Professional Documents
Culture Documents
ADVANCED PERFORMANCE
MANAGEMENT
STUDY NOTES
Study Notes Advanced Performance Management -APM
CONTENTS
Chapter # Chapter Name Page #
2 Environmental influences 10
3 Approaches of budgets 42
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Study Notes Advanced Performance Management -APM
Learning objectives
Explain the role of strategic performance management in strategic planning and control
Assess the changing role of the management accountant in today's business environment as outlined by
burns and scapens
Explore the role of the management accountant in providing key performance information for integrated
reporting to stakeholders.
Discuss the role of performance measurement in checking progress towards the corporate objectives
Compare planning and control between the strategic and operational levels within a business entity
Discuss the scope for potential conflict between strategic business plans and short-term localised decisions
Apply and evaluate the methods of benchmarking performance
Assess the appropriate benchmarks to use in assessing performance
Discuss how the purpose, structure and content of a mission statement impacts on performance
measurement and management
Discuss how strategic objectives are cascaded down the organisation via the formulation of subsidiary
performance objectives
Apply critical success factor analysis in developing performance metrics from business objectives
Identify and discuss the characteristics of operational performance
Discuss the relative significance of planning against controlling activities at different levels of the performance
hierarchy
Evaluate how models such as SWOT analysis, Boston consulting group, porter's generic strategies and 5 forces
may assist with the performance management process
Assess the statement 'what gets measured gets done
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Study Notes Advanced Performance Management -APM
Organisations have objectives they wish to meet, normally these objectives are only possible if the organisation
improves in some way e.g. increase profit, increase market share, improve customer satisfaction etc. Performance
measurement is looking at how we are doing now Performance management is about how we can improve
We could improve by; Measuring different KPIs which are more aligned with our objectives
Improving the way targets are set and behaviour is governed through budgeting
Improving the way that rewards are granted to staff
Introducing new management accounting techniques such as ABM, EMA
Introducing new production techniques such as JIT, Kaizen
Improving the quality of products / services provided
Improving the quality of information used by the organisation
Improving the information systems within the organisation
Improving the way information is presented to those who need it
One of the biggest issues is that all the above are interlinked
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Study Notes Advanced Performance Management -APM
External analysis involves consideration of developments and circumstances outside the organisation which
might affect the organisation in the future. Relevant external factors include the law, politics, economics,
culture, technology and competition.
Internal analysis involves consideration of the strengths and weaknesses within the organisation. Relevant
internal factors include technical skills, know-how, market reputation and liquidity
SWOT analysis involves systematic consideration of the strengths and weaknesses of the organisation against
the background of the opportunities and threats that it faces.
Gap analysis involves consideration of the difference between “where we are” and “where we want to be”
Level Of Management
Strategic management
Tactical management
Operational management
Management accounting system should provide information for strategic management, tactical management and
operational management
In many respects, strategic information, tactical information and operational information are concerned with the
same things (business plans and actual performance) but are provided in different amounts of detail and with
differing frequency. IT systems are used to provide this information
Strategic management is concerned with the development and execution of long term plans. Strategic information
needs are typically:
About the whole organisation and summarised
Relevant to long term and forward looking
Likely to be prepared on an ad hoc basis and may be taken from external sources
Tactical management is concerned with efficient and effective use of resources in the implementation of medium
term plans. Tactical information needs are typically:
About individual departments and detailed
Relevant to medium term and a mix of backward and forward looking material
Likely to be prepared on a systematic and regular basis
Operational management is concerned with the day to day running of the business. Operational information needs
are typically:
‘task specific’ and very detailed, down to transaction level
Relevant to the very short term and backward looking
Likely to be prepared regularly or continuously available on-line
Performance Hierarchy
1. at the top of the hierarchy is the mission statement
2. the mission statement provides a framework for the setting of strategic objectives;
3. strategic objectives form a basis for the setting of tactical plans such as annual budgets
4. operating plans and targets derive from tactical plans
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Mission Statement
Mission statement
A clear expression of the reason why an organisation is in existence and what it is seeking to achieve
Not all organisations have formal statements
Benchmarking
Benchmarking is:
- Data gathering, of targets and comparators;
- Identifying relative levels of performance (and particularly areas of underperformance);
- Adoption of identified best practices to improve performance.
Advantages of benchmarking
- Assess existing resources
- Manager involvement
- Focus on improvement
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- Sharing information
Disadvantages of benchmarking
- Too much focus on efficiency rather than effectiveness
- Looks at now not the future
- Targets and comparisons may not reveal best practice (i.e. what not why!)
Always on catch up when innovation (i.e. a bypass strategy) would be more effective
- Useful information not freely available
Types of Benchmarking:
Internal benchmarking. Here performance is compared to an internally generated target. There has to be some
reference point f o r that target and it could be a target based o n last year‘s achievements or a target
based on another branch or subsidiary. It could be relatively easy to generate that target, but the problem is that
there is no guarantee that the target is appropriate. It could be either too hard or too easy; really some sort of
external reference is needed.
External benchmarking. Here you compare your performance to that seen in other similar organizations. This
gives you a better reference point, but the problem in implementing this is that often other organizations will be
secretive about their performance as their performance will be commercially sensitive. They are therefore unlikely
to cooperate in providing you with internal data and all you might have available is data from published financial
statements.
Best practice. Even better rather than randomly choosing an external, similar organisation, choose the best one
and compare yourself to performance there. This should cause your organisation always to strive to get better as
it seeks to match the performance found in best practice. Once again the best performing organization may not
cooperate in providing you with measurement data.
Integrated Reporting
An integrated report is a concise communication about how an organization‘s strategy, governance,
performance and prospects lead to the creation of value over the short, medium and long term‘ (IIRC
draft framework, April 2013).
You will see that IR has many elements which easily relate to Paper APM
It is useful to imagine yourself investigating a company about which you know nothing to decide whether or not
you want to invest in it. Going to the latest annual report and financial statements would probably be your starting
point, but you will be left with many unanswered questions – certainly if the company shows the minimum
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information required by law and the accounting and financial reporting standards. You will learn relatively little
about the company‘s business activities (though segmental reporting helps), their competitors, their future
plans or how they intend to achieve sustainable competitive advantage. IR aims to fill the gaps so that existing or
prospective investors better understand the company.
However, within the normal financial reporting framework, there is no place for the company to report its
progress (or lack of it) in these important non-financial areas. The integrated report provides the opportunity
for the organization to restate its mission and how its strategy addresses this mission. Central to this will be a
discussion of the CSFs and the KPIs which have been identified to measure business performance. KPIs will have
associated performance objectives which can be reported in the integrated report. Thus, the report not only
restates the KPI and its associated performance objective, it also reports on whether that performance objective
has been met and, if it has not, discusses reasons for failure and the actions which are being taken to ensure
that this objective is met in the next reporting period. If it fails to meet these targets, then it will explain how this
failure is being addressed.
However, an integrated report should be more than a summary of information from other communications; it
should explicitly connect the information to communicate how value is created. Thus current and potential
stakeholders should have better information about the future value of the organization in which they are
interested. Through a restatement of the mission statement, stakeholders will also have the direction and
purpose of the organization emphasized and re-affirmed.
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incorporates the concept of the product life cycle (PLC), is a useful tool which helps management teams to assess
existing and developing products and services in terms of their market potential. More importantly, the model can
also be used to assess the strategic position of SBUs, and in this respect it is particularly useful to those organisations
which operate in a number of different markets.
The matrix offers an approach to product portfolio planning. It has two controlling aspects, namely relative market
share (meaning relative to the competition) and market growth. Management must consider each product or service
marketed, and then position it on the matrix. This should be done for every product manufactured or service
provided, and management should then plot the position of competitors’ products and services on the matrix in
order to determine relative market share.
Stars
Stars are products which have a good market share in a strong and growing market. As a product moves into this
category it is commonly known as a ‘rising star’. While a market is strong and still growing, competition is not yet
fully established. Since demand is strong, and market saturation and over-supply is not an issue, the pricing of such
products is relatively unhindered, and therefore these products generate very good margins. At the same time,
manufacturing overheads are minimised due to high volumes and good economies of scale. These are great
products, and worthy of continuing investment for as long as they have the potential to achieve good rates of growth.
In circumstances where this potential no longer exists, these products are likely to fall vertically in the matrix into
the ‘cash cow’ quadrant (‘fallen stars’), and their cash characteristics will change. It is therefore vital that a company
has ‘rising stars’ developing from its ‘problem children’ in order to fill the void left by the fallen stars.
Problem children
‘Problem children’ have a relatively low market share in a high-growth market, often due to the fact that they are
new products, or that they are yet to receive recognition by prospective purchasers. In order to realise the full
potential of problem children, management needs to develop new business prudently, and apply sound project
management principles if it is to avoid costly disasters. Gross profit margins are likely to be high, but overheads are
also high, covering the costs of research, development, advertising, market education, and low economies of scale.
As a result, the development of problem children can be loss-making until the product moves into the rising star
category, which is by no means assured. This is evidenced by the fact that many problem children products remain
as such, while others become tomorrow’s ‘dogs’.
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Cash cows
A cash cow has a relatively high market share in a low growth market, and should generate significant cash flows.
This somewhat crude metaphor is based on the idea of ‘milking’ the returns from a previous investment that
established good distribution and market share for the product. Activities to support products in this quadrant
should be aimed at maintaining and protecting their existing position, together with good cost management, rather
than aimed at growth. This is because there is little likelihood of additional growth being achieved.
Dogs
A dog has a relatively low market share in a low growth market, might well be loss making, and therefore have
negative cash flow. A common belief is that there is no point in developing products or services in this quadrant.
Many organisations discontinue ‘dogs’, but businesses that have been denied adequate funding for development
may find themselves with a high proportion of their products or services in this quadrant.
Notwithstanding these limitations, the Boston Consulting Group matrix provides a useful starting point in the
assessment of the performance of products and services and, more importantly, of SBUs.
EXAMPLE
Domestic Appliances Ltd (DAL) commenced trading in 1955, when it started to manufacture semi-automatic washing
machines. From 1965, DAL expanded its product portfolio. Core products now include fully automatic washing
machines, dishwashers, and cookers. The market in domestic appliances is extremely competitive. DAL’s principal
competitor is the Jarvis Electrical Group (JEG), which has achieved the position of market leader in many similar
areas of the market. Other information is as follows:
1. JEG is the market leader in dishwashers, having 48% of the market. DAL has only 30% of the market.
Environmentalist pressure groups, concerned about water consumption, have caused a significant diminution
in the size of the market for dishwashers. However, the market remains profitable and this is expected to
continue.
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Study Notes Advanced Performance Management -APM
2. DAL continues to manufacture washing machines using a process which uses new materials for each unit.
Legislation now requires that 35% of all materials used comprise recycled materials, which means that DAL will
no longer be able to sell its washing machines in certain markets.
3. Both DAL and JEG have invested very heavily in the manufacture of steam ovens. DAL has 12% of the new
market, while JEG has an 18% share of the new market.
4. DAL has recently produced a new washing machine, the Celeribus, which washes three times faster than any
other machine on the market. Market awareness of this machine is growing. The development costs of the
Celeribus were significant. At present the company is making heavy losses on production of this product.
Analyse the product portfolio of DAL using the Boston Consulting Group matrix.
The steam oven appears to be a star at the moment since it has a relatively large market share in what is a high
growth market. The Celeribus is a problem child as it has generated losses to date, and has a relatively low market
share in a high-growth market. The challenge facing the management of DAL is to convert the product into a star.
The dishwashers are cash cows as even though the rate of market growth is low, DAL has a relatively high market
share. Cash generated can be used not only to further develop stars but also problem children where it is deemed
appropriate. The washing machines will soon become dogs as they are no longer able to be sold in certain markets.
1. Cost leadership: selling the same product as competitor‘s for lower price (be cheap)
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2. Differentiation: Selling the product which is different from competitors. Product is unique(be better)
3. Focus (niche) Strategy: If a firm lacks the resources to dominate the broad (or mass) market, it can seek to
dominate a niche within the markets.
In earlier management accounting papers you have looked at various topics such as costing techniques, budgeting
and the calculation of variances.
Short-term
Backwards looking
Focused at individual departments
Able to be produced in standard reports
Able to be produced at regular intervals
Produced by junior staff for senior staff to review
Because of this, all of these measures are useful for CONTROL purposes.
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We saw earlier that strategy is concerned with big decisions, such as whether:
Any strategic decision such as those noted above will need to be justified. This means the accountant will be involved
with preparing information to support a decision.
Externally focused.
Forward looking.
Aimed at achieving the goals of the entire organization.
Produced when needed.
Not in a standard form.
Product profitability – why is one product making more profit than another
Customer profitability - why are some customers worth more than others
Pricing decisions – including looking at customers and competitors
Brand values – How much should be invested in a brand
Shareholder wealth – What choices will increase it
Possible acquisition targets
Expected synergistic gains
Decisions on entering new industries or markets
Decisions on launching new products
Decisions on whether to expand certain parts of the business
Decisions on whether to close or sell-off various parts of the business
The last two points are particularly important. Senior management will need to identify which parts of the business
are performing well and which are underperforming.
To do this senior management will need to introduce a set of performance measures which can be used to
summarize the performance of the business.
Important areas
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Management accountants should become internal consultants for managers The main reasons for this change are:
Management accountants should become internal consultants for managers The main reasons for this change are:
A wider role for the management accountants The key areas are
REVOLUTION OF IT SYSTEMS
Managers have access to the more information within the ‘IT system’.
Changed quality and quantity of information used to make decisions.
Wide variety of reports that can be generated from IT systems.
More analytical and interpretative skills required (“Big data”)
COMPETITION
Increasing need to be more responsive to changes from competition.
Being more commercially aware.
Production of a range of measures that looks at all aspects of the business.
There is indeed a broadening of the MA’s responsibility and a transformation into more of a business partner role.
However this is not easy and they may meet problems such as:
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Study Notes Advanced Performance Management -APM
ENVIRONMENTAL INFLUENCES
Learning objectives
Discuss the ways in which stakeholder groups operate and how they influence an organisation and its strategy
formulation and implementation (e.g. using Mendelow’s matrix)
Discuss the social and ethical issues that may impact on strategy formulation, and consequently, business
performance
Assess the impact of different risk appetites of stakeholders on performance management
Evaluate how risk and uncertainty play an important role in long term strategic planning and decision-making
that relies upon forecasts and exogenous variables
Apply different risk analysis techniques in assessing business performance such as maximax, maximin,
minimax regret and expected values
Discuss the need to consider the environment in which an organisation is operating when assess ng its
performance using models such as PEST and Porter's 5 forces, including areas:
Political climate
Market conditions
Evaluate how models such as SWOT analysis, Boston Consulting Group Porter's generic strategies and Porter's
5 Forces may assist in the performance management process.
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Macro Environment
PEST ANALYSIS
It considers the following external factors:
1. Political Factors: e.g. change in government policy, tax incentives, instability of government etc.
2. Economic Factors: e.g. disposable income, inflation rates, employment rates, international trade etc.
3. Social Factors: Demography (average age, ethnicity, family structure, geography, culture, lifestyle etc.
4. Technological Factors: e.g. awareness of stakeholders about technology, new products and services become
available, new media for communication with customers etc.
All above factors are interlinked
All PEST factors help an organization to identify its threats and opportunities in the external environment
which can impact performance
ILLUSTRATION
Speedy Eat is the world’s largest and best-known food service retailing group with more than 30,000 ‘fast-food’
outlets in over 120 countries. Currently half of its restaurants are in the USA, where it first began 50 years ago,
but up to 1,000 new restaurants are opened every year worldwide. Restaurants are wholly owned by the group
(it has previously considered, but rejected, the idea of a franchising of operations and collaborative partnerships).
As market leader in a fiercely competitive industry, Speedy Eat has strategic strengths of instant global brand
recognition, experienced management, site development expertise and advanced technological systems. Speedy
Eat’s basic approach works as well in Kandy or Kuala Lumpur as it does in Kansas: although the products are
broadly similar, menus are modified to reflect local tastes. Analysts agree that it continues to be profitable
because it is both efficient and innovative.
The group’s vision is to be ‘the world’s favourite’ through service, cleanliness and value, and it is following three
main strategies:
a. To achieve profitable growth by building on key strengths.
b. To ‘delight’ every customer in every restaurant.
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c. To be a good employer in each community in which it has a restaurant. (Despite this, some critics claim staff
are mainly unskilled and lowly paid.)
Speedy Eat’s future plans are to maximize global opportunities and continue to expand markets. Speedy Eat has
long recognized that the external environment can be very uncertain and consequently does not move into new
locations or countries without first undertaking a full investigation.
You are part of a strategy steering team responsible for investigating the key factors concerning Speedy Eat’s
entry for the first time into the restaurant industry in the Republic of Borderland.
Required:
(a) Justify the use of a PEST framework to assist your team’s environmental analysis for the Republic of
Borderland.
(8 marks)
(b) Discuss the main issues arising from applying this framework.
(12 marks)
(20 Marks)
Answer
(a) Using a PEST analysis to assist the environmental analysis
PEST analysis examines the broad environment in which the organization is operating. PEST is a mnemonic
which stands for Political/legal, Economic, Social and Technological factors. These are simply four key areas
in which to consider how current and future changes affect the business. Strategies can then be developed
which address any potential opportunities and threats identified.
In entering a new overseas market, an environmental analysis is important to help the organization
understand the factors specific to that market so that the specific opportunities and threats posed can be
assessed and appropriate action taken.
Economic
Economies are different in different parts of the world. Understanding the local economy in
Borderland and how it is expected to develop enables Speedy Eat to assess the potential within that
market as well as any economic issues which they need to consider.
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Social
Each country will have its own cultural differences, and Speedy Eat can change how they operate
depending on Borderland’s culture. Speedy Eat has already shown its willingness to change for
each country’s different tastes and will want to do so in Borderland too.
Technological
Each country has a different level of technological expertise and experience. Speedy Eat might
need to change processes to accommodate local systems, or implement training programs for
staff unfamiliar with their technology.
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Economic factors
Things to consider include:
Economic prosperity
The more prosperous the nation the more money people will have to invest in ‘fast-food’. Examining
the current and likely future prosperity enables the organization to understand the potential of this
market and the likely future investment required.
Interest rates
This affects the cost of borrowing within Borderland. If high it may mean overseas funding is necessary.
A big differential between interest rates in Borderland and the US is also likely to cause instability in the
exchange rate (see below).
Interest rates also affect the availability of money for the people of the country. Low interest rates mean
more disposable income to spend increasing the potential for Speedy Eat.
Exchange rates
Speedy Eat will be affected by exchange rates for items they export to Borderland (clothing, fittings). An
unfavorable movement in exchange rates could make exporting to Borderland expensive and reduce
profitability. It can also affect the value of profits when converted back to US dollars.
Position in economic cycle
Different countries are often at different positions in the economic cycle of growth and recession. The
current position of Borderland will affect the current prosperity of the nation and the potential for
business development for Speedy Eat.
Inflation rates
High inflation rates create instability in the economy which can affect future growth prospects. They
also mean that prices for supplies and prices charged will regularly change and this difficulty would need
to be considered and processes implemented to account for this.
Social factors
Things to consider include:
Brand reputation/anti-Americanism
As a global brand, the reputation of Speedy Eat might be expected to have reached Borderland. If not,
more marketing will be required. If it has, the reputation will need to be understood and the marketing
campaign set up accordingly.
This is particularly relevant given the anti-Americanism which is prevalent currently in some countries.
Speedy Eat may have a significant hurdle to climb to convince people to eat there if this is the case in
Borderland.
Cultural differences
Each country has its own values, beliefs, attitudes and norms of behaviors which means that people of
that country may like different foods, architecture, music and so on, in comparison with US restaurants.
By adapting to local needs Speedy Eat can ensure it wins local custom and improve its reputation.
Different cultures also need to be considered when employing people, especially given the importance
to Speedy Eat of employee relations. People might have different religious needs to be met or may
dislike being given autonomy so the management style needs changing.
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Language problems
Different local languages can create problems, firstly in communication with staff. Secondly, product
names need to be considered to ensure they are acceptable in the local language. General Motor’s Nova
suggested that ‘it won’t go’ in Spanish, for example.
Technological factors
Speedy Eat may need to train people in the use of their technologies if the local population are unfamiliar
with them, e.g. accounting systems or tills. In addition, technology might have to be adapted to work in
local environments, such as different electrical systems.
The use of Porter’s five forces model (see Figure 1) will help identify the sources of competition in an industry or
sector.
The model has similarities with other tools for environmental audit, such as political, economic, social, and
technological (PEST) analysis, but should be used at the level of the strategic business unit, rather than the
organisation as a whole. A strategic business unit (SBU) is a part of an organisation for which there is a distinct
external market for goods or services. SBUs are diverse in their operations and markets so the impact of competitive
forces may be different for each one.
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Five forces analysis focuses on five key areas: the threat of entry, the power of buyers, the power of suppliers, the
threat of substitutes, and competitive rivalry.
Economies of scale
For example, the benefits associated with volume manufacturing by organisations operating in the automobile and
chemical industries. Lower unit costs result from increased output, thereby placing potential entrants at a
considerable cost disadvantage unless they can immediately establish operations on a scale that will enable them to
derive similar economies.
Expected retaliation
In some circumstances, a potential entrant may expect a high level of retaliation from an existing firm, designed to
prevent entry – or make the costs of entry prohibitive.
Government regulation
This may prevent companies from entering into direct competition with nationalised industries. In other scenarios,
the existence of patents and copyrights afford some degree of protection against new entrants.
Differentiation
Differentiated products and services have a higher perceived value than those offered by competitors. Products may
be differentiated in terms of price, quality, brand image, functionality, exclusivity, and so on. However,
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differentiation may be eroded if competitors can imitate the product or service being offered and/or reduce
customer loyalty.
COMPETITIVE RIVALRY
Competitive rivalry is likely to be high where:
There are a number of equally balanced competitors of a similar size. Competition is likely to intensify as one
competitor strives to attain dominance over another
The rate of market growth is slow. The concept of the life cycle suggests that in mature markets, market share
has to be achieved at the expense of competitors
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there is a lack of differentiation between competitor offerings because, in such situations, there is little
disincentive to switch from one supplier to another
The industry has high fixed costs, perhaps as a result of capital intensity, which may precipitate price wars and
hence low margins. Where capacity can only be increased in large increments, requiring substantial
investment, then the competitor who takes up this option is likely to create short-term excess capacity and
increased competition
There are high exit barriers. This can lead to excess capacity and, consequently, increased competition from
those firms effectively ‘locked in’ to a particular marketplace.
In summary, the application of Porter’s five forces model will increase management understanding of an industrial
environment which they may want to enter.
EXAMPLE 1
Kleen-up plc, which provides factory cleaning services, is considering a strategic decision to set up industrial
launderettes in order to enter the market for cleaning industrial work-wear in the country of Eajland. Map the
following eight points onto the five forces model:
1. A government grant, equal to 95% of the start-up costs, will be paid to any organisation setting up an
industrial launderette.
2. Disposable work-wear is available on a nationwide basis from a distributor of imported products.
3. A large number of businesses spend large amounts of money on cleaning employees’ work-wear each week.
4. There are very few high quality launderettes capable of cleaning industrial work-wear to a satisfactory
standard.
5. Health and Safety legislation in Eajland encourages the use of launderettes by businesses.
6. Other launderettes within the community regularly offer free cleaning, or high discounts on the cleaning of
clothing items.
7. The number of industrial firms setting up in Eajland is increasing by 10% per annum.
8. The market in the cleaning of industrial work-wear in Eajland is relatively new, and is projected to grow
rapidly.
Answer
1. A government grant, equal to 95% of the start-up costs, will be paid to any organisation setting up an
industrial launderette. threat of entry – low barriers to entry
2. Disposable work-wear is available on a nationwide basis from a distributor of imported products. product-
for-product substitution
3. A large number of businesses spend large amounts of money on cleaning employees’ work-wear each week.
high bargaining power of buyers
4. There are very few high quality industrial launderettes capable of cleaning industrial work-wear to a
satisfactory standard. high bargaining power of suppliers
5. Health and Safety legislation in Eajland encourages the use of industrial launderettes by businesses. threat
of entry reduced by legislation
6. Other launderettes within the community regularly offer free cleaning, or high discounts on the cleaning of
clothing items. threat of entry – differentiation
7. The number of industrial firms setting up in Eajland is increasing by 10% per annum. bargaining power of
buyers
The market in the cleaning of industrial work-wear is relatively new, and is projected to grow rapidly.
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Stakeholder’s Influence
1. Stakeholder’s Influence
Stakeholders:
Group or individuals whose interests are directly affected by activities of an organization. E.g.
Key players: Stakeholders who have high power and high interest are known as key players.
Management really needs to keep those people happy. They have the power and they have
the willingness to do something about it if they are upset. These stakeholders can stop any
strategy in its tracks.
Keep satisfied: Some stakeholders have high power but they are unlikely to take action even if
management does something which they dislike. They may be unwilling to take because of
professional or ethical reasons. For example, medical staff in hospitals are very unlikely to
take industrial action.
Management doesn‘t have to be quite as careful with these people as with the key players.
However, they have to be kept satisfied otherwise they could be provoked to take action
and turn into key players.
Keep informed: People with low power but high interest have to be kept informed. They can‘t do much
about it themselves but they might be able to influence key players to take action on their
behalf.
Minimal effort: These stakeholders have low power and low interest. Management can almost ignore these
people. After all, what are they going to do if they don‘t like what‘s happening?
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Ethical influence:
Ethics are ideas about right and wrong that set standards for conduct. Ethics are important to business because
society considers such things important. There are also rules of professional conduct to consider. Ideas of right
and wrong have become more fluid and less absolute. As a result there is a greater scrutiny of organization‘s
behaviour since it is likely to be less subject to definitive internal rules.
Ethical stance: The extent to which an organization will exceed its minimum obligation to stakeholders.
Short term stakeholder interest: obey the letter of the law
Long term stakeholder interest: behave ethically to enhance image and reduce pressure for regulation
Multiple stakeholder obligations: the expectations of other groups of stakeholders may be considered, as well
as any right they may have
Shaper of society: really restricted to public sector organizations; businesses should not sacrifice their
commercial viability
Ethical Dilemmas:
Conflicting views of the organization‘s responsibilities create ethical dilemmas for managers at all levels.
Examples are;
Dealing with corrupt or unpleasant regimes
Honesty in disclosing information
Employees-cost or opportunity for them?
Corrupt payments to officials-bribery or gift?
Government influences:
Government influence on corporate strategies may be:
Statutory performance requirements for operations in the transport sector and for public utilities
Government spending programmes and policies are a major feature in some sectors such as defence and
healthcare
Statutory regulation may inhibit corporate acquisitions and divestments
Statutory regulation intended to promote competition and/or prevent monopoly in particular market
Taxation policies and the detailed nature of the tax system may impact heavily on particular strategies
INTRODUCTION
Risk and uncertainty is a topic on which you have been examined previously, but is deemed knowledge and it
therefore repeated here as revision.
Decision making involves making decisions now which will affect future outcomes which are unlikely to be known
with certainty.
Risk exists where a decision maker has knowledge that several possible outcomes are possible – usually due to past
experience. This past experience enables the decision maker to estimate the probability or the likely occurrence of
each potential future outcome.
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Uncertainty exists where the future is unknown and where the decision maker has no past experience on which to
base predictions.
Whatever the reasons for the uncertainty, the fact that it exists means that there is no ‚rule‘ as to how to make
decisions. For the examination you are expected to be aware of, and to apply, several different approaches that
might be useful.
Risk preference
A RISK SEEKER will be interested in the best possible outcome, no matter how small the change that they may occur.
Someone who is RISK NEUTRAL will be concerned with the most likely or ‘average’ outcome.
A RISK AVOIDER makes decisions on the basis of the worst possible outcomes that may occur.
EXPECTED VALUES
Decision-making involves dealing with future events that cannot be predicted with any certainty.
It may, however, be possible to predict a range of possible costs and revenues and the likelihood of them arising.
Expected Values (EVs) are weighted average values based on probabilities. EVs are a useful tool in business.
They can, for Exercise, be used to calculate the likely number of faulty components in a production batch and
the likely sales of a product over a range of time periods.
They can also be used to calculate the likely profits of a project, together with the most profitable course of
action. Expected values are of most use in longer term planning though they still have a role in one off decisions.
Which CONSEQUENCE (or payoff) that arises from each action depends on the CIRCUMSTANCES operating at the
time a decision is made. These circumstances are independent of the actions themselves, and it is often possible to
assign a probability value to each of them.
It is possible to construct a payoff table which shows all of the possible consequences of a particular decision. It is
customary to display circumstances as rows and actions as columns. Consequences or payoffs are cells in the table.
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DECISION RULES
Depending on a decision-maker’s attitude to risk a company may adopt different approaches to deciding which
project or course of action to take.
MaxiMin
In this strategy the decision-maker takes the project that has the least bad outcome – in effect playing it safe.
Remember this is a very conservative strategy that can lead to low returns for a company. It is also one that
completely ignores the likelihood of something happening.
MaxiMax
In this approach the company seeks to maximize the best possible outcome.
Remember this can be a high risk strategy as no account is take of possible losses or how likely each outcome is.
Minimax regret
In this decision making rule the decision maker tries to minimizes the regret from making the wrong decision. Regret
refers to any opportunities lost as a result of making the wrong decision.
ILLUSTRATION 1
Exton Health Centre specializes in the provision of exercise and dietary advice to clients. The service is provided
on a residential basis and clients stay for whatever number of days suits their needs.
Budgeted estimates for the year ending 30 June 2012 are as follows:
(i) The maximum capacity of the center is 50 clients per day for 350 days in the year.
(ii) Clients will be invoiced at a fee per day. The budgeted occupancy level will vary with the client fee level
per day and is estimated at different percentages of maximum capacity as follows:
Client fee per Occupancy level Occupancy as percentage of day maximum capacity
$180 High 90%
$200 Most likely 75%
$220 Low 60%
(iii) Variable costs are also estimated at one of three levels per client day. The high, medium and low levels
per client day are $95, $85 and $70 respectively.
The range of cost levels reflects only the possible effect of the purchase prices of goods and services.
Required:
(a) Prepare a summary which shows the budgeted contribution earned by Exton Health Centre for the year
ended 30 June 2012 for each of nine possible outcomes.
(6 marks)
(b) State the client fee strategy for the year to 30 June 2012 which will result from the use of each of the
following decision rules: (i) maximax; (ii) maximin; (iii) minimax regret.
