Chapter 11 Managerial Accounting

Advantages of Decentralization

1. By delegating day-to-day problem solving to lower-level managers, top management can concentrate on bigger issues, such as overall strategy 2. Empowering lower-level managers to make decisions puts the decision-making authority in the hands of those who tend to have the most detaield and up-to-date information about day-to-day operations 3. By eliminating layers of decision making and approvals, organizations can respond more quickly to customers and to changes in the operating environment 4. Granting decision-making authority helps train lower-level managers for higher-level positions 5. Empowering lower-level maangers to make decisions can increase their motivation and job satisfaction

Criticisms of ROI

1. Just telling managers to increase ROI may not be enough. Managers may not know how to increase ROI; they may increase ROI in a way that is inconsistent with the company's strategy; or they may take actions that increase ROI in the short tun but harm the company in the logn run. This is why ROI is best used as part of a balanced scorecard. A balanced scorecard can provide concrete guidance to managers making it more likely that their actions are consistent with the company's strategy and reducing the likelihood that they will boost short-run performance at the expense of long-term performance 2. A manager who takes over a business segment typically inherits many commited costs over which the manager has no control. These committed costs may be relevant in assesing the performance of the business segment as an investment but they make it difficult to fairly asses the next performance of the manager. 3. A manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but would have a negative impact on the manager's performance evaluation

Major Disadvantages of Decentralization

1. Lower-level managers may make decisions without fully understanding the company's overall strategy 2. If lower-level managagers make their own decisions independently of each other, coordination may be lacking 3. Lower-level managers may have objectives that clash with the objectives of the entire organization. For example, a manager may be more interested in increasing the size of his or her department, leading to more power and prestige, than in increasing the department's effectiveness 4. Spreading innovative ideas may be difficult in a decentralized organization. Someone in one part of the organization may have a terrific idea that would benefit other parts of the organization, but without strong central direction the idea may not be shared with, and adopted by, other parts of the organization.

Inspection Time

Amount of time spent ensuring that the product is not defective

Evaluating Investment Center Performance- Return on Investment

An investment center is responsible for earning an adequate return on investment

Residual Income

Another approach to measuring an investment center's performance. Residual income is the net operating income that an investment center earns above the minimum required retun on its operating assets Residual income= Net operating income - (average operating assets x minimum required rate of return)

Responsibility Accounting

Decentralized organizations need responsibility accounting systems that link lower level managers' decision-making authority with accountability for the outcomes of those decisions The term responsibility center is used for any part of an organiztaion whose manager has control over and is accountable for cost, profit, or investments The three primary types of responsibiity centers are cost centers, profit centers, and investment centers

A Company's Strategy and the Balanced Scorecard

Each company must decide which customers to target and what internal business processes are crucial to attracting and retaining those customers Different companies will target different customers with different kinds of products and services =because of these differences in emphasis, a one-size-fits-all appraoch to performance emasuremetn won't work within this one industry =performance measures must be tailored to the specific strategy of each company If the balanced scorecard is correctly constructed, the performance measures should be linked together on a cause-and-effect basis -each link can then be read as a hypothesis in the form "If we improve this performance measure, then this other performance measure should also improve" The balanced scorecard lays out a theory of how the company can take concrete actions to attain its desired outcomes One of the advantages of the balanced scorecard is that it continually tests the theories underlying management's strategy -if a strategy is not working, it should become evident when some of the predicted effects don't occur -without this feedback, the organization may drift on indefinitely with an ineffective strategy based on faulty assumptions

Balanced Scorecard

Financial measures, such as ROI and residual income, and operating measures, such as those discussed may be included in a balanced scorecard A balanced scorecard consists of an integrated set of performance measures that are derived from and support a company's strategy (a strategy is essentially a theory about how to achieve the organization's goals) Under the balanced scorecard approach, top management translates its strategy into performance measures that employees can understand and influence

Decentralization in Organizations

In a decentralized organization, decision-making authority is spread thoguhout the organization rather than being confined to a few top executives OUt of necessity all large organizations are decentralized to some extent Organizations do differ in the extent to which they are decentralized In strongly cetnralized organizations, decision-making authority is reluctantly delegate to lower-level managers who have little freedom to make decisions In strongly decentralized organizations, even the lowest-level managers are empowered to make as many decisions as possible -most organizations fall somewhere between these two extremes

Operating Performance Measures

In addition to financial perfomance measures, organizations use many nonfianncial performance measures While financial measures pick up the results of what people in the organization do, they do not measure what drives organization performance Many organizations use a variety of nonfinancial performance measures in addition to financial measures -three examples of such measures that are critical to success in many organizations- delivery cycle, time, throughput time, and manufacturing cycle efficienccy -very similar measures can be used by any service organization that experiences a delay between receviing a customer request and responding to that request

