Solution manual cost accounting 8th by kinney chapter 14

What are the common short-term financial performance measures, and how are they calculated and used?. Terminology Asset turnover: a ratio that measures asset productivity and shows the n

Learning Objectives

After reading and studying Chapter 14, you should be able to answer the following questions:

1 Why is a mission statement important to an organization?

2 What roles do performance measures serve in organizations?

3 What guidelines or criteria apply to the design of performance measures?

4 What are the common short-term financial performance measures, and how are they calculated and used?

5 Why should company management focus on long-run performance?

6 What factors should managers consider when selecting nonfinancial performance measures?

7 Why is it necessary to use multiple performance measures?

8 How can a balanced scorecard be used to measure performance?

9 What is compensation strategy, and what factors must be considered in designing the

compensation strategy?

10 What difficulties are encountered in trying to measure performance and design compensation plans for multinational firms?

PERFORMANCE MEASUREMENT, BALANCED SCORECARDS, AND PERFORMANCE REWARDS

CHAPTER

14

Terminology Asset turnover: a ratio that measures asset productivity and shows the number of sales dollars

generated by each dollar of assets

Compensation strategy: a foundation for the compensation plan that addresses the role compensation

should play in the firm

Du Pont model: a model that computes the return on investment as the product of two variables: profit

margin and asset turnover

Economic value added (EVA): conceptually similar to residual income, EVA is a measure of the profit

produced above the cost of capital

Employee Stock Ownership Plan (ESOP): a profit sharing compensation program in which investments

are made in the securities of the employer

Expatriates: parent companies or third-country nationals assigned to a foreign subsidiary or foreign

nationals assigned to the parent company

Lagging indicator: measures or reflections of past decisions

Leading indicator: statistical data about the actionable steps that will create desired results in the future Process productivity: total units produced during a period divided by value-added processing time Process quality yield: the proportion of good units that results from the activities expended

Profit margin: the ratio of income to sales, and an indicator of what proportion of each sales dollar is not

used for expenses

Residual income (RI): profit earned that exceeds an amount charged for funds committed to an

investment center

Return on investment (ROI): a ratio that relates income generated by the investment center to the

resources (or asset base) used to produce that income

Tax-deferral: taxation of current compensation that occurs at a future date rather than currently

Tax-exemption: an item of current compensation that is never subjected to income taxation, in other

words, such income is exempt from taxation

Throughput: the number of good units or quantity of services produced and sold by an organization

during a time period

Values Statement: a statement that reflects the organization’s culture by identifying fundamental beliefs

about what is important to the organization

Lecture Outline LO.1: Why is a mission statement important to an organization?

A Introduction

1 Historically, managers focused almost exclusively on short-run financial performance measures and ignored the long-run and critical nonfinancial activities because managers were commonly judged on a short-term basis and long-run and non-financial performance data were often

unavailable

2 Because many of the recent accounting scandals resulted from intense pressure on managers to achieve short-term performance targets, more managers are beginning to recognize the need for

a longer horizon to gauge performance

3 An organization’s performance evaluation and reward systems are key tools for aligning the efforts and goals of workers, managers, and owners

4 This chapter discusses one of the most important ways of motivating employees to maximize stockholder wealth: the design and implementation of effective employee performance

measurement and reward systems

B Organization Mission Statements

1 Management must conduct the affairs of the company in such a way that both the short-term and long-term needs of the firm are met

2 The mission statement expresses a company’s purpose with regard to how it will meet its

targeted customers’ needs through its products or services

3 A Values Statement reflects the organization’s culture by identifying fundamental beliefs about

what is important to the organization

a Such values may be either objective or subjective Examples include safety of employees, customer orientation, ethical behavior, respect for individuals, and environmental concerns

4 Mission and values statements are two of the underlying bases for setting organizational goals and objectives

a Goals are abstract targets to be achieved

b Objectives are quantified targets with expected completion dates

c Goals and objectives can be short term or long term but they are inexorably linked

i Long-term success cannot be achieved without short-term success along the way

ii Without long-term planning, short-run success will rapidly fade

LO.2: What roles do performance measures serve in organizations?

