control environment.ppt

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Chapter 22

Control:The Management Control

Environment

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


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Management Control

This chapter addresses the controlprocess and the use of accountinginformation in that process.

The activity strategy formulationdevelops strategies to attain anorganizations goals.

Strategies change whenever a newopportunity or a new threat is perceived.


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Management Control Process

Process by which managers influencemembers of the organization to implementthe organizations strategies efficiently and

effectively.

Takes goals and strategies as given.

Seeks to assure that the strategies areimplemented.

Includes planning.


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Two Parts of Planning

A statement of objectives.

Resources required to achieve thoseobjectives.


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Goals and Objectives

Terms often used interchangeably.

Goals = broad, usually non-quantitative,long run plans relating to the organizationas a whole.

Objectives = more specific, oftenquantitative, shorter run plans forindividual responsibility centers.


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The Environment

Four facets of the management controlenvironment:

Nature of organizations.

Rules, guidelines and procedures that governthe actions of the organizations members.

The organizations culture.

External environment.


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The Nature of Organizations

Organization: a group of human beingswho work together for one or morepurposes.

Managers or the management: Leaderswho perform important tasks.


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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 achieveobjectives.

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 topto bottom.

Optimal number of subordinates: (10?)

Organization chart. Line units their activities are associated with achieving

the objectives of the organization. (They produce andmarket goods or services.)

Staff units exist to provide support services to otherunits and to the chief executive officer (CEO).


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Rules, Guidelines, andProcedures

Influence the way members behave.

Written, or verbal; formal, or informal.


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Culture

Norms of behavior determined by:

Tradition.

External influences.

Attitudes of senior management and theboard of directors (BOD).


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External Environment

Everything outside of the organizationitself.

E.g., customers, suppliers, competitors,regulatory agencies.


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Responsibility Accounting

Involves a continuous flow of informationthat corresponds to the continuous flow ofinputs 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 differentways of slicing the same pie.


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Responsibility Centers

Commonly perform work related to severalproducts.

Inputs to a responsibility center are calledcost elements or line items (on adepartment cost report).

Costs have three different dimensions:


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Dimensions of Costs

Responsibility center. Where was costincurred?

Product dimension. For what output wasthe cost incurred?

Cost element dimension. What type ofresource was used?


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Effectiveness and Efficiency

Effectiveness = how well the responsibilitycenter does its job.

Efficiency = the amount of output per unitof input.

Lower cost is more efficient.


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Limitations of Actual CostsCompared to Standard

Not an accurate measure of efficiency forat least 2 reasons:

Recorded costs are not precisely accurate

measures of resources consumed.

Standard are at best only approximatemeasures of what resource consumption

ideally should have been in the circumstancesprevailing.


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Types of Responsibility Centers

Important business goal: earn a satisfactoryreturn 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 measuredin 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 outputsin terms of revenues.

E.g., production departments, staff unitssuch as accounting.


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Standard or Engineered CostCenter

Expense center for which many of its costelements have standard costs established.

Differences between standard costs andactual costs are variances.

E.g., production cost centers, fast foodrestaurants, and blood testing laboratories.


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Discretionary Expense Center

Also called managed cost center.

Difficult to measure output in monetaryterms.

Production support and corporate staff.

E.g., human resources, accounting, R&D.


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Profit Centers

Performance measured as differencebetween revenues and expenses.

E.g., independent division of a company,factory that sells its output to themarketing division.


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Advantage of Profit Center

Encourages managers to act as if they arerunning 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 performedby other responsibility center at no charge, then nota 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 soldbetween responsibility centers within acompany.

Revenue for selling center and cost for thereceiving 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 betweenindependent parties, i.e., a market priceor, equivalently, an arms length price.

Adjusted for quantifiable differences such ascredit costs.

Where available is widely used.

Frequently not available.


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Cost-Based Transfer Prices

When no reliable market price is available.

Cost plus a mark-up.

If based on actual cost, little incentive to

reduce costs.


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Transfer Pricing Issues

Negotiated by responsibility centers orset/arbitrated by top management.

Should manager have freedom to usealternative source?

Sub-optimization: maximize profits for aresponsibility center may not maximizeprofit for the consolidated company.


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Investment Center

Responsible for use of assets as well asprofits.

Expected to earn a satisfactory return onassets employed in the responsibilitycenter.


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Measures of Performance

Return on investment = Profit/Investment

Return on assets = (net income) / (totalassets).

Split between ROS and Asset Turnover

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


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Residual Income

Residual income = Income before taxesless a capital charge.

Capital charge is calculated by applying arate to the investment centers assets or

net assets.


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Advantage of Residual Incomeover ROI

Encourages managers to make allinvestments whose return is greater thanthe capital cost rate.

Example


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Advantage of ROI OverResidual Income:

ROI measures are ratios that can be usedto compare investment centers of differentsizes.

Residual income is an internal number thatis not reported to shareholders and otheroutsiders.


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EVA - overview

EVA is simply annual operating profit after-tax--minus a special charge forthe cost of capital. That charge corrects a glaring loophole in standardaccounting. In financial statements, companies pay nothing for equitycapital. It looks like free money. But equity is really very expensive. To raisemoney from investors, companies must return at least as much asshareholders 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 atleast its capital cost (blended to include the cost of debt), it can't keepattracting new investment.

Far from being new, EVA, in effect, is one of the long- standing pillars offinance 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 andGoldman Sachs have instructed their analysts to de-emphasize measureslike 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 twothings: the true cost of capital and how much capital is tied up. Here's a short guide toget you on your way. Most companies pay for two kinds of capital, borrowed andequity. It's easy to figure the cost of your borrowed capital--it's simply the interest rateyour banks and bondholders charge. But equity capital, the money stockholdersprovide, 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-termtreasury rates around 7.5%, your cost of equity would be about 13.5%--more if you'rein 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 yourbusiness. 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 accountingrules say you have to write them off all at once. Forget theaccounting rules. Treat them as capital, and give them a useful

life. If, say, you're spending $20 million developing new productsthis year, add that to your capital base, and add it back tooperating profits. If you expect the product to have a five-yearlife cycle, deduct $4 million a year from capital--and operatingprofits--in each of the next five years.

Now get out your calculator. Multiply your total capital by yourweighted average cost of capital. Compare that figure with yourafter-tax operating earnings. If they are greater than your cost ofcapital, have a cigar. You've got a positive EVA, which meansyou're creating wealth for your shareholders.


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EVA - Summary

EVA is powerful and widely applicable because in the end it doesn'tprescribe doing anything. If it tried, it would inevitably run aground in certainunforeseen situations. Instead it is a method of seeing and understandingwhat is really happening to the performance of a business. Using it, manymanagers and investors see important facts for the first time. And in

general, they validate EVA's basic premise: If you understand what's reallyhappening, 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 orreplacement cost).

Most companies control investments in fixedassets using capital investment (i.e., capitalbudgeting) procedures addressed in Chapter 27.

Managers focus their day-to-day efforts onmanaging current assets, particularly inventoriesand receivables.


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Non-monetary Measures

Non-monetary as well as monetaryobjectives.

E.g., Quality of goods or services,customer satisfaction.

Management by objectives (MBO) andBalanced Scorecards in Chapter 24.

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