Tutorial 8 Summary

RESPONSIBILTY ACCOUNTING INVESTMENT CENTERS AND PERFORMANCE EVALUATION

Goal Congruence
(For details on Goal Congruence refer lecture notes slide 4)
• Goal congruence means a meshing of objectives, in which the managers throughout an organization strive to achieve goals that are consistent with the goals set by top management. Goal congruence is important for organizational success because managers often are unaware of the effects of their decisions on the organization's other subunits. Also, it is natural for people to be more concerned with the performance of their own subunit than with the effectiveness of the entire organization. In order for the organization to be effective, it is important that everyone in it be striving for the same ultimate objectives. A responsibility-accounting system fosters goal congruence by establishing the performance criteria by which each manager will be evaluated. Development of performance measures and standards for those measures can help to ensure that managers are striving toward goals that support the organization's overall objectives

.. capital invested of the subunits. Profit Centers – Contribution Income Statements. Revenue Centers – Revenue standards. ..Responsibility Accounting What are the useful measurement tools:1. revenue. EVA….. 3.( others such as IRR or returns multiples over the investment horizon or Enterprise Value / market value of Equity) Each of these centers have accountability or responsibility to costs. Investment Centers – ROI. profit .. RI. 2. Cost Centers – Costs standards.. 4.

Return on Investment (ROI) Formula Income before interest and taxes (EBIT) Net operating income ROI = Average operating assets Cash. accounts receivable.Investment Centre . and other productive assets. inventory. plant and equipment. The operating asset base used in the formula is typically computed as the average operating assets {(beginning assets + ending assets) ÷ 2} .

Average operating/productive assets: All assets held for operating purposes. c. including non-operating assets. etc. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of shortterm credit to finance operations. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. Total assets: Includes all divisional assets. Excludes assets that are not in service.Different measures of Invested Capital a. such as construction in progress. a. . investment in another company. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets. Total assets less current liabilities: All divisional assets minus current liabilities.

such as straight-line or declining-balance methods. As a result. . some managers prefer not to allow these depreciation charges to affect ROI or residual-income calculations.Implications of use of Cost or NBV • The use of cost or gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. • Also. the usual methods of computing depreciation. are arbitrary.

Turnover = Sales Average operating assets ROI = Sales Margin × Asset Turnover .Breaking down the formula for ROI ROI = Net operating income (EBIT) Average operating assets Sales Margin = Net operating income Sales A.

the higher the sales margin earned. namely sales margin and asset turnover. Sales Margin is computed as shown in the next slide & is improved by increasing sales or reducing operating expenses. It incorporates a crucial area of a manager’s responsibility – the investment in operating assets.DuPont pioneered the use of ROI and recognized the importance of looking at the components of ROI. Asset Turnover is computed as shown. Excessive funds tied up in operating assets depress asset turnover and lower ROI . The lower the operating expenses per dollar of sales.

3 Primary ways in Improving ROI ROI = Sales Margin × Asset Turnover Reduce Expenses Increase Sales ROI = Sales .Operating expenses Sales × Sales Average operating assets Reduce Assets * Refer to lecture notes slides 26 to 33 on the various scenarios .

its necessary to less the scrap value from the new cost of FA to compute the depreciation. tax and depreciation . Investing in new project or new plant & purchasing new machinery or purchasing another company :• It refers to the capital outlay or purchase price of the investment. 2. For our purpose depreciation is assumed on a straight line basis. the average net operating asset. be it borrowed funds or self funding. Existing operation:• This refers to operating assets i.) EBIT – Earnings before interest and tax EBITDA – Earnings before interest. bal. Average net operating asset is sum of beg. & ending bal. or • In the case of expansion it’s the fresh capital to be injected for expansion.A. ÷ 2 (Note: F.A is taken at NBV and if there is a scrap value for the F.e.Average Operating Asset/ invested capital as used in ROI Two situations 1. amortization ♣ ♣ ♣ .

. Net Average Minimum Residual = operating operating × required rate of income income assets return ( ) This computation differs from ROI. • ROI measures net operating income earned relative to the investment in average operating assets. * Sometimes called imputed interest or notional interest or minimum cost of capital.Residual Income as an investment center’s performance measurement • Residual income measures net operating income earned less the minimum required return* on average operating assets.

000 − ($800. Sometimes this notional interest is called cost of capital.000.000 X12%) = $4.000 & the imputed interest rate is 12% : Residual income = $100. but it is not used in computing ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital. .000 The imputed interest rate is used in calculating residual income. invested capital is $800.Calculating Residual Income Example of the calculation of residual income: Suppose an investment center's profit is $100.

