Learning Objectives
Identify the objectives of management control
Identify the types of management control systems
Explain the objectives and applications of strategic performance measurement in three common strategic business units: cost centers, revenue centers, and profit centers
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Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced ScorecardChapter EighteenMcGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.18-2Identify the objectives of management controlIdentify the types of management control systemsExplain the objectives and applications of strategic performance measurement in three common strategic business units: cost centers, revenue centers, and profit centersLearning Objectives18-3Learning Objectives (continued)Explain the role of variable costing and full costing in evaluating profit centersExplain the role of the balanced scorecard in strategic performance measurement18-4Performance Measurement and ControlPerformance measurement is the process by which managers at all levels gain information about the performance of tasks within the firm and judge that performance against pre-established criteria as set out in budgets, plans, and goalsTop management, middle management, and operating-level personnel should be evaluatedManagement control refers to the evaluation by upper-level managers of the performance of mid-level managers 18-5Performance Measurement and Control (continued)Operational control means the evaluation of operating-level employees by mid-level managersManagement control focuses on higher-level managers and long-term strategic issues (a broader objective), while operational control focuses on detailed short-term performanceOperational control is a management-by-exception approach while management control is more consistent with the management-by-objectives approach18-6Performance Measurement and Control (continued)Management ControlOperational ControlFinancial ManagementOperations ManagementMarketing ManagementPlant APlant BRegion BRegion AChief ExecutiveEmployee1Employee2Employee3Employee 418-7Management-by-ObjectivesIn a management-by-objectives approach, top management assigns a set of responsibilities to each mid-level manager depending on the functional area involved and the scope of authority of the mid-level managerAreas of responsibility are often called strategic business units (SBUs)An SBU consists of a well-defined set of controllable operating activities over which the SBU manager is responsible18-8Objectives of Management ControlMotivate managers to exert a high level of effort to achieve the goals set by top managementProvide the right incentive for managers to make decisions consistent with the goals set by top management (that is, to align managers’ efforts with the desired strategic goals)Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their decision making18-9Achieving Management Control ObjectivesA common mechanism for achieving these multiple objectives is to develop an employment contract between the manager and top managementA contract promotes goal congruence: the contract specifies the manager’s desired behaviors and the compensation to be awarded for achieving specific outcomes by using these behaviorsContracts can be written or unwritten, explicit or implied18-10Employment ContractsAn economic model, the principal-agent model, is a prototype that contains the key elements that a contract must have to achieve the desired objectivesThere are two important aspects of management performance that affect the contracting relationship, uncertainty and lack of observabilityManagers operate in an environment that is influenced by factors beyond the manager’s control; there is some degree of uncertainty (continued)18-11Employment Contracts (continued)Many efforts and decisions made by the manager are not observable to top management, and the manager often possesses information not accessible to top managementBecause of uncertainty and the lack of observability, three principles should be followed in the preparation of an employment contract:Separate the performance of the manager from the performance of the SBU (continued..)18-12Employment Contracts (continued)Exclude known uncontrollable factors from the contractRisk-averse managers make decisions to avoid risk when top management might prefer choices that involve some risk. It is therefore necessary to separate the value of the outcome from the positive or negative weight associated with the risk due to uncertainty.Management control systems should be designed to reduce the negative effects of risk preferences18-13The Principal-Agent ModelOutcome of manager’s decision and effortRiskAversionDecisionMakingEffortReceivesPayUncertaintyExternal FactorsPreparePerformanceReportAccountingPays Manageron the Basis of thePerformanceReportTop Management Manager 18-14Designing Management Control Systems There are four questions management must ask when developing a management control system:Who is interested in evaluating the organization’s performance (owners, directors, creditors, employees, etc.)?What is being evaluated (an individual, team, or SBU)?When is the performance evaluation to be conducted, and should it be based on the master budget (resource inputs –ex ante) or the flexible budget (outputs of the manager’s effort–ex post)?Should the system be formal or informal?18-15Types of Management Control Systems18-16Strategic Performance MeasurementStrategic performance measurement is a system used by top management to evaluate SBU managersBefore designing strategic performance measurement systems, top managers determine when delegation of responsibility is desirableA firm is decentralized if it has chosen to delegate a significant amount of responsibility to SBU managersA centralized firm reserves much of the decision-making at the top-management level 18-17Strategic Performance Measurement (continued)Centralized firms provide more control and the expertise of top management can be effectively utilizedDecentralized firms are able to make more timely decisions at the operational level; top management lacks the necessary local knowledgeDecentralized firms are often more motivating for managers, are an excellent environment for training future top-level managers, and can be a better basis for performance evaluations18-18Types of SBUsCost Centers are a firm’s production or support departments that are charged with the responsibility of providing the best quality product or service at the lowest cost (examples: a plant’s assembly department, data-processing department, and its shipping and receiving department)Revenue Centers focus on the selling function and are