Financial and Non Financial Measures

SEMESTER 1 SESSION 2011/2012UKM GSB

ZCZA6103 ACCOUNTING FOR DECISION MAKING

What are Financial Controls?

Financial control involves the use of financial measures to assess organization and management performance The focus of attention could be a product, a product line, an

organization department, a division, or the entire organization

Financial control provides a counterpoint to the balanced scorecard view that links financial results to its presumed drivers Focuses only on financial results

Managers use and consider both: Internal financial controls

Information used internally and not distributed to outsiders External financial controls

Developed by outside analysts to assess organization performance

Responsibility Accounting Responsibility accounting is an underlying concept of

accounting performance measurement systems. Under responsibility accounting, managers’ performances

are evaluated on matters directly under managers’ control.

A responsibility center is an organization unit for which a manager is made responsible for specific financial results.

Underlying the accounting classifications of responsibility centers is the concept of controllability

The controllability principle states that the manager of a responsibility center should be held responsible only for the revenues, costs, or investment that responsibility center personnel control

Types of Responsibility Centers Cost center Revenue center Profit center Investment center

Cost Center

A responsibility center in which employees control costs but do not control revenues or investment level

Organizations evaluate the performance of cost center employees by comparing the center’s actual costs with target or standard cost levels for the amount and type of work done

Using variance analysis i.e. flexible budgets and standard costing.

Revenue Center A responsibility center is a responsibility

center where managers are responsible mainly on generating revenue with relatively little costs.

Performance measures of profit centers are mainly on sales volume, sales price variances and sales mix variances.

Profit Center

A responsibility center where managers and other employees control both the revenues and the costs of the product or service they deliver

A profit center is like an independent business, except that senior management, not the responsibility center manager, controls the level of investment in the responsibility center

Most units of chain operations are treated as profit centers

Profit Centre

Assessed by using segmented income statement which shows the profit and loss made for period under reviewed

Example: Bersatu Sdn Bhd

Total Business Products

Consumer Products

Sales RM1,000,000

RM600,000 RM400,000

Less: Variable costs 400,000 240,000 160,000Contribution margin RM 600,000 RM 360,000 RM240,000Less: Traceable fixed expenses 200,000 125,000 75,000Segment margin RM 400,000 RM 235,000 RM165,000Less: Common fixed expenses 200,000 Net income RM 200,000

Profit Center Segment margin is an performance indicator

use to measure profit center. Contribution approach is more appropriate in

distinguish costs that are controllable and uncontrollable

Costs are divide into: Traceable costs including variable costs and

traceable fixed costs Common costs is a fixed costs that support the

operations of more than one segment and cannot be directly traceable to a particular segment.

Investment Center A responsibility center in which the manager and

other employees control revenues, costs, and the level of investment in the responsibility center

Performance measures Return on investment (ROI) Residual Income Economic value added

Measuring Return on Investment

Dupont, as a multiproduct firm, pioneered the systematic use of return on investment (ROI) to evaluate the profitability of its different lines of business

ROI = Income/ Investment The following slide presents Dupont’s approach

to financial control in summary form

The Dupont ROI Control System

The Dupont System

The Dupont system of financial control focuses on ROI and breaks that measure into two components: A return measure that assesses efficiency A turnover measure that assesses productivity

It is possible to compare these individual and group efficiency measures with those of similar organization units or competitors

The Dupont System

The productivity ratio of sales to investment allows development of separate turnover measures for the key items of investment The elements of working capital

Inventories, accounts receivable, cash The elements of permanent investment

Equipment and buildings

Comparisons of these turnover ratios with those of similar units or those of competitors suggest where improvements are required

Questioning The ROI Approach

Despite its popularity, ROI has been criticized as a means of financial control: too narrow for effective control profit-seeking organizations should make

investments in order of declining profitability until the marginal cost of capital of the last dollar invested equals the marginal return generated by that dollar

Using Economic Value Added

Economic value added (EVA—previously called residual income) equals income less the economic cost of the investment used to generate that income If a division’s income is $13.5 million and the

division uses $100 million of capital, which has an average cost of 10%:Economic value added = Income – Cost of capital=$13,500,000 – ($100,000,000 x 10%)=$3,500,000

Using Economic Value Added

Like ROI, EVA evaluates income relative to the level of investment required to earn that income

Unlike ROI, EVA does not motivate managers to turn down investments that are expected to earn more than their cost of capital

Recently, EVA has been extended to adjust GAAP income for the conservative approach that GAAP uses to determine income and value assets

Using Economic Value Added

Organizations now use economic value added to identify products or product lines that are not contributing their share to organization return, given the level of investment they require These organizations have used activity-

based costing analysis to assign assets and costs to individual products, services, or customers

This allows them to calculate the EVA by product, product line, or customer

Organizations can also use economic value added to evaluate operating strategies

Critics of Financial Control

Financial information is delayed—and highly aggregated—information about how well the organization is doing in meeting its commitments to its shareowners

This information measures neither the drivers of the financial results nor how well the organization is doing in meeting its other stakeholders’ requirements

Financial control may be an ineffective control scorecard for three reasons: Focuses on financial measures that do not measure the

organization’s other important attributes Measures the financial effect of the overall level of performance

achieved on the critical success factors, and it ignores the performance achieved on the individual critical success factors

Oriented to short-term profit performance, seldom focusing on long-term improvement or trend analysis, instead considering how well the organization or one of its responsibility centers has performed this quarter or this year

The Efficacy ofFinancial Control

If used properly, financial results provide crucial help in assessing the organization’s long-term viability and in identifying processes that need improvement

Financial control should be supported by other tools since it is only a summary of performance

Financial control does not try to measure other facets of performance that may be critical to the organization’s stakeholders and vital to the organization’s long-term success

Financial control can provide an overall assessment of whether the organization’s strategies and decisions are providing acceptable financial returns

Organizations can also use financial control to compare one unit’s results against another

Integration of Financial and Non Financial Performance Measures

The impact of intense competition in business environment resulted changes in the business activities and structure.

