MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES for PERFORMANCE MEASUREMENT

RESPONSIBILITY ACCOUNTING

RESPONSIBILITY ACCOUNTING – a system of accounting wherein costs and revenues

are accumulated and reported by levels of responsibility or by responsibility
centers within the organization.

Responsibility center (also called accountability center)

– a clearly identified part or segment of an organization that is

accountable for a specified function or set of activities.
– any part of the organization that a particular manager is responsible for

TYPES OF RESPONSIBILITY CENTERS:

a. Cost Center (or expense center) – a segment of an organization in which

managers are held responsible for the costs or expenses incurred in the segment.

b. Revenue Center – where management is responsible primarily for revenues.

c. Profit Center – a segment of the organization in which the manager is held

responsible for both revenues and costs.

d. Investment Center – a segment of the organization where the manager controls

revenues, costs, and investments. The center’s performance is measured in terms
of the use of the assets as well as the revenues earned and the costs incurred.

CLASSIFICATIONS OF COSTS IN RESPONSIBILITY ACCOUNTING

1. By responsibility center

2. By cost type, as to controllability

3. By specific cost items or cost elements within each classification in (1)

and (2).

RESPONSIBILITY vs. ACCOUNTABILITY

Responsibility has two facets, (1) the obligation to secure results, and (2)
the obligation to report back the results achieved to higher authority.

Accountability denotes the obligation to report results achieved to higher

authority.

THE CONCEPT OF DECENTRALIZATION

Decentralization refers to the separation or division of the organization into

more manageable units wherein each unit is managed by an individual who is given
decision authority and held accountable for his decisions.

• Goal congruence – all members of an organization have incentives to perform

for a common interest.

• Sub-optimization – occurs when one segment of a company takes action that is

in its own best interests, but is detrimental to the firm as a whole.
BENEFITS OF DECENTRALIZATION

1. Better access to local information

2. Cognitive limitations

3. More timely response

4. Focusing of central management

5. Training and evaluation

6. Motivation

7. Enhanced competition.

COSTS OF DECENTRALIZATION

1. Some decisions made in one sub-unit may bring about negative effect to the
other sub-units or the organization as a whole.

2. Decentralization necessitates a more elaborate reporting system hence, the

costs of gathering and reporting of data increase.

3. Job duplication or overlapping of functions is usually encountered in a

decentralized set-up.

MEASURING THE PERFORMANCE OF INVESTMENT CENTERS

Performance measures for investment centers usually attempt to assess how well
managers are utilizing invested assets of the division to produce profits by
relating operating profits to assets.

Return on investment (ROI) is the most common measure of performance for

investment centers. ROI can be defined as follows:

ROI = Operating Income

Average Operating Assets

Operating income refers to earnings before interest and taxes. Operating assets
include all assets acquired to generate operating income, including cash,
receivables, inventories, land, buildings, and equipment.

The ROI formula can also be broken down into the product of margin and turnover.
Margin is the ratio of operating income to sales. Turnover is defined as
sales divided by average operating assets.

ROI = Margin x Turnover

or

ROI = Operating Income x Sales

Sales Average Operating Assets

Three advantages of using ROI to evaluate the performance of investment centers:

1. It encourages managers to pay careful attention to the relationships among

sales, expenses, and investment, as should be the case for a manager of an
investment center.

2. It encourages cost efficiency.

3. It discourages excessive investment in operating assets.

Two disadvantages of using ROI are:

1. It discourages managers from investing in projects that would decrease the

divisional ROI but would increase the profitability of the company as a whole.
(Generally, projects with an ROI less than a division’s current ROI would be
rejected.)

2. It can encourage myopic behavior, in that managers may focus on the short
run at the expense of the long run.

Residual income (RI) - the difference between operating income and the minimum
peso return required on a company’s operating assets. The equation for RI can
be expressed as follows:

RI = Operating Income - (Minimum Rate of Return x Operating Assets)

ECONOMIC VALUE ADDED (EVA) – a more specific version of residual income. It

represents the segment’s true economic profit because it measures the benefit
obtained by using resources in a particular way.

After-tax operating income

(EBIT x[1 – Tax Rate]) xx
Less desired income
(After-tax WACC* x [Total assets – Current liabilities]) xx
Economic Value Added (EVA) xx

* WACC = Weighted average cost of capital

TRANSFER PRICING

TRANSFER PRICE – the monetary value or the price charged by one segment of a
firm for the goods and services it supplies to another segment of the same firm.

OBJECTIVES OF TRANSFER PRICING

1. To facilitate optimal decision-making.

2. To provide a basis in measuring divisional performance.

3. To motivate the different department heads in improving their performance

and that of their departments.

APPROACHES FOR DETERMINING TRANSFER PRICE:

1. Negotiated transfer price

2. Cost-based transfer price

3. Market-based transfer price

General Rules in Choosing a Transfer Price

• The maximum price should be no greater than the lowest market price at which
the buying segment can acquire the goods or services externally.

• The minimum price should be no less than the sum of the selling segment’s
incremental costs associated with the goods or services plus the opportunity
cost of the facilities used.