C Organizational Roles of Performance Measures

1 Managers design and implement strategies that apply organizational resources to activities in fulfilling organizational missions

a Management talent and time are dedicated to planning, decision making, controlling, and evaluating performance with respect to these activities

b The intent in these managerial processes is for management to implement actions that maximize efficiency and effectiveness of resources used

c Managers must devise appropriate information systems to track resource applications

d Management resources can be gauged effectively and efficiently only if the terms ―effective‖ and ―efficient‖ can be defined, and measures that are consistent with the definitions can be formulated

e As indicated in text Exhibit 14–1, performance measures should exist for all elements that

are critical to an organization’s success in a competitive market

2 Internal Performance Measures

a Internal process measures must reflect concern for streamlined production, high quality, and minimization of product complexity

b Products and services compete with others on the dimensions of price, quality, and product features so superior performance in any of these three areas can provide the competitive advantage needed for success

c Developing performance measures for each competitive dimension can identify alternative ways to leverage a firm’s competencies

d Employee performance is also a critical element of organizational success Internal

performance measures are used to communicate organizational mission, goals, and

strategies and to motivate subordinates to strive to accomplish the stated targets

e Measures are also used to implement organizational control over activities such as

comparing actual to budgeted results in responsibility accounting reports

f Performance measures also compare individuals’ work to make judgments about promotions and retention A firm searching for new ways to provide customers with more value at less cost must develop an organizational culture that promotes employee learning, job

satisfaction, and production efficiency

3 External Performance Measures

a Externally, performance measures must reflect an organization’s ability to satisfy its

customers

b Meeting or exceeding the performance targets set for customers should result in the

increased likelihood of meeting or exceeding the performance targets set for investors and creditors

c The most common performance measure used for all organizations is profit, which can be measured as operating income or net income

d Generally accepted accounting principles are formulated to provide information that is

comparable across firms which facilitates investor/creditor judgments about which firms deserve capital investments and which firms can provide acceptable returns

e Financial performance measures typically determine whether top management is retained or dismissed

i Meeting or exceeding the market’s expectations of performance should create the capital inflows that will result in improved processes, more qualified employees, and more satisfied customers

ii Recent accounting scandals in the business community should remind management that

―good‖ financial performance should not be sought by improper accounting—whether by

―managing‖ either revenues or expenses

LO.3: What guidelines or criteria apply to the design of performance measures?

D Designing a Performance Measurement System

1 Managers will focus on the things by which they are measured

a The critical question to address in evaluating a performance evaluation measure is: What managerial actions will this performance measurement encourage?

b The performance measurement system should be designed to encourage behaviors that will result in outcomes that generate organizational success

2 General Criteria

a As illustrated in text Exhibit 14-2, five general criteria should be considered in designing a

performance measurement system:

i the measures should be established to assess progress toward organizational goals and objectives;

ii the individuals being evaluated should be aware of the measurements to be used and have had some input in developing them;

iii the individuals being evaluated should have the appropriate skills, equipment,

information, and authority to be successful under the measurement system;

iv feedback of accomplishment should be provided in a timely and useful manner; and

v the system should be flexible to adapt to new conditions in the organizational

environment

3 Assess Progress Towards Mission

a Organizations have a variety of objectives, including the need to be financially viable

b In addition to financial success, many companies are now establishing operational targets of total customer satisfaction, zero defects, minimal lead time to market, and environmental and social responsibility

c Nonfinancial performance measures that indicate progress—or lack thereof—toward the achievement of a world-class company’s critical success factors must also be developed

4 Awareness of and Participation in Performance Measures

a Top management must set high performance standards and communicate them to level managers and employees, and the measures should promote harmonious operations among organizational units

lower-b Because people will usually act specifically in accordance with the way they are measured, they must be aware of and understand the performance measures being used

c Employees will not be able to perform at their highest level of potential if measurement information is withheld from them, and such a practice will not foster feelings of mutual respect and cooperation

d Participation in setting performance standards results in a social contract between

participants and evaluators

i Participation generates an understanding and acceptance of the reasonableness of the standards or budget

ii People who have participated in setting targets generally work hard to achieve the results

to affirm that the plans were well founded

5 Appropriate Tools for Performance

a For performance measures to be fair, people must first possess or obtain the appropriate skills for their jobs

i Competent people must then be given the necessary tools (equipment, information, and authority) to perform their jobs in a fashion consistent with the measurement process

ii People cannot be expected to accomplish their tasks if the appropriate tools are

unavailable

b Since upper-level managers in decentralized firms have little opportunity to observe the actions of subordinates, they must make evaluations based on the outcomes that are

captured by performance measures

i This fact makes it imperative that the performance measures selected be those that are highly correlated with the subunit mission, reflect fair and completely the subunit manager’s performance, and measure performance dimensions that are under the subunit manager’s control

c To evaluate performance, benchmarks must be established against which accomplishments can be measured

i Benchmarks can be monetary (such as standard costs or budget appropriation amounts)

or nonmonetary (such as zero defects or another organization’s market share)