Your answer should explain the basis of operation of each rule. Use the information from your answer to
(a) as relevant and show any additional working calculations as necessary.
(9 marks)
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(c) The probabilities of variable cost levels occurring at the high, medium and low levels provided in the
question are estimated as 0.1, 0.6 and 0.3 respectively. Using the information available, determine the
client fee strategy which will be chosen where maximization of expected value of contribution is used as
the decision basis.
(5 marks)
(d) The residents are provided with breakfast and evening meals at no extra cost. However, they also have an
option to buy a lunchtime meal. Each meal costs $7 to prepare and would be priced at $15 to customers.
All lunches must be prepared in advance. Based on expected occupancy levels, the restaurant manager
has predicted that daily demand will either be 10 meals (probability 0.2), 20 meals (probability 0.5) or 30
meals (probability (0.3).
Prepare a pay-off matrix showing the outcomes if the restaurant manager decides to make 10, 20 or 30
lunches in advance. How many lunches should the restaurant manager make? (5 marks)
(25 marks)
ANSWER
Budgeted Net Profit/Loss outcomes for year ending 30 June 2012
Occupancy Client days = Fee per Var. cost Contribution Total level 50 clients x client per per
client contrib.
350 days x day client day per year occupancy% day
$ $ $ $
180 1,732,500
200 1,706,250
220 1,575,000
In this case the decision maker will choose a client fee of $180 per day where there is a possibility
of a contribution of $1,732,500.
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Maximin
The maximin rule looks for the strategy which will maximize the minimum possible contribution.
Client fee per day Minimum possible contribution ($) (S)
180 1,338,750
200 1,378,125
220 1,312,500
In this case the decision maker will choose client fee of $200 per day where the lowest contribution
is $1,378,125.
Minimax regret
The minimax regret rule requires the choice of the strategy which will minimise the
maximum regret from making the wrong decision. Regret in this context is the opportunity
lost through making the wrong decision.
Using the calculations from part (a) we may create an opportunity loss table as follows:
State of variable cost Client fee per day strategy $180 $200 $220
W1 at the high level of variable costs, the best strategy would be a client fee of $200. The
opportunity loss from using a fee of $180 or $220 per day would be $39,375 (1,378,125 -
1,338,750) or $65,625 (1,378,125 - 1,312,500) respectively.
W2 at the medium level of variable costs, the best strategy would be a client fee of $200.
The opportunity loss from using a fee of $180 or $220 per day would be $13,125 (1,509,375
- 1,496,250) or $91,875 (1,509,375 - 1,417,500) respectively.
W3 at the low level of variable costs, the best strategy would be a client fee of $180. The
opportunity loss from using a fee of $200 or $220 per day would be $26,250 (1,732,500 –
$1,706,250) or $157,500 (1,732,500 – 1,575,000) respectively.
The minimum regret strategy (client fee $200 per day) is that which minimizes the maximum
regret (i.e. $26,250 in the maximum regret row above).
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Fee of $200
13,125 client days x (200 – 81.50) contribution
= $1,555,313
Fee of $220
10,500 client days x (220 – 81.50) contribution
= $1,454,250
Conclusion
Hence choose a client fee of $200 per day to give the maximum expected value contribution of
$1,555,313.
Note that there is virtually no difference between this and the contribution where a fee of $180 per
day is used.
(d)
Probability Outcome = lunches Decision =
demanded lunches made
10 20 30
0.2 10 $80 profit $10 profit ($60) loss
0.5 20 $80 profit $160 profit $90 profit
0.3 30 $80 profit $160 profit $240 profit
1.0 - $80 profit $130 profit $105 profit
Example of working - Decision is made to prepare 20 lunches
If demand is 10 lunches: Sales = 10 lunches x $15 per lunch = $150
Costs = 20 lunches x $7 per lunch = $140
Profit = $150 - $140 = $10
If demand is 20 lunches : Sales = 20 lunches x $15 per lunch = $300
Costs = 20 lunches x $7 per lunch = $140
Profit = $300 - $140 = $160
If demand is 30 lunches : Sales = 20 lunches x $15 per lunch = $300
Costs = 20 lunches x $7 per lunch = $140
Profit = $300 - $140 = $160
EV of profit if 20 lunches are prepared = ($10 x 0.2) + ($160 x 0.5) + ($160 x 0.3)
= $130
Conclusion = 20 lunches should be prepared in advance since the expected value of the profit is maximized at this
level of output.
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Risk can take myriad forms – ranging from the specific risks faced by individual companies (such as financial risk, or
the risk of a strike among the workforce), through the current risks faced by particular industry sectors (such as
banking, car manufacturing, or construction), to more general economic risks resulting from interest rate or currency
fluctuations, and, ultimately, the looming risk of recession. Risk often has negative connotations, in terms of potential
loss, but the potential for greater than expected returns also often exists.
Clearly, risk is almost always a major variable in real-world corporate decision-making, and managers ignore its
vagaries at their peril. Similarly, trainee accountants require an ability to identify the presence of risk and incorporate
appropriate adjustments into the problem-solving and decision-making scenarios encountered in the exam hall.
While it is unlikely that the precise probabilities and perfect information which feature in exam questions can be
transferred to real-world scenarios, a knowledge of the relevance and applicability of such concepts is necessary.
In this first article, the concepts of risk and uncertainty will be introduced together with the use of probabilities in
calculating both expected values and measures of dispersion. In addition, the attitude to risk of the decision maker
will be examined by considering various decision-making criteria, and the usefulness of decision trees will also be
discussed. In the second article, more advanced aspects of risk assessment will be addressed, namely the value of
additional information when making decisions, further probability concepts, the use of data tables, and the concept
of value-at-risk.
The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from that which
was expected when the decision was taken. We tend to distinguish between risk and uncertainty in terms of the
availability of probabilities. Risk is when the probabilities of the possible outcomes are known (such as when tossing
a coin or throwing a dice); uncertainty is where the randomness of outcomes cannot be expressed in terms of specific
probabilities. However, it has been suggested that in the real world, it is generally not possible to allocate
probabilities to potential outcomes, and therefore the concept of risk is largely redundant. In the artificial scenarios
of exam questions, potential outcomes and probabilities will generally be provided, therefore a knowledge of the
basic concepts of probability and their use will be expected.
PROBABILITY
The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential values ranging
from 0 (the event will not occur) to 1 (the event will definitely occur). For example, the probability of a tail occurring
when tossing a coin is 0.5, and the probability when rolling a dice that it will show a four is 1/6 (0.166). The total of
all the probabilities from all the possible outcomes must equal 1, ie some outcome must occur.
A real world example could be that of a company forecasting potential future sales from the introduction of a new
product in year one (Table 1).
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From Table 1, it is clear that the most likely outcome is that the new product generates sales of £1,000,000, as that
value has the highest probability.
In contrast, with a conditional event, the outcomes of two or more events are related, ie the outcome of the second
event depends on the outcome of the first event. For example, in Table 1, the company is forecasting sales for the
first year of the new product. If, subsequently, the company attempted to predict the sales revenue for the second
year, then it is likely that the predictions made will depend on the outcome for year one. If the outcome for year one
was sales of $1,500,000, then the predictions for year two are likely to be more optimistic than if the sales in year
one were $500,000.
The availability of information regarding the probabilities of potential outcomes allows the calculation of both an
expected value for the outcome, and a measure of the variability (or dispersion) of the potential outcomes around
the expected value (most typically standard deviation). This provides us with a measure of risk which can be used to
assess the likely outcome.
Expected value
= ($500,000)(0.1) + ($700,000)(0.2) + ($1,000,000)(0.4) + ($1,250,000)(0.2) + ($1,500,000)(0.1)
= $50,000 + $140,000 + $400,000 + $250,000 + $150,000
= $990,000
In this example, the expected value is very close to the most likely outcome, but this is not necessarily always the
case. Moreover, it is likely that the expected value does not correspond to any of the individual potential outcomes.
For example, the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5, and the average family (in
the UK) supposedly has 2.4 children. A further point regarding the use of expected values is that the probabilities are
based upon the event occurring repeatedly, whereas, in reality, most events only occur once.
In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential actual
outcomes around the expected value. The most common measure of dispersion is standard deviation (the square
root of the variance), which can be illustrated by the example given in Table 2 above, concerning the potential returns
from two investments.
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In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential actual
outcomes around the expected value. The most common measure of dispersion is standard deviation (the square
root of the variance), which can be illustrated by the example given in Table 2 above, concerning the potential returns
from two investments.
To estimate the standard deviation, we must first calculate the expected values of each investment:
Investment A
Expected value = (8%)(0.25) + (10%)(0.5) + (12%)(0.25) = 10%
Investment B
Expected value = (5%)(0.25) + (10%)(0.5) + (15%)(0.25) = 10%
The calculation of standard deviation proceeds by subtracting the expected value from each of the potential
outcomes, then squaring the result and multiplying by the probability. The results are then totalled to yield the
variance and, finally, the square root is taken to give the standard deviation, as shown in Table 3.
In Table 3, although investments A and B have the same expected return, investment B is shown to be more risky by
exhibiting a higher standard deviation. More commonly, the expected returns and standard deviations from
investments and projects are both different, but they can still be compared by using the coefficient of variation, which
combines the expected return and standard deviation into a single figure.
For example, assume that investment X has an expected return of 20% and a standard deviation of 15%, whereas
investment Y has an expected return of 25% and a standard deviation of 20%. The coefficients of variation for the
two investments will be:
Investment X = 15% / 20% = 0.75
Investment Y = 20% / 25% = 0.80
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The interpretation of these results would be that investment X is less risky, on the basis of its lower coefficient of
variation. A final statistic relating to dispersion is the standard error, which is a measure often confused with standard
deviation. Standard deviation is a measure of variability of a sample, used as an estimate of the variability of the
population from which the sample was drawn. When we calculate the sample mean, we are usually interested not in
the mean of this particular sample, but in the mean of the population from which the sample comes. The sample
mean will vary from sample to sample and the way this variation occurs is described by the ‘sampling distribution’ of
the mean. We can estimate how much a sample mean will vary from the standard deviation of the sampling
distribution. This is called the standard error (SE) of the estimate of the mean.
The standard error of the sample mean depends on both the standard deviation and the sample size:
SE = SD/√(sample size)
The standard error decreases as the sample size increases, because the extent of chance variation is reduced.
However, a fourfold increase in sample size is necessary to reduce the standard error by 50%, due to the square root
of the sample size being used. By contrast, standard deviation tends not to change as the sample size increases.
DECISION-MAKING CRITERIA
The decision outcome resulting from the same information may vary from manager to manager as a result of their
individual attitude to risk. We generally distinguish between individuals who are risk averse (dislike risk) and
individuals who are risk seeking (content with risk). Similarly, the appropriate decision-making criteria used to make
decisions are often determined by the individual’s attitude to risk.
An ice cream seller, when deciding how much ice cream to order (a small, medium, or large order), takes into
consideration the weather forecast (cold, warm, or hot). There are nine possible combinations of order size and
weather, and the payoffs for each are shown in Table 4.
The highest payoffs for each order size occur when the order size is most appropriate for the weather, ie small
order/cold weather, medium order/warm weather, large order/hot weather. Otherwise, profits are lost from either
unsold ice cream or lost potential sales. We shall consider the decisions the ice cream seller has to make using each
of the decision criteria previously noted (note the absence of probabilities regarding the weather outcomes).
1. Maximin
This criteria is based upon a risk-averse (cautious) approach and bases the order decision upon maximising the
minimum payoff. The ice cream seller will therefore decide upon a medium order, as the lowest payoff is £200,
whereas the lowest payoffs for the small and large orders are £150 and $100 respectively.
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2. Maximax
This criteria is based upon a risk-seeking (optimistic) approach and bases the order decision upon maximising
the maximum payoff. The ice cream seller will therefore decide upon a large order, as the highest payoff is $750,
whereas the highest payoffs for the small and medium orders are $250 and $500 respectively.
3. Minimax regret
This approach attempts to minimise the regret from making the wrong decision and is based upon first
identifying the optimal decision for each of the weather outcomes. If the weather is cold, then the small order
yields the highest payoff, and the regret from the medium and large orders is $50 and $150 respectively. The
same calculations are then performed for warm and hot weather and a table of regrets constructed (Table 5).
The decision is then made on the basis of the lowest regret, which in this case is the large order with the maximum
regret of $200, as opposed to $600 and $450 for the small and medium orders.
DECISION TREES
The final topic to be discussed in this first article is the use of decision trees to represent a decision problem. Decision
trees provide an effective method of decision-making because they:
Clearly lay out the problem so that all options can be challenged
Allow us to fully analyse the possible consequences of a decision
Provide a framework in which to quantify the values of outcomes and the probabilities of achieving them
Help us to make the best decisions on the basis of existing information and best guesses.
A comprehensive example of a decision tree is shown in Figures 1 to 4, where a company is trying to decide whether
to introduce a new product or consolidate existing products. If the company decides on a new product, then it can be
developed thoroughly or rapidly. Similarly, if the consolidation decision is made then the existing products can be
strengthened or reaped. In a decision tree, each decision (new product or consolidate) is represented by a square box,
and each outcome (good, moderate, poor market response) by circular boxes.
The first step is to simply represent the decision to be made and the potential outcomes, without any indication of
probabilities or potential payoffs, as shown in Figure 1 below.
The next stage is to estimate the payoffs associated with each market response and then to allocate probabilities.
The payoffs and probabilities can then be added to the decision tree, as shown in Figure 2 below.
The expected values along each branch of the decision tree are calculated by starting at the right hand side and
working back towards the left recording the relevant value at each node of the tree. These expected values are
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calculated using the probabilities and payoffs. For example, at the first node, when a new product is thoroughly
developed, the expected payoff is:
The calculations are then completed at the other nodes, as shown in Figure 3 below.
We have now completed the relevant calculations at the uncertain outcome modes. We now need to include the
relevant costs at each of the decision nodes for the two new product development decisions and the two consolidation
decisions, as shown in Figure 4 below.
The payoff we previously calculated for ‘new product, thorough development’ was $420,400, and we have now
estimated the future cost of this approach to be $150,000. This gives a net payoff of $270,400.
The net benefit of ‘new product, rapid development’ is $31,400. On this branch, we therefore choose the most
valuable option, ‘new product, thorough development’, and allocate this value to the decision node.
The outcomes from the consolidation decision are $99,800 from strengthening the products, at a cost of $30,000,
and $12,800 from reaping the products without any additional expenditure.
By applying this technique, we can see that the best option is to develop a new product. It is worth much more to us
to take our time and get the product right, than to rush the product to market. And it’s better just to improve our
existing products than to botch a new product, even though it costs us less.
In the next article, we will examine the value of information in making decisions, the use of data tables, and the
concept of value-at-risk.
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Some decision scenarios may involve two uncertain variables, each with their own associated probabilities. In such
cases, the use of data/decision tables may prove helpful where joint probabilities are calculated involving possible
combinations of the two uncertain variables. These joint probabilities, along with the payoffs, can then be used to
answer pertinent questions such as what is the probability of a profit/(loss) occurring?
The other main topic covered in the article is that of Value-at-Risk (VaR), which has been referred to as 'the new
science of risk management'. The principles underlying VaR will be discussed along with an illustration of its potential
uses.
On the basis of these expected values, the optimal decision would be to order a large amount of ice cream with an
expected value of $395. However, it may be possible to improve upon this value if better information regarding the
weather could be obtained. Exam questions often make the assumption that it is possible to obtain perfect
information, ie to predict exactly what the outcome of the uncertain variable will be.
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If this was the case, then the ice cream seller would purchase the size of order which gave the highest payoff for each
weather outcome - in other words, purchasing a small order if the weather was forecast to be cold, a medium order
if it was forecast to be warm, and a large order if the forecast was for hot weather. The resulting expected value
would then be:
Expected value =; 0.2 ($250) + 0.5 ($500) + 0.3 ($750) = $525
The value of the perfect information is the difference between the expected values with and without the information,
ie
The probabilities given do not add up to 1 and so, for example, P (forecast hot but weather cold) cannot mean P
(weather cold given that forecast was hot), but must mean P (forecast was hot given that weather turned out to be
cold).
We can use a table to determine the required probabilities. Suppose that the weather was recorded on 100 days.
Using our original probabilities, we would expect 20 days to be cold, 50 days to be warm, and 30 days to be hot. The
information from our forecast is then used to estimate the number of days that each of the outcomes is likely to occur
given the forecast (see Table 2).
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** If the actual weather is cold, there is a 0.3 probability that hot weather had been forecast. This will occur on 0.3
of the 20 days on which the weather was poor = 6 days (0.3 x 20). Similarly, 20 = 0.5 x 40 and 21 = 0.7 x 30.
T
he revised probabilities, if the forecast is hot, are therefore:
P (Cold)=6/47=0.128
P (Warm) = 20/47 = 0.425
P (Hot) = 21/47 = 0.447
The estimated value for imperfect information appears reasonable, given that the value we had previously calculated
for perfect information was $130.
BAYES' RULE
Bayes' rule is perhaps the preferred method for estimating revised (posterior) probabilities when imperfect
information is available. An intuitive introduction to Bayes' rule was provided in The Economist, 30 September 2000:
'The essence of the Bayesian approach is to provide a mathematical rule explaining how you should change your
existing beliefs in the light of new evidence. In other words, it allows scientists to combine new data with their existing
knowledge or expertise. The canonical example is to imagine that a precocious newborn observes his first sunset, and
wonders whether the sun will rise again or not. He assigns equal prior probabilities to both possible outcomes, and
represents this by placing one white and one black marble into a bag. The following day, when the sun rises, the child
places another white marble in the bag. The probability that a marble plucked randomly from the bag will be white
(ie the child's degree of belief in future sunrises) has thus gone from a half to two-thirds. After sunrise the next day,
the child adds another white marble, and the probability (and thus the degree of belief) goes from two-thirds to
three-quarters. And so on. Gradually, the initial belief that the sun is just as likely as not to rise each morning is
modified to become a near-certainty that the sun will always rise'
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For example, consider a medical test for a particular disease which is 90% accurate, ie if you test positive then there
is a 90% probability that you have the disease and a 10% probability that you have been misdiagnosed. If we further
assume that 3% of the population actually have this disease, then the probability of having the disease (given that
you have tested positive) is shown by:
P(Disease|Test = +) =
P(Test = +|Disease) x P(Disease)
= 0.218
This result suggests that you have a 22% probability of having the disease, given that you tested positive. This may
seem a low probability but only 3% of the population have the disease and we would expect them to test positive.
However, 10% of tests will prove positive for people who do not have the disease. Therefore, if 100 people are tested,
approximately three out of the 13 positive tests will actually have the disease.
Bayes' rule has been used in a practical context for classifying email as spam on the basis of certain key words
appearing in the text.
DATA TABLES
Data tables show the expected values resulting from combinations of uncertain variables, along with their associated
joint probabilities. These expected values and probabilities can then be used to estimate, for example, the probability
of a profit or a loss.
To illustrate, assume that a concert promoter is trying to predict the outcome of two uncertain variables, namely:
1. The number of people attending the concert, which could be 300, 400, or 600 with estimated probabilities of 0.4,
0.4, and 0.2 respectively.
2. From each person attending, the profit on drinks and confectionary, which could be $2, $4, or $6 with estimated
probabilities of 0.3, 0.4 and 0.3 respectively.
As each of the two uncertain variables can take three values, a 3 x 3 data table can be constructed. We shall assume
that the expected values have already been calculated as follows:
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The two tables could then be used to answer questions such as:
1. The probability of making a loss? = 0.12 + 0.12 + 0.16 = 0.40
2. The probability of making a profit of more than $3,500? = 0.08 + 0.12 + 0.06 = 0.26
VALUE-AT-RISK (VAR)
Although financial risk management has been a concern of regulators and financial executives for a long time, Value-
at-Risk (VaR) did not emerge as a distinct concept until the late 1980s. The triggering event was the stock market
crash of 1987 which was so unlikely, given standard statistical models, that it called the entire basis of quantitative
finance into account.
VaR is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio,
probability, and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market
loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading) is the
given probability level. Such information can be used to answer questions such as 'What is the maximum amount
that I can expect to lose over the next month with 95%/99% probability?'
For example, large investors, interested in the risk associated with the FT100 index, may have gathered information
regarding actual returns for the past 100 trading days. VaR can then be calculated in three different ways:
Admittedly, historical data is utilised in identifying possible returns but hypothetical, rather than actual, returns
provide the data for the confidence levels.
Of these three methods, the variance-covariance is probably the easiest as the historical method involves crunching
historical data and the Monte Carlo simulation is more complex to use.
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VaR can also be adjusted for different time periods, since some users may be concerned about daily risk whereas
others may be more interested in weekly, monthly, or even annual risk. We can rely on the idea that the standard
deviation of returns tends to increase with the square root of time to convert from one time period to another. For
example, if we wished to convert a daily standard deviation to a monthly equivalent then the adjustment would be :
σ monthly = σ daily x √T where T = 20 trading days
For example, assume that after applying the variance-covariance method we estimate that the daily standard
deviation of the FT100 index is 2.5%, and we wish to estimate the maximum loss for 95 and 99% confidence intervals
for daily, weekly, and monthly periods assuming five trading days each week and four trading weeks each month:
95% confidence
Daily = -1.65 x 2.5% = -4.125%
Weekly = -1.65 x 2.5% x √5 = -9.22%
Monthly = -1.65 x 2.5% x √20 = -18.45%
99% confidence
Daily = -2.33 x 2.5% = -5.825%
Weekly = -2.33 x 2.5% x √5 = -13.03%
Monthly = -2.33 x 2.5% x √20 = -26.05%
Therefore we could say with 95% confidence that we would not lose more than 9.22% per week, or with 99%
confidence that we would not lose more than 26.05% per month.
On a cautionary note, New York Times reporter Joe Nocera published an extensive piece entitled Risk
Mismanagement on 4 January 2009, discussing the role VaR played in the ongoing financial crisis. After interviewing
risk managers, the author suggests that VaR was very useful to risk experts, but nevertheless exacerbated the crisis
by giving false security to bank executives and regulators. A powerful tool for professional risk managers, VaR is
portrayed as both easy to misunderstand, and dangerous when misunderstood.
CONCLUSION
These two articles have provided an introduction to the topic of risk present in decision making, and the available
techniques used to attempt to make appropriate adjustments to the information provided. Adjustments and
allowances for risk also appear elsewhere in the ACCA syllabus, such as sensitivity analysis, and risk-adjusted discount
rates in investment appraisal decisions where risk is probably at its most obvious. Moreover in the current economic
climate, discussion of risk management, stress testing and so on is an everyday occurrence.
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Study Notes Advanced Performance Management -APM
APPROACHES TO BUDGET
Learning objectives
Evaluate the strengths and weaknesses of alternative budgeting models and compare such
techniques as fixed and flexible, rolling, activity based, zero based and incremental
Evaluate different types of budget variances and how these relate to issues in planning and
controlling organisations
Discuss and evaluate the application of activity-based
management.
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Study Notes Advanced Performance Management -APM
INTRODUCTION
This chapter looks at budgeting used as a method of control within an organisation. You will already have been
examined on budgeting in previous examinations, and much of this chapter is therefore revision.
In this examination, questions are more likely to focus on written aspects, and the syllabus includes budgeting in
not-for-profit organisations; modern developments; and behavioural aspects.
PURPOSE OF BUDGETING
Purpose Explanation
Planning A business needs to map ahead how it intends to operate in its environment. By
planning, management are forced to think and plan ahead as to how their business is
to operate, compete and grow.
Control By setting up a budget a business uses standard cost cards. These set out the expected
sales price to achieve for goods sold, the expected resources that each unit should
consume and at what cost.
Communication The budget is a formal part of the businesses reporting channels, often reflecting the
hierarchy of responsibility in the business. The budget may reflect and indeed dictate
the intended activities of the business. Senior management for example may, through
the budget, set targets for junior management to achieve in terms of sales volume
and activity.
Co-ordination In large organisations especially, it is hard to ensure that all departments are working
towards common aim and objectives. For example, it is critical that if the sales
department are aiming to sell 1,000 units, his must be communicated through the
budget to the production department so that they know how many units they are
expected to make. The production department will need (via budgets) to
communicate with the purchasing department to ensure that enough components
are purchased to cope with the production of 1,000 units and so on.
Evaluation Budgeting can allow the business to have a benchmark in order to assess the
performance of individual departments, functions or indeed managers within a
business. This is a very commonly examined area and is dealt with in later sessions.
Motivation If a departmental manager is given a budget, it acts as a target for that manager to
aspire to. If by achieving that budget the manager is rewarded, the budget acts as an
incentive to the manager. If all managers achieve their targets (and are rewarded for
doing so) then the business as a whole should achieve its aims and objectives.
Authorisation Budgets can act as a tool to authorise junior management to undertake a particular
action. For example if Manager X has $45,000 included in their budget to recruit two
new members of staff, then the manager has in essence been authorised to undertake
the recruitment and spend a set amount of money doing so.
Participation in budget
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Study Notes Advanced Performance Management -APM
Top-down approach
It is a budget, which is set without allowing the ultimate budget holders to have the opportunity to participate in
the budgeting process. It is also called ‘imposed’ budget, or non-participative.
Features
Senior management prepare budgets
Imposed on junior management
Quicker than bottom up approach
Time saving
Advantages
Strategic plans are incorporated in budgets
Increased coordination between plans and long-term objectives of the division
Involvement of senior management in operational decisions
Decreased input from inexperienced employees
Time saving
Disadvantages
Low employees morale ( hard for people to be motivated to achieve targets set by someone else)
Acceptance of organizational goals & objectives could be limited
Operational managers are likely to have a better understanding of day by day operations
Unachievable budgets ( may be for local operations)
Method of budgets
Different approaches to budgeting were studied in Paper F5. In this exam it is important that you not only understa
nd each of the techniques but that you can compare the techniques and evaluate their relative strengths and
weaknesses.
Fixed budget
A Fixed Budget is designed to remain unchanged irrespective of the volume of output or turnover attained. The
budget remains fixed over a given period and does not change with the change in the volume of production or level
of activity attained.
Flexible budget
A flexible budget is a budget which is prepared at the start of the year at more than one activity level and flexible
budget can be flexed to the actual activity level for variance analysis. For preparing flexible budget cost behaviour
of all elements should be known and all cost should be classified as fixed or variable.
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Study Notes Advanced Performance Management -APM
Example
Zenith Ltd. manufactures and sells a single product; Alpha. Operational capacity of plant is 100,000 units of
Alpha a year but due to plant deterioration it is now expected that it can only produce 80,000 units of Alpha a
year. A budget is prepared at 80% and 90% plant capacity.
80% 90%
$ $
Sales 640,000 720,000
Costs:
Direct material 96,000 108,000
Direct labour 128,000 144,000
Production overheads 210,000 230,000
Selling & distribution overheads 50,000 50,000
________ ________
Net income 156,000 188,000
________ ________
Actual production for the period was 68,000 units of Alpha. Actual costs and revenue for the period were as
follows:
$
Sales 680,000
Costs:
Direct material 105,400
Direct labour 132,600
Production overheads 213,200
Selling & distribution overheads 60,000
________
Net income 168,800
________
There was no opening and closing stock. Sales price is fixed.
Required:
You are required to prepare a flexed budget and compare the actual results with the flexed budget.
Incremental budgets
An incremental budget starts with the previous period’s budget or actual results and adds (or
subtracts) an incremental amount to cover inflation and other known changes.
It is suitable for stable businesses, where costs are not expected to change significantly. There should
be good cost control and limited discretionary costs.
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Advantages Disadvantages
Quickest and easiest method. Builds in previous problems and inefficiencies
Suitable if the organisation is stable and historic Uneconomic activities may be continued. E.g. the firm
figures are acceptable since only the increment needs may continue to make a component in-house when it
to be justified. might be cheaper to outsource.
ZBB involves the simple idea of preparing a budget from a ‘zero base’ each period (like a ‘clean sheet of paper’!).
There is no expectation that current activities should continue from one period to the next. ZBB is unlikely to be used
frequently in manufacturing industries, where the manufacturing processes are likely to be identical or very similar
year-on-year. Therefore, there is little point in redrafting the entire budget from scratch. The manufacturing process
largely dictates how costs are incurred.
ZBB is normally found in service industries where costs are more likely to be discretionary. There is more flexibility
to adapt the service provided from one period to the next to better fit in with (say) customer expectation.
Suitability
Fast moving businesses and industries
Public sector organisations such as local authorities
Discretionary costs such as research and development (R&D).
Explanation
SKANS could in one year provide students with:
Tuition Days
Revision Days
Study Text Book
Revision Kit
Study Notes
Revision Notes
Practice Exams
All of these products and services will have their own associated costs. If however student demand is such, or
there is a major selling opportunity, SKANS can undertake ZBB and decide to alter their course structure and
provision dramatically.
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Study Notes Advanced Performance Management -APM
For example SKANS can alter course structure in length and timings, change its course material, run courses from
new locations, offer new products (such as video lectures and discussion board) etc. As a service business it is
much easier to adapt the mode of delivery of its ‘product’ and previous budgets will bear little resemblance to
future activities (i.e. there is little scope for incremental budgeting).
Organisations considering using ZBB would need to consider the four basic steps to follow:
1. Prepare decision packages
Identify all possible services (e.g. courses offered by SKANS) and levels of service (e.g. length of course)
that may be provided and then cost each service or level of service. These are known individually as
decision packages.
Explanation
SKANS can consider a wide variety of methods of delivering courses. Each possible service or level of service
(decision package) needs to be costed (e.g. printing cost of a textbook) and assessed for the likely benefit (e.g.
number of students attracted to SKANS courses) it will bring to the organisation.
Explanation
SKANS have to provide a tuition and revision course for each paper. These are essential services which must be
funded by the business. Other decision packages can then be considered. SKANS may then consider updating its
course study notes as being the next most ‘value-added’ activity. After that the next most important decision
packages are ranked. This forces the management to consider carefully what their aims are for the coming year
and importantly their priorities.
3. Funding
Identify the level of funding that will be available to the business. This may relate to the amount of
cash SKANS has available, its lines of credit with its bankers etc.
4. Utilise
These funds are then used up in the order of the ranking at step 2, until exhausted. The highest ranked
decision packages are financed. Allocation of funding continues until it is exhausted (say at the 12th
ranked decision package). Any lowerranking decision packages, being less of a priority to the business
may not be funded and are ‘shelved’ (e.g. the 13th ranked decision package onwards). If however
more funding becomes available, then the business can select the next decision package (the 13th)
and undertake that decision package.
