Which Management Control Practices?

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Mar 20, 2007
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3. Which management control practices, if followed, in performance measurement of investment centres are likely to induce goal congruence, in respect of following assets:
(i) Cash (ii) Receivables (iii) Inventories (iv) Idle (v) Intangible (vi) Leased

In some business units, the focus is on profit as measured by the difference between revenues and expenses. In other business units, profit is compared with the assets employed in earning it. We refer to the latter group of responsibility centers as investment centers.

Measuring Assets Employed
In deciding what investment base to use to evaluate investment center managers, headquarters asks two questions: First, what practices will induce business unit managers to use their assets most efficiently and to acquire the proper amount and kind of new assets? Presumably, when their profits are related to assets employed, business unit managers will try to improve their performance as measured in this way. \Senior management wants the actions that they take toward this end to be in the best interest of the whole corporation. Second, what practices best measure the performance of the unit as an economic entity?

Cash
Most companies control cash centrally because central control permits use of a smaller cash balance than would be the case if each business unit held the cash balances it needed to weather the unevenness of its cash inflows and outflows. Business unit cash balances may well be only the "float" between daily receipts and daily disbursements. Consequently, the actual cash balances at the business unit level tend to be much smaller than would be required if the business unit were an independent company. Many companies therefore use a formula to calculate the cash to be included in the investment base. For example, General Motors was reported to use 4.5 percent of annual sales; Du Pont was reported to use two months' costs of sales minus depreciation.
One reason to include cash at a higher amount than the balance carried by a business unit is that the higher amount is necessary to allow comparisons to outside companies. If only the actual cash were shown: by internal units would appear abnormally high and might mislead senior management.Some companies omit cash from the investment base. These companies reason that the amount of cash approximates the current liabilities; if this is so, the sum of accounts receivable and inventories will approximate the working capital.

Receivables
Business unit managers can influence the level of receivables, not only indirectly by their ability to generate sales, and directly, by establishing credit terms by approving individual credit accounts and credit limits, and by the collecting overdue amount. In the interest of simplicity, receivable included at the actual end-.of-period balances, although the average of intra period balances is conceptually a better measure of them should be related to profits.Whether to include accounts receivable at selling prices or at cost of goods sold is debatable. One could argue that the business unit's real investment in accounts receivable is only the cost of goods sold and that a satisfactory return on this investment is probably enough.
On the other hand, it is possible to argue that the business unit could reinvest the money collected from accounts receivable, and, therefore, accounts receivable should be included at selling prices. The usual practice is to take the simpler alternative-that is,receivables at the book amount, which is the selling price less an allowance for bad debts.If the business unit does not control credits and collections, receivables may be calculated on a formula basis. This formula should be consistent with the normal payment period-for example, 30 days' sales where payment is made 30 days after the shipment of goods.

Inventories
Inventories ordinarily are treated in a manner similar to receivables –that is they are often recorded at end-of-period amounts even though intra period averages would be preferable conceptually. If the company usesLIFO (last in first out) for financial accounting purposes, a different valuation method usually is used for business unit profit reporting because LIFO inventory balances tend to be unrealistically low in periods of inflation. In these circumstances, inventories should be valued at standard or average costs, and these same costs should be used to measure cost of sales on the business unit income statementIf work-in-process inventory is financed by advance payments or by progress payments from the customer,as is typically the case with goods that require a long manufacturing period, these payments either are subtracted from the gross inventory amounts or reported as liabilities.

For e.g.
with manufacturing periods a year or greater, Boeing received progress payments for its airplanes and recorded them as liabilities.Some companies subtract accounts payable from inventory on the grounds that accounts payable represent financing of part of the inventory by vendors, at zero cost to the business unit. The corporate capital required for inventories is only the difference between the gross inventory amount and accounts payable. If the business unit can influence the payment period allowed by vendors, then including accounts payable in the calculation encourages the manager to seek the most favorable terms. In times of high interest rates or credit stringency,managers might be encouraged to consider forgoing the cash discount to have, in effect, additional financing provided by vendors. On the other hand, delaying payments unduly to reduce net current assets may not be in the company's best interest since this may hurt its credit rating.

Leased Assets
Suppose the business unit whose financial statements are shown in Exhibit 1 (see page 21) sold its fixed assets for their book value of $300,000, returned the proceeds of the sale to corporate headquarters, and then leased back the assets at a rental rate of $60,000 per year. As Exhibit 2 (see page 21) shows, the business unit's income before taxes would decrease because the new rental expense would be higher than the depreciation charge that was eliminated.
Nevertheless, economic valued added would increase because the higher cost would be more than offset by the decrease in the capital charge. Because of this, business unit managers are induced to lease, rather than own, assets whenever the interest charge that is built into the rental cost is less than the capital charge that is applied to the business unit's investment base. (Here, as elsewhere, this generalization oversimplifies because, in the real world, the impact of income taxes must also be taken into account.)
Many leases are financing arrangements-that is, they provide an alternative way of getting to use assets that otherwise would be acquired by funds obtained from debt and equity financing. Financial leases (i.e., long-term leases equivalent to the present value of the stream of lease charges) are similar to debt and are so reported on the balance sheet. Financing decisions usually are made by corporate headquarters. For these reasons, restrictions usually are placed on the business unit manager's freedom to lease assets.

Idle Assets
If a business unit has idle asset that can be used by other units, the business unit may be permitted to exclude them from the investment base if it classifies them as available. The purpose of this permission is to encourage business unit managers to release under utilized assets to units that may have better use for them. However, if the fixed assets cannot be used by other units, permitting the business unit manager to remove them from the investment base could result in dysfunctional actions For example; it could encourage the business unit manager to idle partially utilized assets that are not earning a return equal to the business unit's profit objective. If there is no alternative use for the equipment, any contribution from this equipment will improve company profits.

Intangible Assets
Some companies tend to be R&D intensive (e.g., pharmaceutical firms such as Novartis spend huge amounts on developing new products); others tend to be marketing intensive (e.g., consumer products firms such as Unilever spend huge amounts on advertising).
There are advantages to capitalizing intangible assets such as R&D and marketing and then amortizing the mover a selected life. This method should change how the business unit manager views these expenditures. By accounting for these assets as long-term investments, the business unit manager will gain less short-term benefit from reducing out lays on such item. For instance, if R&D expenditures are expensed immediately, each dollar of R&D cut would be a dollar more in pretax profits.
On the other hand, if R&D costs are capitalized, each dollar cut will reduce the assets employed by a dollar;the capital charge is thus reduced only by one dollar times the cost of capital, which has a much smaller positive impact on economic valued added.
 
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