Resume Chapter 10

Management Control System
Ivana Yustitia
Novegia Ferdini
Safira Yafiq Khairani – 1802112130
Resume Chapter 10
FINANCIAL PERFORMANCE MEASURES AND THEIR EFFECT
Accounting Measures of Performance
Most organizations have based their managers’ evaluations and rewards heavily on standard
accounting-based, summary financial measures. Accounting-based, summary or bottom-line
performance measures come in two basic forms:
(1) residual measures (or accounting profit measures), such as net income, operating profit,
earnings before interest, tax, depreciation and amortization (EBITDA), or residual income; and
(2) ratio measures (or accounting return measures), such as return on investment (ROI), return on
equity (ROE), return on net assets (RONA), or risk-adjusted return on capital (RAROC).
These measures are typically derived from the rules defined by standard setters for financial
reporting purposes.
Advantages of accounting measure of performance :
•Accounting profit and profit can be measured in a timely manner that is relatively precise and
objective, timeliness, precision, and objectivity are important for all critical measurement
qualities.
•Compared to other quantities, it can be measured precise and objective
•Accounting measures can usually be more controlled by the money manager evaluating
performance
•Accounting measurement is a measurement that can be understood. Accounting is a standard
course in every business school, and managers have used the measures for so long that they are
well familiar with what the measures represent and how they can be influenced.
Limitations:
•The accounting system is a transaction-oriented system. Accounting profit is primarily a

summation of the effects of the transactions that took place during a given period.
•Accounting profit depends on the method of measurement. Multiple measurement methods are
often available to account for identical economic events.
•Accounting profit is derived from measurement rules that are often conservatively biased.
Accounting rules require slow recognition of gains and revenues but quick recognition of
expenses and losses.
•Profit calculations ignore some economic values and value changes that accountants feel cannot
be measured accurately and objectively.
• profit reflects the cost of borrowed capital (through interest deductibility) but ignores the cost
of equity capital.
• Accounting profit ignores risk and changes in risk. Firms, or entities within firms, that have not
changed the pattern or timing of their expected future cash flows but have made the cash flows
more certain (less risky) have increased their economic value, and vice versa.
• Profit figures also focus on the past. Economic value is derived from future cash flows, and
there is no guarantee that past performance is a reliable indicator of future performance.
Investment and operating myopia

Accounting performance measures can cause managers to act myopically in making
either investing or operating decisions. Holding managers accountable for short-term profits or
returns may induce managers to reduce or postpone investments that promise payoffs in future
measurement periods, even when those investments have a positive net present value and meet
other criteria to make them worthwhile. This is called investment myopia.
Investment myopia can be sourced directly from two accounting measurement problems, namely
conservative bias and uncertainty over intangible assets. Whereas Operation Myopia which is
generally referred to as "Shipping bricks and other tricks" is a practice of increasing profits by
destroying goodwill
RETURN ON INVESTMENT (ROI) PERFORMANCE SIZE

Even though a divisional organization has the same concept as a decentralized
organization, it has a different meaning. The divisional organization consists of various
responsibility centers, the manager is responsible for profit or some form of accounting return on
investment (ROI). All organizations divisionalize their authority, at least to some degree in some
specific part of the operation. However, not all centralized organizations are are divided into
divisions.
Divisions provide several advantages, especially if the company is quite large and complex. One
of them, with the division, top-level managers can focus more on strategic decisions. In addition,
local managers also become experienced with their products and markets, make decisions faster
and rely on their own success to a more significant level.
ROI is the ratio of the accounting profit generated by the division divided by the investment in
the division. The ROI type of measurement is widely used because it provides several significant
advantages. First, they provide comprehensive measures that illustrate the tradeoffs to be made
between income, costs and investment. Second, they provide a divisor divister’s number that can
be used to compare returns on different businesses, such as outside divisions and competitors, or
investment types. Third, because they are expressed as a percentage, they give the impression
that ROI is comparable to other financial returns. Fourth, almost all managers understand what
ROI measures represent and how they can be affected.
Problems that can be caused by ROI
1. Management myopia. A narrow focus on ROI can lead division managers to make decisions to
improve division ROI even if the decisions are not in the best interests of the company.
2. Limited measurement tendency to cause sub-optimization. Measuring ROI can create

problems by encouraging managers to make investments that make their division look good even
if the investment is not in the best interest of the company.
The asset values reflected on the balance sheet do not always represent the economic value of the
assets available to managers for earning current returns. The assets were added to the business at
various times in the past, under varying market conditions and varying purchasing power of the
monetary unit. As such, the book values of the various assets accumulated over time on the
balance sheet may say little about the economic value of the assets. Nonetheless, many firms use
net book values (NBV) to compute divisional ROI. When NBV is used, ROI is usually
overstated.
A number of researchers and consultants have argued that the use of a residual income
measure can help overcome the suboptimization limitation of ROI. Residual income is calculated
by subtracting from profit a capital charge for the net assets tied up in the entity or division
(investment center). The capital is charged atna rate equal to the weighted average corporate cost
of capital. Conceptually, one could adjust the capital charge rate for each investment center’s
risk, thus making the performance measurement system consistent with the capital budgeting
system. If the residual income charge is made equal to the required corporate investment rate of
return, then the residual income measures give all division managers an equal incentive to invest,
thereby addressing the suboptimization problem inherent in ROI measures. Regardless of the
prevailing levels of return in each of the divisions, the division managers are motivated to invest
in all projects that promise internal rates of return higher than, or at least equal to, the corporate
cost of capital.
One consulting firm, Stern Stewart & Company, recommends a measure called Economic
Value Added (EVA™) that combines several of the modifications to the standard accounting
model in a residual income-type measure. The generic EVA formula is:
EVA = Modified Net Operating Profit After Tax − (Modified Total Capital × WACC)
The word “modified” refers to many adjustments to standard accounting treatments, such
as the capitalization and subsequent amortization of intangible investments such as for R&D,
employee training and advertising and the expensing of goodwill. Just which modifications
should be implemented in any given situation is subject to judgment. The weighted average cost
of capital reflects the weighted average cost of debt and equity financing.
EVA also has some other measurement limitations. It suffers from objectivity problems
as the EVA adjustments require considerable judgment. Managers therefore can bias EVA just as
they can accounting numbers. EVA also is probably not differentially affected by any of the
usual controllability problems. EVA, however, is more likely to create some additional
understandability problems, as the measures can be complex and are not as widely familiar.

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Management Control System

Accounting Measures of Performance

Advantages of accounting measure of performance :

•Compared to other quantities, it can be measured precise and objective

•The accounting system is a transaction-oriented system. Accounting profit is primarily a

Investment and operating myopia

RETURN ON INVESTMENT (ROI) PERFORMANCE SIZE

2. Limited measurement tendency to cause sub-optimization. Measuring ROI can create

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