Week 10

Week 10Chapter 23

Incentives for Responsibility Centres

ROI11

Big Picture

22

Big PictureActivity-Based versus Strategic-Based Responsibility Accounting

33

Responsibility Accounting

Financial-based centers (Cost,

Revenue, Profit, Investment)

Strategy-basedResponsibility accounting system translates

the strategy of the organization into operational objectives and measures

Which one is bottom up/top down?

Activity-based AB system adds a process perspective to the financial perspective of the functional-based

responsibility accounting system.

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003

Big Idea

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1. Size- Large Manufacturing (ODM)

Firm (Fortune Ltd)- Firm with many branches (e.g. Yunhong group), countries

(e.g. MNC)2. Competition- Short life cycle (e.g. customers

buy new mobile phones every 6 months)

3. Environment uncertainty

- Volatility

1. Automation2. Aggregate knowledge

(e.g. ability to use an aggregate measure like accounting to capture knowledge, measure performance)

3. Technology (e.g. CCTV, RFID, Bar code)

Knowledge forces (knowledge transfer

costs)

DecentralizeGive decision authority to managers lower in your firm so that you can do more.

Rewards- Incentives- Monetary- Non-monetary

Measurement- Financial measures

ROIRIEVA

ResponsibilityCenters

- Activity based- Strategy basedAccounting based- Cost center- Revenue center- Profit center- Investment center

Control costs (agency costs)

(E.g. ABC Ltd)

Transfer pricing- Goal congruence- Management effort- Subunit Performance evaluation- Subunit autonomy

+

-

Why decentralize?

Why use responsibility centers?

Why use transfer pricing?

5

Decentralization and Control

-

Made in China 2025-Mission• Gives manufacturing a makeover

• From “world’s factory” to “planet’s leading manufacturing power” by 2025

• Elevate the perception of Chinese goods from “made in China” to “innovated in China”

• Raising domestic content of core components and materials to 40% by 2020 and 70% by 2025

• Set a target of SEI-related industries to account for 8% of the economy by 2015 and 15% by 2020

• Establish a 40 billion yuan (US$6.45 billion) innovation fund to sponsor new business, supporting the creation of manufacturing innovation centers 15 by 2020 and 40 by 2025

www.Chinasourcingacademy.com

Made in China 2025 – Market Size2020 2025

40% 50%

50% 70%

30% 40%

75% 90%

70% 80%

New Energy Vehicles

New Energy Vehicles

Made in China 2025-Opportunities• Support for SMEs and strategic

emerging industries• Leaner and greener

manufacturing• Further ongoing anti-monopoly

efforts to eliminate access barriers across sectors

• More fairness and transparency• Promote innovation• Initiate tax reform to reduce the

overall corporate tax burden

www.Chinasourcingacademy.com


Value Creation Hoverboard

– https://www.youtube.com/watch?v=9FxvBFPTtWQ Worlds first 3D printed car

– https://www.youtube.com/watch?v=iT9A0pBBL2A&list=PLRFN7dMESvQSu_gjOY1TmJVdCpV12phD-&index=2

Cubic– https://www.youtube.com/watch?v=bhPCvwHnk_Q

Robotics– https://www.youtube.com/watch?v=rVlhMGQgDkY

12

https://www.youtube.com/watch?v=iT9A0pBBL2A&list=PLRFN7dMESvQSu_gjOY1TmJVdCpV12phD-&index=2





https://www.youtube.com/watch?v=bhPCvwHnk_Q

https://www.youtube.com/watch?v=rVlhMGQgDkY

FRC (Autonomy

KTC)

SRC (Customer

WHY)

Management Control Systems

- 14 -

Financial Performance Measures and Their effects – Three types of measures

2. Accounting Measures

Summary Measures

3. Combination of measures

Non-financial Measures

1. Market Measures

1. Financial Responsibility

Centers(Wk 10)

2. Strategic Responsibility

Centers(Wk 5-9)


Summary measures Summary, single-number, aggregate, bottom-line financial

measures of performance Reflect the aggregate or bottom-line impacts of multiple

performance areas– For example, accounting profits reflect the aggregate effects of

both revenue- and cost-related decisions Two types

– Market measures» Reflect changes in stock prices or shareholder returns

– Accounting measures» Defined in either residual terms (net income after taxes, operating

profit, residual income, economic value added) or ratio terms (return on investment, return on equity, return on net assets)

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Accounting profits or returns ...

Timeliness —measured in short time periods. Precision —accounting rules (FASB). Objectivity —independent auditors. Congruence

» In for-profit firms, accounting profits or returns are relatively congruent with the true firm goal of maximizing shareholder value.

