. Usage of various resources are measured directly in or converted to a monetary measure. Focuses on responsibility centers.

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Full Cost Accounting

Focuses

on goods and services.

Responsibility

accounting is a different ways of slicing the same pie.

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Responsibility Centers
Commonly

perform work related to several

products.
Inputs

to a responsibility center are called cost elements or line items (on a department cost report). have three different dimensions:
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Costs

Dimensions of Costs
Responsibility

center. Where was cost

incurred?
Product

dimension. For what output was the cost incurred?

Cost

element dimension. What type of resource was used?

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Effectiveness and Efficiency

Effectiveness

= how well the responsibility center does its job. = the amount of output per unit

Efficiency

of input.
Lower

cost is more efficient.

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Limitations of Actual Costs Compared to Standard

Not

an accurate measure of efficiency for at least 2 reasons:

Recorded costs are not precisely accurate measures of resources consumed. Standard are at best only approximate measures of what resource consumption ideally should have been in the circumstances prevailing.

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Types of Responsibility Centers

Important business goal: earn a satisfactory return on investment: ROI = (Revenues - Expenses) / Investment Leads to 4 types of responsibility centers:

Revenue centers. Expense centers. Profit centers. Investment centers.

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Revenue Center

Responsible for outputs of center as measured in monetary terms (revenues). Not responsible for the costs of goods or services that the center sells. E.g., sales organization. Also responsible for selling expenses (e.g., travel, advertising, point-of-purchase displays, sales office salaries, rent).

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Expense Centers
Responsible

for expenses (i.e., the costs) incurred but does not measure its outputs in terms of revenues. E.g., production departments, staff units such as accounting.

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Standard or Engineered Cost Center

Expense

center for which many of its cost elements have standard costs established. between standard costs and actual costs are variances.

Differences

E.g.,

production cost centers, fast food restaurants, and blood testing laboratories.
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Discretionary Expense Center

Also

called managed cost center. to measure output in monetary

Difficult

terms.
Production E.g.,

support and corporate staff.

human resources, accounting, R&D.

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Profit Centers
Performance

measured as difference between revenues and expenses. independent division of a company, factory that sells its output to the marketing division.

E.g.,

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Advantage of Profit Center

Encourages

managers to act as if they are running their own business.

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Criteria for Profit Center

Involves extra record keeping. Only useful if manager influences both revenues, and costs. If senior management requires service performed by other responsibility center at no charge, then not a profit center, e.g., internal audit. If output is homogeneous (e.g., tons) no advantage to monetary measure of revenue. Multiple profit centers creates spirit of competition.
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Transfer Prices
Price

at which goods or services are sold between responsibility centers within a company. Revenue for selling center and cost for the receiving center. 2 general types of transfer prices:

Market based price. Cost based price.

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Market-based Transfer Prices

Based

on price for same product between independent parties, i.e., a market price or, equivalently, an arms length price.

Adjusted for quantifiable differences such as credit costs. Where available is widely used. Frequently not available.

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Cost-Based Transfer Prices

When Cost If

no reliable market price is available.

plus a mark-up.

based on actual cost, little incentive to reduce costs.

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Transfer Pricing Issues

Negotiated

by responsibility centers or set/arbitrated by top management. manager have freedom to use alternative source? maximize profits for a responsibility center may not maximize profit for the consolidated company.
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Should

Sub-optimization:

Investment Center
Responsible

for use of assets as well as

profits.
Expected

to earn a satisfactory return on assets employed in the responsibility center.

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Measures of Performance
Return Return

on investment = Profit/Investment

on assets = (net income) / (total assets).

Split between ROS and Asset Turnover

Residual

income = Pre-interest profit (Capital charge * investment)

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Residual Income
Residual

income = Income before taxes less a capital charge. charge is calculated by applying a rate to the investment centers assets or net assets.

Capital

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Advantage of Residual Income over ROI

Encourages

managers to make all investments whose return is greater than the capital cost rate. Example

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Advantage of ROI Over Residual Income:

ROI

measures are ratios that can be used to compare investment centers of different sizes.
income is an internal number that is not reported to shareholders and other outsiders.
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Residual

EVA - overview

EVA is simply annual operating profit after-tax--minus a special charge for the cost of capital. That charge corrects a glaring loophole in standard accounting. In financial statements, companies pay nothing for equity capital. It looks like free money. But equity is really very expensive. To raise money from investors, companies must return at least as much as shareholders could earn from a basket of stocks with the same risk--say, 12% a year. That's the cost of equity capital. If the company doesn't earn at least its capital cost (blended to include the cost of debt), it can't keep attracting new investment. Far from being new, EVA, in effect, is one of the long- standing pillars of finance theory: Until a company posts a profit greater than its cost of capital, it's not making money for shareholders, no matter how good accounting earnings look. EVA is changing not only how managers run companies, but the way Wall Street prices them. In the past three years, Credit Suisse First Boston and Goldman Sachs have instructed their analysts to de-emphasize measures like earnings per share and return on equity in favor of EVA
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EVA Calculations - Part 1

To figure a company's or operation's economic value added, you must know two things: the true cost of capital and how much capital is tied up. Here's a short guide to get you on your way. Most companies pay for two kinds of capital, borrowed and equity. It's easy to figure the cost of your borrowed capital--it's simply the interest rate your banks and bondholders charge. But equity capital, the money stockholders provide, is tricky. Although you don't have to write a check for it, don't think it's free. The true cost is what your shareholders could be earning elsewhere.

To get that figure, you need to know that shareholders generally earn about six percentage points more on stocks than on government bonds. With long-term treasury rates around 7.5%, your cost of equity would be about 13.5%--more if you're in a riskier than average industry. Assuming you use debt as well as equity capital, the overall cost is the weighted average of the two.

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EVA Calculations - Part 2

Now you need to figure out how much capital is tied up in your business. That includes buildings, machines, and computers. But there's more. What about investments in R&D or training? Those are meant to pay off over the long haul, but accounting rules say you have to write them off all at once. Forget the accounting rules. Treat them as capital, and give them a useful life. If, say, you're spending $20 million developing new products this year, add that to your capital base, and add it back to operating profits. If you expect the product to have a five-year life cycle, deduct $4 million a year from capital--and operating profits--in each of the next five years. Now get out your calculator. Multiply your total capital by your weighted average cost of capital. Compare that figure with your after-tax operating earnings. If they are greater than your cost of capital, have a cigar. You've got a positive EVA, which means you're creating wealth for your shareholders.
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EVA - Summary

EVA is powerful and widely applicable because in the end it doesn't prescribe doing anything. If it tried, it would inevitably run aground in certain unforeseen situations. Instead it is a method of seeing and understanding what is really happening to the performance of a business. Using it, many managers and investors see important facts for the first time. And in general, they validate EVA's basic premise: If you understand what's really happening, you'll know what to do.

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Investment Center Issues

Asset allocation between centers. How to value assets (e.g., historical cost or replacement cost).

Most companies control investments in fixed assets using capital investment (i.e., capital budgeting) procedures addressed in Chapter 27. Managers focus their day-to-day efforts on managing current assets, particularly inventories and receivables.
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Non-monetary Measures
Non-monetary

as well as monetary

objectives.
E.g.,

Quality of goods or services, customer satisfaction. by objectives (MBO) and Balanced Scorecards in Chapter 24.
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Management