Page 83 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes 4.9 Measuring and Controlling of Assets Employed

In deciding on the investment base to be used for evaluating managers of investment centers,
two pertinent questions are:

1. What practice will induce business managers to use their assets most efficiently and to
acquire the proper amount and kind of new assets so as to improve their performance in
terms of profits on capital employed?
2. What practices best measure the performance of the entity as an economic entity?
Cash: Most companies control cash centrally, because central control permits the use of a smaller
cash balance than would be the case if each business unit held cash balances sufficient to provide
the necessary buffer for the unevenness of cash inflows and cash outflows. Business unit cash
balances may be only “float” between daily receipts and daily disbursements. Consequently,
the actual cash balance at the business unit level tends to be much smaller than would be
required, if the business unit was an independent company. Many companies, therefore, calculate
the cash to be included in the investment base by means of a formula e.g. percent of annual sales,
percent of cost of sales minus depreciation, reason being to facilitate comparison with other
units or with outside companies.
Some companies exclude cash from the investment base on the theory that investment base
consists of working capital plus fixed assets, and cash approximates current liabilities; and if this
is so, the sum of accounts receivable and inventories will approximate the working capital.
Receivables: Business unit managers are able to influence the level of receivables, indirectly by
increasing sales and directly by establishing credit terms (by approving individual credit accounts
and credit limits) and by their initiative in collecting overdue amounts. Receivables at end of
period or average of intra-period balance are a better measure that should be related to profits.
Questions are raised whether accounts receivable should be included at selling prices or at the
cost of goods sold. The argument in favour of the cost of goods sold method is that business units
real investment in accounts receivable is only the cost of goods sold. On the other hand, it can be
argued that the business unit has the opportunity to reinvest the money collected from accounts
receivable; hence, accounts receivable should be included at selling prices. The usual practice is
to include receivables at selling prices, i.e., the book amount.

If the business unit does not control credits and collections, receivables may be calculated on a
formula basis e.g. consistent with normal payment period say 60 days’ sales, etc.
Inventories: Inventories are included at the end of period amounts or intra-period average
balances. If the company uses LIFO (Last In, First Out) for financial accounting purposes, a
different valuation method is used for business unit performance reporting because, in periods
of inflation, LIFO inventory balances tend to be very low. In such a situation, inventories should
be valued at standard or average costs for the purpose of the evaluation of the performance of
business unit.
Work in progress inventory is financed by advance payments or by progress payments from
customers, especially with long manufacturing period. These payments are deducted from the
gross inventory or reported as liabilities.
If the business unit can influence the payment period allowed by creditors, the accounts payable
are included in the liabilities or accounts payable are deducted from inventory.

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