» Positive correlations between accounting profits and changes in stock prices.

Understandable Inexpensive —financial reporting requirements.

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ROI performance measures ... Return on Investment

» ROI is a ratio of the accounting profits earned by the business unit divided by the investment assigned to it;

» ROI = profits ÷ investment base.

Residual Income» RI is a dollar amount obtained by subtracting a

capital charge from the reported accounting profits;» RI = profits - capital charge.

ROI is the most commonly used measure» ROI is easy to calculate, easy to understand,

and meaningful in an absolute sense.

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Labels ... Return on investment (ROI) Return on equity (ROE) Return on capital employed (ROCE) Return on net assets (RONA)

» The profit measure in the numerator can be a fullyallocated after-tax profit measure —or, a before-taxoperating income measure.

» The denominator can include all the line-items of assetsand liabilities, including allocations of assets and liabilitiesnot directly controlled by the division manager —or, it can include only controllable assets which include receivablesand inventories at a minimum.

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Problems caused by ROI-measures ...

Numerator ...» Accounting profits, hence, ...» ROI contains all problems associated with these profit measures.

Denominator ...» How to measure the fixed assets portion?

Suboptimization ...» ROI-measures can lead division managers to make decisions

that improve division ROI even though the decisions are not inthe corporation's best interest.

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Example ...

SBU Profit Cur. Assets Req. Earn. Fixed Assets Required Earn. Res. Income A $ 24.0 $ 60 $ 2.4 $ 60 $ 6.0 $ 15.6 B 14.4 70 2.8 50 5.0 6.6 C 10.5 95 3.8 10 1.0 5.7 D 3.8 35 1.4 40 4.0 (1.6) E (1.8) 25 1.0 10 1.0 (3.8)

SBU Cash Receivables Inventories Fixed Assets Total Invest. Profit ROI

A $ 10 $ 20 $ 30 $ 60 $ 120 $ 24.0 20 % B 20 20 30 50 120 14.4 12 C 15 40 40 10 105 10.5 10 D 5 10 20 40 75 3.8 5 E 10 5 10 10 35 (1.8) (6)

RO

IR

I

4% 10%

Residual Income allows for different charges on different termed assets – e.g., Current assets 4%, Fixed assets10%

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Suboptimization ...

– ROI provides different incentives for investmentsacross business units

» SBU-manager will not invest if ...

» SBU-manager will invest if ...

» Hence, if corporate cost of capital is 10%.,– IRR of project is 11%, then A and B are unlikely to invest;

– IRR of project is 9%, then D and E are still likely to invest.

CorporateCost of Capital

10%

IRRof

Project

BusinessUnitROI20%

< <

CorporateCost of Capital

10%

IRRof

Project

BusinessUnitROI5%

> >

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Suboptimization ... Assume Corporate cost of capital = 10%

Investment of $10 to earn $1.10 per yearWorthwhile !

Base situation

Profit Before taxInvestment base

ROI

New situation

Profit before taxInvestment

ROI

Unit A

$ 24$ 12020 %

New situation

$ 25.1$ 130

19.30 %

Unit C

$ 10.5$ 10510 %

New situation

$ 11.6$ 115

10.08 %

Unit D

$ 3.8$ 755 %

New situation

$ 4.9$ 85

5,76%

“WRONG” “RIGHT”“RIGHT”

DOES NOT INVEST INVEST INVEST

Should invest b/c new investment is greater than Corp Cost of Capital

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Suboptimization ... Assume Corporate cost of capital = 15%

Investment of $10 to earn $1.10 per yearNot worthwhile !

Base situation


ROI

New situation


ROI

Unit A

$ 24$ 12020 %

New situation

$ 25.1$ 130

19.30 %

Unit C

$ 10.5$ 10510 %

New situation

$ 11.6$ 115

10.08 %

Unit D

$ 3.8$ 755 %

New situation

$ 4.9$ 85

5,76%

“RIGHT” “WRONG”“WRONG”

DOES NOT INVEST INVEST INVEST

Should not invest b/c new investment is less than Corp Cost of Capital

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Suboptimization ... Residual income makes performance targets uniform, and divisions

will invest if IRR of project is greater than the capital charge (which could be set equal to the corporate cost of capital).

• Capital charge for fixed assets is 10%;• Investment of $10 to earn $1.10 per year.

