Cost Accounting Traditions and Innovations Barfield, Raiborn, Kinney

1. Chapter 19
Measuring Short-Run
Organizational Performance
Cost Accounting
Traditions and Innovations
Barfield, Raiborn, Kinney

2. Learning Objectives (1 of 2)
• Explain how performance measures are tied
to missions and strategies
• Describe the role of performance
measurement
• Identify the guidelines or criteria that apply
to the design of performance measures
• List short-term financial performance
measures for profit and investment centers

3. Learning Objectives (2 of 2)
• Illustrate how the Statement of Cash Flows
is used for performance measurement
• Compare and contrast return on investment
and residual income
• Explain how return on investment may lead
to suboptimal investment decisions

4. Customer Focus
To achieve profitability, it is essential
to attract and satisfy customers

5. Common Causes of
Unprofitable Customers
• Large customers demand low prices and high
service level
• Low volume customers demand the same service
level as high volume customers
• Company provides a high service level, that is
uneconomical, as a competitive advantage
• Sales, administration, and delivery processes are
high cost
• Small customers require highly customized
products/services
• High customer turnover

6. Use Performance Measures to
• Judge organizational performance
• Relate missions and goals to managerial
performance
• Foster growth of subordinate managers
• Stimulate managerial motivation
• Enhance organizational communication
• Make judgments about promotion
• Implement organizational control

7. Types of Performance
Measurements
• Capital market performance
• Organizational learning and change
• Products/subunit performance

8. Capital Market Performance
• Effective and efficient use of capital
resources
• Financial accounting (GAAP)
• Comparability across firms
• Risk/return evaluation
• Maximize return on stockholders’
investment
• Ability to generate profits

9. Organizational Learning and Change
• Assess performance in serving customers
• Provide customers with more value at less
cost
• Embrace a culture of change and
organizational evolution
• Foster cooperation across the organization

10. Product/Subunit Performance
• Measure competitiveness of
– price
– quality
– functionality (product features)
• Measure how each subunit makes specific
contributions to the business

11. Signs of Problems with
Performance Measures
· Performance is acceptable except for profit
· Customers do not buy even when prices are competitive
· No one notices when performance measurement reports
are not produced
· Managers spend lot of time debating the meaning of the
measures
· Share price is lethargic despite solid financial
performance
· Measures have not been changed in a long time
· Corporate strategy was recently changed

12. Designing a Performance
Measurement System
• Select Performance Measures
– Assess progress toward goals and
objectives

13. Designing a Performance
Measurement System
• Select Performance Measures
– Assess progress toward goals
and objectives
– Participant is aware of and
participates in developing
measures

14. Designing a Performance
Measurement System
• Select Performance Measures
– Assess progress toward goals and objectives
– Awareness of and participation in developing
measures
– Available skills, equipment, information, and
authority to achieve goals and objectives

15. Designing a Performance
Measurement System
• Select Performance Measures
– Assess progress toward goals and objectives
– Awareness of and participation in developing
measures
– Available skills, equipment, information, and
authority to achieve goals and objectives
– Timely and useful feedback

16. Multiple Performance Measures
• Financial performance measures
• Customer satisfaction
• Zero defects
• Minimal lead time to market
• Social responsibility for environment

17. Balanced Scorecard
Financial
Customer
Internal
Business
Innovation
and Learning

18. Awareness and Participation in
Performance Measures
• Communicate standards to those being
measured
– Workers act specifically in accordance with
how they are to be measured
• Participation in setting standards forms a
“social contract”
– Workers understand and accept the standards

19. Monitoring Performance
Monitor
Feedback
Adjustment

20. Short-Term Financial
Performance Measures
• Divisional profits
• Achievement of budget objectives
• Variances from budget or standard
• Cash flow

21. Performance Measures
• Cost Center
– Variances from budgeted costs
• Revenue Center
– Compare budget to actual revenue
• Profit Center
– Segment profit margin
– Cost and revenue variances
• Investment Center
– Divisional performance
– Cost and revenue variances

22. Manipulating Segment Margin
• Manage cost of goods sold by accelerating or
deferring inventory purchases
• Minimize expenses by
– deferring the replacement of workers
– delaying or eliminating maintenance,
advertising, and other discretionary costs
– changing depreciation methods
• Reduce overhead per unit by increasing
production
• Manage revenue by shifting sales between periods
Not good,
especially
for the
long run

23. Manipulating Cash Flows
• Statement of Cash Flows shows
– sources and uses of cash
– quality of earnings
– significant noncash transaction
• Manipulate by
– deferring purchases, expenses
– misassigning collections
Not good,
especially
for the
long run

24. Investment Center
Performance Measures
• Return on Investment (ROI)
• Residual Income (RI)
• Economic Value Added (EVA)

25. Return on Investment
• Income
– Segment or operating
– Before tax or after tax
• Assets
– Total assets utilized, total assets available or net assets
– Plant assets at original cost, book value, current value
– Beginning, ending, or average assets
Return on = Income___
Investment Assets Invested

26. Return on Investment
Dupont Formula
Return on = Income Sales ____
Investment Sales * Assets Invested
Profit Margin Asset Turnover
Increase ROI
Raise sales price (if it doesn’t impact demand)
Decrease expenses
Decrease dollars invested in assets

27. Residual Income
• Top management establishes a minimum
rate of return
12%
• Multiply the asset base ($100,000) by the
minimum rate of return
$100,000 * 12% = $12,000 (required return)
• Residual income is income ($30,000) minus
the required return
$30,000 - $12,000 = $18,000 (residual income)

28. Residual Income
• In dollars, not a percentage
• Obtain new assets as long as they provide a
positive residual income
Positive
Residual
Income

29. Economic Value Added (EVA)
• Measure of profit above the cost of capital
• Capital is market value of total equity and
interest-bearing debt
– EVA provides a better measure than ROI if
market value is much greater than book value
• Short-term measure; may discourage
investment in long-term projects
– Invested capital increases before profits
After-Tax Profits - (Capital Invested * Cost of Capital %)

30. ROI, RI, EVA Limitations
• Income
– Income can be manipulated on short-run basis
– To compare, all segments must use the same
accounting methods
– Income is based on accrual accounting; cash
flows and time value of money are not
considered

31. ROI, RI, EVA Limitations
• Asset Investment Base
– Assets may be understated (e.g., R&D)
– Current management may be judged on
decisions of previous managers
– Assets not restated for changing (rising) price
levels (older assets will report higher ROI)
• ROI, RI, EVA do not measure performance
relative to company-wide objectives; can
lead to suboptimization of resources

32. Questions
• What are the short-term financial
performance measures for profit and
investment centers?
• How are return on investment and residual
income similar? How do they differ?
• What is Economic Value Added?