• A good should be transferred internally whenever the minimum transfer price

(set by the selling division) is less than the maximum transfer price (set by
the buying division). By using this rule, total profits of the firm are not
decreased by an internal transfer.

THE BALANCED SCORECARD: STRATEGIC-BASED CONTROL

The Balanced Scorecard is a strategic management system that defines a

strategic-based responsibility accounting system.

Strategy is defined as choosing the market and customer segments the business
unit intends to serve, identifying the critical internal and business processes
that the unit must excel at to deliver the value propositions to customers in
the targeted market segments, and selecting the individual and organizational
capabilities required for the internal, customer, and financial objectives.

The Balanced Scorecard translates an organization’s mission and strategy into

operational objectives and performance measures for four different
perspectives: the financial perspective, the customer perspective, the internal
business process perspective, and the learning and growth (infrastructure)
perspective.

Common characteristics of balanced scorecards

a. It should be possible, by examining a company’s balanced scorecard, to infer

its strategy and the

assumptions underlying that strategy.

b. The balanced scorecard should emphasize continuous improvement rather than

just meeting present standards or targets.

c. Some of the performance measures on the balanced scorecard should be non-

financial.

d. The scorecards for individuals should contain only those performance measures
they can actually influence.

e. The ultimate objectives of the organization are usually financial, but better
financial results cannot be attained without improving customers’ perceptions
of the company’s products and services. In order to improve customers’
perceptions of products and services, it is usually necessary to improve
internal business processes so that the products and services are actually
better. And in order to improve the business processes, it is necessary that
employees learn.

The balanced scorecard as a motivation and feedback mechanism. The performance

measures on the balanced scorecard provide motivation and feedback for
improving.

The Financial Perspective

The financial perspective establishes the long- and short-term financial

performance objectives. The financial perspective is concerned with the global
financial consequences of the other three perspectives. Thus, the objectives
and measures of the other perspectives must be linked to the financial
objectives. The financial perspective has three strategic themes: revenue
growth, cost reduction, and asset utilization.
Customer Perspective

The customer perspective is the source of the revenue component for the
financial objectives. This perspective defines and selects the customer and
market segments in which the company chooses to compete.

Process Perspective

To provide the framework needed for this perspective, a process value chain is
defined. The process value chain is made up of three processes: the innovation
process, the operations process, and the post sales process.

Cycle time is the time required to produce one unit of product.

Velocity is the number of units that can be produced in a given period of

time (e.g., units per hour).

Learning/Innovation and Growth Perspective

The learning and growth perspective is the source of the capabilities that
enable the accomplishment of the other three perspectives’ objectives.

SOME INTERNAL BUSINESS PROCESS PERFORMANCE MEASURES

a. Delivery Cycle Time. This is the total elapsed time between when an order is
placed by a customer and when it is shipped to the customer. Part of this time
is wait time that occurs before the order is placed into production.

b. Throughput (Manufacturing Cycle) Time. This is the total elapsed time between
when an order is initiated into production and when it is shipped to the
customer. It consists of process time, inspection time, move time, and queue
time. The only element that adds value is processing time. Inspection time,
move time, queue time, and their associated activities do not add value and
should be minimized.

c. Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time

(i.e., process time) to total throughput time. It represents the percentage of
time an order is in production in which useful work is being done. The rest of
the time represents non-value-added time (i.e., inspection time, move time, and
queue time).

Manufacturing Cycle Efficiency (MCE) can be found as follows:

Processing time
MCE =
Processing time + Move Time + Inspection Time + Wait time

QUALITY COST MEASUREMENT:

Quality-linked activities are those activities performed because poor quality

may or does exist. Costs of quality are costs that exist because poor quality
may or does exist.

Control activities are performed by an organization to prevent or detect poor

quality. Control costs are the costs of performing control activities. There
are two broad categories of control costs: prevention costs and appraisal costs.
Prevention costs are incurred to prevent poor quality in the products or
services being produced. Appraisal costs are incurred to determine whether
products and services are conforming to their requirements or customer needs.

Failure activities are performed by an organization or its customers in response

to poor quality. Failure costs are the costs incurred by an organization because
failure activities are performed. There are two broad categories of failure
costs: internal failure costs and external failure costs. Internal failure costs
are incurred because products and services do not conform to specifications or
customer needs and the nonconformance is detected prior to being delivered to
outside parties. External failure costs are incurred because products or
services fail to conform to requirements or satisfy customer needs and the
nonconformance is detected after being delivered to outside parties.

PRODUCTIVITY MEASUREMENT

Productivity – measures the relationship between actual inputs used (both

quantities and costs) and actual outputs produced.

Partial productivity – compares the quantity of output produced with the

quantity of an individual input used.

Partial Productivity = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑖𝑛𝑝𝑢𝑡 𝑢𝑠𝑒𝑑

Total Factor Productivity – the ratio of quantity of output produced to the

costs of all inputs used based on current period prices.

Total factor productivity = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

𝐶𝑜𝑠𝑡𝑠 𝑜𝑓 𝑎𝑙𝑙 𝑖𝑛𝑝𝑢𝑡𝑠 𝑢𝑠𝑒𝑑