Financial Control

Soumendra Roy
 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
 The Environment of
Financial Control
• Organizations have developed and exploited
financial measures to assess performance and
target areas for improvement because external
stakeholders have traditionally relied on
financial performance measures to assess
organization potential
 The Environment of
Financial Control
• Financial measures do not identify what is
wrong, but they do provide a signal that
something is wrong and needs attention
 Financial Control
• This chapter focuses on broader issues in
financial control, including the evaluation of
organization units and of the entire organization
• 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
 Decentralization
• Decentralization is the process of delegating
decision making authority down the
organization hierarchy

• Highly centralized organizations tend not to

respond effectively or quickly to their
environments
 Decentralization
• Centralization is best suited to organizations
that:
– Are well adapted to stable environments
– Have no major information differences between
the corporate headquarters and the employees
– Have no changes in the organization’s environment
that required adaptation by the organization
 Centralized Organizations
• In centralized organizations:
– Technology and customer requirements are
well understood
– The product line consists mostly of commodity
products for which the most important
attributes are price and quality
 Centralized Organizations
• To accomplish this, organizations develop
standard operating procedures to ensure
that:
– They are using the most efficient technologies
and practices to promote both low cost and
consistent quality
– There are no deviations from the preferred way
of doing things
 Changing Environment
• In response to increasing competitive
pressures and the opening up of former
monopolies to competition, many
organizations are changing the way they are
organized and the way they do business
• This is necessary because they must be able to
change quickly in a world where technology,
customer tastes, and competitors’ strategies
are constantly changing
 Becoming More Adaptive
• Being adaptive generally requires that the
organization’s senior management delegate or
decentralize decision-making responsibility to
more people in the organization
• Decentralization :
– Allows motivated and well-trained organization
members to identify changing customer tastes quickly
– Gives front-line employees the authority and
responsibility to develop plans to react to these
changes
 Degrees of Decentralization
• The amount of decentralization reflects the
organization’s need to have people on the front
lines who can make good decisions quickly and:
– The organization’s trust in its employees
– The employees’ level of skill and training
– The employees’ ability to make the right choices
 From Task to Results Control
• In decentralization, control moves from task
control to results control
– From where people are told what to do
– To where people are told to use their skill,
knowledge, and creativity to improve results
 Responsibility Centers
• A responsibility center is an organization unit
for which a manager is made responsible
• A responsibility center is like a small business
• But it is not completely autonomous
– Its manager is asked to run that small business to
promote the best interests of the larger organization
 Responsibility Centers
• The manager and supervisor establish goals for
their responsibility center
• These goals should:
– Be specific and measurable so as to provide
employees with focus
– Promote the long-term interests of the larger
organization
– Promote the coordination of each responsibility
center’s activities with the efforts of all the others
 Coordinating Responsibility Centers
• For an organization to be successful, the activities of its
responsibility units must be coordinated
• Sales, manufacturing, and customer service activities are often
very disjointed in large organizations, resulting in diminished
performance
– In general, nonfinancial performance measures
detect coordination problems better than financial
measures
 Responsibility Centers
& Financial Control
• Organizations use financial control to provide a
summary measure of how well their systems of
operations control are working
• When organizations use a single index to
provide a broad assessment of operations, they
frequently use a financial number because it is a
measure that describes the primary objectives
of shareowners in profit-seeking organizations
 Responsibility Center Types
• The accounting report prepared for a
responsibility center reflects the degree to
which the responsibility center manager
