Chapter 19 - Control systems and performance measurement

Question 1

1 Provide examples of financial and non-financial measures of performance

Answer 1

Financial measures such as return on investment and residual income can capture important aspects of both manager performance and organisation-subunit performance. In many cases, however, financial measures are supplemented with non-financial measures of performance, such as those relating to customer service time, number of defects and productivity.

Question 2

What is the balanced scorecard?

Answer 2

Some companies present financial and non-financial performance measures for various organisation subunits in a single report called the balanced scorecard. Different companies emphasize different things must most scorecards include (1) profitability measures, (2) customer-satisfaction measures, (3) internal measures of efficiency, quality and time and (4) innovation measures. The balanced scorecard highlights trade-offs that the manager may have made.

Question 3

Name four advantages of non-financial performance measures

Answer 3

Provide a closer link to long-term organisational strategies;
Provide indirect quantitative information on a company’s intangible assets;
Can be good indicators of future financial performance;
Can improve managers’ performance by providing more transparent evaluation of their
actions.

Question 4

Name four disadvantages of non-financial performance measures

Answer 4

Can be time consuming and costly to implement;
Do not have a common denominator and entail different denominators such as time, percentages, quantities, etc;
Sometimes lack verifying links to accounting profits or stock prices and may have weak statistical reliability;
May be too numerous to translate into main drivers of success.

Question 5

2 What are the five steps to design an accounting-based performance measure?

Answer 5

The steps in designing an accounting-based performance measure are (a) choosing variables to include in the performance measure, (b) defining the terms, (c) measuring the items included in the variables, (d) choosing a target for performance and (e) choosing the timing of feedback.
These five steps need not be done sequentially. The issues considered in each step are interdependent and a decision maker will often proceed through these steps several times before deciding on an accounting-based performance measure.

Question 6

What characterizes a good performance measure and what is special for performance measurement in the long-term?

Answer 6

Good performance measures promote goal congruence with the organisation’s objectives and facilitate comparisons across different subunits.
Performance measurement in the long-run: take investment into account

Question 7

3 What is the return on investment (ROI) method of profitability analysis? How is it calculated?

Answer 7

The DuPont method describes return on investment (ROI) as the product of two components: revenues divided by investment and income divided by revenues. The DuPont approach recognises that there are two basic ingredients in profit making: using assets to generate more revenue and increasing oncome per euro of revenue. ROI can be increased in three ways: increase revenues, decrease costs and decrease investment.
Revenues/investment·Income/Revenues=Income/Investment

Basically asset turnover (asset efficiency measure)* Return on sales/profit margin (profitability measure)

Question 8

What does reducing investment mean?

Answer 8

Reducing investments means decreasing idle cash, managing credit judiciously, determining proper stock levels and spending carefully on fixed assets.

Question 9

4 Describe the residual-income (RI) measure

Answer 9

Residual income is income minus a required monetary return on the investment, i.e. income minus the opportunity cost of invested capital. Residual income was designed to overcome some of the limitations of ROI. For example, residual income is more likely than ROI to promote goal congruence. That is, actions that are in the best interests of the organisation maximise residual income. The objective of maximising ROI, conversely, may induce managers of highly profitable divisions to reject projects that, from the viewpoint of the organisation as a whole, should be accepted.

Question 10

What is the imputed cost of investment and what are imputed costs?

Answer 10

The required rate of return multiplied by investment is also called the imputed cost of the investment. Imputed costs are costs recognised in particular situations that are nor regularly recognised by accrual accounting procedures. An imputed cost is not recognised in accounting records because it is not an incremental cost but instead represents the return foregone by the company as a result of tying up cash in various investments of similar risk.

Question 11

5 Describe the economic value added (EVA®) method

Answer 11

Economic value added (EVA®) is a specific type of residual income calculation. It equals the after-tax operating profit minus the after-tax weighted-average cost of capital multiplied by total assets minus current liabilities. EVA®, like residual income, charges managers for the cost of their investments in long-term assets and working capital (current assets - current liabilities). Value is created only if after-tax operating profit exceeds the cost of investing the capital. To improve EVA®, managers must earn more operating profit with the same capital, use less capital, or invest capital in high-return projects.

