Ama6e Ch11 Inst

Financial Control
Chapter 11
2012 Pearson Prentice Hall. All rights reserved.
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
The Environment of
Financial Control
Organizations have developed and exploited

financial measures to assess performance and
target areas for improvement because external
stakeholders have traditionally relied on financial
performance measures to assess organization
potential
The Environment of
Financial Control
Financial measures do not identify what is wrong,

but they do provide a signal that something is
wrong and needs attention
Financial Control
This chapter focuses on broader issues in financial

control, including the evaluation of organization
units and of the entire organization
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
Decentralization
Decentralization is the process of delegating

decision making authority down the organization
hierarchy
Highly centralized organizations tend not to

respond effectively or quickly to their
environments
Decentralization
Centralization is best suited to organizations that:

Are well adapted to stable environments
Have no major information differences between the
corporate headquarters and the employees

Have no changes in the organizations environment
that required adaptation by the organization
Centralized Organizations
In centralized organizations:
Technology and customer requirements are well
understood
The product line consists mostly of commodity
products for which the most important attributes

are price and quality
Centralized Organizations
To accomplish this, organizations develop

standard operating procedures to ensure that:
They are using the most efficient technologies and
practices to promote both low cost and consistent

quality
There are no deviations from the preferred way of
doing things
Changing Environment
In response to increasing competitive pressures

and the opening up of former monopolies to
competition, many organizations are changing the
way they are organized and the way they do
business
This is necessary because they must be able to

change quickly in a world where technology,
customer tastes, and competitors strategies are
constantly changing
Becoming More Adaptive
Being adaptive generally requires that the

organizations senior management delegate or
decentralize decision-making responsibility to
more people in the organization
Decentralization :
Allows motivated and well-trained organization
members to identify changing customer tastes

quickly
Gives front-line employees the authority and
responsibility to develop plans to react to these
changes
Degrees of Decentralization
The amount of decentralization reflects the

organizations need to have people on the front
lines who can make good decisions quickly and:
The organizations trust in its employees
The employees level of skill and training
The employees ability to make the right choices
From Task to Results Control
In decentralization, control moves from task

control to results control
From where people are told what to do
To where people are told to use their skill,
knowledge, and creativity to improve results
Responsibility Centers
A responsibility center is an organization unit for

which a manager is made responsible
A responsibility center is like a small business
But it is not completely autonomous

Its manager is asked to run that small business to
promote the best interests of the larger organization
The manager and supervisor establish goals for

their responsibility center
These goals should:
Be specific and measurable so as to provide
employees with focus

Promote the long-term interests of the larger
organization
Promote the coordination of each responsibility
centers activities with the efforts of all the others
Coordinating Responsibility
Centers
For an organization to be successful, the activities

of its responsibility units must be coordinated
Sales, manufacturing, and customer service

activities are often very disjointed in large
organizations, resulting in diminished
performance
In general, nonfinancial performance measures
detect coordination problems better than financial

measures
and Financial Control
Organizations use financial control to provide a

summary measure of how well their systems of
operations control are working
When organizations use a single index to provide

a broad assessment of operations, they frequently
use a financial number because it is a measure that
describes the primary objectives of shareowners in
profit-seeking organizations
Responsibility Center Types
The accounting report prepared for a

responsibility center reflects the degree to which
the responsibility center manager controls
revenue, cost, profit, or return on investment
Four types of responsibility centers:
Cost centers
Revenue centers
Profit centers
Investment centers
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
Other Issues in Cost

Center Control
Many organizations make the mistake of

evaluating a cost center solely on its ability to
control costs
Other critical performance measures may include:
Quality
Response time
Meeting production schedules
Employee safety
Respect for the organizations ethical and
environmental commitments
Other Issues in Cost

Center Control
If management evaluates cost center performance

only on the centers ability to control costs, its
members may ignore unmeasured attributes of
performance
Revenue Center
A responsibility center whose members control

revenues but control neither the manufacturing or
acquisition cost of the product or service they sell
nor the level of investment made in the
responsibility center
Some revenue centers control price, the mix of

stock carried, and promotional activities
Costs Incurred by
Revenue Centers
Most revenue centers incur sales and marketing

costs and have varying degrees of control over
those costs
It is common in such situations to deduct the

responsibility centers traceable costs from its
sales revenue to compute the centers net revenue
Traceable costs may include salaries, advertising
costs, and selling costs
Drawbacks of Revenue
Centers
Critics of the revenue center approach argue that

basing performance evaluation on revenues can
create undesirable consequences
In general, focusing only on revenues causes

organization members to increase the use of
activities that create costs in order to promote
higher revenue levels
Profit Centers
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 Centers
It is doubtful that a unit of a corporate-owned

hotel or fast-food restaurant meets the conditions
to be treated as a profit center
These units are sufficiently large that:

