Management Control System
Group 8:
Muhammad Farhan (1910533018)
Muthia Putri Hefra (1910533011)
Mutiara Izzati Diva (1910533027)
Accounting Performance Measurement
1. Concept of performance measurement
2. Weaknesses of financial performance measurement
Summary Measures
Market measures Accounting-based Combinations of
measures measures
that reflect changes in defined in either combinations can
stock prices or residual terms or ratio involve either the use
shareholder returns terms of both summary
market and accounting
measures
If the market value changes are measured in terms of
recent transaction prices, as is
common, the market measures also have other
advantages.
▫ First, there is a feasibility constraint.
▫ Second, market measures present controllability
problems.
ACCOUNTING MEASURES OF PERFORMANCE
Accounting-based, summary or bottom-line performance measures come in
two basic forms: residual measures (or accounting profit measures), such as
net income, operating profit, earnings before interest, tax, depreciation, and
amortization (EBITDA), or residual income; and 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.
The Measurement Criteria
1. Timeliness, 2. Congruent 3. Controlled
precision, and
objectivity
4. Understandable 5. Inexpensive
Many things affect accounting profits but not economic profits, and vice versa.
1. transactions 2. choice of 3. conservatively
oriented measurement method biased
4. ignore some 5. ignores the costs of 6. ignores the cost of
economic values and investments in equity capital
value changes working capital
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
induces managers to reduce or postpone investments that promise payoffs in future measurement
periods, even when those investments clearly have a positive net present value. This is
investment myopia. Investment myopia stems directly from two of the problems with accounting
measures described above: their conservative bias and their ignoring of intangible assets with
predominantly future payoffs. Accounting rules do not allow firms to recognize gains until they
are realized; that is, until the critical income-producing activities (such as a sale) have taken
place and the earnings can be measured in an objective, verifiable way. On the other hand, the
rules require firms to begin recognizing costs when the investments are made.
RETURN-ON-INVESTMENT MEASURES OF PERFORMANCE
ROI measures are in widespread use because they provide some significant advantages.
First, they provide a single, comprehensive measure that reflects the tradeoffs
managers must make between revenues, costs, and investments.
Second, they provide a common denominator that can be used for comparing returns on
dissimilar businesses, such as divisions and outside competitors, or types of investments.
Third, because they are expressed in percentage terms, they give the impression that ROI figures
are comparable to other financial returns, such as those calculated for stocks and bonds, although
this impression is sometimes false (as is explained below). Finally, because ROI measures have
been in use for so long in so many places, virtually all managers understand both what the
measures reflect and how they can be influenced.
Formula chart showing
relationship of factors
RESIDUAL INCOME MEASURES AS A POSSIBLE SOLUTION
affecting ROI
TO THE ROI MEASUREMENT PROBLEMS
Such analyses might show that
a division’s actual ROI of 15%
was Planned ROI (20%) = profit as percent of
below the planned level of 20% sales (20%) × asset turnover (1.0)
even though sales profitability
Actual ROI (15%) = profit as percent of sales
(profit as a percent of sales)
(20%) × asset turnover (0.75)
was on plan but asset turnover
(sales divided by total
investment) was worse than
forecast:
RESIDUAL INCOME MEASURES AS A POSSIBLE SOLUTION
TO THE ROI MEASUREMENT PROBLEMS
Residual income also addresses the financing-type suboptimization problem. By considering the
cost of both debt and equity financing, residual income removes the managers’ temptations to
increase their entity’s leverage through debt financing to excessive levels.
Residual income does not address the distortions often caused when managers make
new investments in fixed assets, however. Many desirable investments initially reduce
residual income, but then the residual income increases over time as the fixed assets
get older.
THANKS!