controls revenue, cost, profit, or return on
investment
• Four types of responsibility centers:
• Cost centers
• Revenue centers
• Profit centers
• Investment centers
 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
 Other Issues in Cost
Center Control
• Many organizations make the mistake of evaluating
a cost center solely on its ability to control costs
• Other critical performance measures may include:
– Quality
– Response time
– Meeting production schedules
– Employee safety
– Respect for the organization’s ethical and
environmental commitments
 Other Issues in Cost
Center Control
• If management evaluates cost center
performance only on the center’s ability to
control costs, its members may ignore
unmeasured attributes of performance
 Revenue Center
• A responsibility center whose members
control revenues but control neither the
manufacturing or acquisition cost of the
product or service they sell nor the level of
investment made in the responsibility center
• Some revenue centers control price, the mix
of stock carried, and promotional activities
 Costs Incurred by
Revenue Centers
• Most revenue centers incur sales and marketing
costs and have varying degrees of control over
those costs
• It is common in such situations to deduct the
responsibility center’s traceable costs from its
sales revenue to compute the center’s net
revenue
– Traceable costs may include salaries, advertising costs,
and selling costs
 Drawbacks of Revenue Centers
• Critics of the revenue center approach argue
that basing performance evaluation on
revenues can create undesirable
consequences
• In general, focusing only on revenues causes
organization members to increase the use of
activities that create costs in order to promote
higher revenue levels
 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 Centers?
• It is doubtful that a unit of a corporate-owned
hotel or fast-food restaurant meets the
conditions to be treated as a profit center
• These units are sufficiently large that:
– Costs may vary due to differences in controlling
labor costs, food waste, and scheduled hours
– Revenues may also shift significantly based on how
well staff manages the property
 Profit Centers?
• Although these organizations do not seem to
be candidates to be treated as profit centers,
local discretion often affects revenues and
costs enough so that they can be
• Many organizations evaluate units as profit
centers even though the corporate office
controls many facets of their operations
– The profit reported by these units reflects both
corporate and local decisions
 Profit Centers? (3 of 3)
• If unit performance is poor, it may reflect:
– Poor conditions no one in the organization can control
– Poor corporate decisions
– Poor local decisions
• Organizations should not rely solely on profit
center’s financial results for performance
evaluations
– Detailed performance evaluations should include
quality, material use, labor use, and service measures
that the local units can control
•
Investment Center
A responsibility center in which the manager and other
employees control revenues, costs, and the level of investment
in the responsibility center
• For example, between 1970 and 2000 General Electric acquired
many businesses
– Including aircraft engines, medical systems, power
systems, transportation systems, consumer
products, industrial systems, broadcasting, plastics,
specialty materials, and financial services
• Senior executives at General Electric developed a management
system that evaluated these businesses as independent
operations – in effect as investment centers
 Evaluating Responsibility Centers
• 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
 Evaluating Responsibility Centers
• Revenues, costs, or investments that people
outside the responsibility center control
should be excluded from the accounting
assessment of that center’s performance
• Although the controllability principle sounds
appealing and fair, it can be difficult,
misleading, and undesirable to apply in
practice
 Problems with the
Controllability Principle
• A significant problem in applying the
controllability principle is that in most
organizations many revenues and costs are
jointly earned or incurred
– The activities that create the final product are
sequential and interdependent
– Evaluating the individual performance of one
center requires the firm to consider many facets of
performance
 Problems with the
Controllability Principle
• As part of the performance evaluation process,
the organization may want to prepare
accounting summaries of the performance of
individual units to support some system of
financial control
 Using Performance Measures to Influence v.
Evaluate Decisions
• The choice of the performance measure may
influence decision-making behavior

