Week 10

Week 10
Chapter 23
Incentives for Responsibility
Centres
ROI
11

Big Picture
Activity-Based versus Strategic-Based Responsibility Accounting
33
Responsibility
Accounting
Financial-based
centers (Cost,
Revenue, Profit,
Investment)
Strategy-based
Responsibility accounting system translates
the strategy of the organization into
operational objectives and measures
Which one is bottom up/top down?
Activity-based
AB system adds a process perspective to the
financial perspective of the functional-based
responsibility accounting system.

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003
Big Idea
- 4 -

1. Size
- Large Manufacturing (ODM)
Firm (Fortune Ltd)
- Firm with many branches
(e.g. Yunhong group), countries
(e.g. MNC)
2. Competition
- Short life cycle (e.g. customers
buy new mobile phones every 6
months)
3. Environment
uncertainty
- Volatility
1. Automation
2. Aggregate knowledge
(e.g. ability to use an aggregate
measure like accounting to
capture knowledge, measure
performance)
3. Technology
(e.g. CCTV, RFID, Bar code)
Knowledge forces
(knowledge transfer
costs)
Decentralize
Give decision authority to
managers lower in your firm so
that you can do more.
Rewards
- Incentives
- Monetary
- Non-monetary
Measurement
- Financial measures
ROI
RI
EVA
Responsibility
Centers
- Activity based
- Strategy based
Accounting based
- Cost center
- Revenue center
- Profit center
- Investment center
Control costs
(agency costs)
(E.g. ABC Ltd)
Transfer pricing
- Goal congruence
- Management effort
- Subunit Performance evaluation
- Subunit autonomy
+
-
Why decentralize?
Why use responsibility
centers?
Why use transfer
pricing?
5
Decentralization and Control
-

Made in China 2025-Mission
• Gives manufacturing a makeover
• From “world’s factory” to “planet’s leading
manufacturing power” by 2025
• Elevate the perception of Chinese goods from “made
in China” to “innovated in China”
• Raising domestic content of core components and
materials to 40% by 2020 and 70% by 2025
• Set a target of SEI-related industries to account for
8% of the economy by 2015 and 15% by 2020
• Establish a 40 billion yuan (US$6.45 billion)
innovation fund to sponsor new business, supporting
the creation of manufacturing innovation centers 15
by 2020 and 40 by 2025
• Gives manufacturing a makeover
• From “world’s factory” to “planet’s leading
manufacturing power” by 2025
• Elevate the perception of Chinese goods from “made
in China” to “innovated in China”
• Raising domestic content of core components and
materials to 40% by 2020 and 70% by 2025
• Set a target of SEI-related industries to account for
8% of the economy by 2015 and 15% by 2020
• Establish a 40 billion yuan (US$6.45 billion)
innovation fund to sponsor new business, supporting
the creation of manufacturing innovation centers 15
by 2020 and 40 by 2025
www.Chinasourcingacademy.com

Made in China 2025 – Market Size 2020 2025
40% 50%
50% 70%
30% 40%
75% 90%
70% 80%

Made in China 2025-Opportunities
• Support for SMEs and strategic
emerging industries
• Leaner and greener
manufacturing
• Further ongoing anti-monopoly
efforts to eliminate access
barriers across sectors
• More fairness and transparency
• Promote innovation
• Initiate tax reform to reduce the
overall corporate tax burden
• Support for SMEs and strategic
emerging industries
• Leaner and greener
manufacturing
• Further ongoing anti-monopoly
efforts to eliminate access
barriers across sectors
• More fairness and transparency
• Promote innovation
• Initiate tax reform to reduce the
overall corporate tax burden
www.Chinasourcingacademy.com

Value Creation
Hoverboard
– https://www.youtube.com/watch?v=9FxvBFPTtWQ
Worlds first 3D printed car
– https://www.youtube.com/watch?v=iT9A0pBBL2A&list=PLRFN7d
Cubic
– https://www.youtube.com/watch?v=bhPCvwHnk_Q
Robotics
– https://www.youtube.com/watch?v=rVlhMGQgDkY
12

FRC
(Autonomy
KTC)
SRC
(Customer
WHY)
Management Control Systems

- 14 -
Financial Performance Measures
and Their effects – Three types of measures
2. Accounting
Measures
Summary
Measures
3. Combination
of measures
Non-financial
Measures
1. Market
Measures
1. Financial
Responsibility
Centers
(Wk 10)
2. Strategic
Responsibility
Centers
(Wk 5-9)

Summary measures
Summary, single-number, aggregate, bottom-line financial
measures of performance
Reflect the aggregate or bottom-line impacts of multiple
performance areas
– For example, accounting profits reflect the aggregate effects of
both revenue- and cost-related decisions
Two types
– Market measures
» Reflect changes in stock prices or shareholder returns
– Accounting measures
» Defined in either residual terms (net income after taxes, operating
profit, residual income, economic value added) or ratio terms (return
on investment, return on equity, return on net assets)

- 16 -
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.

- 17 -
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.

- 18 -
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.

- 19 -
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.