The key with ZBB is that if focuses the business’s attention on where its money must be spent to best effect. It helps
the business to prioritise where it should invest, without being dependent on a previous year’s budget (as with
incremental budgeting). It is a considered allocation of resources.
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Study Notes Advanced Performance Management -APM
Rolling budget
A rolling budget is one that is kept continually up-to-date by revising at the end of each month and also adding a
further month.
For example, on 1 January 2008 prepare a budget for the year to 31 December 2008.
At the end of January 2008, revise the budget for the remaining 11 months of 2008 (in the light of what happened
in January), and also prepare a budget for January 2009.
In this way there is always a budget for the coming 12 month period.
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Study Notes Advanced Performance Management -APM
The benefits of rolling budgets are that they are likely to be more accurate, and also the work-load of budgeting is
spread throughout the year and becomes part of the normal job – again leading to more accurate budgeting.
Example
A company uses rolling budgeting and has a sales budget as follows:
Q1 Q2 Q3 Q4 Total
($) ($) ($) ($) ($)
Sales 125,750 132,038 138,640 145,572 542,000
Actual sales for Quarter 1 were $123,450. The adverse variance is fully explained by competition being more int
ense than expected and growth being lower than anticipated. The budget committee has proposed that the revi
sed assumption for sales growth should be 3% per quarter for Quarters 2, 3 and 4.
Required:
Update the budget figures for Quarters 2–4 as appropriate
Solution
ANSWER
The revised budget should incorporate 3% growth starting from the actual sales figure of Q1.
Example
ABC is a high growth non-alcoholic drinks company, currently it uses a system of incremental budgeting. ABC has
been receiving complaints from customers about late deliveries and poor quality control. ABC's managers have
explained that they are working hard within the budget and capital constraints imposed by the board and have
expressed a desire to be less controlled. ABC's incremental budget for the current year is given below. You can
assume that cost of sales and distribution costs are variable and administrative costs are fixed.
Q1 Q2 Q3 Q4 Total
$'000 $'000 $'000 $'000 $'000
Revenue 8,760 8,979 9,204 9,434 36,377
Cost of sales 4,818 4,939 5,062 5,189 20,008
Gross profit 3,942 4,040 4,142 4,245 16,369
Distribution costs 789 808 829 849 3,275
Administration costs 2,107 2,107 2,107 2,107 8,428
Operating profit 1,046 1,125 1,206 1,289 4,666
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Study Notes Advanced Performance Management -APM
The actual figures for Quarter 1 (which has just completed) are:
$'000
Revenue 8,966
Cost of sales 4,932
Gross profit 4,034
Distribution costs 807
Administration costs 2,107
Operating profit 1,120
On the basis of the Q1 results, sales volume growth of 3% per quarter is now expected.
Required
Recalculate the budget for ABC using rolling budgeting and assess the use of rolling budgets in this context.
ANSWER
A rolling budget is one where the budget is kept up to date by adding another accounting period when the most
recent one expires. The budget is then rerun using the new actual data as a basis.
For ABC, with its quarterly forecasting, this would work by adding another quarter to the budget and then
rebudgeting for the next four quarters.
Rolling budgets are suitable when the business environment is changing rapidly (which is likely to be the case
here) or when the business unit needs to be tightly controlled (which may not be valid here since managers are
complaining about control).
Based on the assumptions that cost of sales and distribution costs increase in line with sales and that
administration costs are fixed as in the original budget.
The budget now reflects the rapid growth of the division. Using rolling budgets like this will avoid the problem of
managers trying to control costs using too small a budget and as a result, choking off the growth of the business.
This may explain some of the quality issues that ABC is experiencing.
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Study Notes Advanced Performance Management -APM
The rolling budgets will require additional resources as they now have to be done each quarter rather than
annually but the benefits of giving management a clearer picture and more realistic targets more than outweigh
this.
Poor budgeting is probably at the core of the managers' desire to be less controlled. Rolling budgets could be
seen as a tightening of control, so it may also be worth considering changing the style of control being used (see
Hopwood later).
Advantages Disadvantages
Planning and control will be based on a more accurate Rolling budgets are more costly and time consuming
budget than incremental budgets
Rolling budgets reduce the element of uncertainty in May demotivate employees if they feel that they spend
budgeting since they concentrate on the short-term a large proportion of their time budgeting or if they feel
when the degree of uncertainty is much smaller that the budgetary targets are constantly changing
There is always a budget that extends into the future There is a danger that the budget may become the last
(normally 12 months) budget 'plus or minus a bit'
It forces management to reassess the budget regularly An increase in budgeting work may lead to less control
and to produce budgets which are more up to date of the actual results
Issues with version control, as each month the full year
numbers will change
Confusion in meetings as to each numbers the business
is working towards; this can distract from the key issues.
as managers discuss which numbers to achieve
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Study Notes Advanced Performance Management -APM
Steps in ABC
1) Group production overheads into activities (cost pools), according to how they are driven.
2) Identify cost drivers for each activity, i.e. what causes the activity costs to be incurred.
3) Calculate an overhead absorption rate (OAR) for each activity.
4) Absorb the activity costs into the product.
5) Calculate the full production cost and/or the profit or loss.
Practice question
Hensau Ltd has a single production process for which the following costs have been estimated for the period
ending 31 December 2010:
$
Material receipt and inspection costs 15,600
Power costs 19,500
Material handling costs 13,650
Three products - X, Y, and Z are produced by workers who perform a number of operations on material blanks
using hand held electrically powered drills. The workers are paid £4 per hour.
The following budgeted information has been obtained for the period ending 31 December 2009:
Product X Product Y Product Z
Production quantity (units) 2,000 1,500 800
Batches of Material 10 5 16
Data per product unit:
Direct material (square metres) 4 6 3
Direct material per square metre (£) 1.25 0.50 2
Direct labour (minutes) 24 40 60
No. of power drill operations 6 3 2
Overhead costs for material receipt and inspection, process power and material handling are presently each
absorbed by product units using rates per direct labour hour.
An activity based costing investigation has revealed that the cost drivers for the overhead costs are as follows:
Material receipt and inspection: Number of batches of material
Process power: Number of power drill operations
Material handling: Quantity of material (square metres) handled
Required
Prepare a summary which shows the budgeted product cost per unit for each product of X, Y, and Z for the
period ending 31 December 2010 detailing the unit costs for each cost element using:
i. The existing method for the absorption of overhead costs and
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Study Notes Advanced Performance Management -APM
ii. an approach which recognises the cost drivers revealed in the activity based costing
investigation. (15 marks)
Solution
X Y Z
Direct materials 5 3 6
Direct labour 1.6 2.7 4
------- -------- ------
6.6 5.7 10
Production Overheads 7.5 12.5 18.75
------- -------- -------
Total Cost per unit 14.1 18.2 28.75
------- -------- --------
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Study Notes Advanced Performance Management -APM
Exam questions will be closely related to the ABC questions we looked at earlier on in the course
Benefit of ABB
1. Better understanding of overhead costs.
2. Identifies the accurate relationship between product and activity.
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Study Notes Advanced Performance Management -APM
Each and every benefit allows for better control of costs together with the opportunity to reduce the costs using
other management accounting techniques.
Disadvantages of ABB
1. Identifying appropriate cost drivers may be subjective and therefore accuracy depends on the
judgment of management.
2. The implementation and maintenance of an ABB system will be expensive and time consuming.
Activity-based management (ABM) can be defined as the entire set of actions that can be taken on a better
informed basis using ABC information. The aim is to achieve the same level of output with lower costs.
Some organisations may try to define only high-level activities to keep the number of activities defined to less than
30, while other organisations may define much more detailed activity lists. These activities may be summarised in
an activity dictionary.
The following list shows examples of some of the activities that may take place in a manufacturing organisation:
Schedule production jobs
Set up machines
Receive materials
Run machines
Support existing products
Introduce new products
Calculate the cost of the activities
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Study Notes Advanced Performance Management -APM
All indirect costs must be apportioned to the particular activities that they relate to using an appropriate basis. Staff
may be asked, for example, to estimate how much time they spend on each of the activities above so that factory
staff costs can be apportioned to the relevant activities. Other costs such as rent and heating and lighting will also
have to be apportioned. This is similar to the principle of allocating and apportioning costs to cost centres in
traditional absorption costing.
As far as ABM is concerned, simply having the information about the cost of each activity may be all that is required.
In the case of ABC however, it is then necessary to apportion the costs of each activity to the products using the cost
driver information.
The cost drivers for the activities listed above may be as follows:
Activity Driver
Schedule production jobs Number of production runs
Set up machines Number of setups
Receive materials Number of receipts
Run machines Machine hours
Support existing products Number of products
Introduce new products Number of new products introduced
ABC then apportions the costs of each activity among the different products that use them, based on the use of the
drivers by each product.
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Study Notes Advanced Performance Management -APM
Rent of factory X
Maintenance X
Depreciation X
------
Total costs X
------
Having costs analysed by activity provides much more relevant information to managers. There may be activities
that are being performed that do not add value, so these can be stopped. Management may also identify activities
that cost more than expected, and can investigate these. Management might decide for example that the cost of
setting up machines is too high. Using their knowledge of the drivers of that activity, management would realise that
having longer production runs could reduce the cost of this activity as the number of set ups would be reduced.
Many writers discuss using ABM to eliminate non-value added activities. Cooper and Kaplan claim that it is not always
clear whether an activity is value added or not. It might be argued for example that setting up the machines is a non-
value added activity, as customers do not value it. However, without setting up machines, there can be no
production. Instead, Kaplan and Cooper suggest discussing how efficient an activity currently is, and therefore how
much opportunity there is for improvement.
In Total Quality Management, costs are analysed into costs of conformance (appraisal and prevention costs) and
costs of non-conformance (internal and external failure costs). The aim of TQM is to reduce the costs of non-
conformance. Activity-based management enables organisations to more accurately calculate these quality related
costs and to monitor improvements.
Six Sigma, Business Process Improvements and Business Process Reengineering aim to achieve large one off
(discontinuous) improvements in particular business processes relating to efficiency and better customer
satisfaction. ABM can support these methodologies in several ways:
1. Identifying processes that need improvement and establishing priorities
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Study Notes Advanced Performance Management -APM
As far as establishing priorities is concerned, ABM enables management to identify which activities or processes it is
spending the most on, and where the biggest financial savings can be made. It can also identify activities where
management believe big improvements can be made. Typically, these are the processes that are highly fragmented,
and involve people from many different departments.
Many business improvement projects may require considerable capital expenditure, and it will be necessary
therefore to do a cost benefit analysis to establish whether it is worthwhile going ahead. ABM can provide more
accurate information about the potential savings from a particular project, therefore leading to a more accurate
assessment.
After completion of a business process improvement project, many businesses do not measure the benefits achieved
by the project, and in some cases fail to take full advantage of them. For example, the project may have reduced the
amount of time spent on dealing with customer complaints, but have the excess staff members whose time has now
been freed up been re-deployed in other departments?
ABM models also provide information about cost incurred on the various activities, so it is easier to monitor how
much the costs of an activity have been cut by a particular project.
Example
A case described by Kaplan and Cooper related to a producer of technical manuals for the computer industry. The
company had run out of storage space in their main factory in South Street, due to a large amount of slow moving
inventory for their biggest customer, IBM. So additional storage space was rented in Elmore Street, several
kilometres away from South Street. After production, the manuals for all other customers were transported to
Elmore Street for storage. They would then be returned to South Street for despatch to the customer when
required. This was often only two or three weeks later.
The management knew that this movement of finished goods to and from Elmore Street was inefficient. However,
since the company used a traditional cost accounting system, the only visible cost relating to this was the cost of
transport – this was $200,000 per year. A solution to redesign the storage process in the South Street factory for
the fast moving goods, and to move the slow moving inventory to Elmore Street (or destroy it entirely) was
estimated to cost $600,000. It did not seem worth investing in this, given that the annual saving would be only
$200,000.
Activity based management was then introduced, and this identified that fact that the actual costs of operating
the inefficient system were much higher than expected. The annual savings of the proposed solution analysed by
activity were:
$
Reduced rental expense 128,000
Reduced transport costs 271,000
Reduced costs of moving WIP within factory 38,000
Reduced costs of moving finished goods within factory 91,000
Reduced costs of finding materials 88,000
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Study Notes Advanced Performance Management -APM
his activity based information clearly gave management a much more accurate idea of the savings that could be
made by going ahead with the proposed solution, and since the required investment was $600,000 it was clearly
worthwhile.
While it may be tempting to suggest that all such loss making products should be stopped, there are two possible
dangers to such a simplistic decision. First, if 80% of the products were stopped, demand for the remaining 20%
might fall, as many customers prefer to buy all their requirements from one supplier. A second danger is that even
if the business were to stop producing the loss making products, the costs associated with them would not all be
saved.
A more realistic approach that can be used is to adjust the price of the loss-making products, or to employ tools such
as target costing to reduce the cost.
A second application of ABM is customer profitability analysis where overheads are allocated to customers using
activity based management processes to obtain a more accurate analysis of the profit or loss generated by each
customer. In traditional costing it is assumed that if a customer generates positive contribution, then servicing that
customer must increase the profits of the company. This ignores the fact that many 'fixed' overhead costs are
customer specific – such as the time spent by customer service departments.
Using ABM, overhead costs are also apportioned to customers using appropriate cost drivers, giving a more accurate
picture of how profitable each customer is. Such exercises have produced surprising results for many businesses,
where the 'best' customers have often turned out to generate losses when ABM is employed.
Example
In Hometown, there are several providers of electricity, and domestic consumers can easily switch from one provider
to another.
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Study Notes Advanced Performance Management -APM
One of the providers of electricity is First Electric. The company recently had an aggressive advertising campaign and
increased its customer base from 30,000 users to 40,000. Management was surprised to discover that this led to a
fall in profits.
The company introduced customer profitability analysis, using activity-based principles. The analysis identified the
following activities, along with their cost per unit of driver.
Activity Driver Cost per unit of
driver
Meter reading Number of visits $20
Customer service Number of calls $30
Invoicing Number of invoices $10
Customer complaints Number of complaints $25
The meter reading took place every three months, after which an invoice was issued.
For an 'easy' customer, the overhead cost per quarter was $30, the cost of reading the metre, and issuing the invoice.
More difficult customers could cost much more. Many customers were out when the metre reader came, so a second
visit was necessary. Sometimes the customer was not home second time either, so was requested to read their own
metre and then call the customer service centre.
Using this information, First Electric was able to analyse accurately the profit per customer. The company was
surprised to learn that it made a loss on 20% of its customers and only broke even on a further 30%.
In order to remedy the situation, the company made a number of changes. First, it reduced the number of meter
readings to once per year, and issued invoices based on estimated consumption for the other quarters of the year.
It introduced a website where customers could enter their own meter readings if they were not home at the date of
the reading, thus reducing the amount of time used by the customer service department. These actions are examples
of operational activity-based costing as they relate to reducing the cost of existing activities.
The company also made attempts to stop supplying loss making customers by increasing prices above those of
competitors, encouraging loss making customers to switch to other providers, while offering big discounts to
profitable customers, encouraging them to remain loyal. This is an example of strategic activity-based costing, as it
focuses on which customers the company should supply to.
Evaluation of ABM
The benefits of ABM (and ABC) are greatest in organisations that have high indirect costs. A major reason for the
increase in the use of ABC in the last 30 years has been the fact that as manufacturing processes have become more
IT based and sophisticated, overhead costs have increased, while direct costs, particularly labour, have fallen.
ABC is most useful in organisations with a wider range of products, as it is these organisations that will have the most
difficulty in allocating overhead costs among different products.
ABM can be criticised for being too inwardly focused. It aims to increase profits by reducing the cost of the activities
that it already performs. It does not consider external factors, such as changes in consumer demand for its product.
Users of ABM and ABC often assume that all overhead costs are variable. This is not the case, and some overhead
costs will be fixed, so will not be saved if activities are reduced.
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Study Notes Advanced Performance Management -APM
ABM is also complex and is expensive to implement. For small businesses, or businesses with narrow product ranges,
the benefits of implementing ABM may not justify the costs.
Question
Note – this question is an abridged version of a question that appeared in the June 2013 Paper APM exam.
Navier Aerials Co (Navier) manufactures satellite dishes for receiving satellite television signals. Navier supplies
the major satellite TV companies who install standard satellite dishes for their customers. The company also
manufactures and installs a small number of specialised satellite dishes to individuals or businesses with specific
needs resulting from poor reception in their locations.
The CEO wants to initiate a programme of cost reduction at Navier. His plan is to use activity-based management
(ABM) to identify non-value adding activities. The first department to be analysed is the customer care
department, as management believe that the costs of this department are too high. The costs for the most recent
year from the existing accounting system are shown in Table 1.
The CEO wants you to consider the implications for management of the customer care process of the costs of
each activity in that department. The CEO is especially interested in how this information may impact on the
identification of non-valued added activities and quality management at Navier.
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Study Notes Advanced Performance Management -APM
Required:
Assess how the information on each activity can be used and improved upon at Navier in assisting cost reduction
and quality management in the customer care department.
(12 marks)
Solution
The information in Table 2 shows that the main cost activities of the CC department are pre-sale preparation
(handling enquiries and quotes) and post-sale complaints handling. Together, these activities consume 65% of the
resources of the customer care department.
The pre-sale work is essential for the organisation and the department converts 46% (16,000/35,000) of enquiries
to orders. It would be beneficial to try to benchmark this ratio to competitor performance although obtaining
comparable data will be difficult, due to its commercially sensitive nature.
However, the complaints handling aspect is one, which would be identified as non-value; adding in an activity-
based management analysis. Non-value adding activities are those that do not increase the worth of the product
to the customer; common examples are inspection time and idle time in manufacturing. It is usually not possible
to eliminate these activities but it is often possible to minimise them. Complaints handling is not value adding as
it results from failure to meet the service standards expected (and so is already included in the price paid).
Complaints handling links directly to issues of quality management at Navier as improved quality of products
should reduce these costs. These costs are significant at Navier as complaint numbers are 20% (3,200/16,000) of
orders. Complaints may arise in many ways and these causes need to be identified. As far as the operation of the
CC department is concerned, it may cause complaints through poor work at the quotation stage where the job is
improperly understood or incorrectly specified to the manufacturing or installation teams. This leads to non-
conformance costs as products do not meet expected standards and, in this case, complaints imply that these are
external failure costs as they have been identified by customers
Quality of the end product could also be affected by the supervision activity and in order to ensure that this is
functioning well, the CC department will need to have the authority to intervene with the work of other
departments in order to correct errors – this could be a key area for prevention of faults and so might become a
core quality activity (an inspection and prevention cost).
The other activities in the department are administrative and the measures of their quality will be in the financial
information systems. Order processing quality would be checked by invoice disputes and credit note issuance.
Credit check effectiveness would be measured by bad debt levels.
Variances
In F5 you learnt that variance analysis was a key element of management control:
1. Targets and standards are set reflecting what should happen.
2. Actual performance is then measured.
3. Actual results are then compared with the (vexed) standards, using
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4. variance analysis.
5. Significant variances can then be investigated and appropriate action taken.
Spend a little bit of time reviewing the !!dances covered in F5 to ensure you are comfortable with the calculations
and the meaning of each variance
A budget should only be revised for items that are beyond the control of the organisation.
Learning curve
In practice, it is often found that the resources required to make a product decrease as production volumes increase.
It costs more to produce the first unit of a product than it does to produce the one hundredth unit. In part, this is
due to economies of scale since costs usually fall when products are made on a larger scale. This may be due to bulk
quantity discounts received from suppliers, for example.
The learning curve, effect, however, is not about this; it is not about cost reduction. It is a human phenomenon that
occurs because of the fact that people get quicker at performing repetitive tasks once they have been doing them
for a while. The first time a new process is performed, the workers are unfamiliar with it since the process is untried.
As the process is repeated, however, the workers become more familiar with it and better at performing it. This
means that it takes them less time to complete it.
The specific learning curve effect is that the cumulative average time per unit decreased by a fixed percentage each
time cumulative output doubled.
The learning process starts as soon as the first unit or batch comes off the production line. Since a doubling of
cumulative production is required in order for the cumulative average time per unit to decrease, it is clearly the case
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that the effect of the learning rate on labour time will become much less significant as production increases.
Eventually, the learning effect will come to an end altogether. You can see this in Figure 1 below. When output is
low, the learning curve is really steep but the curve becomes flatter as cumulative output increases, with the curve
eventually becoming a straight line when the learning effect ends.
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Figure 1
The learning curve effect will not always apply, of course. It flourishes where certain conditions are present. It is
necessary for the process to be a repetitive one, for example. Also, there needs to be a continuity of workers and
they mustn’t be taking prolonged breaks during the production process.
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practice, financial services, publishing and travel. In fact, research has shown that just under half of
users are in the service sector.
Tabular approach
*The learning curve applies when output is doubled
Example:
Time to make first unit=50 hours and learning curve is 90%
So for example if you want to calculate time it took to make 8 th unit, it will be 32.4 from above table
And time it took to make 8 units, it will be 291.6
Formula approach
The learning curve formula, as shown below, is always given on the formula sheet in the exam:
While a value for ‘b’ has usually been given in past exams there is no reason why this should always be the case. All
candidates should know how to use a scientific calculator and should be sure to take one into the exam hall.
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Example
A firm's workforce experiences a 75% learning rate.
The budgeted cost for the first batch is 100 Hours
Required
Using the formula Y= aXb , calculate the cost of producing:
(a) the first 10 batches in total
(b) the 10th batch only
Solution
a) Steps
- First calculate ‘Cumulative Average time per Unit’ (Y)
- Calculate Total time (Hours) by multiplying total no. of units with ‘Y’
b) Steps
- Calculate Total time (Hours) of which you have to find (i.e. 10 batches) as calculated above
- Calculate Total time (Hours) of which you have to find less 1 (i.e. 10 – 1 = 9 batches)
- Difference of step 2 and step 1 is the tome taken to produce a specific unit (i.e. 10th batch)
Total time taken to produce 10 batches: 384.59 hrs (from part ‘a’)
Total time taken to produce 9 batches: 361.60 hrs (Working)
Time to produce the 10th batch only(total cost of 10 batches minus total cost of 9 batches) =384.59-
361.60
=22.99 hrs
Working
Y = 100 x 9 – 0.415
= 40.1781 hrs
Total time to produce 9 batches = 9 x 40.1781 = 361.60 hrs
Cessation of learning
A time will be reached when the learning effect no longer applies and steady state of production will reach for a
product.
When a steady state point is reached a standard time and labour cost for the product can be established (most of
the time it is the time it takes to make the last unit with learning.
For example if learning ceases at 30 units. The time it takes to make 30th unit will be time required to make the rest
of the units (hint: use learning curve formula to calculate time for 30 th unit as shown in detailed example above)
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Introduction
This chapter looks at the different types of business structure, and the effect the structure has on the information
needed. It also looks at the types of changes that business might implement to improve their performance.
Functional structure
One of the common structures found in medium-sized organisations is the functional structure. This means that
people within an organisation are organised by function. So, for example, there is a finance department, a
manufacturing department, a sales department, and so on.
Main board
Budgets are set for each individual function and amalgamated into an overall budget for the business. Actual results
for each function are collected and compared to budget on a periodic basis. The comparison of actual to budget is
made available to functional managers so that they can take corrective action. Again the results are amalgamated
for senior management.
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Divisional structure
As organisations grow they will often develop a divisional structure, where each division has its own functional
departments and where the divisional manager has a degree of autonomy.
Head office does however need to aggregate the information received from each division in order to assess the
overall performance of the organisation.
As a result, an employee working in the tax department of an office in one town will be reporting both to the manager
of that office, and to the nationwide tax manager.
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These employees are responsible to both the project leader of project B and to the quality control manager.
In Virtual Organisations and Beyond (1), Hedberg, Dahlgren, Hansson and Olve describe how the Swedish clothes
retailer GANT operates. The centre of operations is a Swedish company, Pyramid Sportswear AB, which has eight
employees. Pyramid Sportswear owns the rights to use the brand name, selects the designers, performs quality
control of production, arranges advertising, and organises the shipping of clothes from the factories to the retailers.
Design and production of the clothes are outsourced, and the clothes are sold through independent retailers. To the
customer it appears that there is one organisation, the GANT Company, which performs all these activities but in
reality no such organisation exists. This group of independent companies, working together, coordinated by Pyramid
Sportswear is described as an ‘imaginary organisation’ by Hedberg et al although the term ‘hollow organisation’ has
been used by others to describe similar arrangements. Pyramid Sportswear is the core of this imaginary organisation,
and it coordinates the other organisations; the partners.
A virtual organisation is one that has little or no physical premises, but where employees and managers work
remotely (typically from home) and are connected using IT, such as emails, video conferencing, extranet and
intranets. The organisation appears to the outside world to be just like any traditional style organisation. Customers
and suppliers are linked using IT systems which adds to the impression that they are all part of the organisation. The
classic example is Amazon, the online retailer. Most orders placed on Amazon’s web site are forwarded to suppliers,
who then send the goods directly to the customer.
Collaboration is also an important element in many business chains. Organisations such as Apple rely on a network
of independent programmers who develop apps for their products. While these programmers work independently,
they rely on Apple sharing technical information with them about its operating systems, and through Apple’s
developer conference, they become part of the Apple family.
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For the rest of this article, all these different arrangements will be referred to as complex business structures. They
include a core enterprise (such as Pyramid Sportswear) that coordinates the activities of the partners in the
structure.
Typically a contract or service level agreement will specify what activities are expected of each partner, what the
minimum standards are in terms of quality, and the price that will be paid. These agreements may also describe
reporting requirements, whereby partners are required to report their own performance using agreed metrics, such
as % of late deliveries, and number of customer complaints. There may also be fines for repeated failure to achieve
some of the standards.
Planning
In traditional organisations, planning and control is based on the budget. The process of preparing the budget
requires the different parts of the organisation to coordinate their activities for the following year, and this requires
some central coordination. Budgets also aim to ensure that costs of production are controlled. At the end of each
accounting period, actual results are compared with budgets and action taken to remedy any significant variances.
In a complex business structure, the core organisation does not need to have a detailed analysis of costs incurred by
the business partners. From a financial point of view, the core is only interested the prices that partners will charge,
and these will already have been agreed in the service level agreement. The core does need to be sure that suppliers
will have the capacity to meet its demand on time, even though it may not be possible to specify how much that
demand will be at the start of the year. Some type of planning will therefore be required to ensure that all parts of
the structure have the flexibility and capacity to meet the potential demand from the core organisation.
Control
The core is mainly interested in non-financial aspects of the performance of the partners. Quality of goods or services
are obvious areas. Other aspects may include delivery times, quality of customer service and ethical behaviour.
Several large multinational companies have had their reputations damaged by the behaviour of partners in third
world countries who employ child labour for example, or operate sweat shop style operations where employees are
paid subsistence wages, and made to work long hours. Poor ethical behaviour of such partners can harm the
reputation of the whole structure.
Expected standards must be specified in service level agreements. If a partner is required to fulfil sales orders to
customers for example, there may be requirements about the minimum period within which such orders must be
completed. The service level agreement may also require compliance with a corporate code of ethics. Partners will
be expected to provide performance reports showing appropriate measures of performance and must allow
inspections and audits to be performed by the core organisation.
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Information technology can also be used to keep tabs on employees. System logs can record what time employees
log onto and off the system, although there is of course no guarantee that they are being productive all of the time
they are logged in.
Confidentiality of information becomes a risk, due to the fact that the core organisation is sharing key information
with its partners. This may include commercially sensitive information such as production methods, or names and
addresses of customers. Procedures need to be in place to ensure that such information is secure. This would include
requirements relating to the security surrounding the information systems.
Motivation can also be an issue. Where all business processes are carried out in house, it can be easier to motivate
employees using reward systems. Where the processes are carried out by an outside partner, it may not be so easy
to motivate them. It is essential therefore that all partners share the same objectives and understand how they
contribute to the success of the whole organisation. In some relationships, there is an element of profit share or
bonus paid to the partners to motivate them to perform well.
Role of IT
Information systems often play a crucial role in complex business structures. The core organisation may invest in the
development of an information system that it requires all partners to use. This can mitigate many of the challenges
relating to performance management discussed above. Its role in monitoring the work of employees has already
been noted above. Having one system used by all partners means that everyone is using the same data. There should
be less difficulty collecting information about the performance of partners since the information will all be stored
on one system. The core party has greater control over the security of data, and communication between the parties
will be much more fluid allowing greater coordination.
Conclusion
The greater use of business partners to perform crucial business processes may lead to lower costs and greater
specialisation. However, the reliance on external partners can lead to additional challenges for performance
management. These must be considered in drafting of contracts with the partners. The use of shared IT systems can
also assist in many of the challenges.
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Heterogeneity:
Manufacturing often produces many identical units; service industries often produce tailored products eg an audit.
Costing information and efficiency measurement will be quite different. Pricing will be very different as customer
(or clients) will find it more difficult to judge prices.
Perishability:
Many services are perishable ie they lose their value after a certain time. An example is airline seats: once the aircraft
departs the seats have no value. Again, this presents interesting pricing challenges. Performance will be improved
by attracting each extra passenger at the maximum marginal price, but if everyone knows that prices will fall near
the departure date, passengers will be encouraged to postpone booking until prices reduce.
Intangibility:
It is difficult to show potential customer what they will get for their money. Auditing firms cannot show clients an
audit or audit file so how can potential clients judge value for money?
Simultaneity:
in manufacturing, production and sale can be separated. This allows products to be quality checked before dispatch
and allow flexibility in timing. For example, production can be carried out steadily throughout the year and inventory
can be stored until busy sales periods. Services cannot be stored and are often instantly delivered. This places
additional demands on scheduling, pricing and quality control information
No transfer of ownership.
Often services or the use of a service provider is for a limited period of time. Pricing and demand information has to
reflect this. For example, the pricing of hotel rooms will vary from week-days to weekends. In addition because a
service is being provided for a limited period only, consumers are likely to be very demanding during that period.
These differences mean that the performance management will need to adapt, for example it could be argued that:
Information requirements of service businesses will be broader than that of manufacturers.
More qualitative information will be required concerning customer satisfaction and employee morale.
Most of the expenses in service businesses are overheads, making activity based cost information more
valuable.
Business integration
Business integration is about linking an organization’s systems together to streamline processes that will lead to
greater efficiency.
For an example, "you’ll streamline operations and gain a competitive edge by integrating your accounting, business
intelligence, CRM, supply chain and human resource management applications,". BI is mostly applicable to
manufacturers that deal in large quantities of inventory. With a warehouse management B2B integration solution.
