Chapter 8- Session 1- Brief Synopsis

Feedback : Information produced within department/ organization/division and

communicated to management and employees for control/performance evaluation
purposes and for the purpose of deciding on further actions.

Feedback loop in the control cycle- Please refer to Page 181-182 of your manual for
illustrative descriptions.

Steps in the feedback loop:

1. Set plans and targets, e.g. prepare a sales budget or plan.

2. Put plans into operation, e.g. operate sales functions to achieve business
targets.
3. Record and analyse actual results,
4. Results and related information are communicated to management, e.g report
actual sales results to management.
5. Feedback is used by management to compare results against targets, e.g.
sales achievements are compared against sales forecasts/ targets.
6. Take corrective action if necessary, e.g.

• Take control action if results are not in line with targets, e.g. more
hours for sales team, price discounts, increased advertising.
• Do nothing if results are satisfactory.
• Alter plans if results differ from target, e.g. revise sales plan (if
targets are not practically achievable).

Features of effective feedback

• Clear and comprehensive

• Apply Exception principles, i.e. only material differences between target and
achievement should be reported for evaluation
• Should identify controllable costs and revenues as these can be influenced by the
feedback recipient.
• Regularly produced to ensure continuity.
• Communicated timely.
• Sufficiently accurate.
• Exclude irrelevant details.
• Communicated to person in charge and the one with responsibility & accountability.

The behavioral impact of performance measurement

• Performance measures may often lead to a lack of goal congruence.

• For example, a production manager may put excessive emphasis on high production
levels and reduced costs, possibly at the expense of quality and demand realities, if
his KPI is based on production levels only.
• Ways to evaluate performance using budgetary information:

Style of evaluation Comment

Budget Constrained The Manager needs to continuously meet the
budget on a short term basis; most likely to lead
to lack of goal congruence.
Profit conscious Evaluated on the basis of ability to increase the
effectiveness of operations in relation to the long
term purposes of the organization; for instance,
success in reducing long run costs.
Non accounting Other non-financial factors may be preferred over
budgetary evaluation in performance
measurement.

Budget bias

• Manipulation of accounting results more likely where the stress is on achieving short-
term budget targets.
• Budget slack may be introduced by deliberately overestimating costs and/or
underestimating revenue
• In these circumstances, managers may be inclined towards unnecessary spending so
as to use up budget allowances.
• Alternatively, after a period of unsatisfactory results, some managers may
deliberately present over-optimistic budgets for future period, overstating revenues
and underestimating cost estimates.

Divisionalisation/ Decentralisation

• Concept of Responsibility Centers is based on the divisionalisation, where Divisional

managers are given the authority to make decisions concerning the activities of their
divisions, ultimately leading to decentralization of decision making process.

Factors affecting the degree of decentralization

• Management style
• The size of the organisation
• The extent of activity diversification
• Effectiveness of communication
• The ability of management
• The speed of technological advancement
• The geography of locations and the extent of local knowledge needed.
The advantages of decentralization

• Senior Management can spend more time with strategic issues.

• More practical decision making based on local context.
• Motivation to mid and junior managerial level.
• Quicker decision making.
• Training for future managers.

The disadvantages of decentralization

• Difficulties in co-coordinating activities across the organisation.

• Lack of goal congruence in decision making.
• Management’s loss of control over day to day activities.
• Evaluating the performance of managers and their area of responsibility becomes
difficult.
• Duplication of some roles, e.g. administration.

Responsibility accounting

Responsibility accounting is the term used to describe decentralisatin of authority, with

the performance of the decentralized units or responsibility centres measured in terms of
accounting results.

Four main types of responsibility centre

Type of responsibility Manger has control over

centre
Cost center Controllable costs
Revenue centre Revenues only
Profit centre Controllable costs
Sales prices
Investment centre Controllable costs
Sales prices
Output volumes
Investment in non-current assets and working capital

Cost centres

• A cost centre manger is only responsible for, and has control over, the costs incurred
in the cost centre.
• Production and personnel department are examples of cost center.
• Control report for a cost centre should show a clear distinction between Controllable
and uncontrollable costs.
Revenue centers
• In a revenue center, e.g. a sales center, a manager is only responsible for
raising revenue.

Profit centers

• In a profit center, the manager is accountable for both costs and revenues.
• Example may be a branch of a superstore.
• Performance report of a profit center should identify separately the controllable and
non-controllable costs as well as the controllable and non controllable revenue.

