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I'm Larry Walther, this is principlesofaccounting.com Chapter 22.
And in this chapter we're looking at tools for enterprise performance evaluation.
Now, this chapter begins with concepts in responsibility accounting and
management by exception, which is a broad
overview of concepts related to enterprise performance evaluation.
By the end of the chapter, we're looking at variance analysis and
balance scorecard approaches to specifically give us tools for
executing on the evaluation of enterprise performance.
And so responsibility accounting beginning at this broad level
means that managers must be held accountable for
the results of their decisions and the related executions.
Performance feedback signals successes, failures, and
opportunities for improvement.
A manager's area of accountability should align with his or
her area of responsibility.
That area can be a department, product, plant, territory, or whatever.
Attribution of responsibility will usually mirror the firm organizational structure.
Furthering, there are different styles of management.
A centralized style where top leaders make and
direct most of the important decisions in the organization.
Lower-level personnel are looked to to execute on these directives and
are generally powerless to make independent policy decisions.
This provides strong coordination of purpose and methods, but
may lead to the stifling of lower level management talent,
suppression of innovation and reduction of employee morale,
two entirely different thoughts in terms of style of management.
The decentralized style is an attempt to respond to the criticisms of
the centralized style.
That is, top management focuses on strategy, day-to-day operation,
decision making task is left to lower level personnel.
This facilitates rapid front-line response to customer issues, provides for
identifying and training emerging managers.
May provide a fertile ground for cultivating new and improved products and
processes.
However, decision making a highly dispersed and
management performance can be difficult to judge in this environment.
The idea of a responsibility is that the part of an organization under the control
of a manager is their nexus of control or responsiblity area.
The assessment of how they're performing depends on the nature of that area
of responsibility.
Their cost centers incur cost but don't generate any revenue.
Accounting departments, legal departments, maintenance departments, and
so on, these are viewed as cost centers.
And the way we evaluate a cost center might be different than
the way we would evaluate, for example, a profit center.
Under a profit center, the manager controls both costs and revenue.
Cost overruns can be expected if it's coupled with an increase in revenue and
an increase in profitability.
So for a profit center, we're going to be looking at the bottom line of how
the management performs within that unit.
An investment center is a more comprehensive approach.
It's evaluated on costs,
profits in the amount of invested capital that was deployed to achieve the results.
So we have different types of activities and therefore we have different
methodologies for considering how they should be evaluated.
There is an important evaluative tool that's known as ROI or
return on investment.
It's used for evaluating investment centers.
It consists of two components, the margin and the turnover.
Together that reduces to a formula that we'll see is operating income divided by
average assets.
So let's look at a graphic of the ROI calculation.
We've got operating income divided by sales, that's simply our margin, or
our profit expressed as a percentage of sales.
And we've got our turnover, our sales divided by average assets that are in use.
If we multiply the margin times the turnover,
we get our rate of return on investment.
Algebraically, as we noted on the preceding slide,
this is essentially the operating income divided by our average asset.
It's the return on the assets we have deployed in the business.
In evaluating an investment center, you would want to look at margin, turnover and
the collective effect of that or the ROI, return on investment.
Recognize that one can effect or improve their ROI by increasing sales,
by reducing expenses, and/or by decreasing deployed assets.
So managers have a variety of tools to work with in terms of trying to improve
their performance under an ROI model.
This approach encourages a focus on increasing sales while controlling costs
and being mindful of the invested amount of assets in the business.
However, some profitable opportunities may be passed because managers
fear potential dilution of existing successful endeavors.
So, once again, every evaluative tool has to be considered very carefully in terms
of any potential negative effects that can be introduced inadvertently.
The concept of nexus of control,
as we move up the organizational chart within an organization, mid and
upper level managers assume broader levels of responsibility.
At higher steps, individual performance reports are combined to reveal the success
or failure of all activities beneath a particular manager.
And so when we look at an organizational chart, this illustration corresponds to
the book where we have a fast food restaurant chain.
We can see that some particular levels of management, such as the CEO and
the vice presidents, I've colored in green,
they may largely be evaluated as investment centers.