Ideally wherever possible in such situations it is desirable to evaluate them together. It motivates managers to pursue investments where the ROI associated with those investments that exceeds the company’s minimum required return but is less than the ROI being earned by the managers. .Motivation and Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

The Balanced Scorecard Management translates its strategy into performance measures that employees understand and influence. Financial Customers Performance measures Internal business processes Learning and growth .

The Balanced Scorecard: From Strategy to Performance Measures Performance Measures Financial Has our financial performance improved? Customer Do customers recognize that we are delivering more value? Internal Business Processes Have we improved key business processes so that we can deliver more value to customers? Learning and Growth Are we maintaining our ability to change and improve? What are our financial goals? What customers do we want to serve and how are we going to win and retain them? What internal biz processes are critical to providing value to customers? Vision and Strategy .

Top managers are ordinarily responsible for financial performance measures – not lower level managers.The Balanced Scorecard: Non-financial Measures The balanced scorecard relies on non-financial measures in addition to financial measures for two reasons: Financial measures are lag indicators that summarize the results of past actions. Non-financial measures are more likely to be understood and controlled by lower level managers. Non-financial measures are leading indicators of future financial performance. .

profits increase. Profit financial Profits Increase Contribution Increases Cars Sold Increases Contribution per car Number of cars sold customer Customer satisfaction with options Strategies Increase Options Increase Skills Number of options available Internal biz processes Time to install option Time Decreases Employee skills in installing options Learning and Growth .The Balanced Scorecard ─ Jaguar Example Results If number of cars sold and contribution per car increase.

customer satisfaction and product knowledge. Jaguar’s management stresses the availability of options. We can see that the performance measures used are closely linked to the company’s vision. This performance measure would ensure the satisfaction of customers which in turn would increase sales. interior and exterior color combinations. “Dealership performance was measured throughout the year against a balanced scorecard including sales versus objective. and wooden dashboard. this is an internal business Process measure. and the time taken to install such options.Jaguar example • Jaguar offers distinctive. • From the above we can see that Jaguar’s choice of performance measures in its balanced scorecard is complete and consistent with the organization’s objectives.” • Jaguar is concerned about quality. . which is why one of their performance measures is measuring how well the employees’ skills in installing options. richly furnished luxury automobiles to wealthy individuals who prize individualized products such as leather seats.

project knowledge. and pitfalls. • Philips has also seen that the scorecard promotes the sharing of best practices and creates a worldwide communication system where employees can share success practices. product fixes. This communication prevents employees from repeating fellow employees’ mistakes. saving time and money. • Philips created 4 critical success factors (“CSF”) to align indicators that measure markets. operations and laboratories with business success. . North America. interests.Another case example of use of Balanced Scorecard at all levels of the organisation Another example is the Philips Electronics Medical Devices Systems.

For example. top level managers often can see a problem developing before it becomes a serious problem. management can observe this phenomenon and take steps to improve product quality before serious damage is done to customer relations. if a manufacturer's rate of defective products has been increasing over some period of time. • By keeping track of important non-financial data.Non-financial measures • Non-financial information is useful in measuring investment-center performance because it gives top management insight into the summary financial measures such as ROI or residual income. .

rejects and reworks %.g. down time. defects count per • Innovation and learning .) employee. move time. today many organizations use a variety of non-financial& operational measures as well: • Raw Material and Scrap control – e. (JIT inventory system.g. • Production and Delivery – Mfg or throughput and delivery cycle times. etc. • Gains Sharing Plans – an incentive system where any cost or productivity gains are shared with those who helped to achieve those improvements.g. Quality of raw mat. JIT production.( impact of Mar 2011 Japan tsunami. product warranty claims. % of rework. frequency of repairs & maintenance. use of Theory of Constraints. etc) • Inventory control – e. wait time. vendors qualification. % of orders filled on time. setup time.. average duration of inventory hold • Machine performance and Product quality – e. Inventory T/O.Measuring Operational Performance Whilst variances pick up the financial performance measures. % of scrap to RM. . benefits from process improvements. waste management. • Productivity – Finished Goods produced per employee.effective % sales from new products vs competitors.

where • MCE = Value-add time ÷ Mfg Cycle time .Manufacturing Cycle Efficiency(“MCE”) A)Throughput / Manufacturing Cycle time B) Wait time C) Delivery cycle time • C=A+B • Process time is usually the only valueadded time.

& K17 – Team 1 = Qn 1 & 6. Problem 12-24. Problem 13-24. A-7 • Group K 16 – Teams 3 = Qn 1 & 6. Supple.2. A-8 – Team 2 = Qn 3. Problem 13A-5 – Team 3 = Qn 4. A-8 – Teams 1. 4.Tutorial 9 – Segment Reporting & Transfer Pricing • Group K15. Qn – Team 4 = Qn 2 & 5. Problem 13-27. 5 = Qn 2 to 5 respectively .