Financial Control

Soumendra Roy

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
organizations that:

best

suited

to

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

Responsibility Centers
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

Responsibility Centers
& 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 profitseeking 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 Center
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? (3 of 3)
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 operations in 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 v. Evaluate Decisions
The choice of the performance
measure may influence decisionmaking 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

Example from a Dairy

A dairy faced the problem of developing
performance standards in an environment
of continuously rising costs
The costs of raw materials, which were 60% 90% of the final costs, were market determined
Should the evaluation of the managers depend
on their ability to control the quantity of raw
materials used rather than the cost?

Senior management announced that it

would evaluate managers on their ability to
control total costs

Example from a Dairy

The managers quickly discovered that one

way to control raw materials costs was
through long-term fixed price contracts for
raw materials
Contracts led to declining raw materials costs
The company could project product costs several
quarters into the future, thereby achieving lower
costs and stability in planning and product
pricing

When more costs or 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 short-term effect on

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 businesssustaining 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 % 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

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, since 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

Interesting Variations
the receiving division is
charged only for the variable costs of producing
the unit supplied and the supplying division is
credited with the net realizable value of the unit
supplied

A dual rate approach -

This lets marginal cost influence the decisions of the

buying division while giving the selling division credit
for an imputed profit on the transferred good or
service
Target variable cost includes the number of standard
hours allowed for the work done multiplied by the
standard cost per hour, in addition to an assignment
of the supplying divisions committed costs

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, since 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
Dupont, as Investment
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 Duponts
approach to financial control in
summary form

The Dupont ROI Control

System

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

Using Economic Value

Added
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

Using Economic Value

Added
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 since 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