6 Need for Feedback

a Performance should be monitored and feedback (both positive and negative) should be provided on a continuing basis to the appropriate individuals

b In addition to annual evaluations, feedback on performance should be provided periodically during the year so that employees are aware of how they are doing, have ample opportunities

to maximize positive results and correct negative results, and are not negatively ―blindsided‖ during their performance reviews

c The ultimate feedback is that organizational stakeholders exhibit belief in the firm’s viability The primary determinant of this belief is typically provided by short-run financial performance measures

LO.4: What are the common short-term financial performance measures, and how are they

calculated and used?

E Short-Term Financial Performance Measures for Management

1 A traditional focus of performance measurement at the managerial level is on financial aspects of operations, concentrating on monetary measures such as profits, achievement of and variations from budget objectives, and cash flow

2 The type of responsibility center being evaluated affects the performance measure(s) used since managers should only be evaluated using performance measures relating to their authority and responsibility

a In a cost center, the primary financial performance measurements are the variances from budgeted or standard costs

b Performance can be judged in a pure revenue center primarily by comparing budgeted to actual revenues

c Profit and investment center managers are responsible for both revenues and expenses; therefore, other performance measures can be used in addition to the measures used by cost and revenue centers

ii Replacement of workers who have resigned or been dismissed can be deferred to minimize salary expense for the period

iii Routine maintenance can be delayed or eliminated to reduce perceived expenses in the short run

iv If fixed overhead is being allocated to inventory, production can be increased so that cost per unit declines

v Sales recognition can be delayed or accelerated

vi Advertising expenses or other discretionary costs can be delayed or accelerated

vii Depreciation methods can be changed to affect depreciation expense

4 Cash Flow

a To succeed, an entity or an investment center must meet two requirements: long-run

profitability and continuous liquidity

b The Statement of Cash Flows (SCF) provides information about the cash impacts of the three major categories of business activities: operating, investing, and financing

i The SCF explains the change in cash balance by indicating the sources and uses of cash; such knowledge can assist managers in judging the entity’s ability to meet current fixed cash outflow commitments, to adapt to adverse changes in business conditions, and to undertake new commitments

ii The SCF assists managers in judging the quality of the entity’s earnings by identifying the relationships between segment margin (or net income) and net cash flow from operating activities

iii Analysis of the SCF in conjunction with budgets and other financial reports provides information on cost reductions, collection policies, dividend payout, impact of capital projects on total cash flows, and liquidity position

c Many cash flow ratios (such as the current ratio, quick ratio, and number of days’ collections

in accounts receivable) are available to assist managers in conducting their responsibilities effectively

5 Return on Investment

a Return on investment (ROI) is a ratio that relates income generated by the investment

center to the resources (or asset base) used to produce that income The ROI formula is: ROI = Income ÷ Assets Invested

Both terms in the formula must be specifically defined before the ROI calculation can be used effectively as a performance measure to evaluate an investment center and to make

intracompany, intercompany, and multinational comparisons

i See text Exhibit 14-3 for alternative definitions and preferred definitions

ii Text Exhibit 14-4 provides data for an example company, Nationwide Services, that is

used to illustrate return on investment computations

iii Text Exhibit 14-5 provides the return on investment rates using a variety of bases for the

example company

b The Du Pont model is a model that indicates the return on investment as it is affected by

profit margin and asset turnover

ROI = Profit Margin x Asset Turnover

= (Income ÷ Sales) x (Sales ÷ Assets Invested)

c Profit margin is the ratio of income to sales and indicates what proportion of each sales

dollar is not used for expenses and, thus, becomes profit

d Asset turnover is a ratio that measures asset productivity and shows the number of sales

dollars generated by each dollar of assets

e Text Exhibit 14-6 shows the calculations of the ROI components for each of the example

company’s investment centers using segment margin and total historical cost as the income and asset base definitions

i Segment margin is preferred to operating income in the ROI computation if the

investment center manager does not have control in the short run over unavoidable fixed expenses and allocated corporate costs

f Sales prices, volume and mix of products sold, expenses, and capital asset acquisitions and dispositions affect ROI

i Return on investment can be increased through various management actions including (1) raising sales prices if demand will not be impaired, (2) decreasing expenses, and (3) decreasing dollars invested in assets, especially nonproductive ones

g Profit margin, asset turnover, and return on investment can be assessed as favorable or unfavorable only if each component is compared with a valid benchmark such as expected results, prior results, or results of other similar entities

