5A - Financial and Nonfinancial Measures of Performance Management

Which of the following steps in the strategic planning process should be completed first?

- Create a mission statement. A strategic plan is a document that assists a business with implementing its long-term goals and mission statement. In order to have a strategic plan, a business must first have a mission statement. After that, the strategic plan determines the actions to be taken in order to achieve the goals and objectives. Performance measures are indicators of whether or not the stated goals have been achieved.

Minon, Inc., purchased a long-term asset on the last day of the current year. What are the effects of this purchase on return on investment and residual income?

- Decrease in both return on investment and residual income Return on investment (ROI) is calculated by dividing the invested capital into the net income. If the invested capital increases due to a long-term asset purchase, then the ROI will decrease. For example, if net income is $100,000 and invested capital is $25,000, the resulting ROI will be 4.0 (100,000 ÷ $25,000). However, if the invested capital increases by $25,000, the resulting ROI will be 2.0 ($100,000 ÷ $50,000). Residual income is the amount of net income in excess of a minimum desired rate of return on invested capital. This can be expressed in the equation: Reported net income - (Desired rate of return × Invested capital). If invested capital increases, the residual income will decrease. For example, reported net income is $100,000. The desired rate of return is 5%. If invested capital is $25,000, then the residual income is $98,750 ($100,000 - (.05 × $25,000)). If the invested capital increases to $50,000, the resulting residual income will be $97,500 ($100,000 - (.05 × $50,000)).

Controllable revenues would be included in the performance reports of which of the following types of responsibility centers?

- Investment centers A cost center is a subdivision (unit, section, department, or segment) of the business responsible for the incurrence and proper utilization (control) of costs. An investment center adds revenues and investments to subdivision reports. Revenue is not reported for cost center performance reports since they are not controllable by the center manager. Revenue is reported for investment centers since the manager controls costs, revenues, and investments.

Which of the following labor costs for a manufacturing company is deducted from revenues in order to determine gross margin but is not deducted from revenues to determine contribution margin?

- Manufacturing floor manager's salary The question is comparing the variable costing method (which deducts direct material, direct labor, and variable overhead from revenue) to the absorption method (which deducts direct material, direct labor, variable overhead, and fixed overhead from revenue). Revenue less variable manufacturing costs is contribution margin. Revenue less all manufacturing costs is gross margin. The only item listed which is classified as fixed manufacturing overhead is the manufacturing floor manager's salary. Hourly assembly worker's wages are direct labor. The office manager's salary and salesperson's commissions are general, administrative, and selling expenses (nonmanufacturing costs).

Performance measures for investments and business segments sometimes use imputed costs to calculate performance results. Imputed costs reflect what something should or would cost, but they are not recorded in accounts because they are not actual expenditures of cash or other resources. Return on investment (ROI) and residual income (RI) are two commonly used performance measures. Imputed costs are used in:

- RI but not ROI. Return on investment (ROI) is equal to income (actual revenue minus actual expense) divided by investment cost of asset(s) used. It does not utilize any imputed costs. Residual income (RI) is the result of subtracting the imputed cost of investment from operating income. Thus, it utilizes some imputed costs.

Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is incorrect?

- ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation. Many financial measures such as ROI, residual income and contribution margin percentage are capable of being independently verified. Companies strive to find performance measures that are not subject to manipulation but also recognize that most financial measures can be subjected to some financial manipulation. Financial management usually monitors possible manipulation practices. For example, with respect to ROI, financial managers will monitor the results to ensure the appropriate use of accruals and capitalization.

Brent Co. has intracompany service transfers from Division Core, a cost center, to Division Pro, a profit center. Under stable economic conditions, which of the following transfer prices is likely to be most conducive to evaluating whether both divisions have met their responsibilities?

- Standard variable cost Responsibility accounting is segmented reporting useful in management and control that breaks the enterprise into organization subdivisions that are responsible for costs, profits, and investments according to the unit's ability to control these activities. Each center is judged on the basis of an evaluation of its performance relative to the activities over which it has control. Variable costs include direct costs that can generally be controlled by the division to which they are allocated. "Actual cost" and "Actual cost plus mark-up" are incorrect because actual costs can be controlled by the cost center. It should not be allowed to pass the excess costs over standard costs on to the next division. "Negotiated price" is incorrect because a negotiated price usually would include some profit margin for the producing division, but that division only exercises control over costs rather than revenues or profit.

Controllable revenue would be included in a performance report for:

- a profit center. The performance report of a profit center would appear as follows: Controllable revenue XXX Less Controllable costs XX --- Profit center income XX === Note that controllable revenue does appear in this performance report. On the other hand, only controllable costs appear in the cost center performance report.