Question 12

Describe the return on sales method

Answer 12

The income-to-revenue (sales) ratio, often called return on sales (ROS), is a frequently used financial performance measures. ROS is one component of ROI in the DuPont method of profitability analysis. It is profit divided by revenues.

Question 13

Is there one superior financial performance measure?

Answer 13

No, each evaluates a slightly different aspect of performance. E.g. in markets where revenue growth is limited, ROS is the most meaningful indicator of a subunit’s performance. To evaluate overall aggregate performance, ROI or residual-income-based measures are more appropriate since they consider both income earned, and investments made. Residual-income and EVA® measures overcome some of the goal-congruence problems that ROI measures might introduce. Some managers favour EVA® because it explicitly considers tax effects while pre-tax residual-income measures do not. Other managers favour pre-tax residual-income because it is easier to calculate and because it often leads to the same conclusions as EVA®.

Question 14

What are 4 alternative definitions of investments that companies use to illustrate step 2 when designing accounting-based performance measures?

Answer 14

(1) Total assets available
(2) Total assets employed - defines as total assets available minus idle assets and minus assets purchased for future expansion
(3) Working capital (current assets minus current liabilities) plus long-term assets - this definition excludes that portion of current assets financed by short-term creditors

(4) Shareholders’ equity
Most companies that employ ROI, residual income or EVA® for performance measurement use either total assets available or working capital plus long-term assets as the definition of investment. However, when top management directs a division manager to carry extra assets, total assets employed can be more informative than total assets available. The most common rationale for using working capital plus long-term assets is that the division manager often influences decisions on the short-term debt of the division.

Question 15

6 Distinguish between current-cost and historical-cost asset measurement methods. What are the advantages and disadvantages of each?

Answer 15

The current cost of an asset is the cost now of purchasing an identical asset to the one currently held. Historical cost asset measurement methods consider the original cost of the asset net of total depreciation. Adjusting for current costs negates differences in the investment base caused solely by differences in construction price levels. Consequently, compared to historical-cost ROI, current-cost ROI is a better measure of the current economic returns from the investment. A drawback of the current-cost method is that obtaining current-cost estimates for some assets can be difficult. Why? Because the estimate requires a company to consider technological advances when determining the current cost of assets needed to earn today’s operating profit. (When a specific cost index, such as the construction cost index, is not available, companies use a general index, such as the consumer price index, to approximate current costs.)

Question 16

What are the arguments for using gross or net book value for long-term assets?

Answer 16

Those who favour using gross book value claim that it enables more accurate comparisons across subunits. The proponents of using net book value as a base maintain that it is less confusing because (1) it is consistent with the total assets shown on the conventional balance sheet, and (2) it is consistent with net profit computations that include deductions for depreciation. Surveys of company practice report net book value to be the dominant asset measure used by companies in their internal performance evaluations.

Question 17

7 Recognise the role of salaries and incentives in compensation arrangements

Answer 17

Organisations create incentives by rewarding managers on the basis of performance. But managers may face risks because random factors beyond their control may also affect performance. Owners choose a mix of salary and incentive compensation to trade off the incentive benefit against the cost of imposing risk.

Question 18

What does moral hazard describe?

Answer 18

Moral hazard describes contexts in which an employee prefers to exert less effort (or report distorted information) than the effort (or information) desired by the owner because the employee’s effort (or information) cannot be accurately monitored and enforced. In some repetitive jobs the worker’s actions can easily be monitored and the moral hazard problem may not arise. However, the manager’s job is often to gather information and exercise judgement on the basis of the information obtained and monitoring a manager’s effort is thus considerably more difficult.

Question 19

8 Describe the management accountant’s role in designing incentive systems

Answer 19

Obtaining measures of employee performance that are superior is critical for implementing strong incentives. Many management accounting practices, such as the design of responsibility centres and the establishment of financial and non-financial measures, have as their goal better performance evaluation.