defined either by product line or by geographic areaProfit Centers: when an SBU both generates revenues and incurs the major portion of the cost for producing these revenues, it is considered a profit centerInvestment Centers include assets employed by the SBU as well as profits in the performance evaluation18-19Types of SBUs (continued) The choice of a profit, cost, or revenue center depends on the nature of the production and selling environment in the firm:Products that have little need for coordination between the manufacturing and selling functions are good candidates for cost and revenue centersFor products that require close coordination between these functions, profit centers would be the preferred option18-20Cost CentersDirect manufacturing and manufacturing support departments are often evaluated as cost centers since these managers have significant direct control over costs but little control over revenues or decision-making for investment in facilitiesSeveral strategic issues arise when implementing cost centers:Cost shifting occurs when a department replaces its controllable costs with noncontrollable costs (e.g., variable costs to fixed costs) (continued)18-21Cost Centers (continued)Many performance-measurement systems focus excessively on short-term cost figures, neglecting long-term strategic issuesThe majority of cost centers have some amount of budgetary slack, which is the difference between budgeted and expected performanceBudgetary slack can be good as it reduces risk aversion, but too much slack can result in reduced employee effort and (as indicated in Chapter 10) can complicate the planning processTwo Methods of Implementing Cost Centers in Production and Support Departments18-22Implementing Cost Centers in General and Administrative Departments These departments have the same two methods to choose from, but the proper choice may change over time:For example, if cost reduction is a key objective, the human resources department might be treated as an engineered-cost centerLater, it might be changed to a discretionary-cost center to motivate managers to focus on the achievement of long-term goals18-23Implementing Cost Centers in General & Administrative DepartmentsTotal Cost4,8003,6002,4001,200 Cost Driver (number of applications) 100 200 300 400 Cost Variance250Cost behavior in administrative support centers is often a step costEngineered Cost18-2418-25 Cost Centers—Implementation ConsiderationsMany firms are choosing to outsource manufacturing, customer service, engineering, and other servicesWhen using a cost center, how should the firm allocate the jointly incurred costs of service departments to the departments using the service?An allocation method should be chosen based on its ability to motivate managers, encourage goal congruence, and provide a basis for fair evaluation of the managers’ performance (continued)18-26 Cost Centers—Implementation Considerations (continued)Dual allocation is a cost-allocation method that separates fixed and variable costs; variable costs are directly traced to user departments, and fixed costs are allocated on some logical basisIndirect costs should be traced to cost Centers using activity-based costing (ABC)18-27Revenue CentersManagement commonly uses revenue drivers in evaluating the performance of revenue CentersRevenue drivers in manufacturing firms are the factors that affect sales volume, such as price changes, promotions, discounts, customer service, changes in product features, delivery dates, and other value-added factorsRevenue drivers in service firms focus on the quality of the service18-28Marketing Departments Marketing departments can be either a revenue or a cost Center:The revenue center responsibility stems from the fact that the marketing department manages the revenue-generating process and produces revenue reports for evaluationThis department can also be a cost center as it incurs two types of costs, order-getting (advertising and promotion) and order-filling (warehousing, packing, and shipping) costs18-29Profit CentersThe profit center manager’s goal is to earn profitsThree strategic issues cause firms to choose profit Centers rather than cost or revenue Centers:Profit Centers provide the incentive for the desired coordination among marketing, production, and support functionsProfit Centers motivate service department managers to consider their product as marketable to outside customersProfit Centers motivate managers to develop new ways to earn a profit from their products and services18-30SBUs: Two Different Strategic ContextsManufacturingPlantWarehouseSalesManufacturingPlantProfitCenterProfitCenterSalesCost CenterRevenue CenterCost Leadership StrategyDifferentiation Strategy18-31Contribution Income StatementA common form of profit center evaluation is the contribution income statement, which is based on the contribution margin developed for each profit center and for each relevant group of profit centersDetail of the statement varies based on management’s needsContribution by Profit Center (CPC) measures all costs traceable to, and therefore controllable by, the individual profit center, including traceable fixed costs18-32Controllable and Noncontrollable Fixed Costs Fixed costs can be either controllable or noncontrollable from the perspective of each profit Center:Controllable fixed costs are fixed costs that the profit center manager can influence in approximately a year or less, such as advertising, data processing, and management consulting expensesNoncontrollable fixed costs are those that are not controllable within a year’s time, such as depreciation and taxes18-33Profit Center Performance MeasurementSubtracting controllable fixed costs from the contribution margin results in the center’s controllable marginThe contribution margin income statement can also be used to help determine whether a profit center should be dropped or retainedOne complication in the preparation of this statement is that some costs that are not traceable at a detailed level are traceable at a higher level18-34Contribution Income Statement ExampleThe Contribution Income Statement shows the CPC for both Divisions is positive, and when Division B is partitioned into its three product lines, Products 1 and 2 are shown as profitable, while Product 3 has a CPC loss of $70.18-35Contribution Income Statement Example: ContinuedPositive values for CPC mean that the profit center (division or product line) is covering all of its traceable costs, both variable and fixed; since a portion of the fixed costs are not controllable (but traceable), CPC is a useful measure of the economic performance of the profit center and a useful measure of the long-term performance of the manager. To evaluate the short term, controllable performance of the manager, controllable margin is preferred since it excludes non-controllable fixed costs. 