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ZCZA6103 ACCOUNTING FOR DECISION MAKING

Financial and Non Financial Measures


SEMESTER 1 SESSION 2011/2012 UKM GSB

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 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

Responsibility Accounting

Responsibility accounting is an underlying concept of accounting performance measurement systems. Under responsibility accounting, managers performances are evaluated on matters directly under managers control. A responsibility center is an organization unit for which a manager is made responsible for specific financial results. 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

Types of Responsibility Centers


Cost center Revenue center Profit center Investment center

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 centers actual costs with target or standard cost levels for the amount and type of work done Using variance analysis i.e. flexible budgets and standard costing.

Revenue Center

A responsibility center is a responsibility center where managers are responsible mainly on generating revenue with relatively little costs. Performance measures of profit centers are mainly on sales volume, sales price variances and sales mix variances.

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 Centre

Assessed by using segmented income statement which shows the profit and loss made for period under reviewed Example:
Bersatu Sdn Bhd Total
Sales Less: Variable costs Contribution margin Less: Traceable fixed expenses Segment margin Less: Common fixed expenses Net income RM1,000,00 0 400,000 RM 600,000 200,000 RM 400,000 200,000 RM 200,000 Business Products RM600,000 240,000 RM 360,000 125,000 RM 235,000 Consumer Products RM400,000 160,000 RM240,000 75,000 RM165,000

Profit Center

Segment margin is an performance indicator use to measure profit center. Contribution approach is more appropriate in distinguish costs that are controllable and uncontrollable Costs are divide into:

Traceable costs including variable costs and traceable fixed costs Common costs is a fixed costs that support the operations of more than one segment and cannot be directly traceable to a particular segment.

Investment Center

A responsibility center in which the manager and other employees control revenues, costs, and the level of investment in the responsibility center Performance measures Return on investment (ROI) Residual Income Economic value added

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 Duponts 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 Equipment and buildings

The elements of permanent investment

Comparisons of these turnover ratios with those of similar units or those of competitors suggest where improvements are required

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 (EVApreviously called residual income) equals income less the economic cost of the investment used to generate that income

If a divisions 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

Critics of Financial Control

Financial information is delayedand highly aggregatedinformation 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 Financial control may be an ineffective control scorecard for three reasons: Focuses on financial measures that do not measure the organizations 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 organizations 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 organizations stakeholders and vital to the organizations long-term success Financial control can provide an overall assessment of whether the organizations strategies and decisions are providing acceptable financial returns Organizations can also use financial control to compare one units results against another

Integration of Financial and Non Financial Performance Measures


The impact of intense competition in business environment resulted changes in the business activities and structure. Most of the activities required non financial information. Maskell (1989) suggested that day to day control of manufacturing and distribution are better handle with non financial measures Continuous use of financial measures in nowadays environment affected on the behaviors of individual such as myopic behaviour. Kaplan & Norton (1992), by focusing only on financial performance, it can give misleading signals for continuous improvement and innovation activities of customer focused manufacturing strategy.

Contemporary Performance Measurement Systems


Changing evolution from cybernetic to holistic view A cybernetics model of control includes stated objectives or goals, a predictive model and a tool to facilitate the choice of alternative actions In a cybernetic view, control systems is primarily based on financial measures and consider as a component of planning and control cycle Holistic view is based on multiple non financial measures where performance measurement acts a an independent process integrated in a broader set of activities.

Contemporary Performance Measurement Systems


Performance

pyramid (Lynn & Cross,

1991). Determinants and results matrix (Fitzgerald et. al, 1991) Performance prism (Neely et al, 2002) Balanced scored card (Kaplan & Norton, 1992)

Balanced Scorecard history


Measurement and Reporting
1992 Articles in Harvard Business Review:

Alignment and Communication

Enterprise-wide Strategic Management


2000 Acceptance and Acclaim:

1996

The Balanced Scorecard Measures that Drive Performance January - February 1992 Putting the Balanced Scorecard to Work September - October 1993 Using the Balanced Scorecard as a Strategic Management System January - February 1996 1996

The Balanced
Scorecard is translated into 18 languages

Selected by Harvard
Business Review as one of the most important management practices of the past 75 years.

2000

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Balanced Scorecard history


Strategy-mapping Strategy linkages Intellectual Capital Model Converting INTANGIBLE ASSETS into TANGIBLE OUTCOMES 2004

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STRATEGIC DIRECTION

MISSION Why We Exist VALUES Whats Important to Us

STRATEGIES TRANSLATTION

VISION What We Want To Be

Linking Strategy to Performance Management

STRATEGY What Our Game Plan STRATEGY MAP Translate the Strategy BALANCED SCORECARD Measure and Focus TARGET and INITIATIVES What We Need to Do PERSONAL OBJECTIVES What I Need to Do
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PERFORMANCE

MEASURES

Balanced Scorecard Linked to Organizational Performance The most commonly used key performance indicators found in a survey are-

Financial Perspective Customer Perspective Internal Perspective Innovation and Learning Perspective

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Principle of the Strategy Focused Organization:

TRANSLATE THE STRATEGY TO OPERATIONAL TERMS

The Strategy

@ Measurement is the language that gives clarity to vague concepts.


@ Measurement is used to communicate, not to control. @ Strategy can be described as a series of cause and effect relationship

Financial Perspective

If we succeed, how will


we look to our shareholders? Customer Perspective

To achieve my vision,
how must I look to my customers? Internal Perspective To satisfy my customer, at which processes must I excel? Organization Learning To achieve my vision, how must my organization learn and improve?

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Balanced Scorecard
Strategy Map: Diagram of the cause-and-effect relationships between strategic objectives

Strategic Theme: Operating Efficiency


Financial Profitability Fewer planes More customers

Statement of what strategy must achieve and whats critical to its success

How success in achieving the strategy will be measured and tracked

The level of performance or rate of improvement needed

Key action programs required to achieve objectives

Customer
Flight Is on time Lowest prices

Objectives
Internal Fast ground turnaround

Measurement

Target

Initiative

Fast ground
turnaround

On Ground Time On-Time


Departure

30 Minutes 90%

Cycle time
optimization

Learning Ground crew alignment

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CLASS CASE DISCUSSION


Atkinson et al. 6th Edition. Case 2-53 pg. 79, Chadwick Incorporation. Read this case before class and do necessary preparation. A group work of 4 students Time given: 1 hour 15 minutes One group will be selected to present.

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