Most of the activities required non financial information. Maskell (1989) suggested that day to day control of

manufacturing and distribution are better handle with non financial measures

Continuous use of financial measures in nowadays environment affected on the behaviors of individual such as myopic behaviour. Kaplan & Norton (1992), by focusing only on financial

performance, it can give misleading signals for continuous improvement and innovation activities of customer focused manufacturing strategy.

Contemporary Performance Measurement Systems Changing evolution from cybernetic to holistic

view A cybernetics model of control includes stated

objectives or goals, a predictive model and a tool to facilitate the choice of alternative actions

In a cybernetic view, control systems is primarily based on financial measures and consider as a component of planning and control cycle

Holistic view is based on multiple non financial measures where performance measurement acts a an independent process integrated in a broader set of activities.

Contemporary Performance Measurement Systems

Performance pyramid (Lynn & Cross, 1991).

Determinants and results matrix (Fitzgerald et. al, 1991)

Performance prism (Neely et al, 2002)

Balanced scored card (Kaplan & Norton, 1992)

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1992 1996 2000

Balanced Scorecard historyBalanced Scorecard history

Measurement and Reporting

Alignment and Communication

Enterprise-wide Strategic Management

Articles in Harvard Business Review:

“The Balanced Scorecard — Measures that Drive Performance” January - February 1992

“Putting the Balanced Scorecard to Work” September - October 1993

“Using the Balanced Scorecard asa Strategic Management System” January - February 1996

1996 2000

Acceptance and Acclaim:

“The Balanced Scorecard” is translated into 18 languages

Selected by Harvard Business Review as one of the “most important management practices of the past 75 years.“

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2004

Strategy-mapping

Strategy linkages

Intellectual Capital Model – Intellectual Capital Model – Converting INTANGIBLE ASSETSConverting INTANGIBLE ASSETSinto TANGIBLE OUTCOMESinto TANGIBLE OUTCOMES

Balanced Scorecard historyBalanced Scorecard history

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MISSIONMISSIONWhy We ExistWhy We ExistMISSIONMISSION

Why We ExistWhy We Exist

VALUESVALUESWhat’s Important to UsWhat’s Important to Us

VALUESVALUESWhat’s Important to UsWhat’s Important to Us

VISIONVISIONWhat We Want To BeWhat We Want To Be

VISIONVISIONWhat We Want To BeWhat We Want To Be

STRATEGYSTRATEGYWhat Our Game PlanWhat Our Game Plan

STRATEGYSTRATEGYWhat Our Game PlanWhat Our Game Plan

STRATEGY MAPSTRATEGY MAPTranslate the StrategyTranslate the Strategy

STRATEGY MAPSTRATEGY MAPTranslate the StrategyTranslate the Strategy

BALANCED SCORECARDBALANCED SCORECARDMeasure and FocusMeasure and Focus

BALANCED SCORECARDBALANCED SCORECARDMeasure and FocusMeasure and Focus

TARGET and INITIATIVESTARGET and INITIATIVESWhat We Need to Do What We Need to Do

TARGET and INITIATIVESTARGET and INITIATIVESWhat We Need to Do What We Need to Do

PERSONAL OBJECTIVESPERSONAL OBJECTIVESWhat I Need to DoWhat I Need to Do

PERSONAL OBJECTIVESPERSONAL OBJECTIVESWhat I Need to DoWhat I Need to Do

Linking Strategy toLinking Strategy toPerformancePerformanceManagementManagementS

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Financial Perspective Customer Perspective Internal Perspective Innovation and Learning

Perspective

The most commonly used key performance indicators found in a survey are--

Balanced Scorecard Linked to Balanced Scorecard Linked to Organizational PerformanceOrganizational PerformanceBalanced Scorecard Linked to Balanced Scorecard Linked to Organizational PerformanceOrganizational Performance

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Principle of the Strategy Focused Organization: TRANSLATE THE STRATEGY TO OPERATIONAL TERMS

The Strategy

Financial Perspective

“If we succeed, how will we look to our shareholders?”

Customer Perspective

“To achieve my vision, how must I look to my customers?”

Internal Perspective

“To satisfy my customer, at which processes must I excel?”

Organization Learning

“To achieve my vision, how must my organization learn and improve?”

@Measurement is the language that gives clarity to vague concepts.

@ Measurement is used to communicate, not to control.

@Strategy can be described as a series of cause and effect relationship

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Objectives

• Fast ground turnaround

Statement of what strategy must achieve and what’s critical to its success

Target

• 30 Minutes• 90%

The level of performance or rate of improvement needed

• Cycle time optimization

Key action programs required to achieve objectives

InitiativeMeasurement

• On Ground Time• On-Time

Departure

How success in achieving the strategy will be measured and tracked

Strategic Theme: Operating Efficiency

ProfitabilityFinancial

Learning

Morecustomers

Ground crew alignment

Lowest prices

Fewer planes

Customer

Internal

Fast ground turnaround

Strategy Map: Diagram of the cause-and-effect relationships between strategic objectives

Flight Is on time

Balanced ScorecardBalanced Scorecard

CLASS CASE DISCUSSION

Atkinson et al. 6th Edition. Case 2-53 pg. 79, Chadwick Incorporation. Read this case before class and do necessary

preparation. A group work of 4 students Time given: 1 hour 15 minutes One group will be selected to present.