Tying Compensation to the Balanced Scorecard

Incentive compensation for employees can and probably should, be tied to balanced scorecard performance measures -however, this should be done only after the organiztion has been successfully managed with the scorecard for some time- perhaps a year or more Managers must be confident that the performance measures are reliable, sensible, understood by those who are being evaluated, and not easily manipulated

Operating Assets

Include cash, accounts receivable, inventory, plant and equipment, and al other assets held for operating purposes Examples of assets that are not included in operating assets include land held for future use, an investment in another company, or a building rented to someone else. These assets are not held for operating purpsoes and therefore are excluded from operating assets. The operating assets base used in the formula is typically computed as the average of the operatin assets between the beginning and the end of the year

Net Operating Income and Operating Assets Defined

Most companies use the net book value (i.e. acquisition cost less accumulated depreciation) of depreciable assets to calculate average operating assets -this approach has drawbacks -an asset's net book value decreases over time as the accumulated depreciation increases. This decreases the denominator in the ROI calculation, thus increasing ROI Consequently, ROI mechanically increases over time -moreover, replacing old depreciated equipment with new equipment increases the book value of depreciable assets and decreases ROI Using net book value in the calculation of average operating assets results in a predictable pattern of increasing ROI over time as accumulated depreciation grows and discourages replacing old equipment with new, updated equipment an alternative to using net book value is the gross cost of the asset, which ignores accumulated depreciation. Gross cost stays constant over time because depreciation is ignored; therefore ROI does not grow automaticaly over time, and replacing a fully depreciated asset with a comparably priced new asset will not adversely affect ROI Most companies use the net book value approach to computing average operaing assets because it is consistent with their financial reporting practices or recording the net book value of assets on the balance sheet and including depreciation as an operating expense on the income statement

ROI Formula

Net operating income/ Average operating assets The higher a business segment's return on investment (ROI), the greater the profit earned per dollar invested in the segment's operating assets

Common Characteristics of Balanced Scorecards

Performance measures used in balance scorecards tend to fall into the four groups: financial, customer, internal business processes, and learning and growth Internal business processes- whta thte company does in an attempt to satisfy customers The idea underlying these groupings is that learning is necessary to improve internal business processeces; improving business processes is necessary to improve customer satisfaction; and improving customer satisfaction is necessary to improve financial results The empahsis is on improvement- not on just attaining some specific objective In the balanced scorecard approach, continual improvement is encouraged Unltimately, most companies exist to provide financial rewards to owners Financial performance measures are not sufficient in themselves- they should be integrated with nonfinacial measuresi na well-designed baanced scorecard -first, financial measures are lag indicatiors that report on the results of past actions - in contrast, nonfinancial measures of key success drivesr suc has customer satisfaction are leading indciators of future financial performance -second, top managers are ordinarily responsible for the financial performance measures Managers should carefully select performance measures for their own company's balanced scorecard , keeping the following points in mind - The perfomance measures should be conisstent with and follwo from, the company's strategy - If the performance measures are not consistent with the company's strategy, people will find themselves working at cross-purposes -second, the performance measures should be underestandable and controllable to a significant extent by those being evaluated -third, the performance measures should be rpeorted on a frequetn and timely basis fourth, the scorecard should not have too many performancem easures. This can lead to a lack of focus and confuion While the entire organization will have an overall balanced scorecard, each responsible individaul will have his or her own personal scorecard as well -this scorecard should consisto f items the individual can personally influence that relate directly to the performance measures on the overall balanced scorecard - the performance measures on this personal scorecard sshould not be overly influenced by actions taken by others in the company or by events that are outside of the individual's control -focusing on the performance measure should not lead an individual to take actions that are counter to the organization's objectives

Delivery Cycle Time

The amount of time from when a customer order is received to when the completed order is shipped This time is an important concern to many customers who would like the delivery cyle time to be as short as possible Cutting the delivery cycle time may give a company a key competitive advantage- and may be necessary for survival Delivery cycle time= Wait time + throughput time

Throughput (Manufacturing Cycle) Time`

The amount of time required to turn raw materials into completed products The throughput time, or manufacturing cylce time, is made up of process time, inspection time, move time, and queue time Only process time adds value 0 the other three activities add no value and should be eliminated as much as possible throughput time= Process time + Inspection time + Move time + Queue time