A company should be careful about choosing the implementation strategy, because If the most effective integration
strategy is not adopted it runs the risks of deploying standalone systems and applications that only lead to more
silos.
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Performance management can be enhanced by the use of the value chain (Porter) to enhance the linkages between
activities within (and outside) the organisation.
This model represents organizations by setting out the activities they carry out.
Firm infrastructure, technology development, human resources and procurement are known as support activities
(mostly indirect-costs). The other activities are primary activities.
By carrying out these activities organization can manage to make profits. However, it is essential for the organization
to know what gives the right (or ability) to make profits.
Whatever it is that customers value is the key to an organisation’s success and its performance there needs to be
carefully managed. The organisation also has to be careful about changing or removing activities or performance
that customers value. If an organisation is left carrying out tasks that are not valued by customers, how will the
organisation survive? Short term performance improvements in one area might lead to longterm performance
decreases in another.
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McKinsey’s 7s Model
This model represents organizations using the following inter-related elements. To carry out a strategy successfully,
consideration has to be given to getting each element correct:
Structure
Strategy
System
Shared
values
Style
Skills
Staff
Strategy
Plans on how to reach identified goals and for dealing with the environment, competition, customers, new
technology and so on
Structure
The way the organization’s units relate to each other: centralized, functional divisions, divisionalisation, tall/narrow
or wide/flat, decentralized (the trend in larger organizations); matrix etc.
Systems
The procedures, processes and routines define how work is to be done: financial systems, quality control systems,
recruitment, promotion and performance appraisal systems, information systems, safety procedures.
Skills
Distinctive competences of personnel or of the organization as a whole.
Staff
Numbers and types of personnel within the organization.
Style
Cultural style of the organization and how key managers behave in achieving the organization’s goals. For example
an organisation could adopt a role culture or a task culture.
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Shared Values
What the organization stands for and what it believes in. Central beliefs and attitudes.
The upper three elements on the dark background are the ‘hard Ss’ , meaning that they are relatively easy to describe
and define. Many organization focus too much on these because they are easy to define and describe.
The lower three on the white background and the central element are the ‘soft Ss’ and are less easy to describe and
define. Therefore, these tend to be ignored.
Additionally, all the elements are all inter-dependant so that changing one will affect others. For example, the
introduction of a new production system will probably affect skills structure, style and staff. It could even have an
impact on strategy if it allowed, for example, more flexible production.
It is not simply attempting to improve the existing way of doing things, but starting almost with a blank piece of
paper and designing how best to operate the business. The starting point it to determine what the desired outcome
is of the organisation and then to design how best to achieve it.
A leading advocate of business process reengineering – Michael Hammer – claimed that most of the work being
done does not add any value for customers, and that this work should be removed, rather than simply speeded up,
using technology. Information technology in particular has been used primarily for automating existing processes
whereas us should be used as a way of making non-value added work obsolete.
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Learning Objectives
Highlight the ways in which contingent (internal and external) factors influence management accounting and
its design and use
Discuss the principal internal and external sources of management accounting information, their costs and
limitations
Explain how information systems provide instant access to previously unavailable data that can be used for
benchmarking and control purposes and help improve performance (for example, through the use of
enterprise resource planning systems and data warehouses)
Assess the need for businesses to continually refine and develop their management accounting and
information systems if they are to maintain or improve their performance in an increasingly
competitive and global market evaluate the compatibility of management accounting objectives
and management accounting information systems.
Discuss the integration of management accounting information within an overall information system, for
example the use of enterprise resource planning systems
Demonstrate how the information might be used in planning and controlling activities, e.g. Benchmarking
against similar activates discuss how it developments, e.g. Unified corporate databases. Rfids and network
technology may influence management accounting systems
Discuss the integration of management accounting information within an overall information system, for
example the use of enterprise resource planning systems
Discuss the development of big data and its impact on performance measurement and management,
including the risk and the challenges it presents
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Introduction
This chapter considers the impact of IT on management accounting. There is a lot of terminology, which may or may
not be already familiar to you. You are unlikely to be tested on specific terminology, but you should be aware of the
various items listed in this chapter.
Source Information
Sales ledger system Number and value of invoices
Volume of sales
Value of sales, analysed by customer
Value of sales, analysed by product
Purchase ledger system Number and value of invoices
Value of purchases, analysed by supplier
Payroll system Number of employees
Hours worked
Output achieved
Wages earned
Tax deducted
Fixed asset system Date of purchase
Initial cost
Location
Depreciation method and rate
Service history
Production capacity
Production Machine breakdown times
Output achieved
Number of rejected units
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Source Information
Suppliers Product prices
Product specifications
Newspapers, journals Share price
Information on competitors
Technological developments
National and Market surveys
Government Industry statistics
Taxation policy
Inflation rates
Demographic statistics
Forecasts for economic growth
Customers Product requirements
Price sensitivity
Employees Wage demands
Working conditions
Banks Information on potential customers
Information on national markets
Business enquiry agents Information on competitors
Information on customers
Internet Almost everything via databases (public and private), discussion groups
and mailing lists.
Accurate: Sufficient for its purpose. Note that at higher managerial levels information does not
normally need to be as accurate as at lower levels
User-targeted: It should provide the information by needed by the user to make the decision/perform
the job
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Authoritative: Well, you know how unreliable some web-site data is: sometimes deliberately
misleading, sometimes sloppy, sometimes out-of-date.
Timely: Information should be received quickly enough to enable better decisions. There is no
need for all information to be ‘instantly’ available and speed often has a cost.
An effective management information system will define the areas of control within the organisation and the
individuals who are responsible for those areas and ensure that the relevant information is communicated and flows
to the managers in charge of those areas.
Information and management accounting systems need to be developed continually otherwise they will become out
of date either because of advances in technology or because of environmental changes.
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The marketplace is increasingly competitive and increasingly global, creating different information needs for
management.
IT development
IT has made it possible to access data and information instantly. This should mean that delays between events,
processing the results of those events and feedback to alter future events should be much shorter. With manual
accounting systems it took significant time to collect and process results, prepare reports and for those reports to
be distributed to managers. Now is common for managers to have daily update on events (for example sales of many
different products in supermarkets) and to take action to improve performance much more quickly. Indeed this can
often be in real time. For example, as a particular airline flight receives bookings, air fares can be changed many
times per day to try to maximize the marginal revenue that can be earned.
Data warehouse:
A vast amount of data. For example, supermarkets recording every loyalty card owner’s purchases.
Data mining:
Searching through a data warehouse in the hope of finding information of use – particularly unexpected useful
information.
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Groupware:
Allows users to collaborate. An example is Lotus Notes.
Internet:
Gives access to websites. Searches can be made on keywords (eg using Google) to find sites that might be of use.
Intranets:
An internal internet. Very useful for distributing information within an organisation
Extranets:
An organisation’s intranet given access to another’s intranet.
An ERPS can also be used to produce customised reports and can support performance measures such as the
balanced scorecard.
IT has enabled more and more data to be input remotely and/or automatically. You should be aware of the uses of
the following:
Laptop/notebook computers often with WiFi or 3G (or 4FG) connectabiity allow sales personnel to contact head
office to check on inventory and to enter new orders.
Handheld devices (including smartphones and iPads) can be used to input inventory counts and update
production statistics
Barcodes (standard super-market technology)
RFID tags (radio frequency identification tags). RFID tags are tracking consumer products worldwide. Many
manufacturers use the tags to track the location of each product they make from the time it's made until it's
pulled off the shelf and tossed in a shopping cart.
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Big data
There are many definitions of the term ‘big data’ but most suggest something like the following:
'Extremely large collections of data (data sets) that may be analysed to reveal patterns, trends, and associations,
especially relating to human behaviour and interactions.'
In addition, many definitions also state that the data sets are so large that conventional methods of storing and
processing the data will not work.
In 2001 Doug Laney, an analyst with Gartner (a large US IT consultancy company) stated that big data has the
following characteristics, known as the 3Vs:
Volume
Variety
Velocity
These characteristics, and sometimes additional ones, have been generally adopted as the essential qualities of big
data
The commonest fourth 'V' that is sometimes added is: Veracity: is the data true and can its accuracy be relied upon?
VOLUME
The volume of big data held by large companies such as Walmart (supermarkets), Apple and EBay is measured in
multiple petabytes. What is a petabyte? It’s 1015 bytes (characters) of information. A typical disc on a personal
computer (PC) holds 109 bytes (a gigabyte), so the big data depositories of these companies hold at least the data
that could typically be held on 1 million PCs, perhaps even 10 to 20 million PCs.
These numbers probably mean little even when converted into equivalent PCs. It is more instructive to list some of
the types of data that large companies will typically store.
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Retailers
Via loyalty cards being swiped at checkouts: details of all purchases you make, when, where, how you pay, use of
coupons.
Via websites: every product you have every looked at, every page you have visited, every product you have ever
bought.
Banking systems
Every receipt, payment, credit card information (amount, date, retailer, location), location of ATM machines used.
VARIETY
Some of the variety of information can be seen from the examples listed above. In particular, the following types of
information are held:
Browsing activities: sites, pages visited, membership of sites, downloads, searches
Financial transactions
Interests
Buying habits
Reaction to advertisements on the internet or to advertising emails
Geographical information
Information about social and business contacts
Text
Numerical information
Graphical information (such as photographs)
Oral information (such as voice mails)
Technical information, such as jet engine vibration and temperature analysis
Structured data: This data is stored within defined fields (numerical, text, date etc) often with defined lengths, within
a defined record, in a file of similar records. Structured data requires a model of the types and format of business
data that will be recorded and how the data will be stored, processed and accessed. This is called a data model.
Designing the model defines and limits the data which can be collected and stored, and the processing that can be
performed on it.
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An example of structured data is found in banking systems, which record the receipts and payments from your
current account: date, amount, receipt/payment, short explanations such as payee or source of the money.
Unstructured data: Refers to information that does not have a pre-defined data-model. It comes in all shapes and
sizes and it is this variety and irregularity which makes it difficult to store in a way that will allow it to be analysed,
searched or otherwise used. An often quoted statistic is that 80% of business data is unstructured, residing it in word
processor documents, spreadsheets, PowerPoint files, audio, video, social media interactions and map data.
Here is an example of unstructured data and an example of its use in a retail environment:
You enter a large store and have your mobile phone with you. That allows your movement round the store to be
tracked. The store might or might not know who you are (depending on whether it knows your mobile phone
number). The store can record what departments you visit, and how long you spend in each. Security cameras in the
ceiling match up your image with the phone, so now they know what you look like and would be able to recognise
you on future visits. You pass near a particular product and previous records show that you had looked at that
product before, so a text message can be sent perhaps reminding you about it, or advertising a 10% price reduction.
Perhaps the store has a marketing campaign that states that it will never be undersold, so when you pass near
products you might be making a price comparison and the store has to check prices on other stores websites and
message you with a new price. If you buy the product then the store might have further marketing opportunities for
related products and consumables and this data has to be recorded also. You pay with an affinity credit card (a card
with associations with another organisation such as a charity or an airline), so now the store has some insight into
your interests. Perhaps you buy several products and the store will want to discover if these items are generally
bought together.
So just walking round a store can generate a vast quantity of data which will be very different in size and nature for
every individual.
VELOCITY
Information must be provided quickly enough to be of use in decision-making and performance management. For
example, in the above store scenario, there would be little use in obtaining the price-comparison information and
texting customers once they had left the store. If facial recognition is going to be used by shops and hotels, it has to
be more or less instant so that guests can be welcomed by name.
You will understand that the volume and variety conspire against velocity and, so, methods have to be found to
process huge quantities of non-uniform, awkward data in real-time.
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The processing of big data is generally known as big data analytics and includes:
Data mining: analysing data to identify patterns and establish relationships such as associations (where several
events are connected), sequences (where one event leads to another) and correlations.
Predictive analytics: a type of data mining which aims to predict future events. For example, the chance of
someone being persuaded to upgrade a flight.
Text analytics: scanning text such as emails and word processing documents to extract useful information. It
could simply be looking for key-words that indicate an interest in a product or place.
Voice analytics: as above but with audio.
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AGE OF USER
The final table is instructive. OpenTuition.com does not ask for users’ ages, so this data has been pieced together
from other information available to Google. It has been able to do this for only about 58% of users.
Amazon: the world’s leading e-retailer collects huge amounts of information about customers’ preferences and
habits which allow it to market very accurately to each customer. For example, it routinely makes recommendations
to customers based on books or DVDs previously purchased.
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Airlines: they know where you’ve flown, preferred seats, cabin class, when you fly, how often you search for a flight
before booking, how susceptible you are to price reductions, probably which airline you might book with instead,
whether you are returning with them but didn’t fly out with them, whether car hire was purchased last time, what
class of hotel you might book through their site, which routes are growing in popularity, seasonality of routes. They
also know the profitability of each customer so that, for example, if a flight is cancelled they can help the most
valuable customers first.
This information allows airlines to design new routes and timings, match routes to planes and also to make
individualised offers to each potential passenger.
Disease epidemic identification: In 2009, Google was able to track the spread of influenza across the USA faster than
the government’s Center for Disease Control and Prevention. How? They monitored users entering terms like ‘Flu
symptoms’, ‘Flu remedies’, High temperature’. This connection was uncovered by web analytics looking at popular
search terms then finding a correlation with other information confirming influenza infections. Of course, you have
to be careful drawing conclusions about correlations: the association between the use of search terms and the
outbreak of flu might be driven by news articles on the spread of the epidemic rather than the epidemic itself.
Target: Target is the second largest discount retailer in the USA. There is an often quoted story about their ability to
predict when a customer is pregnant – frequently before the customer has informed her family. By looking at about
25 products it is claimed that they can create a pregnancy predictor. For example, early pregnancy often causes
morning sickness so consumers would perhaps change to blander food and less perfumed shower gel. Why would
Target be interested in knowing whether a consumer is pregnant? Well that person will require different products
during the pregnancy then in a few months the baby will have its own product needs: nappies, baby shampoo and
clothes. Early identification of pregnancy can allow Target to establish the shopping habits of the mother and
perhaps even the preferences of the child.
Cost: It is expensive to establish the hardware and analytical software needed, though these costs are continually
falling.
Regulation: Some countries and cultures worry about the amount of information that is being collected and have
passed laws governing its collection, storage and use. Breaking a law can have serious reputational and punitive
consequences.
Loss and theft of data: Apart from the consequences arising from regulatory breaches as mentioned above,
companies might find themselves open to civil legal action if data were stolen and individuals suffered as a
consequence.
Incorrect data (veracity): If the data held is incorrect or out of date incorrect conclusions are likely. Even if the data
is correct, some correlations might be spurious leading to false positive results.
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Learning Objectives
Discuss the difficulties associated with recording and processing data of a qualitative nature
Evaluate the ways in which performance measurement systems may send the wrong signals and result in
undesirable business consequences
Evaluate the output reports of an information system in the light of:
Best practice in presentation
The objectives of the report/organisation
The needs of the readers of the reports
Avoiding the problem of information overload.
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For example:
December 2011, Q3 (b): Using the limited information available, evaluate the usefulness of the pack that is
provided to the board of governors (6 marks).
June 2012, Q1 (i): Critically assess the existing performance report and suggest improvements to its content and
presentation (12 marks).
June 2013 Q1 (ii): Evaluate the current strategic performance report and the choice of performance metrics
used (Appendix 1) (8 marks).
December 2013 Q4 (i): Evaluate the method of calculating and measuring the Force Scores for use in the league
table in achieving the Department of the Interior’s aims and goals.
Of course, performance means different things to different organisations, so there is certainly no single correct way
of measuring or presenting performance. For example, profit-seeking organisations will certainly be interested in
sales and profits, but charitable organisations have neither sales nor profit. Furthermore, even within a single
organisation different aspects of performance may have to be examined in more detail at different times and for
different audiences.
The following approach is suggested as one that may give guidance for good performance report design. Decide on:
Purpose. What is the fundamental purpose of the report?
Audience. For whom is the report produced?
Information. What information is needed? This ties back to the first two considerations.
Layout. The important information, caveats and conclusions must be easy to see.
Purpose
An organisation’s mission should define its purpose, and any judgment of performance report must report on the
extent to which the mission is being achieved.
Sometimes the term ‘mission’ might not be used. December 2011 Q3 used the word ‘ethos’ as in:
The school’s ethos is ‘to promote learning, citizenship and self-confidence among the pupils.’
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As accountants we are prone to thinking that the measurement of profit is all-important. However, none of these
missions, aims or goals mentioned ‘profit’, and only the last one mentioned ‘money’ at all. Therefore, successful
performance cannot simply be rooted in profit: it depends on achieving the factors mentioned in the organisations’
missions, aims or goals.
In the June 2013 question the founders’ initial aim was stated as ‘to make money’. However, as a mission that is
completely inadequate and could apply equally to any profit-seeking business. This question required an
understanding that although money might enable a business to keep score (the more profit made, the better it is
doing), measuring profit says nothing about how profits are to be made. Making profits in the long-term requires
long-term performance in chosen areas such as cost leadership, differentiation, innovation, flexibility, quality, and
customer service. More about this later.
Remember, performance can be judged only with respect to an organisation’s purpose and the ways it has chosen
to achieve its purpose: performance reports must reflect that.
Audience
The audience for performance reports will normally be managers, owners, government or, more generally, those
charged with governance. Often the audience will be sophisticated enough to understand the information presented
without much explanation. However, sometimes the audience will have fewer skills and might need fuller
explanations. For example, the report in the December 2011 Q3 was for use by ‘… a board of governors who are
part-time and selected from the local community and parents’.
Care has to be taken to assess the appropriate level of detail, layout and terminology used in reports so that users
will properly understand the information that is provided.
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Information
Information can be classified as follows:
Examples are:
Financial: sales, profits, costs, GP%, return on capital employed.
Non-financial quantitative: percentage of product rejects, volume of sales, number of complaints.
Non-financial qualitative: reputation, effectiveness, customer satisfaction, staff morale.
The information provided must match the purpose of the performance report. In particular, non-financial
performance is a very important determinant of the long term success of any enterprise. For a business, short-term
financial performance can often be improved by reducing quality, innovation and training. However, a business
pursuing these approaches is likely to suffer financially in the long term. It is not so much that a business is interested
in making high quality products for their own sake, but if the business positions itself as a high quality manufacturer
it must deliver high quality and, therefore, quality needs to be monitored. If the business were known as a ‘cheap
and cheerful’ supplier, the measurement of quality would be much less important but costs per unit would become
more important. It is a common theme of questions for reports to display only financial information; this allows the
opportunity for candidates to criticise the lack of relevant non-financial information.
It might be useful to think about the balanced scorecard in this context. The four perspectives are:
Financial perspective
Customer perspective
Internal business perspective
Innovation and learning perspective
The perspectives form a hierarchy: good financial performance is the result of delighted, loyal customers, and
customers are delighted if the organisation does well what it purports to do – whatever that is. So if customers
require fast delivery, then delivery times have to have targets and actual delivery performance has to be measured.
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The need for non-financial information is more obvious in not-for profit organisations and, indeed, in those
organisations non-financial performance is often an end in itself, rather than an enabler of profitability. If reporting
on the success of the school described in December 2011 Q3 which has the ethos of ‘to promote learning, citizenship
and self-confidence among the pupils’, then the following might be suitable:
Learning Details of exam marks, grades and exams passed together with comparatives
from previous years and neighbouring schools.
Questionnaires
Non-financial qualitative information is likely to be as important as quantitative information, but is harder to pin-
down. Technically, qualitative information is known as a ‘construct’, an attribute that cannot be measured directly.
Examples of constructs are enthusiasm and empathy. Both are very important in business, but there is no direct way
in which they can be measured. Usually, for communication, assessment and comparative purposes an effort has to
be made to try to turn qualitative information into quantified information. For example, in a hospital it would be
important for patients to feel that they were treated sensitively and with dignity. Assuming management feels that
these are important qualities, targets need to be set for them and performance assessed. Inevitably this will be done
by setting up some type of numerical assessment system so that qualitative becomes quantitative.
The transition from qualitative to quantitative can introduce distortions to the information. For example, does what
is measured truly reflect what the undertaking wants to assess? For example, in an effort to measure enthusiasm an
organisation might measure when staff arrive in the morning. However, the person who always arrives early might
simply be a victim of an hourly train service: arrive 40 minutes early or 20 minutes late.
Question 4 in the December 2013 exam has an excellent example of how performance measure information can be
distorted. In summary, divisional raw scores were translated into rankings and performance was judged on average
ranking. However, this approach would change very similar scores of, say, 65, 64, 63 and 62 (perhaps well within
measurement error) into rankings of 1, 2, 3, and 4. The effect is to greatly magnify the differences.
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Another way in which information can be distorted in to use proportional or percentage changes without regard to
absolute values. This is often seen in health scares where research claims that consumption of a product doubles
your chance of succumbing to a disease. What the headlines might well leave out is that your absolute chance in
increasing from 1 in 5,000,000 to 2 in 5,000,000. You might worry about that, but you should realise that it is
insignificant compared to, say, the danger arising from crossing the road.
Graphical presentation is another way in which information can either be exaggerated or played down. For example,
here is a graph of the €/£ exchange rate for 30 days:
It looks very volatile – until you see the y-axis scale and realise that the rate moves between only about 1.191 and
1.214, a percentage change of around 2%.
Narrative explaining the information is also needed. For example, even something as simple as an adverse material
prices variance needs an explanation about what caused it. If no explanation is given it will simply mean that
questions will be raised later. Explanations might be accepted or might be challenged, but simply to report a variance
without stating how it might have arisen is rather useless.
Layout
Layout must help users to understand the information presented and to see quickly the important amounts, trends,
results and explanations.
One of the most common criticisms of reports is that they present too much information and are much too cluttered.
There might be valuable information there but it is almost impossible to find and interpret it. There is always the
suspicion that large volumes of information have been deliberately provided to obfuscate the facts and to blunt the
message.
Although the misuse of graphical information was mentioned above, graphical displays can be used to greatly
enhance performance information.
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For example, Question 3 of the December 2011 exam and Question 1 of the June 2012 exam both provide good
examples of too detailed, cluttered and badly explained performance reports. It might be right to provide high levels
of detail, but that should be in appendices. The main body of any performance report should be immediately
understandable by users and easy to follow.
For Question 1 of the June 2012 exam, a bar chart of the 2010 revenue and costs of sales figures on a would look as
follows:
The relative performance of the different sectors is now much more obvious.
Similarly, the addition of narratives can be very important in drawing attention to important matters and explaining
their significance or causes. A much more satisfactory presentation of this report would be to have the detailed
information in an appendix and then in the body of the report explain how each sector was performing – both
financially and in terms of important non-financial performance measures.
Conclusion
Remember, when drafting or criticising a performance report consider:
Purpose. The organisations purpose determines what is meant by good performance.
Audience. Make the report suitable for the interests, responsibilities and ability of the audience.
Information. Above all, remember the importance of non-financial information and beware of measurement
distortion.
Layout. Not too cluttered; allow the important information to be easily seen and understood.
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COMMON MISTAKES AND MISCONCEPTIONS IN THE USE OF NUMERICAL DATA USED FOR PERFORMANCE
MEASUREMENT
Introduction
The September 2016 APM syllabus contains the learning outcome:
‘Advise on the common mistakes and misconceptions in the use of numerical data used for performance
measurement’.
The mistakes and misconceptions can be divided into two causes:
The quality of the data: what measures have been chosen and how have data been collected?
How have the data been processed and presented to allow valid conclusions to be drawn?
Inevitably, these two causes overlap because the nature of the data collected will influence both processing and
presentation.
For example:
A company boasts about impressive revenue increases but downplays or ignores disappointing profits.
A manager wishing to promote one of two mutually exclusive projects might concentrate on its impressive IRR
whilst glossing over which project has the higher NPV.
A production manager measures the quantity of units produced but not their quality.
An investment company with 20 different funds advertises only the five most successful ones.
Not only might inappropriate amounts be measured, but they might be deliberately undefined. For example, a
marketing manager in a consumer products company might claim that the company’s new toothbrush is reported
by users to be 20% better.
But what’s meant by that statement? What is ‘better’? Even if that quality could be defined, is the toothbrush 20%
better than: using nothing, competitors’ products, the company’s previous products, or better than using a tree
twig?
Another potential way to confuse readers is to report relative rather than absolute changes. For example, you will
occasionally read reports claiming that eating a particular type of food will double your risk of getting a disease.
Doubling sounds serious but what if you were told that consumption would change your risk from 1 in 10m to 1 in
5m? For most people doubling the risk does not look quite so serious now. The event is still rare and the risk remains
very low.
Similarly, if you were told that using a new material would halve the number of units rejected by quality control, you
might be tempted to switch to using it. But if the rate of rejections is falling from 1 in 10,000 to 1 in 20,000, the
switch does not look so convincing – though it would depend on the consequences of failure.
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Sampling
Many statistical results depend on sampling. The characteristics of a sample of the population are measured and,
based on those measurements, conclusions are drawn about the characteristics of the population. There are two
potential problems:
1) For the conclusions to be valid, the sample must be representative of the population. This means that random
sampling must to be used so that every member of the population has an equal chance of being selected for the
sample. Other sorts of sampling are liable to introduce bias so that some elements of the population are over
or under represented and false conclusions are likely to be drawn. For example, a marketing manager could
sample customer satisfaction only at outlets known to be successful.
2) Complete certainty can only be obtained by looking at the whole population and there are dangers in relying on
samples which are too small. It is possible to quantify these dangers and, in particular, you need to know
information like “to a 95% confidence level, average salaries are $20,000 ± 2,300". This means that, based on
the sample, you are 95% confident (the confidence level) that the population mean salary is between $17,700
and $22,300 (the confidence interval). Of course, there is a 5% chance that the true mean salary lies outside this
range. Conclusions based on samples are meaningless if confidence intervals and confidence levels are not
supplied.
The larger the sample the greater the reliance that can be placed on conclusions drawn. In general, the confidence
interval is inversely proportional to the square size of the sample. So, to halve the confidence interval the sample
size has to be increased four times – often a requiring a significant amount of work and expense.
Even if the ad were completely ineffective and only 50% of the population recognises the brand it can be shown that
there is a 25% chance that at least 12 out of the 20 selected will recognise the brand. So, if the director didn’t get a
favourable answer in the first sample of 20, another small sample could be quickly organised. There is a good chance
that by the time about four surveys have been carried out one of the results will show the improved recognition that
the marketing director wants. (Note: these results make use of the binomial distribution, which you do not need to
be able to use.)
It’s rather like flipping a coin 20 times – you intuitively know that there is a good chance of getting an 8:12 split in
the results.
If instead of just 20 people being surveyed, 100 were asked, then the chance of getting a recognition rate of at least
60% would be only 1.8%. In general, small samples:
Increase the chance that results are false positives.
Increase chance that important effects will be missed. Always be suspicious of survey results that do not tell you
how many items were in the sample.
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Another example of a danger arising from small samples is that of seeing a pattern where there is none of any
significance.
Imagine a small country of 100 km x 100 km. The population is evenly distributed and that four people will suffer
from a specific disease. In the graphs below, the locations of the sufferers have been generated randomly using Excel
and plotted on the 100 x 100 grid. These are actual results from six consecutive recalculations on the spreadsheet
data and represent the six possible scenarios. Now imagine you are a researcher who believes that the disease might
be caused high-speed trains. The dark diagonal line represents the railway track going through the country.
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Have a look at the position of the dots (sick people) compared to the rail-tracks. If you wanted to see a clustering of
disease close to the railway tracks you could probably do so in several of the charts. Yet the data has been generated
randomly.
I didn’t have to do many more recalculations before the following pattern emerged:
For people predisposed to believing what they want to believe, this graph is presenting them with a pattern they
will interpret as conclusive evidence of the effect.
The problem is that if you are dealing with only four pieces of data then there is a good chance that they will often
cluster around any given shape. The negative results such as seen in Graph C are easily dismissed and researchers
concentrate on the patterns they want to see.
Now think about the following business propositions: ๏ A business receives very few complaints about its level of
service, but in one year all relate to one branch. Does that indicate that the branch is performing poorly or is it just
an artefact of chance? ๏ In a year a business tenders for 1000 contracts but only three are won – all by the same
sales team. Does that really mean that that sales team is fantastic or is it again simply the result of chance?
Averages
Almost certainly when you use the term ‘average’ you are referring to the arithmetic mean. This is calculated by
adding up all results and dividing by the number of results. So, for example:
Person Height (cm)
A 175
B 179
C 185
D 179
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E 176
Total 894
So the arithmetic mean of these 5 people is 894/5 = 178.8 and this feels as though it is a natural way to describe an
important measurement about the data. However, as we will see below, it can lead you astray.
The arithmetic mean is one measure of the data’s location. The other common measures are:
Mode: the most commonly occurring value. In the table above, the mode is 179. This measure would be more useful
to you than the mean if you were a mobile phone manufacturer and needed to know customer preferences for
phones of 8, 16, 32 or 64 GB. You need to know the most popular.
Median: this is the value of the middle ranking item. So, for the data above arrange it in ascending order of height
and find the height of the person at the mid-point
So, the height of the mid-ranking person is 179 and this is the median
Unless the distribution of the data is completely symmetrical, the mean, mode and median will generally not have
the same values. In particular, the arithmetic mean can be distorted by extreme values that give rise to its
misinterpretation.
To demonstrate this we will initially set up a theoretical symmetrical distribution of the annual income of a
population:
The mean, median and mode are all $55,000. If you earned that you would feel that you were on ‘average’ pay with
as many people earning more than you as less than you.
Now let’s say that into this population comes the founder of a hi-tech internet company called Mark Gutenberg who
invented a social medium service called U-Twit-Face. Mr Gutenberg has a very high income - $10m/year. The salary
distribution now looks like:
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The arithmetic mean of this distribution is $55,400, so now earning only $55,000 you feel that you are earning less
than average. In fact over 50% of the population is earning less than ‘average’ – something that at first glance would
seem impossible.
This distortion could allow a government to claim that people are now better off because average earnings are
higher. In fact, even if all the salary bands were reduced by 5%, the arithmetic mean including Gutenberg would be
around $55,380. So the government could claim that on average the population is better off when, in fact, almost
everyone is worse off.
In situations where the data is not symmetrical, the median value will often provide a more useful measure. The
inclusion of Gutenberg does not change the median value and if everyone’s income fell by 5%, so would the median.