Costs may vary due to differences in controlling
labor costs, food waste, and scheduled hours

Revenues may also shift significantly based on
how well staff manages the property
Profit Centers
Although these organizations do not seem to be

candidates to be treated as profit centers, local
discretion often affects revenues and costs enough
so that they can be
Many organizations evaluate units as profit centers
even though the corporate office controls many
facets of their operations
The profit reported by these units reflects both
corporate and local decisions
Profit Centers
If unit performance is poor, it may reflect:

Poor conditions no one in the organization can
control
Poor corporate decisions
Poor local decisions
Organizations should not rely solely on profit

centers financial results for performance
evaluations
Detailed performance evaluations should include
quality, material use, labor use, and service

measures that the local units can control
Investment Center
A responsibility center in which the manager and other

employees control revenues, costs, and the level of
investment in the responsibility center
For example, between 1970 and 2000 General Electric
acquired many businesses
Including aircraft engines, medical systems, power systems,
transportation systems, consumer products, industrial

systems, broadcasting, plastics, specialty materials, and
financial services
Senior executives at General Electric developed a

management system that evaluated these businesses as
independent operationsin effect as investment centers
Evaluating Responsibility
Centers
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
Evaluating Responsibility
Centers
Revenues, costs, or investments that people

outside the responsibility center control should be
excluded from the accounting assessment of that
centers performance
Although the controllability principle sounds

appealing and fair, it can be difficult, misleading,
and undesirable to apply in practice
Problems with the

Controllability Principle
A significant problem in applying the

controllability principle is that in most
organizations many revenues and costs are jointly
earned or incurred
The activities that create the final product are
sequential and interdependent

Evaluating the individual performance of one
center requires the firm to consider many facets of
performance
Problems with the

Controllability Principle
As part of the performance evaluation process, the

organization may want to prepare accounting
summaries of the performance of individual units
to support some system of financial control
Using Performance Measures

to Influence vs. Evaluate
Decisions
The choice of the performance measure may

influence decision-making behavior
When more costs or even revenues are included in

performance measures, managers are more
motivated to find actions that can influence
incurred costs or generated revenues
Using Segment Margin

Reports
Despite the problems of responsibility center

accounting, the profit measure is so
comprehensive and pervasive that organizations
prefer to treat many of their organization units as
profit centers
Because most organizations are integrated

operations, the first problem designers of profit
center accounting systems must confront is the
interactions between the various profit center units
The Segment Margin Report
A common form of the segment margin report for

an organization that is divided into responsibility
centers includes one column for each profit center
The revenue attributed to each profit center is the
first entry in each column
Variable costs are deducted from its revenue to
determine the contribution margin
The costs not proportional to volume are deducted
from each centers contribution margin to
determine that units segment margin
The Segment Margin Report
Allocated avoidable costs are deducted from the

units segment margin to compute its income
The organizations unallocated costs, which

represent the administrative and overhead costs
incurred regardless of the scale of operations, are
deducted from the total of the profit center
incomes to arrive at total profit
Evaluating the Segment

Margin Report
What can we learn from the segment margin

report?
The contribution margin for each responsibility
center is the value added by the manufacturing or
service-creating process before considering costs
that are not proportional to volume
A units segment margin is an estimate of its shortterm effect on the organizations profit
Evaluating the Segment

Margin Report
The units income is an estimate of the long-term

effect of the responsibility centers shutdown on
the organizations profit after fixed capacity is
allowed to adjust
The difference between the units segment margin

and income reflects the effect of adjusting for
business-sustaining costs
Good or Bad Numbers
Organizations use different approaches to evaluate

whether the segment margin numbers are good or
bad
Two sources of comparative information are:
Is performance this period reasonable, given past
experience?
How does performance compare with similar
organizations?
Evaluations include comparisons of:

