Activity - Based Costing for Economic Value Added ® by Regina

Economic value added, which is the currently popular term for the traditional accounting concept of residual income (RI), subtracts from operating income an interest charge for invested capital. This paper provides an activity-based cost system that supports RI maximization. We construct a model of participative budgeting for a multiactivity firm in which the cost system allocates plant and equipment cost to products using a formula that includes the interest charge. The budget system we design enables decision makers to identify RI-improving opportunities for outsourcing and dropping unprofitable products. The budget system also has the “open-architecture” property that additional informal communication among activity managers can only serve to increase RI. Cost and performance measurement are two areas of managerial accounting which have undergone great scrutiny and innovation in recent years. Two concepts that have attracted widespread interest are activity-based costing (ABC) and the Economic Value Added performance measure. Economic Value Added, which is the currently popular name for the traditional accounting concept of residual income (RI), subtracts from operating income an interest charge for invested capital (Stewart (1991)). The present paper combines ABC and RI in a comprehensive budgeting system for a decentralized firm, a system which encompasses all of the firm’s revenue, production, and capital activities. The model of budgeting offered here, unlike most of the theoretical literature in managerial accounting, is based on accounting information in the narrow sense: transactions and accruals. Theoretical constructs such as marginal revenue, marginal cost and opportunity cost are not transmitted or even recorded by the accounting process. Such constructs being central to the logic of maximization, the sense in which the budget process supports RI maximization is necessarily imperfect. RI maxima are supported as budget equilibria, but some submaximal outcomes are equilibria as well. Not surprisingly, the latter could be excluded by appropriate linearity assumptions, but only at the cost of drastically confining the scope of the model. Instead, we have chosen to formalize the sense in which the budget equilibria are guaranteed to be at least “second-best”. The objective of this somewhat unconventional approach to managerial accounting theory is not simply to achieve congruence with a textbook image of reality, but to develop a coherent framework of analysis for the accounting that we teach and our students do. The objective of maximizing RI is itself an imperfection that requires some justification. Ideally, a budget should maximize the discounted value of cash flows (DCF). But coordinating the requisite information about cash flows far into the future is not always practical when the elements of such information are dispersed throughout the firm. Anctil (1996) showed that RI maximization can serve as a heuristic substitute for DCF maximization. More specifically, RI enables decision makers to treat the capital-budgeting problem as if it were a single-period problem, which greatly simplifies the capital-budgeting process.