• When more costs or even revenues are included

in performance measures, managers are more
motivated to find actions that can influence
incurred costs or generated revenues
 Example from a Dairy
• A dairy faced the problem of developing
performance standards in an environment of
continuously rising costs
– The costs of raw materials, which were 60% - 90% of the
final costs, were market determined
– Should the evaluation of the managers depend on their
ability to control the quantity of raw materials used
rather than the cost?
• Senior management announced that it would
evaluate managers on their ability to control total
costs
 Example from a Dairy
• The managers quickly discovered that one way
to control raw materials costs was through long-
term fixed price contracts for raw materials
– Contracts led to declining raw materials costs
– The company could project product costs several
quarters into the future, thereby achieving lower
costs and stability in planning and product pricing
• When more costs or revenues are included in
performance measures, managers are more
motivated to find actions that can influence
incurred costs or generated revenues
 Using Segment Margin Reports
• Despite the problems of responsibility center
accounting, the profit measure is so comprehensive
and pervasive that organizations prefer to treat
many of their organization units as profit centers
• Because most organizations are integrated
operations, the first problem designers of profit
center accounting systems must confront is the
interactions between the various profit center units
 The Segment Margin Report
• A common form of the segment margin report for an
organization that is divided into responsibility centers
includes one column for each profit center
• The revenue attributed to each profit center is the first
entry in each column
• Variable costs are deducted from its revenue to
determine the contribution margin
• The costs not proportional to volume are deducted
from each center’s contribution margin to determine
that unit’s segment margin
 The Segment Margin Report
• Allocated avoidable costs are deducted from the
unit’s segment margin to compute its income
• The organization’s unallocated costs, which
represent the administrative and overhead costs
incurred regardless of the scale of operations,
are deducted from the total of the profit center
incomes to arrive at total profit
 Evaluating the Segment
Margin Report
• What can we learn from the segment margin
report?
• The contribution margin for each responsibility
center is the value added by the manufacturing
or service-creating process before considering
costs that are not proportional to volume
• A unit’s segment margin is an estimate of its
short-term effect on the organization’s profit
 Evaluating the Segment
Margin Report
• The unit’s income is an estimate of the long-
term effect of the responsibility center’s
shutdown on the organization’s profit after
fixed capacity is allowed to adjust
• The difference between the unit’s segment
margin and income reflects the effect of
adjusting for business-sustaining costs
•
Good or Bad Numbers?
Organizations use different approaches to evaluate
whether the segment margin numbers are good or
bad
• Two sources of comparative information are:
– Is performance this period reasonable, given past
experience?
– How does performance compare with similar
organizations?
• Evaluations include comparisons of:
– Absolute amounts, such as cost or revenue levels
– Relative amounts, such as each item’s % of revenue
 Interpreting Reports
with Caution
• Segment margin statements should be
interpreted carefully, however, because they
reflect many assumptions that disguise
underlying issues
– Segment margins present an aggregated summary of
each organization unit’s past performance
• Important to consider critical success factors that
will affect future profits
 Interpreting Reports
with Caution
– Segment margin reports usually contain “soft
numbers”
• Allocations that may be quite arbitrary and over which
there can be legitimate disagreement
• These assumptions relate to the transfer pricing issue,
which focuses on how revenues the organization earns
can be divided among all the responsibility centers that
contribute to earning those revenues
 Transfer Pricing
• Transfer pricing is the set of rules an
organization uses to allocate jointly earned
revenue among responsibility centers
• To understand the issues and problems
associated with allocating revenues in a simple
organization, consider the activities that occur
when a customer purchases a new car at a
dealership:
 Transfer Pricing
– The new car department sells the new car and takes in
a used car as a trade
– The used car is transferred to the used car department
– There, it may undergo repairs and service to make it
ready for sale, or may be sold externally on the
wholesale market
• The value placed on the used car transferred
between the new and used car departments is
critical in determining the profits of both
departments:
 Transfer Pricing
– The new car department would like the value
assigned to the used car to be as high as possible
to increase revenue
– The used car department would like the value to
be as low as possible because that makes its
reported costs lower
• The same considerations apply for any product
or service transfer between any two
departments in the same organization
 Approaches to Transfer Pricing
• Organizations choose among four main approaches
to transfer pricing:
– Market-based transfer prices
– Cost-based transfer prices
– Negotiated transfer prices
– Administered transfer prices
• Transfer prices serve different purposes; however,
the goal of using transfer prices is always to
motivate the decision maker to act in the
organization’s best interests
 Market-Based Transfer Prices
• If external markets exist for the intermediate
(transferred) product or service, then market prices
are the most appropriate basis for pricing the
transferred good or service between responsibility
centers
• The market price provides an independent valuation
of the transferred product or service, and of how
much each profit center has contributed to the total
profit earned by the organization on the transaction
 Cost-Based Transfer Prices
• Some common cost-based transfer prices are:
– Variable cost
– Variable cost plus a percent markup on variable cost
– Full cost
– Full cost plus a percent markup on full cost
• Economists argue that any cost-based transfer
price other than marginal cost leads
organization members to choose a lower than
optimal level of transactions
 Problems with
Cost-Based Price
• Cost-based approaches to transfer pricing do
not support the intention of having the
transfer pricing mechanism support the
calculation of unit incomes