Residual income of an investment center is the center's:

- income less the imputed interest on its invested capital. Residual income is the amount of net income in excess of the imputed interest on its invested capital, so "income less the imputed interest on its invested capital" is correct. The imputed interest on investment is a rate determined by corporate headquarters to encourage the investment center managers to invest in projects that would return more than that rate since residual income will be increased.

Each of the following will affect a company's return on investment, except:

- maintaining the company's cost of capital at current levels.

Benchmarking is a measurement of quality. Which of the following is not a characteristic of benchmarking?

-Measuring only an organization's industry Benchmarking is a measurement of quality which entails comparing an entity's policies, products, programs, strategies, etc. with standards or peers, usually those considered best-in-class. These performers are not limited to the benchmarking entity's industry or area. The objectives of benchmarking are to analyze how other organizations achieve their high performance levels, determine what improvements are needed for the given entity, and implement this information to improve performance.

Which of the following is one of the four perspectives of a balanced scorecard?

A balanced scorecard considers several areas in comparing performance results of different business units, including customer satisfaction, learning and growth (innovation), internal business process improvements, and financial measures related to operations of the unit. JIT (just-in-time) and benchmarking are management policies related to corporate strategies, but they have no relationship to performance measurement. Activity-based costing is a method of assigning costs to products rather than a performance measurement tool.

Smart Co. uses a static budget. When actual sales are less than budget, Smart would report favorable variances on which of the following expense categories?

A favorable variance means actual costs were less than the budget. Sales commissions are a variable cost since they are a percentage of sales revenue. A static budget is not adjusted for changes in the sales level, so sales commissions would be expected to be less than the budgeted amount if sales were less than budgeted sales. Thus, actual sales commissions are less than budget. Building rent is a fixed cost; it does not vary as sales increase or decrease. Having sales less than the budgeted amount would not change the budget for fixed costs. If building rent does not change for some other reason, there would be no building rent variance, either favorable or unfavorable; actual rent would equal the budgeted rent.

The following selected data pertain to the Darwin Division of Beagle Co. for the current year: Sales $400,000 Operating income $40,000 Capital turnover 4 Imputed interest rate 10% What was Darwin's current-year residual income?

Capital turnover = Sales / Invested capital 4 = $400,000 / Invested capital 4 x Invested capital = $400,000 Invested capital = $400,000 / 4 = $100,000 Operating income $40,000 Less imputed interest on invested capital (10% x $100,000) 10,000 Equals residual income $30,000

Continuous improvement, also called target-based costing, looks to reduce costs while maintaining quality. Which of the following is not a characteristic of continuous improvement?

Continuous improvement seeks to reduce costs that frequently disturb the established order. One way to achieve this is by using market-driven standards rather than engineering-driven standards, which are based on current technology. Under continuous improvement, a competitive market price that yields the desired market share less the desired markup equals allowable cost. The allowable cost becomes the target standard. Continuous improvement is sought until the target standard is achieved by modifying technology and not optimizing existing technology.

Using a real options approach in capital investments planning helps managers in dealing with which of the following?

Correct The major benefit of using a real options approach is its effectiveness in dealing with uncertainty. An investment is considered similar to acquisition of stock using options. The option is purchased but will be exercised only if investment in the related shares of stock appears profitable. If not, the option is not exercised and the potential loss minimized. Capital investment projects can be dealt with similarly.

Which of the following terms represents the residual income that remains after the cost of all capital, including equity capital, has been deducted?

Economic value added (EVA) is after-tax operating income less the weighted average cost of capital. Free cash flow is a measure of financial performance calculated as operating cash flow minus capital expenditures, not a measure of income. Market value added is the difference between the current market value of a firm measured by the price of stock on the stock exchange and the capital contributed by investors, not the income remaining after cost of capital is deducted. Net operating capital is a term used to describe working capital (current assets less current liabilities), not the cost of capital.

Which of the following is not a characteristic of life cycle costing?

It measures the purchaser's cost only at the point of initial purchase. Life cycle costing does not only measure the purchaser's cost at the point of initial purchase. Life cycle costing examines the entire life cycle of a purchase, from the point of purchase to the ultimate disposition of the product by the consumer. It is the relationship between what the customer pays for the product and the cost the customer incurs over the product's entire lifespan, resulting in better product design to reduce post-purchase costs to the customer and improved market segmentation and product positioning.

Key Co. changed from a traditional manufacturing operation with a job order costing system to a just-in-time operation with a back-flush costing system. What are the expected effects of these changes on Key's inspection costs and recording detail of costs tracked to jobs in process?

Key's inspection costs will decrease because in a just-in-time operation the number of vendors is reduced and remaining vendors are expected to deliver higher-quality materials on a timely basis. A back-flush system is based on removal of the standard cost of finished products from the work-in-process inventory upon completion. The effect is to significantly decrease the detail of costs tracked to jobs.

