Management Control Systems

Chapter 11: Accounting Performance Measures

and Their Effects

Wim Van der Stede

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
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.

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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.

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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.

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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.

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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.

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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.

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 Example ...
SBU Cash Receivables Inventories Fixed Assets Total Invest. Profit ROI
A $ 10 $ 20 $ 30 $ 60 $ 120 $ 24.0 20 %
ROI

B 20 20 30 50 120 14.4 12
C 15 40 40 10 105 10.5 10
D 5 10 20 40 75 3.8 5
E 10 5 10 10 35 (1.8) (6)

SBU Profit Cur. Assets Req. Earn. Fixed Assets Required Earn. Res. Income
A $ 24.0 $ 60 $ 2.4 $ 60 $ 6.0 $ 15.6
B 14.4 70 2.8 50 5.0 6.6
RI

C 10.5 95 3.8 10 1.0 5.7

D 3.8 35 1.4 40 4.0 (1.6)
E (1.8) 25 1.0 10 1.0 (3.8)

4% 10%

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Suboptimization ...

– ROI provides different incentives for investments

across business units
Corporate IRR Business
Cost of < of < Unit
» SBU-manager will not invest if ...
Capital Project ROI

Corporate IRR Business

» SBU-manager will invest if ... Cost of > of > Unit
Capital Project ROI

» 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.

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Suboptimization ...
Assume Corporate cost of capital = 10%
Worthwhile ! Investment of $10 to earn $1,1 per year

DOES NOT INVEST INVEST INVEST

Base situation Unit A Unit C Unit D

Profit Before tax $ 24 $ 10.5 $ 3.8

Investment base $ 120 $ 105 $ 75
ROI 20 % 10 % 5%

New situation New situation New situation New situation

Profit before tax $ 25.1 $ 11.6 $ 4.9

Investment $ 130 $ 115 $ 85
ROI 19.30 % 10.08 % 5,76%

“WRONG” “RIGHT” “RIGHT”

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Suboptimization ...
Assume Corporate cost of capital = 15%
Not worthwhile ! Investment of $10 to earn $1,1 per year

DOES NOT INVEST INVEST INVEST

Base situation Unit A Unit C Unit D

Profit Before tax $ 24 $ 10.5 $ 3.8

Investment base $ 120 $ 105 $ 75
ROI 20 % 10 % 5%

New situation New situation New situation New situation

Profit before tax $ 25.1 $ 11.6 $ 4.9

Investment $ 130 $ 115 $ 85
ROI 19.30 % 10.08 % 5,76%

“RIGHT” “WRONG” “WRONG”

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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 Unit A Unit C Unit D

Profit Before tax $ 24 $ 10.5 $ 3.8

Investment base $ 120 $ 105 $ 75
RI $ 15.6 $ 5.7 ($ 1.6)

New situation New situation New situation New situation

Profit before tax $ 25.1 $ 11.6 $ 4.9

Investment $ 130 $ 115 $ 85
RI $ 15.7 $ 5.8 ($ 1.5)
(=25.1-2.4-7) (=11.6-3.8-2) (=4.9-1.4-5)

INVEST INVEST INVEST

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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.

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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)

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

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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.

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