False positives and false negatives: Bayes’ theorem
This will first be demonstrated using a medical example, then it will be applied to a more business-related area.
Assume there is a serious medical condition called ‘lurgy’ suffered by 5% of the population. There is a diagnostic test
available, but this is not perfect. If the test result is positive there is a 90% chance that it is correct, and a 10% chance
that it is wrong (false positive). If the test is negative, there is an 80% chance that the result is correct, but a 20%
chance that the disease was missed (false negative).
You are tested and the result is positive, so what is the probability that you have lurgy? You might assume the answer
is 90%, but that is far from the truth.
The easiest way to solve this is to construct a table, based (say) on 10,000 people.
Suffers from lurgy Does not suffer Total
from lurgy
Positive test result
Negative test result
Total 500 9,500 10,000
First, put in the true number of the 10,000 who suffer from the disease: 5% and 95% of 10,000.
So, of the 500 who have the disease, the test will report correctly on 90% of them and incorrectly on 10%. In numbers
this will be 90% x 500 = 450 who have the disease and who are correctly reported on, and 10% x 500 = 50 who have
the disease but are not reported on.
Similarly, of the 9,500 non-sufferers, the test will correctly report on 80% of them. The numbers are 80% x 9,500 =
7,600. The remainder will be reported as having the disease, 20% x 9,500 = 1,900
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are true positives. Therefore your chance of actually having the disease is 450/2,350 = 19% - a far cry from the 90%
you might have thought at the start.
Maxter Software Co creates software and web-sites for clients. They prefer to recruit employees with no
programming experience and train them. It is believed that 1% of the population has the aptitude to become a
programmer. The company asks each applicant to undergo an aptitude test. If someone has the proper aptitude the
test will identify them correctly on 80% of occasions, but 20% are missed. If a recruit does not have aptitude there
is a 5% chance that they will pass the test.
If someone is identified as having aptitude, what is the chance that they actually do?
Has aptitude Does not have Total
aptitude
Passes test 80 475 555
Does not pass test 20 9,525 9,545
Total 100 9,900 10,000
So the chance that a person who passes the test actually has aptitude is 80/555 = 14.4: not a great way to recruit
successful staff. 3.3 Correlation
One of the commonest misuses of data is to assume that good correlation between two sets of data (ie they move
closely together) implies causation (that one causes the other). This is an immensely seductive fallacy and one that
needs to be constantly fought against.
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The two sets of data follow one another closely and indeed the coefficient of correlation between the variables is
0.99, meaning very close association.
It is unlikely that any of you believe that owning a smart phone causes diabetes or vice versa and you will easily
prefer to believe that the high correlation is spurious. However, with other sets of data showing with high correlation
it is easier to assume that there is causation. For example:
Use of MMR vaccines and incidence of autism. Almost no doctors now accept there is any causal connection. In
addition the whole study was later discredited and the doctor responsible was struck off the UK medical register.
Cigarette smoking and lung cancer. A causal effect is well-established, but it took more than correlation to do
so.
Concentration of CO2 in the atmosphere and average global temperatures. Not universally accepted (but
increasingly accepted).
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Here’s a graph of the £/€ exchange rate for September to October 2015. It seems to be quite a rollercoaster:
However, the effect has been magnified because the y axis starts at 1.3, not 0. The whole graph only stretches from
1.3 to 1.44. If the graph is redrawn starting the y axis at 0, then the graph will look a follows:
Note that a board of directors that wants to accentuate profit changes could easily make small increases look
dramatic, simply by starting the y axis at a high value.
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Pictograms are often used to make numerical results more striking and interesting. Look at the following set of
results:
Year Profit ($m)
2013 100
2014 110
2015 120
The increase has been a relatively modest 10% per year and on a bar chart would appear as:
Look at the first and last bag of money and think about how much you could fit into each. I would suggest the capacity
of the third one looks at least 50% greater than the first one. That’s because the linear dimensions have increased
by 20%, but that means that the capacity has increased by 1.23 = 1.73, flattering the results.
So it is important to consider how data is collected, processed and presented as it can be used to indicate that
performance of an organisation is better or worse than it actually is.
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Introduction
This chapter looks at the nature of human resource management, and at the link between human resource
management and performance management. It then examines aspects of the staff appraisal system, and considers
the impact of these on the performance of an organisation.
From this definition, we can see that human resource management has grown in importance from the traditional
view of the personnel department, whose role was primarily seen as that of hiring and firing employees to a much
broader role. Human resource management includes the recruitment of employees, the development of policies
relating to human resources, and the management and development of employees.
It also follows that human resources management is not carried out exclusively by the HR department. Line managers
are involved in managing the human resources in their departments.
In service industries such as restaurants, for example, where employees have direct contact with customers, having
employees that are friendly and helpful has a large impact on how customers will view the business. In IT industries,
having staff with good technical knowledge is essential.
The problem with human resources is that they require more management than other factors of production. We
humans are complex, emotional creatures, and it can be challenging to ensure that we behave in the right way,
remain motivated and give our best to the employer. William James, the 19th century American sociologist, once
remarked that most people only use 15% of their combined intelligence, skills and aptitudes in their employment.
Whether this still remains the case or not, it is clearly a challenge to get employees to contribute more of their
abilities in the workplace.
The human resources management process should support the corporate strategy by:
ensuring that the organisation has the right number of qualified employees
employees have the right skills and knowledge to perform efficiently and effectively
employees exhibit the appropriate behaviours consistent with the organisation’s culture and values
employees meet the organisation’s motivational needs.
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A low-cost supermarket, for example, may have an HR policy of recruiting unskilled staff, who are prepared to work
for low wages, but would not provide customers with excellent service. A more upmarket supermarket on the other
hand would want to provide excellent customer care. HR strategies would include the recruitment of individuals
who have excellent personal skills, and training of all staff in customer care.
Recruitment is the first stage in the process of human resource management. The organisation needs to recruit
individuals with the right skills, and the right attitudes to contribute to the strategic goals of the organisation.
Employees should also have the personality that will fit into the culture of the organisation.
From the point of view of potential employees, the recruitment process provides them with the opportunity to see
if the organisation matches their expectations. The organisation should provide honest information about the
position so that the potential employee forms the right expectations about the role that they are applying for. If not,
this may lead to disappointment and high staff turnover.
When recruiting, the amount of time and effort spent in selecting the right employee depends on the amount of
responsibility that the position requires. Managerial or problem-solving positions, where employees would be
required to have deeper skills, a higher level of responsibility and greater commitment, thus contributing to the
strategy of the organisation, would merit a much greater effort in the selection process. The selection process will
need to ensure that candidates should possess the ability to acquire the skills needed, and the attitude that fits the
culture of the organisation. Organisations may use psychometric tests to assess candidates for such positions.
Psychometric tests are described later in this article.
Lower level employees would be employed if they have the right skills. Less screening would take place for this group
of employees.
Competency framework
In many organisations, competency frameworks may be developed prior to the recruitment stage. A competency
framework shows a set of behaviour patterns and skills that the candidate needs in order to perform a job with
competence.
ACCA has developed a comprehensive competency framework for ACCA students to help plan careers in different
roles. In ACCA's competency frameworks, competencies are categorised into exams, experience, ethics, job profiles,
technical competencies and behavioural competencies. An example of a technical competence relating to
management accounting is performance objective 13, Contribute to budget planning and production.
Appraisal system
An appraisal is the analysis of the performance of an individual, which usually includes assessment of the individual’s
current and past work performance. Broadly speaking, there are two main reasons for the appraisal process. The
first is the control purpose, which means making decisions about pay, promotions and careers. The second is about
identifying the development needs of individuals.
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Appraisal is, therefore, seen as part of management control. By measuring the performance of employees against
targets, management is seen to be proactively managing the performance of employees and therefore improving
the performance of the organisation.
While such an approach may appear rational, in practice it is very unpopular with employees, who do not like to feel
they are being controlled. It can also be criticised for trying to make a complex relationship between employees and
managers appear to be too simple. In practice, however, such control models are the most popular models of
assessment.
Difficulties in appraisal
In assessing employees, managers are required to make judgments about an employee’s performance and
capabilities. Such judgments are naturally subject to potential bias in favour of some and against others. There are
many statistics showing how prejudice may affect the promotional prospects of some groups. In the UK, for example,
40% of the workforce are women, but only 30% of managers are women.
Another difficulty is the effect that negative criticism can have on performance. A study carried out in the 1960s by
Meyer, Kay and French (3) investigated the impact of the appraisal process at a factory in the US. The study
concluded that where staff are given criticism, they react defensively to the criticism and try to blame others for
their shortcomings. They will also become demotivated. Interestingly, praise given during the process had little
impact on performance.
One potential solution to the difficulties mentioned above in relation to appraisal is to be aware that, in addition to
the formal appraisal process, employees receive continuous informal feedback from their managers on the job.
Employees generally accept this informal feedback more readily, and it is more likely to lead to improvement in their
performance. Placing more emphasis on this informal type of assessment, and less on the formal appraisal process,
may improve the overall performance of employees.
Measure of input
When measuring the performance of employees for the purpose of appraisal, three different approaches can be
used:
Measurement of inputs
Behaviour in performance
Measurement of results and outcomes.
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Measurement of inputs
Measurement of inputs means attempting to assess the traits of an individual. Traits are those skills, knowledge and
attitudes that the employee possesses. Assessment aims to identify whether the staff member has the competencies
(or traits) for a job, perhaps with reference to a competency framework. Attributes such as leadership, commitment,
ability to work within a team and loyalty are traits that are typically desired.
Where assessment is performed by the line manager, the subjectivity of the exercise may well lead to real or
perceived bias in the assessment. As a result of this, many organisations now use professionally designed
psychometric tests.
Psychometric testing aims to ‘measure’ the abilities and personal skills of an individual. An example of an ability
would be the number of words per minute that the individual can type on a keyboard. Personal skills focus on areas
such as emotional stability of the individual, whether the individual is introvert or extrovert, and how flexible the
employee is.
Some organisations hold ‘moderation meetings’ for bigger teams. The purpose of these meetings is to ensure that
the various managers involved in assessing the different members of staff within a team are doing so consistently.
Behaviour in performance
This type of appraisal looks at the behaviour of the employee during work, and at how the employee applies his or
her skills. Both quantitative and qualitative data is collected on a continuous basis relating to how the employee
displays the expected behaviour for the position – for example, ‘gives praise where it is due to others on the team’
might be one of the behaviours looked for.
A common method for assessing behaviour in performance is the use of behaviour-anchored rating scales (BARS).
Descriptions of desired (and undesirable) behaviour are listed, and the appraiser gives a score for each one. A good
example of BARS is the course assessment forms used by many ACCA tuition providers, where students are asked to
rate the tutor on various attributes, such as ‘clarity of explanations’, and ‘approachability’. Students then give the
tutor a grade for each of these attributes – for example, from 1 to 5, where 5 is excellent, and 1 is poor.
Behavioural observation scales (BOS) are where specific actions are listed, and the appraisee is judged on how many
times he performs that action. For example, how often does a supervisor provide constructive feedback to
colleagues?
An obvious problem with BARS and BOS is the subjectivity involved. BOS are designed to be slightly less subjective
as they are based on the number of times behaviour is observed, which is more factual.
Measurement of behaviour in performance generally is beneficial because not only is information about the
employee’s performance obtained, but more detailed understanding of the requirement of the job can be
ascertained, and this can be used for defining standards in future.
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competency frameworks are used, it may also be possible to measure the number of competencies achieved during
a period.
Frequently, targets may be set for individuals and their performance will be judged against these. In setting such
targets, it is appropriate to consider the principles relating to the setting of standards from the Fitzgerald and Moon
building blocks model. In particular, standards should be achievable, or staff will become demotivated; they should
be controllable – that is, staff should not be judged on targets that are outside of their control.
Measurement of results and outcomes is usually easy to perform, but suffers from the problem that it does not take
into account the differing external factors that may have occurred. It may also lead to measure fixation among staff,
such as the famous example in the call centres, where the performance of call centre staff was measured based on
the number of calls per day. It was quite common for call centre staff to keep this high by simply hanging up when
presented with difficult customers.
The type of control system that is appropriate depends on two variables – the ability to measure output, and the
knowledge of the transformation process. Ouchi forms a matrix from these two that helps to determine what types
of control system are most appropriate for a particular organisation:
Knowledge of the transformation process is low in situations where there is no obvious way to do a task. Those
performing the task may have to learn on the job, rather than be provided with a detailed instruction manual
showing them how to do it. This may occur in project-based work, for example, where each project brings new tasks
and challenges to the project team.
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In manufacturing industries, it is likely that it is easy to measure output, and knowledge of the transformation
process is high – the tasks have been performed many times before. So behavioural or output controls are
appropriate, and appraisal will focus on the behaviour of employees or on results and outcomes.
A situation where the knowledge of the transformation system is imperfect but measurement is easy might be a
sales department. Management may not be aware of the exact processes involved by the sales team, and there may
not be one ‘right way’ of making sales. However, measurement of sales is easy to do, so output controls may be
used. The problem with this approach, however, is that it does not take into account external factors. It may be
difficult to make sales in some markets, for example, and so appraising employees on results alone might be deemed
unfair.
The ability to measure output may be difficult in certain activities, such as research work. Where people work in
teams, measuring the output of the individuals within the team may be difficult. Some individuals may put in more
effort than others, for example. If knowledge of the transformation process is also low, then the organisation may
have to rely on personnel and clan controls. In such situations, the appraisal process may focus on traits.
Rewards schemes may include extrinsic and intrinsic rewards. Extrinsic rewards are items such as financial payments
and working conditions that the employee receives as part of the job. Intrinsic rewards relate to satisfaction that is
derived from actually performing the job such as personal fulfilment, and a sense of contributing something to
society. Many people who work for charities, for example, work for much lower salaries than they might achieve if
they worked for commercial organisations. In doing so, they are exchanging extrinsic rewards for the intrinsic reward
of doing something that they believe is good for society.
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may be appropriate as less skilled staff are required, new staff are easy to recruit and need little training, so there is
less incentive to offer generous rewards. The US supermarket group Walmart competes on low cost. It recruits
employees with low skills, and pays low wages. It discourages staff from working overtime, as it wishes to avoid
paying overtime rates.
To recruit and retain sufficient number of employees with right skills
If rewards offered are not competitive, it will be difficult to recruit staff since potential employees can obtain better
rewards from competitors. Existing staff may also be tempted to leave the organisation if they are aware that their
reward system is uncompetitive.
High staff turnover can lead to higher costs of recruitment and training of new staff. Losing existing employees may
also mean that some of the organisation’s accumulated knowledge is lost forever. For many knowledge-based
organisations, the human capital may be one of the most valuable assets they have. High technology companies
such as Microsoft are companies that trade on knowledge, so offer competitive remuneration to key staff.
To motivate employees
Motivation of employees is clearly an important factor in the overall performance of an organisation. Organisations
would like their employees to work harder, and be flexible. The link between reward schemes and motivation is a
complex issue that is hotly debated in both accounting and human resource-related literature.
A well-known theory relating to motivation is Maslow’s hierarchy of needs. Maslow stated that people’s wants and
needs follow a hierarchy. Once the needs of one level of the hierarchy are met, the individual will then focus on
achieving the needs of the next level in the hierarchy. The lower levels of the hierarchy are physiological, relating to
the need to survive (eg eating and being housed); once these have been met, humans then desire safety, followed
by love, followed by esteem, and finally at the top of the hierarchy, self actualisation, or self fulfilment.
Applying Maslow’s hierarchy of needs to reward schemes suggests that very junior staff, earning very low wages will
be motivated by receiving higher monetary rewards, as this will enable them to meet their physiological needs. As
employees become progressively more highly paid, however, monetary rewards become relatively less important
as other needs in the hierarchy, such as job security, ability to achieve one’s potential, and feeling of being needed
become more important.
Herzberg argued that increasing rewards only motivates employees temporarily. Once they become de-motivated
again, it is necessary to ‘recharge their batteries’ with another increase. A far better way to motivate employees is
to ‘install a generator in an employee’ so they can recharge their own batteries; in other words to find out what
really motivates them. According to Herzberg, it is the intrinsic factors in a job that motivate employees, such as
‘achievement, recognition for achievement, the work itself, responsibility and growth or advancement.’ Giving
greater responsibility to employees, for example, can increase motivation.
Perhaps the conclusion to be gained from this is that monetary rewards alone are insufficient to motivate employees.
Other factors such as giving greater recognition and greater responsibility may be equally important, for example
giving praise at company meetings, promoting staff, and involving staff more in decision making.
Aligning the risk preference of managers and employees with those of the organisation
Managers and senior employees make decisions on behalf of the company, acting as agents of the company. It is
desirable that the risk preferences of these employees should match the risk preferences of the organisation and its
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stakeholders. One problem with many reward schemes is that managers are too risk averse, and will not make
investments that may risk their targets not being met.
The events leading up to the financial crisis of 2008 are a good example of the opposite situation, where the risk
appetites of employees at investment banks did not match the risk appetites of the owners. During this period,
individuals working in the banks were paid large commissions for selling mortgage loans to customers. The problem
was that the employees were selling loans to customers that posed a large risk to the banks, due to their low credit
worthiness.
The problem was confounded by the fact that in many cases, the employees of the banks were paid commissions on
the date that the loan agreements were signed, while the loans lasted for 25 years. In situations where the borrower
defaulted, however, there was no claw back, so the employee would not be required to repay the commission.
Many countries have put in place new laws and codes to change this situation. In the UK for example, the financial
services authority introduced a code whereby remuneration structures should be based on sound risk management
practices, incentive payments should be deferred over a number of years, and there should be claw back provisions
whereby employees are required to repay bonuses in the event that the longer term results of their actions leads to
similar problems experiences in the financial crisis.
Share options may also create a miss-match between the risks faced by the organisation and the risks faced by the
holders of the options, since the holders benefit if share prices increase, but do not bear any losses if the share price
falls. Share options are discussed in more detail later in this article.
The size of total remunerations paid to directors of large public companies has also become a hot political issue, with
a perception that the gap between top earners, and average earners is becoming larger. In the US, the average
directors of S&P 500 companies earn 200 times more than the average household income in the US. Defenders of
such large differences in pay point out that this difference has actually declined in recent years; in the year 2000,
directors of S&P 500 companies earned 350 times the average household income. According to some research, such
high packages are justified as they do reflect the performance of those directors.
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Target setting
Many reward schemes are based on employees achieving pre-determined targets, so some consideration of target
setting is required.
In Fitzgerald and Moon’s building block’s model, three principles are given when setting standards or targets: equity,
ownership and achievability. Equity in this context means fairness; when setting targets for the various managers,
those targets should be equally challenging. Ownership means that the targets should be accepted and agreed by
those managers for whom they are set. This can usually be achieved by participation. Finally targets must be
achievable; otherwise the employees for whom they were set will become demotivated.
The building block’s model then goes on to specifically cover reward schemes. It states that there are three principles
of a good reward scheme. First, there should be clarity – it should be clear how the reward scheme works. If your
boss tells you that you will receive a bonus at the end of the year ‘if you do a good job,’ that is not very clear, since
the boss has not specified what doing a good job means. Rewards should be motivational. Finally there is the
important controllability principal. Employees should only be judged and rewarded based on things within their
control. This is why profit-related pay might not be relevant to a junior administrative assistant, for example.
Hope and Fraser warn against the use of linking rewards to fixed performance targets, as this leads to gaming. In
particular, managers whose rewards depend on fixed targets may be tempted to ‘always negotiate lowest targets
and highest rewards,’ which suggests that management plans will understate the potential that the organisation can
make. ‘Always make the bonus, whatever it takes,’ is another example of gaming suggested by Hope and Fraser,
which suggests that managers may indulge in unethical behaviour such as fraudulent accounting in order to ensure
that targets are met.
Hope and Fraser suggest divorcing the planning process and the target setting process, and basing rewards on
relative targets and benchmarks. A relative target might be market share, for example, where rather than setting an
absolute target for a sales manager, a market share (%) target is provided. If the market rises, then more is expected
in absolute terms. This adds to controllability, since the sales manager could not be held responsible for a rise (or
fall) in the overall market, which is outside of his control, but would be able to control whether or not he achieves
the expected share of the market.
Basic pay
Base pay, or basic pay, is the minimum amount that an employee receives for working for an organisation. For
example, the employee may be paid $10 per hour for a minimum of 40 hours per week. The employee will therefore
earn at least $400 per week. This will be paid regardless of how many of those 40 hours the employee is actually
working. A fixed annual salary is another example of basic pay.
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Basic pay may be supplemented by other types of remuneration. A blue collar worker may be paid overtime for
example if he works more than 40 hours per week, and a manager may receive some form of performance pay in
addition to the base pay. Basic pay is likely to address the lower levels of Maslow’s hierarchy of needs mentioned
above.
In recent decades there has been a move toward performance-related pay schemes in many organisations. This has
lead to a situation where a higher portion of the employees pay is dependent on performance. This rationale for
performance-related pay is that it motivates employees to work harder, and rewards those who make a greater
contribution to the organisation’s goals. This should lead to efficiency savings. There are many types of performance-
related pay, and the most popular ones are described below:
Piece work scheme Under Piecework schemes, a price is paid for each unit of output. Piecework schemes
are the oldest form of performance pay, and were used for example in the textile
industries in Great Britain during the industrial revolution. Piecework schemes are
appropriate where output can be measured easily in units. They are typically used for
paying freelance, creative people. Freelance writers for example are often paid based
on the number of words.
The benefit of piecework schemes is their inherent fairness. The higher the output,
the more the employee (or subcontractor) receives. From the employer’s perspective,
the employer does not have to pay for idle time or inefficiencies.
From the employee’s perspective, such schemes mean that the employee bears
commercial risk if demand for their product falls.
A further disadvantage of piecework schemes is that the payment is not based on the
quality of output. However, some sort of quality control is likely, and if the quality is
not of a required standard, the employee or subcontractor will not be paid.
Individual performance Individual performance-related pay schemes are where the employee receives either
related pay scheme a bonus, or an increase in base pay on meeting previously agreed objectives or based
on assessment by their manager, or both. They are typically used for middle managers
in private sector organisations and for professional staff.
The advocates of individual performance-related pay schemes claim that their they
are an obvious way to align to objectives of middle managers with the goals of the
organisation. If performance targets set are based on the goals of the organisation,
then it appears obvious that making part of the rewards of employees’ contingent on
achieving those targets will mean that employees are motivated to achieve the goals
of the organisation.
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Critics of such schemes point out that the link between rewards and motivation is far
from clear, as discussed above. It is also argued that performance-related schemes
lead a situation of tunnel vision whereby if something is not measured, and then
rewarded, it won’t get done.
Individual reward schemes may lead to a lack of teamwork and may lead to variances
in pay among individuals, which can lead to ill feeling.
Group performance Group-related performance-related schemes are similar to individual, in that rewards
related pay schemes are paid based on the achievement of targets. However the targets are set for a group
of employees, such as a particular department, or branch of a company, rather than
for an individual. Since the rewards apply to a group, they are likely to be based on a
pre-determined quantitative formula, rather than on assessment of staff.
A bonus pool is calculated based on the performance of the team, and this is shared
among the members of the team. Bonuses may be paid up at the end of the year, or
may be deferred, and paid at a later date, as this may encourage staff and managers
to take a longer term view, rather than simply focusing on the current year’s bonus.
The advantage claimed for group schemes is that they encourage teamwork. The
disadvantage is that the lazier members of the team benefit from the hard work of
the more dedicated.
Hope and Fraser give the example of a scheme operated by Svenska Handelsbanken,
where each year, a portion of the banks profits are paid to a profit sharing pool for
employees, provided that certain conditions are made. The main conditions are that
the Handelsbanken Group must have a higher return on shareholder’s equity than the
average of its peer group. The upper limit of the amount paid into the scheme is 25%
of the total dividends paid to shareholders. Employees do not actually receive
anything from the pool until they reach the age of 60, at which point they receive a
pay out based on the number of years that they have worked for the bank. The CEO
of Handlesbanken claimed that employees are not motivated by financial targets, but
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The advantages of commission are that they should motivate sales staff to achieve
higher sales, as their rewards depend on it, and they mean that the large part of the
salesman’s salary becomes variable. If sales are low, the organisation will have to pay
less.
The obvious disadvantage with profit-related pay is that it does not match the primary
objective of commercial organisations, which is to maximise the wealth of the
shareholders. Managers may be motivated to increase profits by taking short-term
actions that will harm the business in the long run, for example, or destroy wealth by
investing in projects that increase the profits of the organisation, but produce a return
that is below the cost of capital of the organisation.
Profit-related pay might not be a motivator for junior employees, who may fail to see
the link between their effort and the overall profits of the organisation.
Stock option plans Stock option plans have become very popular since the 1990s, when greater emphasis
started to be given to shareholder value. Under stock option plans, staff receive the
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right to buy shares in their company at a certain date in the future, at a price agreed
today.
For example, Alpha Co is listed on the stock exchange of Homeland. Today, shares in
Alpha Co are trading at $100 each. The company has just awarded the CEO of Alpha
Co the option to buy 1 million shares for $100 each in exactly ten years time. These
options have no intrinsic value at the granting date.
If the share price rises to say $200 in 10 years time, the CEO could exercise his options,
buying 1 million shares at a price of $100 each. Since the shares would be worth $200
each by then the CEO would make a gain of $100 per share, or $100m in total.
Stock option plans are most appropriate for the senior management of organisations
as they are the people who have the most influence over its share price. The rational
for using stock option plans is that they align the objectives of the directors with the
objectives of shareholders. If the share price rises, the senior management benefit
because their options increase in value. Thus senior managers will start to think like
investors.
The big weakness of stock option plans is that share prices may depend on external
factors as much as on the performance of the directors. During the bull markets of
the 1990s and 2000s, many companies share prices rose simply because the market
rose.
Another weakness is risk misalignment. Share options reward managers if the share
price goes up. If the share price falls, however, there is no difference in reward
between the share price remaining the same ($100) and falling to ($1) – so managers
may be motivated to take extreme risks where the exercise price may not be met.
What shareholders really want is the performance of their company to be better than
the market. One solution to this is to use an indexed exercise price, where the price
at which the director can buy the shares is equal to the current market price, plus the
increase in the stock market index between the date that the options are issued, and
the exercise date. This means that the share option reflects the controllability
principle more closely, as directors would not be rewarded for rises in the stock
market in general.
Pensions scheme
Defined benefit pension schemes used to be a popular form of reward. Under such schemes, the employee pays a
pension to former employees based on their final salary, and the number of years that the employee worked for the
organisation. A typical example is that the former employee receives 1/60ths of their final salary for every year of
service. An employee who works for 40 years for the same organisation would therefore receive a pension equal to
40/60ths of their final salary from the date of retirement to the date of death.
Defined benefit schemes leave organisations with an uncertain, often large liability, and for this reason, many
organisations have now discontinued such schemes.
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Defined contribution schemes are another form of pension scheme where the employer pays a certain percentage
of the employee’s salary into an account for the employee in a pension ‘pot.’ The employee may also have the option
of making additional voluntary contributions into this pension pot. The pension pot is then invested, and the
employee receives whatever is in their account on retirement. In some countries, employees may be required to use
what is in the pot to buy an annuity, which pays them a fixed income for the rest of their lives.
Many countries offer tax incentives for such pension schemes, such as allowing employees to reduce their taxable
income by the value of contributions made to the schemes.
Benefit in kinds
Benefits in kind (or indirect pay) are paid to employees in addition to their base salary and performance-related pay.
Benefits in kind include items such as health insurance and meal vouchers. They are usually provided to more junior
staff in order to provide additional incentives at a lower cost. They are often used as a form of recognition, so the
employee of the month for example will be given a benefit rather than a cash payment.
The advantage of benefits in kind is that greater flexibility can be given in designing a reward scheme for an
individual.
‘Cafeteria’ schemes have also become popular, whereby employees are told that they may select benefits from a
menu up to a certain value. The advantage of this is that employees will select the benefits that they value most.
Benefits from which the employees can choose typically include such items as health insurance, holiday vouchers,
company cars or sports vouchers.
Cafeteria schemes may be difficult to administer. Staff may also find them complex to understand, as they will have
to select a number of benefits that have a value that is within the agreed limit.
As already mentioned above, unless the level of pay is competitive, it will be difficult to recruit and retain the right
number of skilled employees. If it is too much, the cost to the organisation will be too high. Here the organisation
will compare its pay levels with competitors. Such information may be available from job adverts in newspapers or
on the Internet, or from recruitment consultants.
Internal equity relates to the pay differentials within the organisation itself. Staff will become demotivated if they
feel that the remuneration system is ‘unfair’ and that other people are being paid more generously. Job evaluation
techniques are used that try to determine the value of a specific job to the organisation. Based on this, the level of
rewards for that particular position will be determined.
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assessed on a regular basis, for example twice a year. During the appraisal, targets will be set for the next period,
and rewards agreed if the targets are met.
Tunnel vision Undue focus on performance measures to the detriment of other areas (‘What you
measure you change’)
Sub-optimisation Ceasing effort when acceptable performance is achieved (eg when budgeted sales have
been achieved), even though better performance might be achievable.
Myopia Focussing on the short-term resulting in the ignoring of the long-term
Measure fixation Behaviour and activities in order to achieve specific performance measure that may not
be effective. For example, measuring behavior or results that are not important
Misrepresentation Using creative reporting to suggest that performance measures have been achieved
Gaming Behaviour designed to achieve some strategic advantage. For example, not passing on
sales leads to a colleague so that your sales are comparatively higher.
Ossification The unwillingness to change a performance measure scheme once it has been set up.
Management style
Hopwood identified three distinct management styles.
Hopwood believed that the profit-conscious style was often optimal, but appreciated that style could be contingent
on the organisation and activity undertaken.
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Benefits to
Measures
shareholders
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INTRODUCTION
It is very common in the examination to be given information about a company and to be asked to comment on the
performance. It is clearly important in practice to have measures in order to determine whether or not the company
is performing well.
It is important to measure both financial and non-financial performance, but in this chapter we will consider only
financial performance. You will be given extracts from the company’s accounts for several years and be expected to
analyse and interpret this information.
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Although you must be aware of several key measures of financial performance, it is important that you do not fall
into the trap of simply calculating every ratio imaginable for every year available. What the examiner is after is much
more of an over-view and being able to determine the key measures and to comment adequately.
However, if you are looking at how well the managers are performing, the growth (or otherwise) in the profit (to
the extent to which they control it) is perhaps of more importance.
Growth
Always make some comment as to the level of growth. The amount of detail required depends on the information
available and the number of marks allocated, but growth in turnover, in profit, and in share price are all potentially
relevant.