Understanding ROI

The equation for ROI does not provide much help to managers interested in taing actions to improve their ROI -it only offers two levers for improving performance- net operating income and average operating assets ROI= Margin x Turnover Margin= Net operating income / sales Turnover= Sales/Average operating assets Either formula for ROI will give the same answer. Margin and turnover are important concepts in understanding how a manger can affect ROI All other things the same, margin is ordinarily improved by increasing selling prices, reducing operating expenses, or increasing until sales Increasing selling prices and reducing operating expenses both increase net operating income and therefore margin Increasing unit sales also ordinarily increases the margin because of operating leverage Because of operating levearge, a given percentage increase in unit sales usually leads to an even larger percentage in crease in net operating income An increase in unit sales ordinarily has the effect of increasing margin Some managers tend to focus too much on margin and ignore turnover -however, turn over incorporates a crucial area of a manager's responsibility- the investment in operating assets Excessive funds tied up in opearting assets depress turnover and lower ROI Excessive operating assets can be just as much of a drag on ROI as excessive operating expenses, which depress margin Many actions involve combination of chagnes in sales, expenses, and operating assets ROI is now widely used as the key measure of investment center performance. ROI reflects in a single figure many aspects of the manager's responbilities -it can be compared to the returns of other investment centers in the organization, the returns of other companies in the industry, and to the past returns of the investment center itself

Cost Center

The manager of a cost center has control over costs, but not over revenue or the use of investment funds Service departments such as accounting, finance, general administration, legal, and personnel are usually classified as cost centers Manufacturing facilities are often considered to be cost centers The managers of cost centers are expected to minimize costs while providing the level of products and services demanded by other parts of the organization Standard cost variances and flexible budget variances are often used to evaluate cost center performance

Profit Center

The manager of a profit center has control over both costs and revenue, but not over the use of investment funds Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit

Investment Center

The manager of an investment center has control over cost, revenue, and investments in operating assets Investment center managers are often evaluated using return on investment (ROI) or residual income measures

Motivation and Residual Income

The residual income approach encourages managers to make investments that are profitable ofr the entire company but that would be rjeected by managers who are evaluated using the ROI formula A manager who is evaluated based on ROI wil reject any project whose rate of return is below the divison's current ROI even if the rate of return on the project is above the company's minimum required rate of return Managers who are evalauted using residual income will pursue any project whose rate of reutnr is above the minimum required rate of return because it will increase their residual income -because it is in the best interests of the company as a whole to accept any project whose rate of return is abvoe the minimum required rate of return, managers who are evaluated based on residual income will tend to make better decisions concerning investment projects than managers who are evaluated based on ROI

Divisional Comparison and Residual Income

The residual income approach has one major disadvantage -it can't be used to compare the performance of divisions of different sizes - Larger divisions often have more residual income than smaller divisions, not necesarily because they are better managed but simply because they are bigger When comparing investment centers, it is proabbly better to focus on the percentage change in residual income from year to year rather than on the absolute amount of the residual income

Economic Valued Added (EVA)

adaptation of residual income that has been adopted by many companies Under EVA, companies often modify their accounting principles in various ways When residual income or EVA is used to measure performance, the objective is to maximize the total amount of residual income or EVA, not to maximize ROI -if the objective were to maximize ROI, then every company should divest all of its products except the single product with the highest ROI

Queue time

amount of time a product spends waiting to be worked on, to be moved, to be inspected, or to be shipped

Net operating income

income before interest and taxes and is somtimes referred to as EBIT (earnings before interest and taxes) Net operating income is used in the formula because the base consists of operating assets. To be consistent, we use net operating income in the numerator

Process time

the amount of time work is actually done on the product

Move Time

the time required to move materials or partially completed products from workstation to workstation

Manufacturing Cycle Efficiency (MCE)

through concerted efforts to eliminate the non-value-added activities of inspecting, moving, and queing, some companies have reduced their throughput time to only a fraction of previous levels In turn, this has helped to reduce the delivery cylce time from montsh to only weeks or hours Throughput time, which is a key measure in delivery performance, can be put into better perspective by computing the manufacturing cycle efficiency (MCE) MCE= Value added time (Process time)/Throughput (manufacturing cycle) time Any non-value added time results ina mCE of less than 1 An MCE of 0.5 would mean that half of the total productio ntime consists of inspection, moving and similar non-value added-activities In many manufacturing companies, the MCE is less than 0.1 (10 %) which means that 90% of the time a unit is in process is spent on activities that do not add value to the product Monitoring the mCE helps companies to reduce non-value added activities and thus get products into the hands of customers more quickly and at a lower cost