- 21 -
Example ...
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
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)
SBU Cash Receivables Inventories Fixed Assets Total Invest. Profit ROI
A $ 10 $ 20 $ 30 $ 60 $ 120 $ 24.0 20 %
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)
ROIRI
4% 10%
Residual Income allows for different
charges on different termed assets –
e.g., Current assets 4%, Fixed assets10%

- 22 -
Suboptimization ...
– ROI provides different incentives for investments
across business units
» SBU-manager will not invest if ...
» SBU-manager will invest if ...
» 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.
Corporate
Cost of
Capital
10%
IRR
of
Project
Business
Unit
ROI
20%
< <
Corporate
Cost of
Capital
10%
IRR
of
Project
Business
Unit
ROI
5%
> >

- 23 -
Suboptimization ...
Assume Corporate cost of capital = 10%
Investment of $10 to earn $1.10 per yearWorthwhile !
Base situation
Profit Before tax
Investment base
ROI
New situation
Profit before tax
Investment
ROI
Unit A
$ 24
$ 120
20 %
New situation
$ 25.1
$ 130
19.30 %
Unit C
$ 10.5
$ 105
10 %
New situation
$ 11.6
$ 115
10.08 %
Unit D
$ 3.8
$ 75
5 %
New situation
$ 4.9
$ 85
5,76%
“WRONG” “RIGHT”“RIGHT”
DOES NOT INVEST INVEST INVEST
Should invest b/c new investment is
greater than Corp Cost of Capital

- 24 -
Suboptimization ...
Assume Corporate cost of capital = 15%
Investment of $10 to earn $1.10 per yearNot worthwhile !
Base situation
Profit Before tax
Investment base
ROI
New situation
Profit before tax
Investment
ROI
Unit A
$ 24
$ 120
20 %
New situation
$ 25.1
$ 130
19.30 %
Unit C
$ 10.5
$ 105
10 %
New situation
$ 11.6
$ 115
10.08 %
Unit D
$ 3.8
$ 75
5 %
New situation
$ 4.9
$ 85
5,76%
“RIGHT” “WRONG”“WRONG”
DOES NOT INVEST INVEST INVEST
Should not invest b/c new investment
is less than Corp Cost of Capital

- 25 -
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 $1.10 per year.
Base situation
Profit Before tax
Investment base
RI
New situation
Profit before tax
Investment
RI
Unit A
$ 24
$ 120
$ 15.6
New situation
$ 25.1
$ 130
$ 15.7
(=25.1-(2.4+7.0)
Unit C
$ 10.5
$ 105
$ 5.7
New situation
$ 11.6
$ 115
$ 5.8
(=11.6-(3.8+2.0)
Unit D
$ 3.8
$ 75
($ 1.6)
New situation
$ 4.9
$ 85
($ 1.5)
(=4.9-(1.4+5.0)
INVEST INVESTINVEST
The adj for RI comprises
-$2.4 Current asset charge (4%*$60)
-$7 Fixed asset charge (10% *$70)

- 26 -
Residual Income (RI) allows managers 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.
Miscellaneous ...
The adj for RI comprises
-$2.4 CA charge (4%*$60)
-$7 FA charge (10% *$70)

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

- 28 -
SBU-managers are encouraged to retain
assets beyond their
optimal life and not to invest in new assets.
Because it immediately inflates the denominator
in the ROI equation
Corporate managers are induced to over-
allocate resources
to business units with older assets.
“Squeeze the Cash Cow and Feed the Dog”
Misleading performance signals ...

Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003 - 29 -
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.
Misleading performance signals ...

- 30 -
Economic Value Added (EVA) ...
Modified after-tax operating profit
– (total capital x weighted average cost of capital)
Similar to RI (=profit–capital charge), except for the
modifications (164 in total, as suggested by Stern
Stewart & Co)
» e.g., Capitalization and subsequent amortization of intangible
investments (e.g., in R&D, employee training, etc.);
Adding LIFO-reserves to correct for undervalued inventories;
etc.

Economic Value Added (EVA) ...

Financial Performance Measures
and Their effects – Three types of measures
2. Accounting
Measures
Summary
Measures
3. Combination
of measures
Non-financial
Measures
1. Market
Measures
1. Financial
Responsibility
Centers
(Wk 10)
2. Strategic
Responsibility
Centers
(Wk 5-9)

What is the return on investment
for the Denver Hotel?
Return on Investment
Denver Hotel: $240,000 Operating income
÷ $1,000,000 Total assets = 24%

The DuPont method of profitability analysis
recognizes that there are two basic
ingredients in profit making:
DuPont Method
1. Using assets to generate more revenues
2. Increasing income per dollar of revenues

DuPont Method
Investment turnover = Revenues ÷ Investment
Return on sales = Income ÷ Revenues
ROI = Return on sales × Investment turnover

DuPont Method
How can Relax Inns attain a 30% target
ROI for the Denver Hotel?
Present situation: Revenues ÷ Total assets
= $1,200,000 ÷ $1,000,000 = 1.20
Operating income ÷ Revenues
= $240,000 ÷ $1,200,000 = 0.20
1.20 × 0.20 = 24%

DuPont Method
Alternative A: Decrease assets, keeping
revenues and operating income per
dollar of revenue constant.
Revenues ÷ Total assets
= $1,200,000 ÷ $800,000 = 1.50
1.50 × 0.20 = 30%

DuPont Method
Alternative B: Increase revenues, keeping
assets and operating income per dollar
of revenues constant.
= $1,500,000 ÷ $1,000,000 = 1.50
1.50 × 0.20 = 30%
= $300,000 ÷ $1,500,000 = 0.20

DuPont Method
Alternative C: Decrease costs to increase
operating income per dollar of revenues,
keeping revenues and assets constant.
= $1,200,000 ÷ $1,000,000 = 1.20
1.20 × 0.25 = 30%
= $300,000 ÷ $1,200,000 = 0.25

Residual Income
Residual income (RI)
= Income
– (Required rate of return × Investment)
Assume that Relax Inns’ required
rate of return is 12%.
What is the residual income from the Denver hotel?

Residual Income
Denver Hotel:
Residual Income = $240,000 - ($1,000,000 X 12%)
= $120,000

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