Look at the overall level of growth and look for any trends, do not waste time doing detailed year- by-year analysis.
Basis of comparison
Most measures mean little on their own, and are only really useful when compared with something. Depending on
the information given in the question, any comparison is likely to be with one of the following:
Previous years for the same company
Other similar companies
Industry averages
Against budget
Against other performance measures.
Profitability ratios
It gives a measure of the underlying performance of the business before finance. It gives an indication of the health
of the business in generating a return on its investments.
Gearing has no impact on the return and hence this is the most important measure of profitability to calculate. The
ratio is calculated before tax allowing return to be compared between companies under differing tax regimes.
Note: Capital employed represents the total funds invested in the business, it includes equity and long-term debt.
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A high gross profit margin indicates that either sales prices are high or production costs are being kept well under
control.
Asset turnover
𝒔𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 = 𝒙 𝟏𝟎𝟎
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅
A measure that considers the level of sales in relation to the capital employed. The asset turnover will depend very
much on the type of industry, manufacturing would be likely to have more assets relative to sales than a retail
operation. When used to compare one company with another within the same industry then the measure may
highlight the difference between a wholesaler or high volume retailer with high turnover rather than a specialist
retailer with relatively low turnover.
Investors ratios
The portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves
as an indicator of a company’s profitability.
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The higher the P/E ratio, the greater the market expectation of future earnings growth. This may also be described
as market potential.
P/E ratios are deemed to reflect the future prospects of a company. A high P/E ratio indicates that investors believe
the company will have:
(a) Higher future earnings; or
(b) Lower risk. than others in its market.
P/E ratios of quoted companies are often used as starting points for valuing unquoted companies in the same sector.
Dividend cover
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑐𝑜𝑣𝑒𝑟 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
Interest cover
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑜𝑓𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟 =
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
The interest cover ratio shows whether company is earning enough profit before interest to pay its interest costs
comfortable, or whether its interest costs are high in relation to the size of its profit, so that a fall in profit before
interest and tax would then have a significant effect on profits available for ordinary shareholders. An interest cover
of 2 times or less would be low, although benchmarks are different industry by industry.
Risk ratios
Gearing ratio
Capital gearing may be calculated in a number of different ways and it is likely that the examiner will specify the
method required.
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𝐷𝑒𝑏𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑒𝑎𝑟𝑖𝑛𝑔 =
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦
Debt
All permanent capital charging a fixed interest may be considered debt. This includes:
Debentures and loans.
Possibly bank overdraft if significant and considered part of the permanent financing.
Finally, preference share capital may also be included because of its fixed coupon. Note a company may be able
to defer payment of preference share dividends and hence these are less risky to the company than straight
debt.
Equity
All ordinary share capital and share premium together with reserves
It is important to note that the level of operating risk will impact on the level of financial risk that a company is willing
to take on.
Liquidity ratio
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A simple measure of how much of the total current assets are financed by current liabilities. If, for example the
measure is 2:1 this means that only a limited amount of the assets are funded by the current liabilities.
A measure of how well current liabilities are covered by liquid assets. A measure of 1:1 means that we are able to
meet our existing liabilities if they all fall due at once.
These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company suddenly finds that
it is unable to renew its short term liabilities (for instance if the bank suspends its overdraft facilities) there will be a
danger of insolvency unless the company is able to turn enough of its current assets into cash quickly.
OVERTRADING
Overtrading is trading by an organization beyond the resources provided by its existing capital.
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Overtrading tends to lead to liquidity problems as too much stock is bought on credit and too much credit is extended
to its customers, so that ultimately there is not sufficient cash available to pay the debts as they arise.
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Indicators:
Rapid increase in turnover
No matching increase in permanent capital (overtrading is sometimes called under-capitalization)
Increase in trade creditor balances
Increasing operating cycle
Decrease in cash/increase in overdraft
Remedies:
Cut back trading
Raise further permanent capital
Improve working capital management
Calculation of days
𝐹𝑖𝑛𝑠𝑖𝑠ℎ𝑒𝑑 𝑔𝑜𝑜𝑑 𝑠𝑡𝑜𝑐𝑘
𝐹𝑖𝑛𝑠𝑖𝑠ℎ𝑒𝑑 𝑔𝑜𝑜𝑑𝑠 𝑑𝑎𝑦𝑠 = 𝑥 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 = 𝑥 365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑑𝑎𝑦𝑠 = 𝑥365
𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒
Consideration of earnings before interest and tax has long been common – before interest in order to measure the
overall profitability before any distributions to providers and capital, and before tax on the basis that this is not
under direct control of management.
The reason that EBITDA additionally considers the profit before depreciation and amortisation is in order to
approximate to cash flow, on the basis that depreciation and amortisation are non-cash expenses.
A major criticism, however, of EBITDA is that it fails to consider the amounts required for fixed asset replacement.
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Advantages Disadvantages
1. It is a measure of underlying performance. 1. It ignores changes in working capital and the
2. Tax and Interest are externally generated and therefore not impact on cash flows.
relevant to underlying performance. 2. It fails to consider the amount of fixed asset
3. It is easy to calculate. replacement needed.
4. It is easy to understand 3. It can easily be manipulated by aggressive
accounting policies
Practice questions
Web Co is an online retailer of fashion goods and uses a range of performance indicators to measure the
performance of the business. The company’s management have been increasingly concerned about the lack of
sales growth over the last year and, in an attempt to resolve this, made the following changes right at the start of
quarter 2
Advertising: Web Co placed an advert on the webpage of a well-known online fashion magazine at a cost of
$200,000. This had a direct link from the magazine’s website to Web Co’s online store.
Search engine: Web Co also engaged the services of a website consultant to ensure that, when certain key words
are input by potential customers onto key search engines, such as Google and Yahoo, Web Co’s website is listed
on the first page of results. This makes it more likely that a customer will visit a company’s website. The
consultant’s fee was $20,000.
Website availability: During quarter 1, there were a few problems with Web Co’s website, meaning that it was
not available to customers some of the time. Web Co was concerned that this was losing them sales and the IT
department therefore made some changes to the website in an attempt to correct the problem.
Incentive 2: A $10 discount to all customers spending $100 or more at any one time.
The results for the last two quarters are shown below, quarter 2 being the most recent one. The results for quarter
1 reflect the period before the changes and incentives detailed above took place and are similar to the results of
other quarters in the preceding year.
Quarter 1 Quarter 2
Total sales revenue $2,200,000 $2,750,000
Net profit margin 25% 16·7%
Total number of orders from customers 40,636 49,600
Total number of visits to website 101,589 141,714
Conversion rate – visitor to purchaser 40% 35%
The percentage of total visitors accessing website through magazine link 0 19·9%
Website availability 95% 95%
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Number of customers spending more than $100 per visit 4,650 6,390
Number of subscribers to online newsletter 4,600 11,900
Required:
Assess the performance of the business in Quarter 2 in relation to the changes and incentives that the company
introduced at the beginning of this quarter. State clearly where any further information might be necessary,
concluding as to whether the changes and incentives have been effective.
(20 marks)
Solutions
Web Co has made three changes and introduced two incentives in an attempt to increase sales. Using the
performance indicators given in the question, it is possible to assess whether these attempts have been
successful.
Whilst it is not clear how long the advert is going to run for in the fashion magazine, $200,000 does seem to be a
very large cost. This expense is largely responsible for the fall in NPM. This is discussed further under ‘number of
visits to website’.
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An increase in the number of orders would also be expected, given that the number of visitors to the site has
increased substantially. This leads on to the next point.
Website availability
Rather than improving after the work completed by Web Co’s IT department, the website’s availability has stayed
the same. This means that the IT department’s changes to the website have not corrected the problem. Lack of
availability is not good for business, although its exact impact is difficult to ascertain. It may be that visitors have
been part of the way through making a purchase only to find that the website then becomes unavailable. More
information would need to be available about aborted purchases, for example, before any further conclusions
could be drawn.
Conclusion
With the exception of the work carried out to make the system more available, all of the other measures seem to
have increased sales or, in the case of Incentive 1, increased subscribers. More information is needed in relation
to a couple of areas, as noted above. The business has therefore been responsive to changes made and incentives
implemented but the cost of the advertising was so high that, overall, profits have declined substantially. This
expenditure seems too high in relation to the corresponding increase in sales volumes.
Workings
1. Increase in sales revenue $2·75m – $2·2m/$2·2m = 25% increase.
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2. NPM: 25% x $2·2m = $550,000 profit in quarter 1. 16·7% x $2·75m = $459,250 profit in quarter 2.
3. No. of visits to website: increase = 141,714 – 101,589/101,589 = 39·5%.
4. Increase in orders = 49,600 – 40,636/40,636 = 22%.
5. Customers accessing website through magazine line = 141,714 x 19·9% = 28,201.
6. Increase in subscribers to newsletter = 11,900 – 4,600/4,600 = 159%.
Example 1
Summary financial information for Repse plc is given below, covering performance over the last four years.
$ thousands Year 1 Year 2 Year 3 Year 4
Turnover 43,800 48,000 56,400 59,000
Cost of sales 16,600 18,200 22,600 22,900
Salaries and Wages 12,600 12,900 11,900 11,400
Other costs 5,900 7,400 12,200 13,400
Solution
Begin with a review of the summary information - notable points
Growth in turnover
Growth in PBIT
Growth in PAT
Growth in total assets, debtors approx. in line with turnover, creditors at a higher rate.
Reduction of gearing (result of rights issue?) and reduced interest charge
Dividend growth
P/E ratio has overtaken industry average.
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Introduction
You have studied investment appraisal previously so most of this chapter will be revision for you. Of the few new
items in this chapter, the most important is Modified Internal Rate of Return and you should make sure that you
learn the technique involved.
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X Discount Factor X X X X X
Present Values (X) X X X X
Net Present Value X
Example 1
Rome plc is considering buying a new machine in order to produce a new product.
The machine will cost $1,800,000 and is expected to last for 5 years at which time it will have an estimated scrap
value of $1,000,000.
They expect to produce 100,000 units p.a. of the new product, which will be sold for $20 per unit in the first year.
Production costs p.u. (at current prices) are as follows:
Materials $8
Labour $7
Materials are expected to inflate at 8% p.a. and labour is expected to inflate at 5% p.a..
The management accountant has decided that 20% of these should be absorbed into the new product.
The company expects to be able to increase the selling price of the product by 7% p.a..
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An additional $200,000 of working capital will be required at the start of the project.
Capital allowances: 25% reducing balance Tax: 25%, payable immediately Cost of capital: 10%
Calculate the NPV of the project and advise whether or not it should be accepted.
Solution
0 1 2 3 4 5
Sales 2,000 2,140 2,290 2,450 2,622
Materials (864) (933) (1,008) (1,088) (1,175)
Labour (735) (772) (810) (851) (893)
Net operating flow 401 435 472 511 554
Tax on operating flow (100) (109) (118) (128) (139)
Cost (1,800)
Scrap 1,000
Tax on saving on capital 113 84 63 47 (107)
allowed
Working Capital (200) 200
Net cash flow (2,000) 414 410 417 430 1,508
d.f. @ 10% 1 0.909 0.826 0.751 0.683 0.621
P.V. (2,000) 376 339 313 294 936
NPV = $258
Sensitivity
A technique that considers a single variable at a time and identifies by how much that variable has to change for the
decision to change (from accept to reject).
It indicates which variables may impact most upon the net present value (critical variables) and the extent to which
those variables may change before the investment results in a negative NPV.
Formula to calculate
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Modified internal rate of return is a calculation of the return from a project, as a percentage yield, where it is
assumed that cash flows earned from a project will be reinvested to earn a return equal to the company’s cost of
capital.
Calculating MIRR
The MIRR of a project is calculated as follows:
Take the negative net cash flows in the early years of the project, and discount these to a present value. The
total PV of these cash flows is the PV of the investment phase of the project.
Take the cash flows from the year that the project cash flows start to turn positive and compound these to an
end-of-project terminal value, assuming that cash flows are reinvested at the cost of capital.
The MIRR is then calculated as follows:
𝑃𝑉𝑅 1
𝑀𝐼𝑅𝑅 = { }𝑛 (1 + 𝑟𝑒 ) − 1
𝑃𝑉𝐼
where
n = the project life in years
PVR = the end-of-year investment returns during the recovery phase of the project (as calculated in Step 2)
PVI = the present value of the capital investment in the investment phase (as calculated in Phase 1).
The MIRR is usually lower than the IRR, because it assumes that the proceeds are re-invested at the Cost of Capital.
However in practice the proceeds are often re-invested elsewhere within the firm. It does however have the
advantage of being much quicker to calculate than the IRR.
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Learning Objectives
Discuss the appropriateness of, and apply the following as measures of performance:
Return on investment (roi)
Residual income (ri)
Economic value added (eva)
Describe, compute and evaluate performance measures relevant in a divisionalised organisation structure
including roi, ri and economic value added (eva)
Discuss the need for separate measures in respect of managerial and divisional performance
Discuss the circumstances in which a transfer pricing policy may be needed and discuss the necessary criteria
for its design
Demonstrate and evaluate the use of alternative bases for transfer pricing
Explain and demonstrate issues that require consideration when setting transfer prices in multinational
companies
Evaluate and apply the valuebased management approaches to performance management
Discuss the problems encountered in planning, controlling and measuring performance levels, e.g.
Productivity, profitability, quality and service levels, in complex business structures.
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Introduction
In this chapter we will consider the situation where an organisation is divisonalised (or decentralised) and the
importance of proper performance measurement in this situation.
We will also consider the possible problems that can result from the use of certain standard performance measures.
Meaning of divisionlisation
Divisionalisation is a term for the division of an organisation into divisions. Each divisional manager is responsible
for the performance of the division. A division may be a cost centre (responsible for its costs only), a profit centre
(responsible for revenues and profits) or an investment centre or Strategic Business Unit (responsible for costs,
revenues and assets).
Advantages
a) Divisionalisation can improve the quality of decisions made because divisional managers (those taking the
decisions) know local conditions and are able to make more informed judgements. Moreover, with the personal
incentive to improve the division's performance, they ought to take decisions in the division's best interests.
b) Decisions should be taken more quickly because information does not have to pass along the chain of command
to and from top management. Decisions can be made on the spot by those who are familiar with the product
lines and production processes and who are able to react to changes in local conditions quickly and efficiently.
c) The authority to act to improve performance should motivate divisional managers.
d) Divisional organisation frees top management from detailed involvement in day-to-day operations and allows
them to devote more time to strategic planning.
e) Divisions provide valuable training grounds for future members of top management by giving them experience
of managerial skills in a less complex environment than that faced by top management.
f) In a large business organisation, the central head office will not have the management resources or skills to
direct operations closely enough itself. Some authority must be delegated to local operational managers.
Disadvantages
a) Divisional managers may make dysfunctional decisions (decisions that are not in the best interests of the
organisation).
b) There is a need for a performance appraisal system to assess the performance of individual managers.
c) Top management may lose control by delegating decision making to divisional managers, since they are not
aware of what is going on in the whole organisation.
d) Lack of economies of scale. For example, efficient cash management can be achieved much more effectively if
all cash balances are centrally controlled.
Responsibility accounting
Responsibility accounting is the term used to describe decentralisation of authority, with the performance of the
decentralised units measured in terms of accounting results.
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The way to control their performance is to establish in advance a set of measures that will be used to evaluate their
performance at (normally) the end of each year. These measures provide a way of determining whether or not they
are managing their division well, and also communicate to the managers how they are expected to perform.
For example, suppose a manager was simply given one performance measure – to increase profits. This may seem
sensible, in that in any normal situation the company will want the division to become more profitable. However, if
the manager expects to be rewarded on the basis of how well he achieves the measure, all his actions will be
focussed on increasing profit to the exclusion of everything else. This would not however be beneficial to the
company if the manager were to achieve it by taking actions that reduced the quality of the output from the division.
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(In the long- term it may not be beneficial for the manager either, but managers tend to focus more on the short-
term achievement of their performance measures.)
It is therefore necessary to have a series of performance measures for each division manager.
Maybe one measure will relate to profitability, but at the same time have another measure relating to quality. The
manager will be assessed on the basis of how well he has achieved all of his measures.
We wish the performance measures to be goal congruent, that is to encourage the manager to make decisions that
are not only good for him but end up being good for the company as a whole also.
In this chapter we will consider only financial performance. However, non-financial performance is just as important
and we will consider that in the next chapter.
Controllable profits
The most important financial performance measure is profitability.
However, if the measure is to be used to assess the performance of the divisional manager it is important that any
costs outside his control should be excluded.
For example, it might be decided that pay increases in all division should be fixed centrally by human resources staff
at Head Office. In this case it would be unfair to penalise (or reward) the manager for any effect on the division’s
profits in respect of this cost. For these purposes therefore a profit and loss account would be prepared ignoring
wages and it would be on the resulting controllable profit that the manager would be assessed.
In the case of an investment centre, the manager is given decision-making authority not only over costs and
revenues, but additionally over capital investment decision.
In this situation it is important that any measure of profitability is related to the level of capital expenditure. Simply
to assess on the absolute level of profits would be dangerous – the manager might increase profits by $10,000 and
be rewarded for it, but this would hardly be beneficial to the company if it had required capital investment of
$1,000,000 to achieve!!
The most common way of relating profitability to capital investment is to use Return on Investment as a measure.
However, as we will see, this can lead to a loss of goal congruence and a measure known as Residual Income is
theoretically better.
controllable profit
Return on investment = x100
controllable capital employed
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Return on investment
Advantages Disadvantages
1. It is easy to understand and easy to calculate. 1. It fails to take account of the project life or the
2. ROCE is still the most common way in which timing of cash flows and time value of money
business unit performance is measured and within that life.
evaluated, and is certainly the most visible to 2. When assets are valued at net book value,
shareholders. reported performance improves with time as the
3. Managers may be happy in expressing project assets get old. In this case there is a disincentive
attractiveness in the same terms in which their to invest in new assets.
performance will be reported to shareholders, and 3. It uses accounting profit and capital employed,
according to which they will be evaluated and hence subject to manipulation due to various
rewarded. accounting conventions.
4. The continuing use of the ROCE method can be 4. Performance measurement based on ROCE
explained largely by its utilisation of balance sheet encourages short-termism in decision making.
and income statement magnitudes familiar to Failure to invest in new assets could be harmful
managers, namely profit and capital employed. to the long term interest of the division and the
5. It is relative measure. organisation as a whole.
5. It is difficult to assess the significance of ROI.
There is no definite investment signal. The
decision to invest or not remains subjective in
view of the lack of objectively set target ROI
6. ROI is sometime confused with internal rate of
return (IRR)
Residual income
Advantages Disadvantages
Residual income overcomes many of the problems of Like ROI, residual income is also based on
ROI: accounting profit and capital employed which can
It encourages investment centre managers to be manipulated.
undertake new investments if they add to residual It encourages investment centers managers to
income. think in the short-term about how to increase next
As a consequence, it is more consistent with the year’s residual income for the centre, hence does
objective of maximizing the total profitability of not encourage decision making for long-term.
the company. Residual income is not as widely used as the ROI
It is possible to use different rates of interest for despite overcoming some of the problems in ROI
different types of asset.
It aware managers about cost of financing their
division.
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Question 1
There are two divisions with the following performance for the current year
Division X Y
Investment ($m) 10 30
Controllable Profit 2 3
Required rate of return 15%
Required:
Calculate the performance of each division based using:
a) ROI
b) RI
Question 2
Continuing from the previous example each division has the opportunity to invest in a new project.
Division X Y
Investment ($000s) 500 1,000
Controllable Profit 80 120
Required:
Using the measures of performance above assess the decisions that would be made by:
(a) The divisional managers;
(b) Head office;
Solution
X ROI = $80,000/$500,000 = 16% RI = $80,000 - $75,000 = $5,000
Y ROI = $120,000/$1,000,000 = 12% RI = $120,000 - $150,000 = -$30,000
a) X would accept the project on the basis of both measures. Y can accept the project on the basis of ROI as it
is higher than current one, but overall they would resist as it still not meeting the requirements of the head
office.
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b) Head office should go for both projects. Clearly X is acceptable. But Y can also be accepted on the basis of
ROI as it will improve the results, and may motivate the managers of Y in the long run.
One reason for this is that in order to make a profit, capital is invested. Capital is a resource which has a cost. The
actual creation of extra value should therefore be the profit less the cost of capital invested. Residual income is the
accounting profit earned by a division less a notional charge for capital employed. In theory, there is a connection
between residual income and the expected increase in the value of a business.
Suppose for example that a company has $10 million in cash and keeps it in a bank deposit account earning 2% per
year interest. The cash will earn interest of $200,000 less tax in one year, and this will be reported as income.
However although keeping money in a low-interest account adds to accounting profit, it does not ’add value’ to the
company (or ‘create value’), because the cost of capital needed to finance the cash is probably higher than 2%. The
management writer Peter Drucker once wrote that: ‘until a business returns a profit that is greater than its cost of
capital, it operates at a loss.’
There is a second – and more important – reason why profits are not a good measure of the expected increase in
the value of a business. This is that profit measured by accounting conventions is not a proper measure of ‘real’
economic profit.
It can be argued that if economic profit is measured, instead of accounting profit, we will arrive at a better
measurement of the increase in the value of a business during a given period of time.
A management consultancy firm, Stern Stewart, devised a method of measuring economic profit, which they have
called economic value added or EVA. The term ‘EVA’ is a trademark of the Stern Stewart organisation.
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3. Management is encouraged to focus on the creation of value (EVA), which is in the long-term interest s of
shareholders.
4. Management reward schemes based on EVA are likely to align the interests of management and shareholders
more closely than a bonus system linked to annual accounting profits.
5. It is a simple measure, like profit, and so one that line managers (including those with limited financial
understanding) can understand.
In practice the computation of EVA involves making adjustments to accounting profit and the accounting value (book
value) of assets. These adjustments can becomplex, and although you are not required to know them in detail, an
examination question may as you to calculate EVA from a given set of simplified data.
NOPAT = Profit after tax + [Interest costs less tax relief on the interest]
(3) Other non-cash expenses. Other non-cash expenses should also be added back in order to measure NOPAT.
These include additional provisions for irrecoverable debts and other provisions.
(4) Investments in intangible items. Investments in intangible items include spending on promotion activities,
investing in a brand name, research and development spending and spending on employee training (to increase
the economic value of the work force). In conventional accounting systems, these items of expense are usually
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written off as expenses in the year that they occur. However, they are items of discretionary spending by
management that add to the value of the business.
To measure NOPAT, these items of expense that have been written off in the conventional accounts should be
added back.
(They should also be added to the value of the company’s capital. Economic depreciation charges will be applied
as appropriate to this economic capital, in subsequent years.)
Charge of capital
Cost of capital. The capital charge is calculated by applying the weighted average cost of capital (WACC) to the value
of capital employed.
WACC is the weighted average of equity capital and debt capital in the company’s target debt structure.
If the current debt structure of the company is close to the long-term target debt structure of the company, the
weighted average cost of capital can be calculated from the current value of equity and debt capital.
However, if the target capital structure is different from the current capital structure, the weighted average cost
of capital is calculated using the target proportions of equity and debt.
The cost of equity and the cost of debt can vary from one year to the next. A new WACC may therefore be
calculated each year, with appropriate costs for equity and debt in each year.
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$000 $000
Profit before interest and tax 80,000 62,000
Interest cost 8,000 6,000
__________ __________
Profit before tax 72,000 56,000
Tax at 25% 18,000 14,000
__________
__________
Profit after tax 54,000 42,000
Dividends paid 29,000 24,000
__________ __________
Retained profit 25,000 18,000
___________ __________
Notes
1. Capital employed at the beginning of Year 1 was $410 million.
2. The company had non-capitalised leased assets of $18 million in each of the past three years. These assets
are not subject to depreciation.
3. The estimated cost of equity in Year 2 was 12% and the cost of debt was 8%. The estimated cost of equity in
Year 1 was 10% and the cost of debt was 7%
4. The company’s target capital structure is 50% equity and 50% debt.
5. It should be assumed that accounting depreciation was equal to economic depreciation, in each of the two
years, and that this was also the amount used for the calculation of the tax charge in each year. (The purpose
of this assumption is to remove the need to make an adjustment to get from accounting depreciation and to
economic depreciation, and to remove the need for adjustments to capital employed.)
6. Other non-cash expenses were $16 million in Year 2 and $14 million in Year 1.
Required
Use the information provided to calculate a figure for EVA in each of the two years,
Year 2 and Year 1.
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Solution
Net operating profit after tax Year just ended Previous year
Year 2 Year 1
$000 $000
Profit after tax 54,000 42,000
Add: Interest cost less tax: (8,000 less 25%) 6,000 (6,000 less 25%) 4,500
Add: Non-cash expenses 16,000 14,000
_________ _________
453,000 428,000
____________ ___________
____________
WACC
Year 2: (12% × 50%) + [8% (1 – 0.25) × 50%] = 9%.
Year 1: (10% × 50%) + [7% (1 – 0.25) × 50%] = 7.625%.
These figures suggest that in each year the company created value, because the EVA was positive.
Financial performance in Year 2 was better than in Year 1 because the EVA is higher.
Allowing for the payment of dividends ($29 million in Year 2 and $24 million in Year 1) some of this created
value was retained within the company each year.
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The adjustments required to get from accounting profit to NOPAT and from accounting capital employed to
economic capital employed can be complex. In particular, it may be very difficult to estimate economic
depreciation
Transfer price
Transfer prices are almost inevitably needed whenever a business is divided into more than one department or
division
In accounting, many amounts can be legitimately calculated in a number of different ways and can be correctly
represented by a number of different values. For example, both marginal and total absorption cost can
simultaneously give the correct cost of production, but which version of cost you should use depends on what you
are trying to do.
Similarly, the basis on which fixed overheads are apportioned and absorbed into production can radically change
perceived profitability. The danger is that decisions are often based on accounting figures, and if the figures
themselves are somewhat arbitrary, so too will be the decisions based on them. You should, therefore, always be
careful when using accounting information, not just because information could have been deliberately manipulated
and presented in a way which misleads, but also because the information depends on the assumptions and the
methodology used to create it. Transfer pricing provides excellent examples of the coexistence of alternative
legitimate views, and illustrates how the use of inappropriate figures can create misconceptions and can lead to
wrong decisions.
Example 1
Take the following scenario shown in Table 1, in which Division A makes components for a cost of $30, and these
are transferred to Division B for $50. Division B buys the components in at $50, incurs own costs of $20, and then
sells to outside customers for $90.
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As things stand, each division makes a profit of $20/unit, and it should be easy to see that the group will make a
profit of $40/unit. You can calculate this either by simply adding the two divisional profits together ($20 + $20 =
$40) or subtracting both own costs from final revenue ($90 – $30 – $20 = $40).
You will appreciate that for every $1 increase in the transfer price, Division A will make $1 more profit, and Division
B will make $1 less. Mathematically, the group will make the same profit, but these changing profits can result in
each division making different decisions, and as a result of those decisions, group profits might be affected.
knock-on effects that different transfer prices and different profits might have on the divisions:
Performance evaluation. The success of each division, whether measured by return on investment
(ROI) or residual income (RI) will be changed. These measures might be
interpreted as indicating that a division’s performance was unsatisfactory
and could tempt management at head office to close it down.
Investment appraisal. New investment should typically be evaluated using a method such as net
present value. However, the cash inflows arising from an investment are
almost certainly going to be affected by the transfer price, so capital
investment decisions can depend on the transfer price.
Taxation and profit remittance. If the divisions are in different countries, the profits earned in each country
will depend on transfer prices. This could affect the overall tax burden of the
group and could also affect the amount of profits that need to be remitted
to head office.
As you can see, therefore, transfer prices can have a profound effect on
group performance because they affect divisional performance, motivation
and decision making.
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Example 2
See Table 2. The following rules on transfer prices are necessary to get both parties to trade with one another:
For the transfer-out division, the transfer price must be greater than (or equal to) the marginal cost of production.
This allows the transfer-out division to make a contribution (or at least not make a negative one). In Example 2,
the transfer price must be no lower than $18. A transfer price of $19, for example, would not be as popular with
Division A as would a transfer price of $50, but at least it offers the prospect of contribution, eventual break-even
and profit.
For the transfer-in division, the transfer in price plus its own marginal costs must be no greater than the marginal
revenue earned from outside sales. This allows that division to make a contribution (or at least not make a
negative one). In Example 2, the transfer price must be no higher than $80 as:
$80 (transfer-in price) + $10 (own variable cost) = $90 (marginal revenue)
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Usually, this rule is restated to say that the transfer price should be no greater than the net marginal revenue of
the receiving division, where the net marginal revenue is marginal revenue less own marginal costs. Here, net
marginal revenues = $80 = $90 – $10.
So, a transfer price of $50 (transfer price ≥ $18, ≤ $80), as set above, will work insofar as both parties will find it
worth trading at that price.
As well as permitting interdivisional trade to happen at all, this rule will also give the correct economic decision
because if the final selling price is too low for the group to make a positive contribution, no operative transfer price
is available.
So, in Example 2, if the final selling price were to fall to $25, the group could not make a contribution because $25 is
less than the group’s total variable costs of $18 + $10. The transfer price that would make both divisions trade must
be no less than $18 (for Division A) but no greater than $15 (net marginal revenue for Division B = $25 – $10), so
clearly no workable transfer price is available.
If, however, the final selling price were to fall to $29, the group could make a $1 contribution per unit. A viable
transfer price has to be at least $18 (for Division A) and no greater than $19 (net marginal revenue for Division B =
$29 – $10). A transfer price of $18.50, say, would work fine.
Therefore, all that head office needs to do is to impose a transfer price within the appropriate range, confident that
both divisions will choose to act in a way that maximises group profit. Head office therefore gives each division the
impression of making autonomous decisions, but in reality each division has been manipulated into making the
choices head office wants.
Note, however, that although we have established the range of transfer prices that would work correctly in terms of
economic decision making, there is still plenty of scope for argument, distortion and dissatisfaction. Example
1 suggested a transfer price between $18 and $80, but exactly where the transfer price is set in that range vastly
alters the perceived profitability and performance of each sub-unit. The higher the transfer price, the better Division
A looks and the worse Division B looks (and vice versa).
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In addition, a transfer price range as derived in Example 1 and 2 will often be dynamic. It will keep changing as both
variable production costs and final selling prices change, and this can be difficult to manage. In practice, management
would often prefer to have a simpler transfer price rule and a more stable transfer price – but this simplicity runs
the risk of poorer decisions being made.