18-36Contribution Income Statement Example: ContinuedTo assess whether a profit center should be retained or deleted, the value of the contribution margin, if positive, shows the short-term loss of dropping the unit (dropping product 3 means a loss of $50,000)The controllable margin, if positive, shows the longer-term (approximately a year) effect on total firm profits of dropping the unit (dropping product three means a loss of $50,000)The CPC of the unit, because it includes non-controllable fixed costs, represents the long-term (up to several years) profitability of the unit (dropping product 3 would save $70,000 in the long-term)18-37Variable vs. Full CostingThe use of the contribution income statement is often called variable costing because it separates variable and fixed costsFull costing is the conventional costing system that includes fixed manufacturing cost as part of product costFull costing, also called absorption costing, is required by GAAP for financial reporting and by the IRS for computing taxable incomeFull costing satisfies the matching principle while variable costing meets the three objectives of management control systems18-38Variable CostingThe reasons for using variable costing include better planning and decision making (Chapters 9-11), and also improved performance measurement: Although net income determined using full costing is affected by changes in inventory levels, net income using variable costing is not affected -- under variable costing, fixed manufacturing costs are treated as period costs, not product (inventoriable) costsThe following example compares the two costing methods over two periods, one with increasing inventory and the other with decreasing inventory18-39Variable vs. Full Costing Example$4000/100 units = $40 fixed manufacturing cost per unit Inventory increased by 40 unitsInventory decreased by 40 units18-40Variable vs. Full Costing Example (continued)Difference in Ending Inventory$2,800 - $1,200 = $1,600Difference in Income$300 – ($1,300) = $1,60018-41Variable vs. Full Costing Example (continued)Difference in Beginning Inventory$2,800 - $1,200 = $1,600Difference in Income$2,300 - $3,900 = $1,60018-42Variable vs. Full Costing Summary AnalysisFull costing net income exceeds variable costing net income by the amount of fixed cost in the inventory change when inventory increases, and variable costing net income is higher than full-costing net income when inventory decreasesVariable costing is not affected by the change in inventory because all fixed costs are deducted from income in the period in which they occur; fixed costs are not included in inventory so that changes in inventory levels do not affect net income18-43Contribution Income Statement and International Accounting StandardsThroughout the world, 125 countries use International Financial Reporting Standards (IFRS) developed by the International Accounting Standards Board (IASB)IFRS are different from U.S. GAAP, though the SEC and IASB are working on the convergence of the two sets of standardsBenefits of a worldwide set of financial reporting standards include:U.S. companies with foreign units will have an easier time preparing consolidated financial reportsPerformance measurement for managers of foreign units will benefit from greater consistency18-44The Contribution Income Statement and Value StreamsIn applications of lean accounting, products and services are collected into groups called value streams. The value stream income statement shows the contribution of each of the organization’s value streams in much the same way as the contribution income statement; each value stream is a profit center.A unique feature of the value stream income statement is that it shows separately the gain (or loss) associated with an increase (or decrease) in inventory, as determined by a comparison of full vs variable costing 18-45Strategic Performance Measurement and the Balanced Scorecard (BSC)The BSC measures SBU performance in four key perspectives:Customer satisfactionFinancial performanceInternal business processesLearning and innovationCost, revenue, and profit Centers focus on the financial dimension18-46Strategic Performance Measurement and the Balanced Scorecard (BSC): ContinuedThe BSC is an important performance measurement method because it aligns manager’s performance with the organization’s strategic goals – financial, customer, internal process, and learning and innovation. The BSC is particularly important in difficult economic times, when traditional profit-based measures may be distorted and difficult to benchmark against established benchmarks such as prior year earnings, industry earnings, and competitors’ earnings. 18-47The Balanced Scorecard (BSC): Implementation Issues There are implementation issues when using the BSC in performance measurement:BSC measures are often difficult to compare across SBUs, and are used only to compare the unit to prior periodsThe BSC is often used in evaluation but less often in compensation, and the two need to be linkedValidation is needed of the links between measures that are assumed to improve performance and actual performance Managers must provide information on the strategic linkages in the strategy map18-48The Balanced Scorecard (BSC): Implementation Issues (continued)Many large firms have installed enterprise resource planning systems (ERPs) to collect BSC information, but firms lacking such a system may have trouble collecting the necessary dataThe nonfinancial information used in the BSC is not subject to control or audit and may be unreliable or inaccurateNonfinancial information is often prepared on a weekly or daily basis while performance reviews are generally conducted quarterly or annuallyConcern arises related to the timeliness and reliability of nonfinancial data prepared by external sources18-49Managements Control in Service Firms and Not-for-Profit OrganizationsService firms and not-for-profit organizations commonly use cost centers and/or profit centersCost centers are used when the manager’s critical mission is to control costsProfit centers are preferred when the department manager must manage both costs and revenues, or alternatively (in a not-for-profit), manage costs without exceeding budgeted revenues18-50There are formal, informal, team, and individual management control systemsThe objectives of management control are to:Motivate managers to exert a high level of effort to achieve the goals set by top managementProvide the right incentive for managers to make decisi