• Transfer prices based on actual costs provide

no incentive to the supplying division to
control costs, since the supplier can always
recover its costs
 Problems with
Cost-Based Price
• Cost-based pricing does not provide the proper
economic guidance when operations are
capacity constrained
– Production decisions near full capacity should reflect
the most profitable use of the capacity, not only cost
considerations
– The transfer price should be the sum of the marginal
cost and the opportunity cost of capacity, where
opportunity cost reflects the profit of the best
alternative use of the capacity
 Interesting Variations
• A dual rate approach - the receiving division is charged
only for the variable costs of producing the unit
supplied and the supplying division is credited with
the net realizable value of the unit supplied
– This lets marginal cost influence the decisions of the
buying division while giving the selling division credit
for an imputed profit on the transferred good or service
– Target variable cost includes the number of standard
hours allowed for the work done multiplied by the
standard cost per hour, in addition to an assignment of
the supplying division’s committed costs
 Cost Allocations to
Support Financial Control
• Organizations should design and present
responsibility center income statements in
such a way that they isolate the discretionary
components included in the calculation of
each center’s reported income
– Show the revenue and variable costs separately
from the other costs in the profit calculation
– Separate from the indirect or joint costs that are
allocated
 Allocation of Indirect Costs
• Many different activity bases for selecting a
method to allocate indirect costs
• Allocating indirect costs in proportion to benefit
is one option
 Interpreting Segment Financials
• Responsibility center income statements
should be interpreted with considerable
caution and healthy skepticism
• They may include arbitrary and questionable
revenue and cost allocations
• They often disguise interrelationships among
the responsibility centers
 Negotiated Transfer Price
• Some organizations allow supplying and receiving
responsibility centers to negotiate transfer prices between
themselves

• Negotiated transfer prices reflect the controllability

perspective inherent in responsibility centers, since each
division is ultimately responsible for the transfer price
that it negotiates
– Negotiated transfer prices and therefore production decisions
may reflect the relative negotiating skills of the two parties
rather than economic considerations
 Optimal Transfer Price
• In an economic sense, the optimal transfer price
results when the purchasing unit offers to pay the
net realizable value of the last unit supplied for all
the units supplied
– The net realizable value of a unit of transferred material
is the selling price of the product less all the costs that
remain to prepare the final product for sale
• If the supplying unit is acting optimally, it chooses
to supply units until its marginal cost equals the
transfer price offered by the purchasing unit
 Problem with Negotiated Prices
• Problems arise when negotiating transfer prices,
because the bilateral bargaining situation causes:
– The supplying division to want a higher than optimal
price
– The receiving division to want a lower than optimal
price
• When the actual transfer price is different from
the optimal transfer price, the organization as a
whole suffers
 Administered Transfer Price
• An arbitrator or a manager applies some
policy to set administered transfer prices
– Organizations often used administered transfer
prices when a particular transaction occurs
frequently
• Such prices reflect neither pure economic
considerations, as do market-based or cost-
based transfer prices, nor accountability
considerations, as negotiated transfer prices
do
 Administered Transfer Price
• Administered transfer prices inevitably create
subsidies among responsibility centers
– Subsidies obscure the normal economic
interpretation of responsibility center income
– Subsidies may provide a negative motivational
effect if members of a responsibility center believe
the rules are unfair
 Transfer Prices Based
on Equity Considerations
• Administered transfer prices are usually based
on cost
• Sometimes administered transfer prices are
based on equity considerations:
– Relative cost method
– Base the allocation of cost on the profits that each
manager derives from using the asset
– Assign each manager an equal share of the asset’s
cost
 Assigning and Valuing
Assets in Investment Centers
• When companies use investment centers to
evaluate responsibility center performance,
there are:
– All the problems associated with profit centers
– Plus some new problems unique to investment
centers
• The additional problems concern how to
identify and value the assets used by each
investment center
 Determining Level of Asset Use
• In determining the level of assets that a
responsibility center uses, the management
accountant must assign the responsibility for:
– Jointly used assets
– Jointly created assets
• Once decision makers have assigned assets to
investment centers, they must determine the value
of those assets
– What cost should be used—historical cost, net book
value, replacement cost, or net realizable value?
 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
 Assessing Productivity Using
Financial Control
• The most widely accepted definition of
productivity is the ratio of output over input
• Organizations develop productivity measures
for all factors of production, including people,
raw materials, and equipment
 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
 The Efficacy of
Financial Control
• Critics of financial control have argued that:
– 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
 The Efficacy of
Financial Control
• 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 of
Financial 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
 The Efficacy of
Financial Control
• 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