Question 20

9 Describe the incentive problems arising when employees perform multiple tasks

Answer 20

Most employees perform multiple tasks as part of their jobs. In some situations, one aspect of a job is easily measured (for example, the quantity of work done), while another aspect is not (for example, the quality of work done). Creating incentives to promote the aspect of the job that is easily measured (quantity) may cause workers to ignore an aspect of their job that is more difficult to measure (quality).

Question 21

10 Describe the four levers of control and understand their effects

Answer 21

Implementing the four levers of control can assist a company to achieve its pursued performance, engage in ethical behaviour, inspire its employees and to act proactively in the fact of strategic threats and opportunities. The four levers of control are diagnostic control systems, boundary systems, belief systems and interactive control systems.

Question 22

What are diagnostic control systems?

Answer 22

Quantitative financial and non-financial performance-evaluation measures that companies use to implement their strategies. These measures - such as ROI, RI, EVA, customer satisfaction and employee satisfaction - monitor critical performance variables that help managers track progress towards achieving a company’s strategic goals. Because these measures help diagnose whether a company is performing to expectations, they are collectively called diagnostic control systems. Companies motivate managers to achieve these goals by holding managers accountable for, and by rewarding them for, meeting these goals. The concern, however, is that the pressure to perform may cause managers to cut corners and misreport numbers to make their performance look better than it is. To avoid unethical behaviour, companies need to balance the push for performance resulting from diagnostic control systems, the first of four levers of control, with three other levers: boundary systems, belief systems and interactive control systems.

Question 23

What are boundary systems?

Answer 23

Boundary systems describe standards of behaviour and codes of conduct expected of all employees, especially action that are off-limits. Ethical behaviour on the part of managers is paramount. Codes of practice conduct signal appropriate and inappropriate individual behaviours. Division managers often cite enormous pressure from top management ‘to make the budget’ as excuses or rationalisations for not adhering to ethical accounting policies and procedures. A healthy amount of motivational pressure is desirable, as long as the ‘tone from the top’ and the code of conduct simultaneously communicate the absolute need for all managers to behave ethically at all times. Managers should train employees to behave ethically. They should promptly and severely reprimand unethical conduct, regardless of the benefits that might accrue to the company from unethical actions.

Question 24

What are belief systems?

Answer 24

Belief systems articulate the mission, purpose and core values of a company. They describe the accepted norms and patterns of behaviour expected of all managers and employees with respect to each other, shareholders, customers and communities. Belief systems play to employees’ intrinsic motivations.
Intrinsic motivation is the desire to achieve self-satisfaction from good performance regardless of external rewards such as bonuses or promotion. Intrinsic motivation comes from being given greater responsibility, doing interesting and creative work, having pride in doing that work, establishing commitment to the organisation, and developing personal bonds with co-workers. High intrinsic motivation enhances performance because managers and worker have a sense of achievement in doing something important, feel satisfied with their jobs, and see opportunities for personal growth.

Question 25

What are interactive control systems?

Answer 25

Interactive control systems are formal information systems that managers use to focus organisation attention and learning on key strategic issues. An excessive focus on diagnostic control systems and critical performance variables can cause an organisation to ignore emerging threats and opportunities – changes in technology, customer preferences, regulations and industry competition that can undercut a business. Interactive control systems track strategic uncertainties that businesses face. The result is ongoing discussion and debate about assumptions and action plans. New strategies emerge from the dialogue and debate surrounding the interactive process. Interactive control systems force busy managers to step back from the actions needed to manage the business today and to shift their focus forward to positioning the organisation for the opportunities and threats of tomorrow.

Question 26

What is a general problem of performance measures?

Answer 26

General problem: Performance measures based on single time period (mostly 1 year)
Actions which increase current ROI or RI can be value decreasing in the long run
Important to evaluate performance over multiple years
“Bonus Bank Systems“ allow to pay out bonuses over several years