Section 2.6- page 186- Proforma Income Statement format for profit center

Investment centers

• The Manager is accountable for cost, revenue, profit as well as some Investment. A
manager of a division is allowed some discretion about the amount of investment
undertake by the division.
• The profit earned is typically evaluated in relation to the amount of capital invested/
employed.
• Performance can typically be measured by Return on capital employed (ROCE) and
residual income (RI).
• The amount of capital employed would consist of directly attributable non-current
assets and working capital (net current assets). Excluded from this calculation, for
instance, are the following:

(a) Cash balance if the investment center is subsidiary company required to

remit spare cash to the central treasury department at group head office. In
this situation the directly attributable working capital would normally
consist of inventories and receivable less payables, but minimal amounts of
cash.

(b) If an investment centre is apportioned a share of head office non-

current assets, the amount of capital employed in these assets should be
recorded separately because it is not directly attributable to the investment
centre or controllable by the manager of the investment centre.

Attempt Interactive Question 1- Page 187.

General requirements for effective performance measures

Key performance indicators (KPIs), might be used to monitor the performance of each
responsibility centre. Features of effective performance measures can be the following:

• Promote goal congruence

• Measurements to include only those factors over which the responsibility centre
manger has control over.
• Encourage the pursuit of longer term objectives as well as short-term.

Problems with inappropriate performance measures

• Manipulation of information to display achievement of KPIs.

• De-motivation and stress-related conflict.
• Excessive concern for the control of short-term costs.
• Assessment of a responsibility centre as an insolated unit, leading to lack of goal
congruence.

Performance measures for a cost center

• Cost variance
• Cost per unit
• Cost per employee
• Other non-financial measures such as the rate of labour turnover.

Performance measures for a revenue centre

• Revenue variances, which are the differences between the budgeted or standard
revenue and the actual revenue achieved.
• Revenue earned per employee
• Percentage market share achieved
• Growth in revenue.

Performance measures for a profit centre

• All of the above performance measures for cost and revenue center
• Gross profit margin
• Operating profit margin.

Performance measures for an investment centre

All of the measures appropriate for a cost, revenue and profit centre would be suitable for
monitoring the performance of an investment centre.

• All of the above performance measures for cost, revenue and profit center
• Current ratio
• Quick ratio
• Rate of inventory turnover
• Receivables collection period
• Payables payment period
• Return on investment (ROI)
• Residual income (RI)

Return on investment (ROI)

ROI compares the profit earned against the amount of capital invested in the investment
centre.

ROI = Controllable divisional profit X 100%

Divisional capital employed

See worked example: Ranking using ROI- page 189

Calculation of Capital employed

• Total of controllable non-current assets and controllable net current assets

(current assets less current liabilities)
• Centrally-controlled assets should be excluded from this calculation
• Usually, opening capital employed or an average of opening and closing
capital is used.

See worked example: The effect of changing the capital employed base- page 189

Using the historical cost/carrying amounts of assets may be misleading due to the
following issues:

• Assets have been bought at different points in time and prices have changed due to
inflation.
• Assets of one division are older than those of another and have been written down to
a lower value.
• Different depreciation policies are applied by different division.

Calculation of Profit
• Typically includes controllable pre-tax profits only, since the company’s ultimate tax
charge may be subject to centralized decision making and is therefore not controllable
by divisional managers.

ROI and goal congruence

• ROI as a performance measure might not lead to goal congruent decisions.

See worked example- page 190

Residual income (RI)

RI is a measure of the centre’s profits after deducting a notional or imputed interest cost
of the capital invested in the centre.

See worked example (2)- page 190 and Interactive Question 2

Particulars Advantages Disadvantages

ROI • Effective measure of • May lead to rejection of
performance marginally profitable
comparison between investments when
two or more investment managers are judged by
centers. ROI.
• Risk of lack of goal
congruence in decision
making.
RI • RI will increase when • Does not facilitate
investments earning comparison between
above cost of capital in investment centers.
undertaken and thus • Does not relate size of a
provides a clear guide centers income to size
on whether to accept a of investment.
project or not.
• RI method is a flexible
performance measure as
the cost of capital can
be varied in evaluation
investments with
different risk
characteristics.

RI is less useful as a comparative measure because it is absolute.