1. Management Control Systems
Chapter 11: Accounting Performance Measures and Their Effects
Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003

2. 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.

3. Limitations ...
Accounting income does not reflect economic income perfectly, because accounting measures:
Are transactions oriented;
Are dependent on the choice of measurement method;
Are conservatively biased;
Ignore intangibles;
Ignore the cost of investments in working capital;
Ignore the cost of equity capital;
Ignore risk;
Focus on the past.
The change in the value of the entity
over a given period, where “value” is
obtained by discounting future cash flows.

4. Myopia ... Investment myopia
Reduce or postpone investments that promise payoffs in future measurement periods.
cf., accounting number’s conservative bias.
Operational myopia
e.g., destroying goodwill with customers, suppliers, employees, or the society at large.

5. 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.

6. 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 fully allocated after-tax profit measure —or, a before-tax operating income measure.
The denominator can include all the line-items of assets and liabilities, including allocations of assets and liabilities not directly controlled by the division manager —or, it can include only controllable assets which include receivables and inventories at a minimum.

7. 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 in the corporation's best interest.

8. Example ... ROI RI 4% 10% A $ 10 $ 20 $ 30 $ 60 $ 120 $ 24.0 20 %
SBU Profit Cur. Assets Req. Earn. Fixed Assets Required Earn Res. Income
A $ $ $ $ $ $ 15.6 B C
D (1.6)
E (1.8) (3.8)
SBU Cash Receivables Inventories Fixed Assets Total Invest Profit ROI
A $ $ $ $ $ $ % B C D
E (1.8) (6)
ROI RI 4%
10%

9. Suboptimization ...
ROI provides different incentives for investments across 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.
Corporate
Cost of
Capital
IRR of
Project
Business
Unit
ROI
<
>

10. Suboptimization ... Assume Corporate cost of capital = 10%
Investment of $10 to earn $1,1 per year
Worthwhile !
Base situation
Profit Before tax
Investment base
ROI
New situation
Profit before tax
Investment
Unit A
$ 24
$ 120
20 %
$ 25.1
$ 130
19.30 %
Unit C
$ 10.5
$ 105
10 %
$ 11.6
$ 115
10.08 %
Unit D
$ 3.8
$ 75
5 %
$ 4.9
$ 85
5,76%
“WRONG”
“RIGHT”
DOES NOT INVEST
INVEST

11. Suboptimization ... Assume Corporate cost of capital = 15%
Investment of $10 to earn $1,1 per year
Not worthwhile !
Base situation
Profit Before tax
Investment base
ROI
New situation
Profit before tax
Investment
Unit A
$ 24
$ 120
20 %
$ 25.1
$ 130
19.30 %
Unit C
$ 10.5
$ 105
10 %
$ 11.6
$ 115
10.08 %
Unit D
$ 3.8
$ 75
5 %
$ 4.9
$ 85
5,76%
“RIGHT”
“WRONG”
DOES NOT INVEST
INVEST

12. 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 $1,1 per year.
Base situation
Profit Before tax
Investment base RI
New situation
Profit before tax
Investment
Unit A
$ 24
$ 120
$ 15.6
$ 25.1
$ 130
$ 15.7
(= )
Unit C
$ 10.5
$ 105
$ 5.7
$ 11.6
$ 115
$ 5.8
(= )
Unit D
$ 3.8
$ 75
($ 1.6)
$ 4.9
$ 85
($ 1.5)
(= )
INVEST

13. Miscellaneous ...
Residual Income (RI) allows to use different interest charges for different types of assets
e.g., fixed assets - longer term / higher risk - higher charge.
Return on equity (ROE)-measures induce managers to use debt financing
This is not the case with RI if the capital charge is equal to the corporate 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 business unit's investment base.

14. 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 1 2 3 4 5
NBV
100 80 60 40 20
Incremental
Income 7
Capital
Charge 10 8 6 RI -3 -1
ROI 7% 9%
12%
18%
35%
(=27-20)
10 %

15. Misleading performance signals ...
SBU-managers are encouraged to retain assets beyond their optimal life and not to invest in new assets.
Corporate managers are induced to over-allocate resources to business units with older assets.
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 are still expressed at lower values than new assets, so ROI is still overstated.

16. 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.