The yellow centers would be largely cost centers such as the food supervisor,
dishware supervisor or procurement manager.
And then the blue centers indicate profit centers, our individual store locations,
our store management, our catering management.
Many times managers, such as the vice president of operations,
they're evaluated both as a profit center and an investment center.
And so this is further discussed in the book, but you can see how
different levels of management may be evaluated for different purposes.
In any event, our reporting system, the company's accounting system, should
support preparation of an accounting report for each responsibility center.
This is essential to monitoring, controlling, and directing.
It generally results in a comparison of budget to actual results.
And as you would suspect, as we move up higher within the organization,
reports tend to include less detailed transaction-specific information and
more information about combined results.
And so here for Store A, this illustration is repeated in the textbook,
here's our actual results, not only in total dollars but in percentages of sales.
For example, hamburger sales were 40% of total sales.
We have our budgeted results.
You can see the variances.
The bottom line is here we sold less than we anticipated but
we also made more than we anticipated.
If you take time to drill down in this data what you'll discover is that
we didn't sell as high a proportion as hamburgers as we thought.
We sold more drinks and fries.
So total sales were down, but our drinks and
fries were our higher profit margin items, and actually caused our favorable overall
performance for that particular store location.
Remember, this individual store is a profit center, so
we can be pleased with the fact that they had profit margins that exceeded
expectations, despite the faltering overall sales.
Now, store location A will be rolled up higher.
The next step up the organizational chart is Senior Manager of Store Operations.
This person's job would be to identify underperforming stores and
take corrective actions.
Little time is spent on locations that are meeting or exceeding their profit goals.
And so here is a roll up so we've got store location A, but
we also have locations for B, C, and D and so forth.
And we can come up with the combined results of all stores, their total sales,
their variable expenses and their margins.
Importantly there are certain costs, common fixed costs in this case of 1.5
million that were not allocated to any particular store.
And so it's important that the higher levels of an organization at those common
costs get rolled into the equation.
It may not be unfair or
cause a mis-measurement of performance evaluation for any particular store.
But in evaluating the combined results for
all stores we cannot ignore those common fixed costs.
Once again, this will be rolled up higher into the organization.
So I say continuing up the organizational chart,
the Vice President of Operations will focus on summary data, from the stores,
from the catering, and from procuring management.
And so here is the stores from the preceding spreadsheet.
The results total sales for all stores, total variable expenses for all stores.
The traceable fixed costs for that unit are included there.
And we have the margin for the stores.
That was combined with catering and
procurement to come up with the combined results.
And again, we throw in common fixed costs that occur at that higher level
of corporate organization that are not pushed down.
And we've got an operations margin of 2,923,410.
The concept
of rolling out successfully individual units into higher levels of reporting such
as I've illustrated supports the concept of management by exception, that is we
enable management to focus on areas where corrective measures are necessary.
In preparing our performance reports, remember we had traceable fixed costs,
those would not exist if a unit under evaluation ceased to exist.
Those are ordinarily assigned or
captured in the performance report of that particular unit.
Common fixed costs support the operations of more than one unit, on a store by store
evaluation, we may not assign those costs to those individual locations, but they're
taken into account at the successively higher levels of an organization,
to the extent the unit manager's burdened with allocations of common costs,
poor signaling of performance can result.
In other words, we may have something that's contributing to overall
profitability, but not those common costs and so we want to be careful not to
burden that unit with those common costs and draw an incorrect conclusion
about whether that unit should be continued or changed, for example.
In closing this particular module, let me point out that many businesses have robust
accounting information systems or databases.
These provide accurate and real-time retrieval information.
They allow detailed mining of data that would not be possible from the static
reports that I've just illustrated.
For example, this company may want to know about
the corporate proportion of sales of hamburgers, fries and drinks.
That could be mined from a database where it would be a little harder to do by
looking at the static reports that we've illustrated in this chapter.
But clearly the concepts are the same, the results and objectives are the same.
It's just the speed to which information can be captured,
retrieved and refined to make more defined decision processes.
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