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Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain
drawbacks:
Division A will make a loss as its fixed costs cannot be covered. This is demotivating.
Performance measurement is distorted. Division A is condemned to making losses while Division B gets an easy
ride as it is not charged enough to cover all costs of manufacture. This effect can also distort investment
decisions made in each division. For example, Division B will enjoy inflated cash inflows.
There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price.
Inefficiencies in Division A will be passed up to Division B. Therefore, if marginal cost is going to be used as a
transfer price, at least make it standard marginal cost, so that efficiencies and inefficiencies stay within the
divisions responsible for them.
Example 3
See Table 3.
A transfer price set at full cost as shown in Table 3 (or better, full standard cost) is slightly more satisfactory for
Division A as it means that it can aim to break even. Its big drawback, however, is that it can lead to dysfunctional
decisions because Division B can make decisions that maximise its profits but which will not maximise group
profits. For example, if the final market price fell to $35, Division B would not trade because its marginal cost
would be $40 (transfer-in price of $30 and own marginal costs of $10). However, from a group perspective, the
marginal cost is only $28 ($18 + $10) and a positive contribution would be made even at a selling price of only
$35. Head office could, of course, instruct Division B to trade but then divisional autonomy is compromised and
Division B managers will resent being instructed to make negative contributions which will impact on their
reported performance. Imagine you are Division B’s manager, trying your best to hit profit targets, make wise
decisions, and move your division forward by carefully evaluated capital investment.
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The full cost plus approach would increase the transfer price by adding a mark up. This would now motivate Division
A, as profits can be made there and may also allow profits to be made by Division B. However, again this can lead to
dysfunctional decisions as the final selling price falls.
A transfer price set to the market price of the transferred goods (assuming that there is a market for the intermediate
product) should give both divisions the opportunity to make profits (if they operate at normal industry efficiencies),
but again such a transfer price runs the risk of encouraging dysfunctional decision making as the final selling price
falls towards the group marginal cost. However, market price has the important advantage of providing an objective
transfer price not based on arbitrary mark ups. Market prices will therefore be perceived as being fair to each
division, and will also allow important performance evaluation to be carried out by comparing the performance of
each division to outside, stand-alone businesses. More accurate investment decisions will also be made.
The difficulty with full cost, full cost plus, variable cost plus, and market price is that they all result in fixed costs and
profits being perceived as marginal costs as goods are transferred to Division B. Division B therefore has the wrong
data to enable it to make good economic decisions for the group – even if it wanted to. In fact, once you get away
from a transfer price equal to the variable cost in the transferring division, there is always the risk of dysfunctional
decisions being made unless an upper limit – equal to the net marginal revenue in the receiving division – is also
imposed.
Variable cost plus lump sum. In this approach, transfers are made at variable cost. Then, periodically, a transfer is
made between the two divisions (Credit Division A, Debit Division B) to account for fixed costs and profit. It is argued
that Division B has the correct cumulative variable cost data to make good decisions, yet the lump sum transfers
allow the divisions ultimately to be treated fairly with respect to performance measurement. The size of the periodic
transfer would be linked to the quantity or value of goods transferred.
Dual pricing:. In this approach, Division A transfers out at cost plus a mark up (perhaps market price), and Division B
transfers in at variable cost. Therefore, Division A can make a motivating profit, while Division B has good economic
data about cumulative group variable costs. Obviously, the divisional current accounts won’t agree, and some
period-end adjustments will be needed to reconcile those and to eliminate fictitious interdivisional profits.
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Basically, the transfer price must be as good as the outside selling price to get Division B to transfer inside
the group.
CONCLUSION
You might have thought that transfer prices were matters of little importance: debits in one division, matching
credits in another, but with no overall effect on group profitability. Mathematically this might be the case, but only
at the most elementary level. Transfer prices are vitally important when motivation, decision making, performance
measurement, and investment decisions are taken into account – and these are the factors which so often separate
successful from unsuccessful businesses.
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There are four essential management processes involved in the implementation of VBM
Step 1 A company or business unit develops a strategy to maximise value. Critical success factors are
identified.
Step 2 This strategy translates into short- and long-term performance targets defined in terms of the key
value drivers.
These targets are likely to involve a structured mix of financial and nonfinancial KPIs (eg balanced
scorecard, performance pyramid, building blocks models).
A key financial measure is likely to be EVA® (because this embeds the WACC into the performance
measure).
Step 3 Plans are drawn up to define the steps that will be taken to achieve these targets.
Step 4 Finally performance metrics and incentive systems are cascaded through the organisation that are
compatible with these targets.
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Performance management
in the not-for-profit
organisations
What is not-for-
Problems with
profit The use of
performance
organisation? league table
measurement
and target in a
in NFP
public sector.
organisation.
Introduction
Non-profit seeking organisations are those whose prime goal cannot be assessed by economic means. Examples
would include charities and state bodies such as the police and the health service.
For this sort of organisation, it is not possible or desirable to use standard profit measures. Instead (in for example
the case of the health service) the objective is to ensure that the best service is provided at the best cost.
In this chapter we will consider the problems of performance measures and suggestions as to how to approach it.
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Multiple objectives: Even if all objectives can be clearly identified, it may be impossible to identify an
overriding objective or to choose between competing objectives
The difficulty of measuring An objective of the health service is obviously to make ill people better. However,
outputs: how can we in practice measure how much better they are?
Financial constraints: Public sector organisations have limited control over the level of funding that they
receive and the objectives that they can achieve.
Political, social and legal The public have higher expectations from public sector organisations than from
considerations: commercial ones, and such organisations are subject to greater scrutiny and more
onerous legal requirements.
Little market competition measures such as ROI and RI cannot be used to gain an overall measure of
and no profit motive performance
Identification of cost unit The cost unit is likely to be relatively complex and there is likely to be more than
one cost unit. For example what is a cost unit for a hospital/ there are likely to be
multiple such cost units being used by a single patient.
A useful approach to setting performance targets and performance measures in a not-for-profit entity is to group
performance indicators into three groups:
Financial measurements, which indicate the efficiency in using available financial resources and economy in
spending
Non-financial measurements, which indicate whether the entity has achieved its strategic objectives
(measurements of effectiveness)
Qualitative indicators, which also indicate effectiveness in achieving objectives, but which cannot be measured
in quantifiable terms.
Example
The performance targets and performance measurements for a hospital might include the following items:
Financial measures Budgeted annual expenditure. Comparison of actual spending with the budget.
(efficiency, Costs per selected units of activity, such as average costs per treatment, average costs
economy) per operation, average annual cost per hospital bed. Benchmarking costs against costs
in other hospitals. Major items of cost as a percentage of total costs: for example,
administration and management costs as a percentage of total running costs.
Non-financial Units of service delivered, such as the number of patients treated each year, and the
measures number of operations performed. The speed of delivery of services, such as the speed
(effectiveness)
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of an ambulance service, average waiting time for treatment, average time between
start and completion of treatment.
Quality of service, measured in terms of successful treatments, number of serious
errors in treatment. Utilisation of resources, such as ‘bed occupancy rates’ (percentage
of beds occupied on average by patients each day).
Qualitative Public confidence and satisfaction with the services provided. Morale of the work force.
Standards of cleanliness in the hospital.
Economy
Economy means keeping spending within limits, and avoiding wasteful spending. It also means achieving the same
purpose at a lower expense. A simple example of economy is found in the purchase of supplies. Suppose that an
administrative department buys items of stationery from a supplier, and pays $2 each for pens. It might be possible
to buy pens of the same quality to fulfil exactly the same purpose for $1.50 each. Economy would be achieved by
switching to buying the $1.50 pens, saving $0.50 per pen with no loss of operating efficiency or effectiveness.
Efficiency
Efficiency means getting more output from available resources. Applied to employees, efficiency is often called
‘productivity’. Suppose that a sales order clerk processes 50 customer orders each day. Efficiency would be improved
if a sales order clerk increases the rate of output, and processes 60 orders each day, without any loss of effectiveness.
Effectiveness
Effectiveness refers to success in achieving end results or success in achieving objectives. Whereas efficiency is
concerned with getting more outputs from available resources, effectiveness is concerned with achieving outputs
that meet the required aims and objectives. For example, the efficiency of sales representatives will be improved if
they increase their calls to customers from eight to ten each day, but their effectiveness will not be increased if they
do not achieve any more sales from the extra calls.
Management accounting systems and reporting systems may provide information to management about value for
money. Has VFM been achieved, and if so, how much and in what ways?
Value for money audits may be carried out to establish how much value is being achieved within a particular
department and whether there have been improvements to value for money. Internal audit departments may carry
out occasional VFM audits, and report to senior management and the manager of the department they have audited.
VFM budgeting can be particularly useful in not-for-profit organisations, whose purpose is to achieve a stated
objective as closely as possible, with the resources available.
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Example
State-owned schools may be given a target that their pupils (of a specified age) must achieve a certain level of
examination grades or ‘passes’ in a particular examination.
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Learning Objectives
Discuss the interaction of nonfinancial performance indicators with financial performance indicators
Identify and discuss the significance of nonfinancial performance indicators in relation to product/service
quality, e.g. Customer satisfaction reports, repeat business ratings, access and availability
Discuss the difficulties in interpreting data on qualitative issues
Discuss the significance of brand awareness and company profile and their potential impact on business
performance
Apply and evaluate the 'balanced scorecard' approach as a way in which to improve the range and linkage
between performance measures
Apply and evaluate the 'performance pyramid' as a way in which to link strategy, operations and performance
Apply and evaluate the work of fiitzgerald and moon that considers performance measurement in business
services using building blocks for dimensions, standards and rewards.
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Introduction
In the previous two chapters we were looking at measures of financial performance. However, as we stated, it is
important to have a range of performance measures considering non-financial as well as financial matters.
In general, financial performance is easy to measure (earning per share, profit, dividends, EVA etc) but these
measurements do not tell managers why financial performance has improved. For example, sales might have
increased either because prices have been lowered or the company has spent money developing a new, innovative
product. In this chapter we will consider the various areas where performance measures are likely to be needed.
Note that although we might all like to think that, for example, customer service is a foundation for company success,
it is not necessarily so. Some low-cost airlines have been very successful despite giving poor customer service. Good
customer service, and the other non-financial qualities which are mentioned about below are not ends in
themselves. They become important in profit seeking organisations only if the enable financial success.
The reason for having a balanced scorecard is that by setting targets for several key factors, managers will take a
more balanced and long-term view about what they should be trying to achieve. A balanced scorecard approach
should remove the emphasis on financial targets and short-term results.
In a balanced scorecard, critical success factors are identified for four aspects of performance, or four ‘perspectives’:
Customer perspective
Internal perspective
Innovation and learning perspective
Financial perspective.
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Financial How does the organisation create value for its owners? Financial measures of performance
perspective in a balanced scorecard system might include share price growth, profitability and return on
investment. Financial performance is likely to be the main perspective that shareholders will
use to assess how well the business has performed.
Examples of measures of performance for each of the four perspectives are as follows:
Perspective Possible measures
Critical financial measures Return on investment
Profitability
Economic value added (EVA)
Revenue growth
Productivity and cost control
Cash flow
Critical customer measures Market share
Customer profitability
Attracting new customers
Retaining existing customers
Customer satisfaction
On-time delivery
Critical internal measures Success rate in winning contract orders
Production cycle time/throughput time
Amount of re-working of defective units
Capacity utilisation of a key resource
Critical innovation and learning measures Revenue per employee
Employee productivity
Percentage of total revenue earned from sales
of new products
Time to develop new products
Number of new products developed to market
launch stage
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Example
Kaplan and Norton described the example of Mobil in the early 1990s, in their book The Strategy-focussed
Organisation. Mobil, a major supplier of petrol, was competing with other suppliers on the basis of price and the
location of petrol stations. Its strategic focus was on cost reduction and productivity, but its return on capital was
low.
The company’s management re-assessed their strategy, with the aim of increasing market share and obtaining
stronger brand recognition of the Mobil brand name. They decided that the company needed to attract high-
spending customers who would buy other goods from the petrol station stores, in addition to petrol.
As its high-level financial objective, the company set a target of increasing return on capital employed from its
current level of about 6% to 12% within three years.
From a financial perspective, it identified key success factors as productivity and sales growth. Targets were
set for productivity (reducing operating costs per gallon of petrol sold) and ‘asset intensity’ (ratio of
operational cash flow to assets employed).
From a customer perspective, Mobil carried out market research into who its customers were and what
factors influenced their buying decisions. Targets were set for providing petrol to customers in a way that
would satisfy the customer and differentiate Mobil’s products from rival petrol suppliers. Key issues were
found to be having petrol stations that were clean and safe, and offering a good quality branded product and
a trusted brand. Targets were set for cleanliness and safety, speedy service at petrol stations, helpful
customer service and rewarding customer loyalty.
From an internal perspective, Mobil set targets for improving the delivery of its products and services to
customers, and making sure that customers could always buy the petrol and other products that they wanted,
whenever they visited a Mobil station.
Performance can therefore be seen as a pyramid structure, with a large number of operational performance targets
supporting higher-level targets, leading to targets for the achievement of overall corporate objectives at the top.
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These key ‘driving forces’ can be monitored at the operational level with performance measures relating to quality,
delivery, cycle time and waste.
Lynch and Cross argued that within an organisation, there are different levels of management and each has its own
focus. However, there must be consistency between performance measurement at each management level, so that
performance measures at the operational level support the corporate strategy.
They presented these ideas in the form of a pyramid of targets and performance that links operations to corporate
strategy.
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o Achieving improvements in productivity depends on reducing the cycle time (from order to delivery) or
reducing waste.
Lynch and Cross argued that the performance measures that are chosen should link operations to strategic goals.
All operational departments need to be aware of how they are contributing to the achievement of strategic
goals.
Performance measures should be a combination of financial and non-financial measures that are of practical
value to managers. Reliable information about performance should be readily available to managers whenever
it is needed.
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Performance measurement for services may differ from performance measurement in manufacturing in several
ways:
Feature Explanation
Simultaneity. With a service, providing the service (‘production’) and receiving the service (‘consumption’
by the customer) happen at the same time. With production, the product is sold to the
customer after it has been manufactured.
Perishability. It is impossible to store a service for future consumption: unlike manufacturing and retailing,
there is no stock or inventory of unused services. The service must be provided when the
customer wants it.
Heterogeneity. A product can be made to a standard specification. With a service provided by humans, there
is variability in the standard of performance. Each provision of the service is different. For
example, even if they perform the same songs at several concerts, the performance of a rock
band at a series of concerts will be different each time. Similarly, a call centre operator
answering telephone calls from customers will be unable to deal with each call in exactly the
same way.
Intangibility. With a service, there are many intangible elements of service that the customer is given, and
that individual customers might value. For example, a high quality of service in a restaurant is
often intangible, but noticed and valued by the customer.
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Dimensions of performance
Dimensions of performance are the aspects of performance that are measured. A critical question is: What are the
dimensions of performance that should be measured in order to assess performance?
Research by Fitzgerald and others (1993) and by Fitzgerald and Moon (1996) concluded that there are six aspects to
performance measurement that link performance to corporate strategy.
These are:
Profit (financial performance)
Competitiveness
Quality
Resource utilisation
Flexibility
Innovation.
Some performance measures that might be used for each dimension are set out in the following table:
Performance area Possible measures
Financial performance Profitability
Sales growth
ROI
Cash flow/liquidity
EVA
Competitive performance Sales growth
Proportion of contracts won
Customer assessment/feedback
Market share
Quality Rejects/reworks
Customer complaints/feedback
Claims for compensation
Peer review assessments
Flexibility Spare capacity
Time order to delivery
Set-up time
% of work declined
Resource utilization Idle time
Non-chargeable time
Machine utilization
Wastage
Innovation New products brought to market
Patents files
R&D spend
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These are dimensions of competitive success now and in the future, and so are appropriate for measuring the
performance of current management. Measuring performance in these dimensions ‘is an attempt to address the
short-termism criticism frequently levelled at financially-focused reports’ (Fitzgerald). This is because they recognise
that by achieving targets now, future performance will benefit. Improvements in quality, say, might not affect
profitability in the current financial period, but if these quality improvements are valued by customers, this will affect
profits in the future.
Standards
The second part of the framework for performance measurement suggested by Fitzgerald and Moon relates to
setting expected standards of performance, once the dimensions of performance have been selected.
It is recognised that individuals should ‘own’ the standards that will be used to assess their performance, and
managers are more likely to own the standards when they have been involved in the process of setting the standards.
It has also been argued that if an individual accepts or ‘owns’ the standards of performance, better performance will
be achieved when the standard is more demanding and difficult to achieve than when the standard is easy to
achieve. This means that the standards of performance that are likely to motivate individuals the most are standards
that will not be achieved successfully all the time. Budget targets should therefore be challenging, but not impossible
to achieve.
Finding a balance between standards that the company thinks are achievable and standards that the individual thinks
are achievable can be a source of conflict between senior management and their subordinates.
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Standards should also be fair for everyone in all business units, and should not be easier to achieve for some
managers than others. To achieve fairness or equity, when local conditions for the individual business units can vary,
it is often necessary to assess performance by relying on subjective judgement rather than objective financial
measurements.
Rewards
The third aspect of the performance measurement framework of Fitzgerald and Moon is rewards. This refers to the
structure of the rewards system, and how individuals will be rewarded for the successful achievement of
performance targets.
One of the main roles of a performance measurement system should be to ensure that strategic objectives are
achieved successfully, by linking operational performance with strategic objectives.
According to Fitzgerald, there are three aspects to consider in the reward system.
The system of setting performance targets and rewarding individuals for achieving those targets must be clear
to everyone involved. Provided that managers accept their performance targets, motivation to achieve the
targets will be greater when the targets are clear (and when the managers have participated in the target-setting
process).
Employees may be motivated to work harder to achieve performance targets when they are rewarded for
successful achievements, for example with the payment of a bonus.
Individuals should only be held responsible for aspects of financial performance that they can control. This is a
basic principle of responsibility accounting. A common problem, however, is that some costs are incurred for
the benefit of several divisions or departments of the organisation. The costs of these shared services have to
be allocated between the divisions or departments that use them. The principle that costs should be controllable
therefore means that the allocation of shared costs between divisions must be fair. In practice, arguments
between divisional managers often arise because of disagreements as to how the shared costs should be shared.
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CORPORATE FAILURE
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Introduction
This chapter considers the reasons for companies failing, and various suggestions as to how corporate failure might
be predicted.
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Proper application of these key factors is a function of good leadership. According to the study, in the business
planning category, 78% of businesses fail due to the lack of a well-developed business plan. Remember the old
saying: ‘If you fail to plan, you plan to fail.’
Leadership is about planning for success before it happens. Sun Tzu, the 6th century Chinese philosopher, in his epic
work The Art of War, gave some sound advice that still applies to business today: ‘When your strategy is deep and
far-reaching, then what you gain by your calculations is much, so you can win before you even fight. When your
strategic thinking is shallow and near-sighted, then what you gain by your calculations is little, so you lose before
you do battle.’
In the financial planning category, 82% of businesses failed due to poor cash flow management skills, followed closely
by starting out with too little money. Business leadership is about taking financial responsibility, conducting sound
financial planning and research, and understanding the unique financial dynamics of one’s business. Half of the UK’s
small businesses fail within the first three years because of cash flow problems. They either run out of money or run
out of time. Consumer debt, personal bankruptcies, and company insolvencies are all now on the increase.
The third business failure factor profiled in the study, and a critical one, was marketing. Over 64% of the businesses
surveyed in the marketing category failed because their owners ignored the importance of properly promoting their
business, and then ignored their competition. Again, as a business leader, you must be able to effectively
communicate your idea to the right people and understand their unique needs and wants. Leadership is all about
taking initiative, taking action, getting things done, and making decisions. If you are not doing anything of significance
to market and promote your business, you are most likely headed for business failure.
You must also know your competition. Leadership is about providing value to customers; if your main competitors
are all providing a better quality and lower priced product, how can you possibly create any value? Either you harness
your strengths to provide different benefits (such as speed, convenience, or better service), lower your price and
improve quality, create a different product for an unmet demand, or get out of the game.
Finally, one of the most important reasons why businesses fail is due to poor management. In the management
category, 70% of businesses failed due to owners not recognising their failings and not seeking help, followed by
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insufficient relevant business experience. Not delegating properly and hiring the wrong people were additional
major contributing factors to business failure in this category.
An interesting, alternative method of classifying reasons for failure is provided by Richardson et al (1994), who use
the analogy of frogs and tadpoles:
1. Boiled frog failures
These are long-established organisations which exhibit the often observed organisational characteristics of
introversion and inertia in the presence of organisational change. This category can be illustrated by the
problems faced by ICI.
2. Drowned frog failures
Less to do with management complacency and more to do with managerial ambition and hyperactivity. In the
smaller company context, this is the failed ambitious entrepreneur, whereas in the bigger context this is the
failed conglomerate kingmaker, perhaps typified by Robert Maxwell.
3. Bullfrogs
Expensive show-offs who need to adorn themselves with the trappings of success. The bullfrog exists on a
continuum from the ‘small firm flash’ to the ‘money messing megalomaniac’. The behaviour of bullfrogs often
raises ethical issues due to a failure to separate business expenditure from personal expenditure (for example,
Conrad Black).
4. Tadpoles
Tadpoles never develop into frogs and represent the failed business start-up in the small business setting. In the
large business context, the tadpole is typified by the business which is dragged down by a big new project which
turns out to be such an expensive failure that it destroys its parent. New products and services often fail, such
as the Sinclair home computer. Small tadpoles usually fail to become frogs because of over-optimism, a failure
to make contingency plans and a lack of interest in overall success as a result of too much focus on the product.
Poor cash flow Poor cash flow might render an organization unable to pay its debts as and when they
fall due for payment. This might mean, for example, that providers of finance might
be able to invoke the terms of a loan covenant and commence legal action against an
organization which might eventually lead to its winding-up.
Lack of new Innovation can often be seen to be the difference between ‘life and death’ as new
production/service products and services provide continuity of income streams in an ever-changing
introduction business environment. A lack of new product/service introduction may arise from a
shortage of funds available for re-investment. This can lead to organizations
attempting to compete with their competitors with an out of date range of products
and services, the consequences of which will invariably turn out to be disastrous.
General economic Falling demand and increasing interest rates can precipitate the demise of
conditions organizations. Highly geared organizations will suffer as demand falls and the weight
of the interest burden increases. Organizations can find themselves in a vicious circle
as increasing amounts of interest payable are paid from diminishing gross margins
leading to falling profits/increasing losses and negative cash flows. This leads to the
need for further loan finance and even higher interest burden, further diminution in
margins and so on.
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Lack of financial The absence of sound financial controls has proven costly to many organizations. In
controls extreme circumstances it can lead to outright fraud (e.g. Enron and WorldCom).
Internal rivalry The extent of internal rivalry that exists within an organization can prove to be of
critical significance to an organization as managerial effort is effectively channeled into
increasing the amount of internal conflict that exists to the detriment of the
organization as a whole. Unfortunately, the adverse consequences of internal rivalry
remain latent until it is too late to redress them.
Loss of key personnel In certain types of organization the loss of key personnel can ‘spell the beginning of
the end’ for an organization. This is particularly the case where individuals possess
knowledge which can be exploited by direct competitors, e.g. sales contacts, product
specifications, product recipes, etc.
Quantitative models
Beaver
Beaver looked at various financial ratios and concluded that the best predictor was the ratio of cash flow to total
debt.
The approach is simple, but suffers as a result because in reality many factors are likely to result in failure – not just
one factor (a univariate approach).
Altman’s Z score
Developed in 1968 by Altman. He researched bankrupt manufacturing companies in the US.
Z score attempts to anticipate strategic and financial failure by examining company financial statements.
Calculating five ratios generates the Z score. These five ratios, once combined were considered to be the best
predictor of failure.
Z score = 1.2x1 + 1.4x2 + 3.3x3 + 0.6x4 + 1.0x5
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Altman also adapted this quantitative model to allow relative scoring from 0 to 100. A score of 75, for example,
would indicate that 25% of companies have higher Z-scores than the company under consideration. Relative
measurement over time permits trends to be identified more easily
Example
ABC is a manufacturer of fancy dress costumes. It has expanded rapidly in the last few years under the leadership
of its autocratic chairman and chief executive officer, Sally Maysmith.
The company has developed a major new product range linked to the relaunch of a major film franchise, which
has necessitated a large investment in new equipment. However, the recent share price performance has caused
concern at board level and there has been comment in the financial press about the increased gearing and the
strain that this expansion is putting on the company.
A junior analyst in the company has correctly prepared a spreadsheet calculating the Z-scores as follows
20X8 20X9 20Y0
X1 WC/TA –0.28 –0.25 –0.20
X2 RE/TA 0.12 0.21 0.21
X3 PBIT/TA 0.16 0.09 0.05
X4 MVE/Total long-term debt 1.62 0.95 0.60
X5 revenue/TA 1.50 0.72 0.84
z 2.832 1.581 1.419
Required
Comment on the results in the junior analyst's spreadsheet.
Solution
The Z-score for ABC in 20Y0 is 1 .41 9 which is below the danger level of 1 .8 and so suggests a likelihood of
insolvency in the next two years. It has fallen over the past three years between 2.832 and 1 .419.
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During this period the variables making up the model have been mostly static or declining. Roughly half the decline
in the Z-score arises from variable X4 which has fallen from 1 .62 to 0.60 or 63%. This represents the market value
of equity to total long term debt. This is due to the increase in gearing and may also be due to recent falls in the
share price.
The other variable that has seen most decline is variable X3 (PBIT/TA) falling from 0.16 to 0.05 which is likely to
reflect a sharp fall in profits and an increase in total assets. The company has failed to extract profit from available
assets. Maybe this will improve in future periods as revenue from the new investments is earned.
It is likely at the early stage of the project that costs will be high and revenues low. So a longer-term view needs
to be taken before concluding the company is definitely failing.
Qualitative model
Argenti’s A-score
This category of model rests on the premise that the use of financial measures as sole indicators of organisational
performance is limited. For this reason, qualitative models are based on non-accounting or qualitative variables. One
of the most notable of these is the A score model attributed to Argenti (1976), which suggests that the failure process
follows a predictable sequence:
Defects
Mistakes
Symptoms
Failure
Defects can be divided into management weaknesses and accounting deficiencies as follows:
Management weaknesses:
Autocratic chief executive (8)
Failure to separate role of chairman and chief executive (4)
Passive board of directors (2)
Lack of balance of skills in management team – financial, legal, marketing, etc (4)
Weak finance director (2)
Lack of ‘management in depth’ (1)
Poor response to change (15).
Accounting deficiencies:
No budgetary control (3)
No cash flow plans (3)
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Each weakness/deficiency is given a mark (as shown) or given zero if the problem is not present. The total mark for
defects is 45, and Argenti suggests that a mark of 10 or less is satisfactory.
If a company’s management is weak, then Argenti suggests that it will inevitably make mistakes which may not
become evident in the form of symptoms for a long period of time. The failure sequence is assumed to take many
years, possibly five or more. The three main mistakes likely to occur (and attached scores) are:
1. High gearing – a company allows gearing to rise to such a level that one unfortunate event can have disastrous
consequences (15)
2. Overtrading – this occurs when a company expands faster than its financing is capable of supporting. The capital
base can become too small and unbalanced (15)
3. The big project – any external/internal project, the failure of which would bring the company down (15).
The final stage of the process occurs when the symptoms of failure become visible. Argenti classifies such symptoms
of failure using the following categories:
1. Financial signs – in the A score context, these appear only towards the end of the failure process, in the last two
years (4).
2. Creative accounting – optimistic statements are made to the public and figures are altered (inventory valued
higher, depreciation lower, etc). Because of this, the outsider may not recognise any change, and failure, when
it arrives, is therefore very rapid (4).
3. Non-financial signs – various signs include frozen management salaries, delayed capital expenditure, falling
market share, rising staff turnover (3).
4. Terminal signs – at the end of the failure process, the financial and non-financial signs become so obvious that
even the casual observer recognises them (1).
The overall pass mark is 25. Companies scoring above this show many of the signs preceding failure and should
therefore cause concern. Even if the score is less than 25, the sub-score can still be of interest. If, for example, a
score over 10 is recorded in the defects section, this may be a cause for concern, or a high score in the mistakes
section may suggest an incapable management. Usually, companies not at risk have fairly low scores (0–18 being
common), whereas those at risk usually score well above 25 (often 35–70).
The A score has therefore attempted to quantify the causes and symptoms associated with failure. Its predictive
value has not been adequately tested, but a misclassification rate of 5% has been suggested. While Argenti’s model
is perhaps the most notable, a large number of non-accounting or qualitative variables have been included in other
studies. These include:
Company-specific variables – such as management experience, customer concentration, dependence on one or
a few suppliers, level of diversification, qualified audit opinions, etc
General characteristics – such as industry type
Factors in the external environment – such as the macroeconomic situation, including interest rates, the
business cycle, and the availability of credit.
Weaknesses of the model
a) Subjective scores chosen
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Avoiding failure
Perhaps the best way to avoid failure is to examine the myriad explanations for business failure. Many books and
articles have focused on identifying reasons for failure as a remedy for prevention. One of the more significant earlier
works was by Ross and Kami (1973); they gave ‘Ten Commandments’ which, if broken, could lead to failure:
1. You must have a strategy.
2. You must have controls.
3. The Board must participate.
4. You must avoid one-man-rule.
5. There must be management in depth.
6. Keep informed of, and react to, change.
7. The customer is king.
8. Do not misuse computers.
9. Do not manipulate your accounts.
10. Organise to meet employees’ needs.
Introduction:
Life cycle costing aims to cost a product, service, customer or project over its entire lifecycle with the aim of
maximizing the return over the total life while minimizing costs.
Traditionally the costs and revenues of a product are assessed on a financial year or period by period basis.
Product life cycle costing considers all the costs that will be incurred from design to abandonment of a new
product and compares these to the revenues that can be generated from selling this product at different target
prices throughout the product's life.
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Training cost
Sampling cost
Manufacturing cost
Distribution cost
Introduction Low Revenue Loss
High Marketing cost
Inventory
Manufacturing cost
Distribution cost
Growth Growing Growing Profit
Marketing cost
Inventory
Manufacturing cost
Distribution cost
High High
Maturity Inventory High profits
(Maximum) (maximum)
Marketing cost if long life
cycle product.