Which of the following management practices involves concentrating on areas that deserve attention and placing less attention on areas operating as expected?

Management by exception involves concentrating on areas that deserve attention and paying less attention to areas operating as expected. - Management-by-objectives (MBO) involves having manager and subordinate jointly develop objectives and plans. - Responsibility accounting is a method whereby responsibility is identified and related to managers. Then, managerial performance is monitored and evaluated based on this identification. - Benchmarking involves identifying "best in class" performance or other measure(s), then comparing the company's performance to that benchmark or standard.

The proper discount rate to use in calculating certainty equivalent net present value is the:

Normally, investment projects are perceived to be subject to some degree of risk with regards to amount and timing of future cash flows. This risk is incorporated into the analysis by using a discount rate higher than the risk-free rate. If there is no risk (i.e., the cash flows are certain), the appropriate discount rate is the risk-free rate.

What is process management?

Process management is the planning and monitoring of the operations of an actual business process. Knowledge of the process, process skills, techniques, tools, and systems must be applied to improve the business processes already in place.

The resource base figures prominently in performance measures such as return on investment, residual income, and economic value added. The theoretically superior (not necessarily the one most widely used) investment base would be:

Replacement cost is a measure of current value. Since revenue and most expenses are also stated in terms of current value, a more consistent performance measure (i.e., return on investment or residual income) will result when all variables are stated in current dollars. Use of replacement or current values assures that a more relevant performance result will be obtained.

Which of the following performance measures may lead a manager of an investment center to forgo investments that could benefit the company as a whole?

Return on investment (ROI) is net income divided by invested capital. It does not consider profitability to the company as a whole because it does not use the corporate cost of capital. A division manager may decide to forego an investment that has an ROI below the division ROI even though it is above the overall corporation cost of capital. Residual income (RI) is net income above a minimum desired rate of return on invested capital. The minimum desired net income is found by multiplying the desired rate of return by invested capital. Division managers would desire to accept projects that exceed the overall corporate cost of capital. The profitability index is an analysis of investment alternatives rather than a performance measurement. It is calculated as the present value of the cash flows not counting the initial investment divided by the amount of that investment. Economic value-added (EVA) is the earnings above the required cost of capital for shareholders; this measure is similar to residual income, but it is applied by external investors rather than the company's management.

The strategic planning process should focus on the firm's internal and external environment. An evaluation process that can be used to accomplish this is:

SWOT analysis looks at a business and attempts to identify its strengths, weaknesses, opportunities, and threats. Strengths and weaknesses make up the organization's internal environment, while its external environment includes opportunities and threats. - Activity-based costing is a method for costing products or services based on the consumption of activities. - Capital budgeting is a project evaluation tool used for the evaluation of proposed investment projects. - Full costing is a product costing methodology which assigns material, labor, and overhead to products.

What is strategic planning?

Strategic planning answers questions such as the following: What product or service do we supply? Who are our customers? How can we perform well? The answers to these questions provide a general direction for the organization.

Which of the following balanced scorecard perspectives examines a company's success in targeted market segments?

The balanced scorecard concept is a management method used to help companies achieve the goals in their mission statements. There are four sections, or perspectives, to this method: financial performance, customer knowledge, internal business processes, and learning and growth. Targeted market segments would be specific groups of customers to whom a company wishes to advertise and sell. The study or review of success in these markets would fall under the customer perspective. Learning and growth encompass the continued improvement of the major resource of companies—the training and mentoring of human resources, or employees. The financial perspective is the more traditional way to manage a business. It is based on financial data such as overall profits and financial ratios. Internal business processes allow managers to receive information that provides feedback regarding how well the products or services fulfill the overall mission of the business.

Integrating TQC (total quality control), TQM (total quality management), and JIT (just-in-time) controls achieves many benefits. Which of the following is not a benefit of using these techniques?

The techniques focus on finding and fixing the problem after it occurs. TQC, TQM, and JIT are preventive measures and are used to identify critical process points to reduce problems or defective units at the earliest point of identification, resulting in fewer defective units produced before the problem is identified (no need to wait for defective units to reach a critical threshold) and the process causing the problem being fixed before more bad units are produced. The immediate attention gives rise to easier problem identification and solution, and higher-quality products which improve customer satisfaction.

Residual income is a performance evaluation that is used in conjunction with return on investment (ROI) or instead of ROI. In many cases, residual income is preferred over ROI because:

residual income concentrates on maximizing absolute dollars of income rather than a percentage return as with ROI Residual income is determined by subtracting imputed interest on assets used by a segment or project from the segment or project's calculated net income. Residual income seeks to maximize absolute dollars of income. Both residual income and ROI measure results for a single time period and use average investment. The target rate is the same as the imputed interest rate.