FBS FINAL STUDY NOTES ST1 PERFORMANCE MANAGEMENT AND REPORTING

Comprehensive Study Notes: Responsibility Accounting & Performance Measurement

1. Organizational Structure: Decentralization

  • Definition: A decentralized organization distributes decision-making power to managers at various levels rather than concentrating it solely at the top.

  • Spectrum of Decentralization:

    • Strongly decentralized (maximum freedom)

    • Strongly centralized (little freedom)

  • Temporary ReCentralization: During times of crisis (e.g., economic downturns), organizations may temporarily recentralize to regain tighter control.

Benefits of Decentralization (5)

  1. Frees top management to focus on strategy and high-level coordination.

  2. Develops the decision-making skills of lower-level managers for future promotions.

  3. Increases job satisfaction and motivation through added responsibility.

  4. Leverages the closer operational knowledge of lower-level managers for better-informed decisions.

  5. Facilitates easier performance evaluation when managers have genuine decision-making authority.

Disadvantages of Decentralization (4)

  1. Lower-level managers may lack a "big picture" understanding of the company's overall strategy.

  2. There is a risk of poor coordination among autonomous managers.

  3. Managers may prioritize departmental goals over the company's overall objectives.

  4. Innovative ideas may not spread effectively across the organization without central direction.

2. Responsibility Centres: The Building Blocks of Decentralization

  • Concept: Effective decentralization relies on responsibility accounting, treating each business unit as a responsibility centre.

  • Definition: A responsibility centre is any part of an organization where the manager has control over costs, revenue, or investment funds.

Types of Responsibility Centres

  1. Cost Centre

    • Manager Control: Costs only (not revenue or investment).

    • Primary Goal: Minimize costs while providing required service levels.

    • Examples: Service departments (Accounting, Legal, HR), manufacturing facilities.

  2. Profit Centre

    • Manager Control: Both costs and revenue (but not investment).

    • Primary Goal: Maximize profits.

    • Examples: An amusement park, a product line, a retail store.

  3. Investment Centre

    • Manager Control: Costs, revenue, and investments in operating assets.

    • Primary Goal: Generate a return on the assets under their control.

    • Examples: A major divisional GM's Truck Division, a standalone subsidiary.

All Responsibility Centres

  • Collectively referred to as responsibility centres.

3. Segmented Reporting: The Tool for Evaluation

  • Purpose: Managers use segmented reporting to evaluate responsibility centres, typically through income statements broken down for individual business segments (e.g., divisions, product lines, regions).

  • Contribution Format Income Statement: Preferred over traditional absorption costing because it clearly separates costs to highlight segment performance.

Structure of a Contribution Format Segmented Income Statement

  1. Revenue: Sales generated by the segment.

  2. Less Variable Expenses: Costs that vary with sales volume.

  3. = Contribution Margin: The amount available to cover fixed costs and contribute to profit, key for short-run decisions like special orders.

  4. Less Traceable Fixed Expenses: Fixed costs directly caused by the segment's existence.

  5. = Segment Margin: The profit generated by the segment after covering all its costs.

  6. Less Common Fixed Expenses: Fixed costs that support multiple segments and are not traceable to any individual segment.

  7. = Net Operating Income: The profit for the entire company.

Key Concepts in Segmented Reporting

  • Traceable Fixed Cost:

    • Definition: A fixed cost incurred because of the existence of the segment.

    • Implication: It would disappear over time if the segment were eliminated.

    • Examples: Salary of a product line manager, advertising for a specific division.

  • Common Fixed Cost:

    • Definition: A fixed cost that supports the operations of multiple segments and would not disappear if a single segment were eliminated.

    • Examples: CEO's salary, cost of a shared corporate headquarters, receptionist's salary for a shared office.

Segment Margin

  • Calculation: Segment Margin = Contribution Margin - Traceable Fixed Costs.

  • Significance: This is the single best gauge of the long-run profitability of a segment, as it includes only the costs that are directly attributable to it.

Critical Rules for Assigning Costs to Segments

  1. Traceable Costs Can Become Common: A cost traceable to one segment might be common to its sub-segments.

    • Example: The divisional manager's salary is traceable to the division but is a common cost of the product lines within it.

  2. Include the Full Value Chain:

    • All costs attributable to a segment from the entire value chain (R&D, design, manufacturing, marketing, distribution, service) must be included for accurate profitability analysis.

    • Mistake: Including only manufacturing costs leads to incomplete analysis.

  3. Avoid Arbitrary Allocations:

    • Failure to Trace: Costs that can be traced directly to a segment must be charged directly.

    • Inappropriate Allocation Base: Allocation bases must be cost drivers. Using revenue to allocate SG&A costs is misleading unless SG&A expenses change in direct proportion to sales.

    • Dividing Common Costs: Arbitrarily allocating common costs to segments can make profitable segments appear unprofitable and hold managers accountable for costs they cannot control.

    • Risk: Misallocation may lead to the elimination of a seemingly "profitable" segment, resulting in loss of revenue while common costs remain, ultimately hurting the company overall.

4. Measuring Performance in Investment Centres: ROI and Residual Income

  • Investment Centres: Where managers control assets, requiring more sophisticated performance metrics.

  • Primary Metrics: Return on Investment (ROI) and Residual Income (RI).

Return on Investment (ROI)

  • Popularity: The most common metric for evaluating investment centre performance.