Manufacturing cost
Distribution cost
Decline Marketing cost Decreasing Decreasing Low profits
Inventory
Disposal
Issue 2: The stages of the life cycle have different intrinsic levels of risk:
The development and introduction periods are clearly a time of high business risk as it is quite possible that the
product will fail. Revenues will be low and expenditure high.
The risk is still quite high during the growth phase because the ultimate size of the industry is still unknown and
the level of market share that can be gained and retained is also uncertain.
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During the maturity phase the risk decreases. Revenues will be high and total assets will be static or decreasing.
The final phase should be regarded as low risk because the organisation knows that the product is in decline
and its strategy should be tailored accordingly. However, costs such as decommissioning costs may be incurred
during this stage.
Understanding and responding to these risks is vital for the future success of the organisation. If there is an analysis
of the developing risk profile it should be compared with the financial risk profiles of various strategic options,
making it much easier to select appropriate combinations and to highlight unacceptably high or low total risk
combinations. Thus for an organisation to decide to finance itself with debt during the development stage would
represent a high total risk combination.
It will be the scale of financial resources which the organisation call on over the life of its products which will dictate
its survival.
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Importance of quality
Success in business depends on satisfying the needs of customers and meeting the requirements of customers. An
essential part of meeting customer needs is to provide the quality that customers require. Quality is therefore an
important aspect of product design and marketing.
Quality is also important in the control of production processes. Poor quality in production will result in losses due
to rejected items and wastage rates, sales returns by customers, repairing products sold to customers (under
warranty agreements) and the damaging effect on sales of a loss of reputation.
If there is a strategic target for quality, the aim should be to achieve the target for a minimum total of quality-related
costs.
Even if an entity does not have a specific quality target, it should seek to minimise quality-related costs. In order to
do this, quality-related costs should be measured, analysed and controlled.
Quality management Quality management involves planning and controlling activities to ensure the
product or service is fit for purpose, meets design specifications and meets the
needs of customers. Quality management should lead to improvements in
performance.
Quality control Quality control involves a number of routine steps which measure and control the
quality of the product/service as it is developed.
Quality assurance Quality assurance involves a review of the quality control procedures,
usually by an independent third party, such as ISO (see section 3). It aims to verify
that the desired level of quality has been met.
Quality standards
Total Quality Management is a philosophy of management. It includes statistical quality measurement and control,
but it does not provide a specific statement of what an entity should do to achieve an acceptable quality standard
in its processes and products or services.
The recognition of quality as an important factor in business planning and performance has led to the development
of specific quality management standards.
Companies and other entities might establish their own quality standards. However, external quality standards have
been developed for a wide range of business activities, including:
Quality standards in specific industries or products, and
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Standards produced by the BSI influenced the development of international quality standards by the International
Organisation for Standardisation (ISO) which is based in Switzerland.
Like the BSI, ISO has a range of quality standards for specific industries and products, but also has a series of
standards for quality management. This is called the ISO9000 series, or sometimes the ISO9000:2000 series, because
the standards were revised in 2000.
The ISO9000 series specifies the requirements for a generic management system, and the same standards can be
applied to all types of entity, large and small, business and non-business.
ISO9000 and the eight principles of quality management
Principal Explanation
Customer focus Entities depend on their customers. They should therefore understand the current and
future needs of their customers, and should meet these requirements and should try to
exceed customer expectations. The benefits of meeting this requirement are:
more sales revenue and a bigger market share achieved through flexible responses to
market opportunities
increased effectiveness in using the resources of the entity to increase customer
satisfaction
improved customer loyalty, leading to repeat business in the future.
Leadership The leaders of an entity provide purpose and a sense of direction. Leaders should create
and maintain an ‘internal environment’ in which individuals can become fully involved in
achieving the entity’s objectives. The benefits of meeting this requirement are:
motivating individuals towards the entity’s goals and objectives
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The auditing body then records the certification in its client register. The entity’s management system is therefore
both certified and registered.
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In addition, if an entity is certified under ISO9000, this provides independent ‘evidence’ that the entity has an
excellent system of quality management, and so is in control of its processes and is focussed on customer
satisfaction. This can have marketing benefits.
Some large companies and governments insist that their suppliers should have ISO9000 certification. This provides
a specific commercial reason for achieving – and maintaining – ISO9000 certification.
Non-conformance cost
Internal failure costs: These costs arise from inadequate quality where the problem is discovered before
the transfer of ownership from supplier to buyers.
Rework costs
Down time or idle time due to quality problem
Disposal of defective products
Re-inspection cost
Cost of reviewing product after failure
External failure costs: The cost arising from poor quality discovered after the transfer of ownership from
suppliers to buyers.
Warranty claims
Cost of lost sales
Cost of customer service section
Complaint, investigation and processing costs
Conformance cost
Appraisal costs: It is a cost incurred in initial ascertaining the product to quality requirement
Inspection and tests
Product quality audits
Process control monitoring
Test equipment expense
Prevention costs: Cost of any action taken to prevent or reduce defects of failures
Customer surveys
research of customer needs
quality education and training programs
supplier reviews
investment in improved production equipment
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Quality practices
Target costing
Introduction:
When a new product is launched, traditionally profit was added to cost i-e cost plus pricing considering internal
factors to get to the selling price but, TARGET COSTING involves setting a target cost by subtracting a desired profit
margin from a target selling price.
In a modern environment with shortening product lifecycles, organistaions have to continually redesign their
products. It is essential that they try to achieve a target cost during the product’s development.
TARGET COST is the cost at which a product must be produced and sold in order to achieve the required amount of
profit at the target selling price. When a product is first planned, its estimated cost will often be higher than its target
cost. The aim of target costing is then to find ways of closing this target cost gap, and producing and selling the
product at the target cost.
Target costing
As product life cycles have become much shorter, the planning, development and design stage of a product is critical
to an organisation's cost management process. Cost reduction must be considered at this stage of a product’s life
cycle, rather than during the production process.
Target costing involves setting a selling price for your product by reference to the market.
From this, your desired profit margin is deducted leaving you with a target cost.
Implementing Target Costing-The Steps:
1. Determine a product specification of which an adequate sales volume is estimated
2. Decide a target selling price at which the organisation will be able to sell the product successfully and achieve a
desired market share.
3. Estimate the required profit, based on required profit margin or return on investment
4. Calculate: Target cost
Target cost = Target selling price – Target profit.
5. Prepare an estimated cost for the product, based on the initial design specification and current cost levels.
6. Calculate: Target cost gap = Estimated cost – Target cost.
7. Make efforts to close the gap. This is more likely to be successful if efforts are made to 'design out' costs prior
to production, rather than to 'control out' costs after ‘live’ production has started.
Cost Target
Reduce the cost gap
now cost
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Example:
A company manufactures digital watches and is in the process of introducing new watch into the market. Their
research shows the following;
Cost Estimates $
Direct material 3.21
Direct labour 24.03
Machinery 1.12
Ordering and Receiving 0.23
Quality Assurance 4.60
Marketing 8.15
Distribution 3.25
After Sales Service 1.30
Target Profit Margin 30%
Requirement:
a) Calculate Target Cost
b) Calculate Cost gap
Solution
Solution:
$
competitive Selling price 60
The projected cost exceeds the target cost by $3.89. This is target cost gap. This company will have to find out
the ways to reduce this gap by controlling costs.
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The most effective stage to reduce non value added feature is the product design and development stage and most
cots are determined at this stage.
Benefit of target costing
Benefits Explanation
The organization will have an early external focus to its product development. Businesses
Early external focus have to compete with others (competitors) and an early consideration of this will tend to
make them more successful. Traditional approaches (by calculating the cost and then
adding a margin to get a selling price) are often far too internally driven.
Only those features that are of value to customers will be included in the product design.
Value adding Target costing at an early stage considers carefully the product that is intended. Features
features only that are unlikely to be valued by the customer will be excluded.
Cost control will begin much earlier in the process. If it is clear at the design stage that a
Early cost control cost gap exists, then more can be done to close it by the design team. Traditionally, cost
control takes place at the ‘cost incurring’ stage, which is often far too late to make a
significant impact on a product that is too expensive to make.
Costs per unit are often lower under a target costing environment. This enhances
Lower costs per unit profitability. Target costing has been shown to reduce product cost by between 20% and
40% depending on product and market conditions. In traditional cost plus systems an
organization may not be fully aware of the constraints in the external environment until
after the production has started. Cost reduction at this point is much more difficult as
many of the costs are ‘designed in’ to the product.
It is often argued that target costing reduces the time taken to get a product to market.
Reduced time to Under traditional methodologies there are often lengthy delays whilst a team goes ‘back
market to the drawing board’. Target costing, because it has an early external focus, tends to help
get things right first time and this reduces the time to market.
Kaizen costing
Kaizen is a Japanese term for continuous improvement in all aspects of an entity's performance at every level. Often
associated with total quality management, many firms limit Kaizen to improving production.
Characteristic
Kaizen involves setting standards and then continually improving these standards to achieve long-term
sustainable improvements.
The focus is on eliminating waste, improving processes and systems and improving productivity.
Involves all employees and all areas of the business.
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Illustration - Kaizen
Many Japanese companies have introduced a Kaizen approach:
In companies such as Toyota and Canon, a total of 60-70 suggestions per employee are written down and
shared every year.
It is not unusual for over 90% of those suggestions to be implemented.
In 1999, in one US plant, 7,000 Toyota employees submitted over 75,000 suggestions, of which 99% were
implemented.
Eliminating waste
Kaizen costing has been developed to support the continued cost reduction of existing components and products.
Cost reduction targets are set on a regular, e.g. monthly basis and variance analysis is carried out at the end of each
period to compare the target cost reduction with the actual cost.
One of the main ways to reduce costs is through the elimination of the seven main types of waste:
Over-production - produce more than customers have ordered.
Inventory - holding or purchasing unnecessary inventory.
Waiting - production delays/idle time when value is not added to the product.
Defective units - production of a part that is scrapped or requires rework.
Motion - actions of people/equipment that do not add value.
Transportation - poor planning or factory layout results in unnecessary transportation of materials/work-in-
progress.
Over-processing - unnecessary steps that do not add value.
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Customer focus: Organisation-wide there must be acceptance that the only thing that matters is the
customer. Organisations depend on their customers and so must strive to
understand and meet customer needs and expectations.
Internal customers and All parts of the organisation are involved in quality issues, and need to work
internal suppliers: together. Every person and every activity in the organisation affects the work done
by others. The work done by an internal supplier for an internal customer will
eventually affect the quality of the product or service to the external customer.
Identify causes of Instead of relying on inspection to a predefined level of quality, the cause of the
defects: defect in the first place should be prevented.
Quality culture: Every person within an organisation has an impact on quality, and it is the
responsibility of all employees to get quality right. Each employee or group of
employees must be personally responsible for defect-free production or service in
their area of the organisation.
Zero defects: There should be a move away from 'acceptable' quality levels. Any level of defects
must be unacceptable.
Right first time: All departments should try obsessively to get things right first time; this applies to
misdirected phone calls and typing errors as much as to production.
Quality certification Quality certification programmes should be introduced.
programmes
Costs of poor quality: The cost of poor quality should be emphasised; good quality generates savings (for
example, though not having to rework items with defects, or through a reduction in
the level of refunds or replacement products given to customers).
Just in time
JIT aims for zero inventory and perfect quality and operates by demand-pull. It consists of JIT purchasing and JIT
production and results in lower investment requirements, space savings, greater customer satisfaction and increased
flexibility.
Just-in-time (JIT) is 'A system whose objective is to produce or to procure products or components as they are
required by a customer or for use, rather than for inventory.
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A JIT system is a "pull" system, which responds to demand, in contrast to a "push" system, in which inventories act
as buffers between the different elements of the system, such as purchasing, production and sales.'
Just-in-time production is 'A production system which is driven by demand for finished products, whereby each
component on a production line is produced only when needed for the next stage.'
Just-in-time purchasing is 'A purchasing system in which material purchases are contracted so that the receipt and
usage of material, to the maximum extent possible, coincide.'
JIT purchasing Parts and raw materials should be purchased as near as possible to the time they are
needed, using small frequent deliveries against bulk contracts. Inventory levels are
therefore minimised.
Close relationship In a JIT environment, the responsibility for the quality of goods lies with the supplier. A
with suppliers long-term commitment between supplier and customer should therefore be
established. If an organisation has confidence that suppliers will deliver material of
100% quality, on time, so that there will be no rejects, returns and hence no consequent
production delays, usage of materials can be matched with delivery of materials and
inventories can be kept at near zero levels. However, flexibility and establishing good
communication channels are also important aspects of the relationship with suppliers.
Uniform loading All parts of the productive process should be operated at a speed which matches the
rate at which the final product is demanded by the customer. Production runs will
therefore be shorter and there will be smaller inventories of finished goods because
output is being matched more closely to demand (and so storage costs will be reduced).
Set-up time reduction No value is added during set-up times, so set-ups are non-value added activities.
Consequently, time spent setting up machinery should be minimised.
Simplification There is a constant focus on the simplification of products and processes in order to
maximise the utilisation of available resources.
Machine cells Machines or workers should be grouped by product or component instead of by the
type of work performed. Products can flow from machine to machine without having to
wait for the next stage of processing or returning to stores. Lead times and work in
progress are thus reduced.
Quality Production management should seek to eliminate scrap and defective units during
production, and to avoid the need for reworking of units since this stops the flow of
production and leads to late deliveries to customers. Product quality and production
quality are important 'drivers' in a JIT system. Also, note that the fundamental
requirement in relation to quality is that the level of quality satisfies the customer.
Pull system ('kanban') Products/components are only produced when needed by the next process. Nothing is
produced in anticipation of need, to then remain in inventory, consuming resources.
Preventive Production systems must be reliable and prompt, without unforeseen delays and
maintenance breakdowns.
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Employee Workers within each machine cell should be trained to operate each machine within
involvement that cell and to be able to perform routine preventive maintenance on the cell machines
(i.e. to be multi-skilled and flexible). Employee involvement in JIT programmes is also
important at a more general level. The successful operation of JIT requires workers to
possess a flexibility of both attitude and aptitude.
Continuous The ideal target is to meet demand immediately with perfect quality and no waste. In
improvement practice, this ideal is never achieved. However, the JIT philosophy is that an organisation
('Kaizen') should work towards the ideal, and therefore continuous improvement is both possible
and necessary.
Six sigma
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The main theory of quality improvement in Paper APM is the Six Sigma concept. The idea is to try and reduce the
chance of an item failing to be of a good enough quality. This does not mean having a single standard, there may be
a range of values which are acceptable.
This range is known as the tolerance. For example, a hamburger chain may say that as long as a burger is not too
hot or too cold it is acceptable. This would give a range of acceptable temperatures (the tolerance).
The six sigma approach is about many gradual improvements rather than occasional large ones.
Six Sigma can be implemented using the DMAIC approach:
Define
Define the problem.
Clarify the purpose of the project.
Develop the project plan.
Measure
Data collection to quantify the problem.
Measure the key processes that are critical to quality.
Analyze
Analyze data to find the root cause of the problem.
Consider the process itself, materials, environmental factors and the activities of staff involved in the process.
The results from the analysis may lead to modifications in the definition of the problem.
Improve
Develop solutions.
Implement them.
Control
Monitor changes.
Deal with problems arising.
The control process will focus on key performance measures.
Lean production
History of Lean
The term lean was first used by Womack, Jones and Roos to describe the Toyota Production system. It means far
more than simply cutting costs, as the history of lean production shows.
In the early 20th century, American car manufacturers such as Ford and General Motors developed mass production
systems. These allowed car manufacturers to produce thousands of identical cars, using standardised parts and
components. The moving production line was introduced, where the car body moved along a conveyor belt, and at
each stage, factory workers added components to it until the finished product came off the production line. The
resulting economies of scale meant that the motor car became much more affordable to the average family.
In 1950, Eiji Toyoda, an engineer, and member of the family that started the Toyota Company, visited the Ford Rouge
plant in Detroit. He studied the production techniques being used at Ford closely and on return to Japan discussed
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them with his production manager Taiichi Ohno. The two of them came to the conclusion that the methods used at
Ford could not be copied directly at Toyota. Over the years, they made several innovations that we now refer to as
lean:
1. More flexible production lines allowing smaller batch sizes
2. Greater involvement of employees
3. Elimination of non-value adding functions
4. Identifying the root causes of problems
5. Constructive relations with suppliers
6. Greater contact with customers
In the mass production factories, the solution to the long set-up process was to have long production runs, making
hundreds or even thousands of a particular part before resetting the machine to make parts for a different model.
Alternatively, a dedicated set of machines might be used for one particular car, meaning that once the initial set up
had taken place, no further set ups were required.
In the early post-war years, Toyota was a small company producing for the domestic market. Demand was
insufficient to allow the company the luxury of having long production runs when only a small number of units of
each part were required. Toyota spent time investigating a quicker way of setting up the machines so that production
could feasibly take place in small batch sizes. In some cases, such as the stamping machine, they managed to reduce
set up times from typically one day to three minutes. What’s more, the production line staff were trained to do the
set-ups, so it was not necessary to employ engineers.
The small batch sizes meant that the volume of work in progress and the associated inventory holding costs were
much lower; as soon as a part was made in one process, it was used in the next. An unintended advantage was also
discovered; because parts from one process were used almost straightaway in the next, any defects were noticed
very quickly. Thus, any faulty machine set-ups would be corrected before many bad units had been made.
A further advantage was that the factories became much more flexible, allowing a wider variety of products to be
made. Having shorter set-up times allowed machines to be used to produce a greater variety of parts and, therefore,
cars.
Staff at Toyota on the other hand were offered jobs for life – a guarantee that they would not be laid off during the
next downturn. They were also provided with a steep career path, where promotion led to a high increase in salary.
In return, employees at all levels would be expected to become involved in helping to continuously improve the
operations.
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The teams would be expected to have meetings periodically with the industrial engineers, to discuss ways to improve
the production process. Toyota recognised that the assembly workers on the floor, far from being replaceable, were
a great source of knowledge.
Elimination of non-value adding functions
In the mass production factories, the assembly workers were given very basic monotonous tasks to perform. The
foremen who supervised the workers did not perform any assembly tasks. Engineers reset the machines,
housekeepers cleaned the factory area, and so on. The assembly workers were treated with little respect and
considered to be easily replaceable.
In Toyota, production was based on teams. All members of a team were highly trained, and could do all tasks –
assembly, machine sets-ups, and cleaning the factory area. The team leader replaced the foreman, but unlike the
foreman the team leader would perform assembly tasks as well as coordinating the team. This led to more motivated
teams and ensured that no wages were wasted on indirect labour that did not add value to the final product.
In the Toyota factory, if a worker spotted a defect, he would pull a cord that would stop the production line, so the
error could be fixed. Workers were then required to identify the cause of the error using a technique called 'the five
whys'. The five whys approach involved firstly asking why the defect arose. Having identified the cause, then it was
asking why the cause arose, and so on, thus drilling down to find the root cause that would then be fixed. Such errors
were unlikely to arise again. These days, virtually no Toyota cars require reworking when they come off the
production line.
Toyota did not design the parts, but would tell the suppliers what was needed – for example, a braking system that
would stop a 1,000kg car that was moving at 100 kilometres per hour within 60 metres. The supplier would then be
required to use their own expertise to design and produce such a system. Thus, Toyota could benefit from the
expertise of their suppliers and save time on detailed design of all components needed.
Toyota would pay their suppliers a price that would enable them to make a fair profit, but would work with the
suppliers to reduce costs using techniques such as target costing. Cost savings would then be shared by the two
organisations.
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In order to overcome the problem of coordinating the supply of parts from suppliers and avoiding over or under
production, Ohno had the idea of the famous ‘just in time’ or ‘pull’ system. The idea of this was that a part would
only be produced when an instruction was received from the next link in the supply chain. There would be no
producing for inventory and no need for buffer inventory. The point of this was not only to reduce inventory levels
and associated costs, but to put pressure on all parts of the supply chain to become more responsive to changes in
demand.
Zero inventory is an ideal that has not been achieved in practice, even at Toyota. A small amount of inventory is still
maintained, particularly in the final processes of the production line. This is to avoid failing to meet demand when
there is a sudden spike. In spite of this, the principle of just in time leads to a more responsive supply chain focused
on meeting the changing demands of customers quickly.
Toyota’s flexible approach to manufacturing enabled the company to produce a wider product range, and to design
new models much quicker than the western car manufacturers. Womack et al reported that, in 1990, Toyota was
producing as many different products as General Motors, even though at the time the company was half the size of
GM.
In 2001, Toyota launched 'The Toyota Way', which aimed to take lean beyond its manufacturing and product
development into all other areas of the business. Even after 60 years, lean is still evolving within Toyota.
Plenty of lean implementations have not been successful. Bicheno and Holweg believe the reason for this is that
many organisations think lean is a one off programme. It is actually a culture of continuous improvement, and its
success relies on the continued support of management. Predictably, managers in many businesses lose interest in
initiatives that do not produce immediate improvements to the bottom line.
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Sort means sort out the items in the workplace. Items that are not used should be thrown out as they are just taking
up space and getting in the way. Those items that are used less frequently should be kept away from the workplace,
in cupboards or in store rooms. Sorting should be repeated regularly – for example, every six months.
Simplify involves putting items in the best place, where they will easily be found when needed (eg a carpenter might
keep the tools that he uses every day on shelves or in cupboards close to his work bench, while those tools that are
used less often will be located further from the bench).
Scan refers to continuously scanning the workplace for things that are out of place and need tidying away. It also
involves performing routine maintenance tasks, such as lubricating the machines.
Standardise means setting standards or procedures once the sort and simplify processes have been performed to
make it easier to keep the workplace sorted and simplified. Colour coded stickers could be introduced – for example,
indicating which locations items should be stored in.
Sustain – the use of the Five S Model should not be a one-off exercise, but should continue to be used after its
introduction, and become part of the routine in the workplace.
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business processes. The time accuracy trade-off can also be applied here, where 90% accurate in half the time may
be preferred.
Simplify means identifying the best methods of communicating the information. At Toyota, key information was
communicated to all employees on the factory floor using large TV screens. Simplify also considers the way the
information is stored in the system, such as the file structures to avoid duplications.
Scan involves regularly auditing the reports and who is actually using them. It also involves removing obsolete data
such as old customers or inventory items that are no longer used.
Stabilise includes coming up with standards such as standards for reports and rules about who should be copied in
on emails.
Sustain involves continuously performing the above four steps and therefore continuously improving the
information systems.
Conclusion
The lean principles that evolved in the Toyota car factories have led to a new approach to management in many
industries. They attempt to focus on satisfying the needs of the customer, and not wasting time and money on
activities that do not ultimately add value to the customer. Lean principles can also be applied to information systems
to ensure that only useful information is produced on a timely basis.
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Learning Objectives
Discuss, evaluate and apply environmental management accounting using for example lifecycle costing,
input/output analysis and activity based costing.
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ENVIRONMENTAL ACCOUNTING
In an ideal world, organizations would reflect environmental factors in their accounting processes via the
identification of the environmental costs attached to products, processes, and services.
Many existing conventional accounting systems are unable to deal adequately with environmental costs and as a
result simply attribute them to general overhead accounts.
Consequently, managers are unaware of these costs, have no information with which to manage them and have no
incentive to reduce them.
Many overestimate the cost and underestimate the benefits of improving environmental practices.
Management accounting techniques can distort and misrepresent environmental issues, leading to managers
making decisions that are bad for businesses and bad for the environment. The most obvious example relates to
energy usage.
Environmental Management Accounting (EMA) is an attempt to integrate best management accounting thinking and
practice with best environmental management thinking and practice.
EMA is the generation and analysis of both financial and non-financial information in order to support internal
environmental management processes. It is complementary to the conventional financial management accounting
approach, with the aim to develop appropriate mechanisms that assist in the identification and allocation of
environment-related costs.
EMA is concerned with the accounting information of managers in relation to corporate objectives. It involves:
Identifying and estimating costs of environmental related activities.
Identifying and monitoring the usage and cost of resources such as water and fuels.
Ensuring the environment is considered as part of capital investment decisions.
Assessing the likelihood of environmental risks.
Setting environmental related indicators as part of the control and monitoring process.
Benchmarking activities against environmental best practice
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Classification of costs:
Environmental prevention costs: the costs of activities undertaken to prevent the production of waste.
Environmental detection costs: costs incurred to ensure that the organization complies with regulations and
voluntary standards.
Environmental internal failure costs: costs incurred from performing activities that have produced contaminants
and waste that have not been discharged into the environment.
Environmental external failure costs: costs incurred on activities performed after discharging waste into the
environment.
Identification of costs:
Conventional costs: raw material and energy costs which have environmental relevance.
Potentially hidden costs: costs captured by accounting systems but then losing their identity in ‘general
overheads’.
Contingent costs: costs to be incurred at a future date, e.g. clean up costs.
Image and relationship costs: costs that, by their nature, are intangible, for example, the costs of preparing
environmental reports.
Input/outflow analysis
This technique records material inflows and balances this with outflows on the basis that, what comes in, must go
out.
So, if 100kg of materials have been bought and only 80kg of materials have been produced, for example, then the
20kg difference must be accounted for in some way. It may be, for example, that 10% of it has been sold as scrap
and 90% of it is waste. By accounting for outputs in this way, both in terms of physical quantities and, at the end of
the process, in monetary terms too, businesses are forced to focus on environmental costs.
Activity-based costing
ABC allocates internal costs to cost centers and cost drivers on the basis of the activities that give rise to the costs.
In an environmental accounting context, it distinguishes between environment-related costs, which can be
attributed to joint cost centers, and environment‑driven costs, which tend to be hidden on general overheads.
Lifecycle costing
Within the context of environmental accounting, lifecycle costing is a technique which requires the full
environmental consequences, and, therefore, costs, arising from production of a product to be taken account across
its whole lifecycle, literally ‘from cradle to grave’.
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The increase in environmental costs is likely to continue, which will result in the increased information needs of
managers and provide the stimulus for the agreement of a clear definition.
However, whatever the difficulties, the use of EMA will probably increase with positive effects for both
organizations and the environment in which they operate.
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December 2007
1. Performance Evaluation Bus Co
2. EVA and RI
3. Selling Price, CSF and ERPS
4. ABC
5. 5 Forces and Corporate Failure
June 2008
1. EVA, ROI and RI
2. Written Budget
3. Strategic & Economic Factors
4. NPV and Sensitivity
5. TQM Cost Analysis
December 2008
1. League Table Performance
2. Assess Financial Performance
3. Planning Gap, Ansoff and Problems
4. Transfer Pricing and TQM
5. ABC and ABM
June 2009
1. Balance Scorecard
2. NPV and Minimax Regret
3. Agency and Expectancy Theory
4. Pricing MR = MC
5. Six Sigma
December 2009
1. Actual and Budget Assess Performance
2. Beyond Budgeting and KPI
3. Transfer Pricing
4. Financial and Social and Econ
5. Mission Statements and CSF
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June 2010
1. Balanced Scorecard
2. Profit Statement and Expected Value
3. VFM
4. ABC and ABM
5. Cost Target and Performance
December 2010
1. CSF and EIS
2. ABC and Beyond Budgeting
3. EVA and Other Measures
4. Environmental Strategy
5. Z Score
June 2011
1. Performance and Transfer Pricing
2. Balanced Scorecard and Stakeholders
3. Fitzgerald and Moon
4. BCG Matrix and Remuneration
5. Environmental Strategy
December 2011
1. Risk and Uncertainty
2. Performance Pyramid and KPI
3. Control of Information and IT
4. Performance/Reward
5. Quality/Kaizen and JIT
June 2012
1. Performance MIRR, EVA & NPV
2. Performance Prism
3. Six Sigma
4. Benchmarking
5. Difficulties in Performance
December 2012
1. Divisional Performance
2. Budgeting – Incremental & Rolling
3. EVA and ROCE
4. Gearing and Corporate Failure
5. Changes in Role of Mgmt A/C
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June 2013
1. Balanced Scorecard
2. ABC and ABM
3. Porter’s 5 Forces
4. Divisional Performance and Transfer Pricing
December 2013
1. PEST, CSF, KPI and Planning Gap
2. Performance Pyramid & Performance Problems
3. RFID Design & Performance Measurement
4. Performance & League Tables
June 2014
1. Evaluate performance, EVA, VBM & suitable performance measures
2. Assess the impact of BPR financially, culturally and on the MIS. Review the appraisal
process.
3. Assess risk appetites, evaluate the choice of turbines & problems with managing
performance.
4. Assess the influence of plan & op variances for performance management. Evaluate the
current budgeting system and the proposal to move to beyond budgeting.
Dec 2014
1. Explain the Performance Prism, justify the management of stakeholders, approaches to
benchmarking & JIT
2. Explain public sector NFI’s and how VFM can be assessed.
3. Assess the environmental investments & lifecycle costing
4. Evaluation of corporate failure models & suggest recommendations to reduce the
possibility of failure.
June 2015
1. Assess metrics, calculate impact of change of strategy & value chain
2. Discuss impact of IT system and reliability of internal and external data
3. Discuss how improving some metrics impacts on others
4. Assess use of EVA and calculate ROI and RI
September/December 2015
1. Discuss calculation of EVA, identify KPIs and how improvements impact them & IT systems
2. Discuss improvements in a budget system and possibility of beyond budgeting
3. Discuss how six sigma could improve a process and the new information required
4. Assess use of balanced scorecard and difficulty in its implementation
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March/June 2016
1. Evaluate a performance report and introduction of new measures, calculate and comment
on an expected value & how an information system could help
2. Assess impact of BPR on performance and reward systems
3. Assess benefits of using ABC and how the use of ABM could improve performance
4. Advise on the use of 3Es and league tables in not for profit organisations
September/December 2016
1. Assess the problems of using a balanced scorecard at Monza, evaluation of current
performance measures and proposed other performance measures, Total quality
management and lean information system.
2. preparation of rolling budget and comparison between rolling and incremental budget
3. activity based coting, life cycle costing and environmental management accounting.
4. identification if critical success factor, key performance measurement and transfer pricing
March/June 2017
1. Evaluate the links between the current key performance indicators, Assess the assumptions
and definitions used in the calculation of the current KPI, building block model and reward
scheme.
2. calculation of target cost gap, target costing and kaizen costing.
3. evaluation of current management information system and lean management information.
4. divisional performance measurement and EVA
September/December 2017
1. Role of Management accountant in integrated accounting, calculation of target cost gap
and Categorise and calculate the costs of quality
2. evaluation of financial performance and benchmarking
3. Non-financial performance measures and not for profit making organisations, value for
money audit and Hopwood style of budgeting.
4. risk and uncertainty
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