wim van der stede management control systems chapter 11: accounting performance measures and their...

Wim Van der Stede

Management Control Systems

Chapter 11: Accounting Performance Measures and Their Effects

mevrouw prof. dr J.P. Bahlmann2 juni 2004

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003

- 2 -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.


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 entityover a given period, where “value” isobtained by discounting future cash flows.


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.


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.


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 fullyallocated after-tax profit measure —or, a before-taxoperating income measure.

» The denominator can include all the line-items of assetsand liabilities, including allocations of assets and liabilitiesnot directly controlled by the division manager —or, it can include only controllable assets which include receivablesand inventories at a minimum.


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 decisionsthat improve division ROI even though the decisions are not inthe corporation's best interest.


Example ...

SBU Profit Cur. Assets Req. Earn. Fixed Assets Required Earn. Res. Income

A $ 24.0 $ 60 $ 2.4 $ 60 $ 6.0 $ 15.6 B 14.4 70 2.8 50 5.0 6.6 C 10.5 95 3.8 10 1.0 5.7 D 3.8 35 1.4 40 4.0 (1.6) E (1.8) 25 1.0 10 1.0 (3.8)

SBU Cash Receivables Inventories Fixed Assets Total Invest. Profit ROI

A $ 10 $ 20 $ 30 $ 60 $ 120 $ 24.0 20 % B 20 20 30 50 120 14.4 12 C 15 40 40 10 105 10.5 10

D 5 10 20 40 75 3.8 5 E 10 5 10 10 35 (1.8) (6)

RO

IR

I

4% 10%


Suboptimization ...

– ROI provides different incentives for investmentsacross business units

» SBU-manager will not invest if ...

» SBU-manager will invest if ...

» 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.

CorporateCost of Capital

IRRof

Project

BusinessUnitROI

< <

CorporateCost of Capital

IRRof

Project

BusinessUnitROI

> >


Suboptimization ... Assume Corporate cost of capital = 10%

Investment of $10 to earn $1,1 per yearWorthwhile !

Base situation

Profit Before taxInvestment base

ROI

New situation

Profit before taxInvestment

ROI

Unit A

$ 24$ 12020 %

New situation

$ 25.1$ 130

19.30 %

Unit C

$ 10.5$ 10510 %

New situation

$ 11.6$ 115

10.08 %

Unit D

$ 3.8$ 755 %

New situation

$ 4.9$ 85

5,76%

“WRONG” “RIGHT”“RIGHT”

DOES NOT INVEST INVEST INVEST


Suboptimization ... Assume Corporate cost of capital = 15%

Investment of $10 to earn $1,1 per yearNot worthwhile !

Base situation


ROI

New situation


ROI

Unit A

$ 24$ 12020 %

New situation

$ 25.1$ 130

19.30 %

Unit C

$ 10.5$ 10510 %

New situation

$ 11.6$ 115

10.08 %

Unit D

$ 3.8$ 755 %

New situation

$ 4.9$ 85

5,76%

“RIGHT” “WRONG”“WRONG”

DOES NOT INVEST INVEST INVEST


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


RI

New situation


RI

Unit A

$ 24$ 120$ 15.6

New situation

$ 25.1$ 130$ 15.7

(=25.1-2.4-7)

Unit C

$ 10.5$ 105$ 5.7

New situation

$ 11.6$ 115$ 5.8

(=11.6-3.8-2)

Unit D

$ 3.8$ 75

($ 1.6)

New situation

$ 4.9$ 85

($ 1.5) (=4.9-1.4-5)

INVEST INVESTINVEST


Residual Income (RI) allows to use different interestcharges for different types of assets

» e.g., fixed assets - longer term / higher risk - higher charge.

Return on equity (ROE)-measures induce managersto use debt financing

» This is not the case with RI if the capital charge is equal to thecorporate 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 businessunit's investment base.

Miscellaneous ...


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

12345

NBV

100 80 60 40 20

IncrementalIncome

77777

Capital Charge

10 8 6 4 2

RI

-3-1 1 3 5

ROI

7%9%

12%18%35%

(=27-20)10 %


SBU-managers are encouraged to retain assets beyond theiroptimal life and not to invest in new assets.

Corporate managers are induced to over-allocate resourcesto 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" projectswith 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.

Misleading performance signals ...


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.

Wim Van der Stede

Management Control Systems

Chapter 12: Financial Results Control Remedies to the Myopia Problem

mevrouw prof. dr J.P. Bahlmann

2 juni 2004

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 entityover a given period, where “value” isobtained by discounting future cash flows.


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.


Overcoming myopia …

Measure changes in economic income directly» Measurement precision and objectivity of future cash flows?

Control investments with preaction reviews» Operating expenses — Developmental expenses

» Today businesses — Tomorrow businesses

» Distinction between operating and developmental expenses?

Financial results controls Combination of nonfinancial

performance indicatorsand action controls


Improve accounting profit measures

» Adjust depreciable lives of fixed assets, adopt current value depreciation, charge depreciationfor 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?



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?



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 break-throughs.

» 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?




Measure a set of drivers of future financial performance.

– Also use non-financial performance measures.

» Managers should not have to choose betweenfinancial and operational measures.

– Balanced scorecard

» The BSC includes financial measures that tell theresults 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.


The Balanced Scorecard ...

Business ProcessesWhat business

processes are the value drivers?

Organization LearningAre we able to sustain innovation, change and

improvement

Financial PerspectiveHow do we look to our shareholders?

Vision Strategy

Customer PerspectiveHow do we look to

our customers?


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.


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.


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.


Financial perspective ...

The extent to which the company’s strategy, implementation and execution are contributingto the bottom-line.

Measures?– EPS, EVA, ROE, RI, CF; – Operating income by division;– etc.


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.


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.


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 indicatorsof 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 communicateits strategic vision throughout the firm.


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.



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?



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?


In sum ...

The BSC is future-oriented.

It is perhaps particularly useful if an organizationis 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.


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.


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.

Bottom-line measures vs. BSC ...

wim van der stede management control systems chapter 11: accounting performance measures and their...

Documents

u accounting income

u numerator

u denominator

u timeliness

u congruence

u suboptimization

investment roi u return

u investment myopia