Base situation


RI

New situation


RI

Unit A

$ 24$ 120$ 15.6

New situation

$ 25.1$ 130$ 15.7

(=25.1-(2.4+7.0)

Unit C

$ 10.5$ 105$ 5.7

New situation

$ 11.6$ 115$ 5.8

(=11.6-(3.8+2.0)

Unit D

$ 3.8$ 75

($ 1.6)

New situation

$ 4.9$ 85

($ 1.5) (=4.9-(1.4+5.0)

INVEST INVESTINVEST

The adj for RI comprises -$2.4 Current asset charge (4%*$60)-$7 Fixed asset charge (10% *$70)

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Residual Income (RI) allows managers to use different interestcharges for different types of assets

» e.g., fixed assets - longer term / higher risk - higher charge.

Return on equity (ROE)-measures induce managersto use debt financing

» This is not the case with RI if the capital charge is equal to thecorporate cost of capital (i.e., weighted average of debt + equity).

ROI-measures create incentives for managers to lease assets» This is also true for RI if the interest charge that is built into the

rental cost is less than the capital charge applied to the businessunit's investment base.

Miscellaneous ...The adj for RI comprises -$2.4 CA charge (4%*$60)-$7 FA charge (10% *$70)

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The fixed assets portion ... Net Book Value

» Both ROI and RI get better merely to passage of time.» Both ROI and RI are usually overstated if the business

unit includes a relatively large number of older assets.» Example

Invest $100; Cash flow $27 per year; Depreciation $20 (5 years)

Yr

12345

NBV

100 80 60 40 20

IncrementalIncome

77777

Capital Charge

10 8 6 4 2

RI

-3-1 1 3 5

ROI

7%9%

12%18%35%

(=27-20)10 %

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SBU-managers are encouraged to retain assets beyond theiroptimal life and not to invest in new assets.

Because it immediately inflates the denominator in the ROI equation

Corporate managers are induced to over-allocate resourcesto business units with older assets.

“Squeeze the Cash Cow and Feed the Dog”

Misleading performance signals ...

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003 - 29 -

Combined with the suboptimization issues discussed above, manager of units with older assets, and, hence, a higher ROI,are likely to be more reluctant to invest in "desirable" projects with an IRR higher than the corporate cost of capital.

Gross Book Value (GBV)?» However, in periods of inflation, old

assets valued at GBV arestill expressed at lower values than new assets, so ROI is still overstated.

Misleading performance signals ...

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Economic Value Added (EVA) ... Modified after-tax operating profit

– (total capital x weighted average cost of capital)

Similar to RI (=profit–capital charge), except for the modifications (164 in total, as suggested by Stern Stewart & Co)

» e.g., Capitalization and subsequent amortization of intangible investments (e.g., in R&D, employee training, etc.);

Adding LIFO-reserves to correct for undervalued inventories;

etc.


Economic Value Added (EVA) ...


Financial Performance Measures and Their effects – Three types of measures

2. Accounting Measures

Summary Measures

3. Combination of measures

Non-financial Measures

1. Market Measures

1. Financial Responsibility

Centers(Wk 10)

2. Strategic Responsibility

Centers(Wk 5-9)


What is the return on investment for the Denver Hotel?

Return on Investment

Denver Hotel: $240,000 Operating income÷ $1,000,000 Total assets = 24%


The DuPont method of profitability analysisrecognizes that there are two basic

ingredients in profit making:

DuPont Method

1. Using assets to generate more revenues2. Increasing income per dollar of revenues


DuPont Method

Investment turnover = Revenues ÷ Investment

Return on sales = Income ÷ Revenues

ROI = Return on sales × Investment turnover


DuPont Method

How can Relax Inns attain a 30% targetROI for the Denver Hotel?

Present situation: Revenues ÷ Total assets= $1,200,000 ÷ $1,000,000 = 1.20

Operating income ÷ Revenues= $240,000 ÷ $1,200,000 = 0.20

1.20 × 0.20 = 24%


DuPont Method

Alternative A: Decrease assets, keepingrevenues and operating income per

dollar of revenue constant.Revenues ÷ Total assets

= $1,200,000 ÷ $800,000 = 1.501.50 × 0.20 = 30%


DuPont Method

Alternative B: Increase revenues, keepingassets and operating income per dollar

of revenues constant.Revenues ÷ Total assets

= $1,500,000 ÷ $1,000,000 = 1.50

1.50 × 0.20 = 30%



DuPont Method

Alternative C: Decrease costs to increaseoperating income per dollar of revenues,

keeping revenues and assets constant.Revenues ÷ Total assets

= $1,200,000 ÷ $1,000,000 = 1.20

1.20 × 0.25 = 30%



Residual Income

Residual income (RI)= Income

– (Required rate of return × Investment)Assume that Relax Inns’ required

rate of return is 12%.What is the residual income from the Denver hotel?


Residual Income

Denver Hotel:Residual Income = $240,000 - ($1,000,000 X 12%)

= $120,000