Basic Formula for ROI

  • ROI=OperatingProfitAverageOperatingAssetsROI = \frac{OperatingProfit}{AverageOperatingAssets}

  • Components:

    • Operating Profit: Profit before interest and taxes (EBIT).

    • Operating Assets: Assets used for core operations (cash, accounts receivable (AR), inventory, property, plant, and equipment (PP&E)).

    • Exclusions: Non-operating assets like land held for future use.

Expanded ROI Formula (DuPont Formula)

  • ROI=Margin×AssetTurnoverROI = Margin \times AssetTurnover

  • Definitions of Components:

    • Margin: Measures control over operating expenses.

    • Margin=OperatingProfitRevenueMargin = \frac{OperatingProfit}{Revenue}

    • Asset Turnover: Measures efficiency of asset use.

    • AssetTurnover=RevenueAverageOperatingAssetsAssetTurnover = \frac{Revenue}{AverageOperatingAssets}

Three Ways to Improve ROI (The DuPont Framework)

  • Baseline Example:

    • Revenue £100k, Profit £10k, Assets £50k → ROI = 20%.

Strategies Overview

  1. Increase Revenue:

    • Action: Increase revenue to £110k, profit to £12k (costs controlled).

    • Impact on ROI: Margin ↑, Turnover ↑ → ROI = 24%.

  2. Reduce Expenses:

    • Action: Cut costs by £1k, increasing profit to £11k. Revenue & assets unchanged.

    • Impact on ROI: Margin ↑, Turnover unchanged → New ROI = 22%.

  3. Reduce Assets:

    • Action: Reduce inventory to lower operating assets to £40k. Profit & revenue unchanged.

    • Impact on ROI: Margin unchanged, Turnover ↑ → New ROI = 25%.

Criticisms of ROI

  1. Short-Termism: Managers may focus on boosting short-run ROI in ways that can harm the company long-term (e.g., cutting R&D).

  2. Inherited Costs: Managers may be judged on assets and costs they inherited and cannot control.

  3. The "Drop" Problem (Disincentive to Invest):

    • A manager with a high current ROI may reject a profitable new project if that project's ROI, while above the company's minimum, is below the division's current ROI, fearing it will decrease the division's overall ROI.

Residual Income (RI)

  • Definition: An alternative metric designed to overcome ROI's "drop problem" by measuring absolute value creation rather than percentage.

  • Formula:

    • ResidualIncome=OperatingProfit−(AverageOperatingAssets×MinimumRequiredRateOfReturn)ResidualIncome = OperatingProfit - (AverageOperatingAssets \times MinimumRequiredRateOfReturn)

  • Minimum Required Rate of Return: Set by top management (e.g., the company's cost of capital).

  • Advantage of RI: Motivates managers to accept any project whose return exceeds the minimum required rate, aligning their interests with the company's best interests.

Example: Marine Services Corporation

  • Scenario:

    • A new project requires £25,000 in assets and will generate £4,500 profit (18% return).

    • The company's minimum required return is 15%.

  • Metrics Comparison:

    Metric

    Without Project

    New Project Only

    With Project (Overall)

    Operating Assets

    £100,000

    £25,000

    £125,000

    Operating Profit

    £20,000

    £4,500

    £24,500

    ROI

    20%

    18% → 19.6% (DECREASES)

    Residual Income (15% req.)

    £5,000

    £750

    £5,750 (INCREASES)

  • Decision Impact: An ROI-based manager would reject the project to protect their 20% average, while an RI-based manager would accept it, as it increases total residual income by £750.

Major Disadvantage of RI

  • Comparison Limitation: RI is an absolute measure and cannot be used to compare divisions of different sizes.

  • Example of Comparison:

    Metric

    Division X

    Division Y

    Operating Assets

    £1,000,000

    £250,000

    Operating Profit

    £120,000

    £40,000

    Min. Return (10%)

    £100,000

    £25,000

    Residual Income

    £20,000

    £15,000

  • Conclusion: Although Division X has a higher RI, Division Y is arguably better managed, generating nearly the same RI with significantly fewer assets.

  • Recommendation: Focus on the percentage change in RI year-over-year, rather than the absolute amount, to provide a clearer picture of performance.

5. Beyond Single-Period Metrics: The Bonus Bank

  • Observation: ROI, RI, and Economic Value Added (EVA) are all single-period metrics.

  • Criticism: These metrics can encourage managers to make decisions that improve results in one period while harming long-term value (e.g., slashing R&D).

  • Solution: The bonus bank system was developed, often used alongside EVA.

How the Bonus Bank Works

  • Mechanism: Executive bonuses are not fully paid out in the year earned; instead, they accumulate in a "bonus bank".

  • Objective: Payouts are based on sustained performance over multiple years to prevent manipulation of short-term results for quick bonuses.

  • Performance Alignment: Discourages poor subsequent performance that could reduce a banked bonus, aligning managerial incentives with long-term shareholder wealth.

The formula for calculating residual income is as follows:

Residual Income=Net Income−(Cost of Capital×Invested Capital)\text{Residual Income} = \text{Net Income} - (\text{Cost of Capital} \times \text{Invested Capital})

In this formula:

  • Net Income: The total profit of the company after all expenses have been deducted.

  • Cost of Capital: The return rate the company aims to earn on its investments.

  • Invested Capital: The total amount of capital that has been invested in the company.