Absolute amounts, such as cost or revenue levels
Relative amounts, such as each items percent of
revenue
Interpreting Reports
with Caution
Segment margin statements should be interpreted

carefully, however, because they reflect many
assumptions that disguise underlying issues
Segment margins present an aggregated summary
of each organization units past performance
Important to consider critical success factors that

will affect future profits
Interpreting Reports
with Caution
Segment margin reports usually contain soft
numbers
Allocations that may be quite arbitrary and over

which there can be legitimate disagreement
These assumptions relate to the transfer pricing
issue, which focuses on how revenues the
organization earns can be divided among all the
responsibility centers that contribute to earning
those revenues
Transfer Pricing
Transfer pricing is the set of rules an organization

uses to allocate jointly earned revenue among
responsibility centers
To understand the issues and problems associated

with allocating revenues in a simple organization,
consider the activities that occur when a customer
purchases a new car at a dealership:
Transfer Pricing
The new car department sells the new car and takes
in a used car as a trade

The used car is transferred to the used car
department
There, it may undergo repairs and service to make
it ready for sale, or may be sold externally on the
wholesale market
The value placed on the used car transferred

between the new and used car departments is
critical in determining the profits of both
departments:
Transfer Pricing
The new car department would like the value
assigned to the used car to be as high as possible to

increase revenue
The used car department would like the value to be
as low as possible because that makes its reported
costs lower
The same considerations apply for any product or

service transfer between any two departments in
the same organization
Approaches to
Transfer Pricing
Organizations choose among four main

approaches to transfer pricing:
Market-based transfer prices
Cost-based transfer prices
Negotiated transfer prices
Administered transfer prices
Transfer prices serve different purposes; however,

the goal of using transfer prices is always to
motivate the decision maker to act in the
organizations best interests
Market-Based Transfer Prices
If external markets exist for the intermediate

(transferred) product or service, then market prices
are the most appropriate basis for pricing the
transferred good or service between responsibility
centers
The market price provides an independent
valuation of the transferred product or service, and
of how much each profit center has contributed to
the total profit earned by the organization on the
transaction
Cost-Based Transfer Prices
Some common cost-based transfer prices are:

Variable cost
Variable cost plus a percent markup on variable
cost
Full cost
Full cost plus a percent markup on full cost
Economists argue that any cost-based transfer

price other than marginal cost leads organization
members to choose a lower than optimal level of
transactions
Problems with
Cost-Based Price
Cost-based approaches to transfer pricing do not

support the intention of having the transfer pricing
mechanism support the calculation of unit incomes
Transfer prices based on actual costs provide no

incentive to the supplying division to control
costs, because the supplier can always recover its
costs
Problems with
Cost-Based Price
Cost-based pricing does not provide the proper

economic guidance when operations are capacity
constrained
Production decisions near full capacity should
reflect the most profitable use of the capacity, not

only cost considerations
The transfer price should be the sum of the
marginal cost and the opportunity cost of capacity,
where opportunity cost reflects the profit of the
best alternative use of the capacity
Cost Allocations to
Support Financial Control
Organizations should design and present

responsibility center income statements in such a
way that they isolate the discretionary components
included in the calculation of each centers
reported income
Show the revenue and variable costs separately
from the other costs in the profit calculation

Separate from the indirect or joint costs that are
allocated
Allocation of Indirect Costs
Many different activity bases for selecting a

method to allocate indirect costs
Allocating indirect costs in proportion to benefit is

one option
Interpreting Segment
Financials
Responsibility center income statements should be

interpreted with considerable caution and healthy
skepticism
They may include arbitrary and questionable

revenue and cost allocations
They often disguise interrelationships among the

responsibility centers
Negotiated Transfer Price
Some organizations allow supplying and receiving

responsibility centers to negotiate transfer prices
between themselves
Negotiated transfer prices reflect the
controllability perspective inherent in
responsibility centers, because each division is
ultimately responsible for the transfer price that it
negotiates
Negotiated transfer prices and therefore production
decisions may reflect the relative negotiating skills

of the two parties rather than economic
considerations
Optimal Transfer Price
In an economic sense, the optimal transfer price

results when the purchasing unit offers to pay the
net realizable value of the last unit supplied for all
the units supplied
The net realizable value of a unit of transferred
material is the selling price of the product less all

the costs that remain to prepare the final product
for sale
If the supplying unit is acting optimally, it chooses

to supply units until its marginal cost equals the
transfer price offered by the purchasing unit
Problem with Negotiated