6 Residual Income

a Residual income (RI) is the profit earned that exceeds an amount ―charged‖ for funds

committed to an investment center The RI calculation is:

Residual Income = Income – (Target Rate x Asset Base)

b Text Exhibit 14-7 illustrates the calculation of RI for each of the example company’s

investment centers

i The ―charged‖ amount is equal to a specified target rate of return multiplied by the asset base and is comparable to an imputed interest rate of interest on the divisional assets used; such rate can be changed from period to period consistent with market rate fluctuations or to compensate for risk

ii Residual income yields a dollar figure rather than a percentage

iii Expansion (or additional asset investments) should occur in an investment center if positive residual income is expected on the dollars of additional investment

c One difficulty in using RI as a performance measure is that it is hard to make valid

comparisons among divisions of various sizes

7 Economic Value Added (EVA)

a One of the most well-known measures that has been developed to directly align the interests

of common shareholders with managers’ is economic value added (EVA®) Conceptually

similar to RI, EVA is a measure of the profit produced above the cost of capital

b However, EVA applies the target rate of return to the market value of the capital invested in the division rather than the book value of assets used for RI

c The EVA calculation is as follows:

EVA = After-Tax Profits – (Cost of Capital % x Market Value of Invested Capital)

d Text Exhibit 14-8 presents the EVA computations for the example company

e As the difference between the market value of invested capital (total equity and bearing debt) and the book value of assets increases, so do the relative benefits of using EVA rather than RI as a performance measure

interest-f Despite its growing popularity, EVA cannot measure all dimensions of performance and is short-term focused

i Accordingly, the EVA measure can discourage investment in long-term projects because such investments cause an immediate increase in the amount of invested capital but increase after-tax profits only at some future point

ii For greatest benefit, EVA should be supplemented with longer term financial and

nonfinancial performance measures

8 Limitations of ROI, RI, and EVA

a Income can be manipulated on a short-run basis and does not consider cash flows or the time value of money

b Asset investment is difficult to properly measure and assign to center managers since assets are acquired at different times and are subject to price-level changes

c Since ROI and RI both focus attention on how well an investment center itself performs in isolation, rather than how well that center performs in relation to company-wide objectives, suboptimization of resources can result

LO.5: Why should company management focus on long-run performance?

F Differences in Perspectives

1 Financial measures are lagging indicators, or reflections of the results of past decisions

2 Measurements for improving performance should involve tracking leading indicators or

statistical data about the actionable steps that will create the results desired

3 As presented in text Exhibit 14–9, leading indicators reflect causes and lagging indicators reflect

effects or outcomes

4 Managing for the long run has commonly been viewed as managing a series of short runs Although appealing, this approach fails when the firm does not keep pace with long-range

technical and competitive improvement trends

a Thinking only of short-run performance and ignoring the time required to make long-term improvements can doom a firm in the global competitive environment

b Short-run objectives generally reflect a focus on the effective and efficient management of current operating, investing, and financing activities

c A firm’s long-term objectives generally involve resource investments and proactive efforts to enhance competitive position, such as customer satisfaction issues of quality, delivery, price, and service

d Because competitive position results from the interaction of a variety of factors, a firm must identify the most important drivers (not just predictors) of the achievement of a particular long-run objective

e The true drivers of increased market share for a firm are likely to be product and service quality, speed of delivery, and reputation relative to competitors Measurements of success

in these areas would be leading indicators of increased market share and profitability

LO.6: What factors should managers consider when selecting nonfinancial performance

measures?

G Nonfinancial Performance Measures

1 Managerial performance can be evaluated using both qualitative and quantitative measures; qualitative measures are often subjective

2 Managers are usually more comfortable with and respond better to quantitative measures of performance since such measures provide a defined target at which to aim Quantifiable

performance measures are of two types: nonfinancial and financial

3 Selection of Nonfinancial Measures

a Nonfinancial performance measures (NFPMs) are based on nonmonetary details, such as time (e.g., manufacturing cycle time or setup time), quantities (e.g., number of patents

generated or pounds of material moved), and ratios (e.g., percentage of good units to total units produced or percentage of sales generated by repeat customers)

b Appropriate nonfinancial metrics are those that can be clearly articulated and defined, are relevant to the performance objective, can trace responsibility, rely on valid data, have target objectives, and have established internal and/or external benchmarks

c As indicated in text Exhibit 14–10, NFPMs have many distinct advantages over financial

performance measures