Prices
Problems arise when negotiating transfer prices,

because the bilateral bargaining situation causes:
The supplying division to want a higher than
optimal price
The receiving division to want a lower than
optimal price
When the actual transfer price is different from the

optimal transfer price, the organization as a whole
suffers
Administered Transfer Price
An arbitrator or a manager applies some policy to

set administered transfer prices
Organizations often used administered transfer
prices when a particular transaction occurs

frequently
Such prices reflect neither pure economic

considerations, as do market-based or cost-based
transfer prices, nor accountability considerations,
as negotiated transfer prices do
Administered Transfer Price
Administered transfer prices inevitably create

subsidies among responsibility centers
Subsidies obscure the normal economic
interpretation of responsibility center income

Subsidies may provide a negative motivational
effect if members of a responsibility center believe

the rules are unfair
Transfer Prices Based

on Equity Considerations
Administered transfer prices are usually based on

cost
Sometimes administered transfer prices are based
on equity considerations:
Relative cost method
Base the allocation of cost on the profits that each
manager derives from using the asset

Assign each manager an equal share of the assets
cost
Assigning and Valuing

Assets in Investment Centers
When companies use investment centers to

evaluate responsibility center performance, there
are:
All the problems associated with profit centers
Plus some new problems unique to investment
centers
The additional problems concern how to identify

and value the assets used by each investment
center
Determining Level of
Asset Use
In determining the level of assets that a

responsibility center uses, the management
accountant must assign the responsibility for:
Jointly used assets
Jointly created assets
Once decision makers have assigned assets to

investment centers, they must determine the value
of those assets
What cost should be usedhistorical cost, net
book value, replacement cost, or net realizable

value?
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 DuPont's approach to

financial control in summary form
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
The elements of permanent investment
Equipment and buildings
Comparisons of these turnover ratios with those of

similar units or those of competitors suggest
where improvements are required
Assessing Productivity Using

Financial Control
The most widely accepted definition of

productivity is the ratio of output over input
Organizations develop productivity measures for

all factors of production, including people, raw
materials, and equipment
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
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
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
The Efficacy of
Financial Control
Critics of financial control have argued that:

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
The Efficacy of
Financial Control
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 because 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
The Efficacy of
Financial Control
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

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Financial Control

2012 Pearson Prentice Hall. All rights reserved.

What Are Financial Controls?

Financial control involves the use of financial

product line, an organization department, a

Financial control provides a counterpoint to the

Organizations have developed and exploited

2012 Pearson Prentice Hall. All rights reserved.

Financial measures do not identify what is wrong,

2012 Pearson Prentice Hall. All rights reserved.

This chapter focuses on broader issues in financial

Information used internally and not distributed to

External financial controls

Developed by outside analysts to assess

Decentralization is the process of delegating

Highly centralized organizations tend not to

2012 Pearson Prentice Hall. All rights reserved.

Centralization is best suited to organizations that:

corporate headquarters and the employees

that required adaptation by the organization

2012 Pearson Prentice Hall. All rights reserved.

products for which the most important attributes

2012 Pearson Prentice Hall. All rights reserved.

To accomplish this, organizations develop

practices to promote both low cost and consistent

2012 Pearson Prentice Hall. All rights reserved.

In response to increasing competitive pressures

This is necessary because they must be able to

Becoming More Adaptive

Being adaptive generally requires that the

members to identify changing customer tastes

The amount of decentralization reflects the

2012 Pearson Prentice Hall. All rights reserved.

From Task to Results Control

In decentralization, control moves from task

knowledge, and creativity to improve results

2012 Pearson Prentice Hall. All rights reserved.

A responsibility center is an organization unit for

A responsibility center is like a small business

But it is not completely autonomous

promote the best interests of the larger organization

2012 Pearson Prentice Hall. All rights reserved.

The manager and supervisor establish goals for

employees with focus

2012 Pearson Prentice Hall. All rights reserved.

For an organization to be successful, the activities

Sales, manufacturing, and customer service

detect coordination problems better than financial

Organizations use financial control to provide a

When organizations use a single index to provide

2012 Pearson Prentice Hall. All rights reserved.

Responsibility Center Types

The accounting report prepared for a

Four types of responsibility centers:

2012 Pearson Prentice Hall. All rights reserved.

A responsibility center in which employees

Organizations evaluate the performance of cost

2012 Pearson Prentice Hall. All rights reserved.

Other Issues in Cost

Many organizations make the mistake of

Other Issues in Cost

If management evaluates cost center performance

2012 Pearson Prentice Hall. All rights reserved.

A responsibility center whose members control