F2-18 Performance Measurement

Session 18
Performance Measurement
FOCUS
This session covers the following content from the ACCA Study Guide.
E. Performance Measurement
1. Performance measurement overview
a) Discuss the purpose of mission statements and their role in performance
measurement.
b) Discuss the purpose of strategic and operational and tactical objectives and
their role in performance measurement.
c) Discuss the impact of economic and market conditions on performance
measurement.
d) Explain the impact of government regulation on performance
measurement.
2. Performance measurement—application
a) Discuss and calculate measures of financial performance (profitability,
liquidity, activity and gearing) and non financial measures.
c) Economy, efficiency and effectiveness.
d) Unit costs
e) Resource utilisation
f) Profitability
3. Cost reductions and value enhancement
a) Compare cost control and cost reduction.
b) Describe and evaluate cost reduction methods.
c) Describe and evaluate value analysis.
(see ACCA Study Guide for expanded learning objectives)
Session 18 Guidance
Understand the idea of a mission statement (s.1) and its role and the concept of performance
measures (s.2).
Learn financial measures of performance, which can be grouped into the categories of profitability,
liquidity, efficiency and position, and attempt Examples 1 and 2.
Note the distinction between contract and process costing and the suggestions for the choice of
performance measures (s.4).
Read section 5, which explains two mechanisms useful in performance measurement: cost reductions
and value enhancement. (continued on next page)
F2 Management Accounting Becker Professional Education | ACCA Study System
Sadia sadia Afzal - gentledove004@gmail.com

VISUAL OVERVIEW
Objective: To understand the scope of performance measurement and to describe
measures of performance and performance indicators.
OVERVIEW
• Mission Statements • Economic and Market Conditions
• Performance Hierarchy • Government Regulation
PERFORMANCE MEASURES
• Introduction
• Measuring Success
• Ensuring Success
FINANCIAL ECONOMY, PERFORMANCE INVESTMENT

PERFORMANCE EFFICIENCY AND UTILIZATION CENTRES
EFFECTIVENESS
• Measures • Manufacturing • Profitability
• Concepts Environment
• Return • Return on
on capital • Performance • Service Investment
employed Indicators Environment • Residual
(ROCE) • Control Ratios Income
• Profitability • Comparison
ratios
• Limitations
• Liquidity ratios
• Advantages of
• Activity ratios ROI and RI
• Gearing
COST REDUCTIONS AND VALUE ENHANCEMENT

UNIT COSTS • Cost Control vs Cost Reduction
• Contract Costing • Cost Reduction Methods
• Process Costing • Value analysis
Session 18 Guidance
Understand the concepts of efficiency, economy and effectiveness (s.6) and work through
Illustration 3 and Examples 2 and 3 to check your understanding.
Learn the characteristics and properties set out in the theoretical section on performance
utilisation (s.7).
Pay particular attention to profitability measures in investment centres (s.8) and work through
Illustration 5 and 6 and Examples 4, 5 and 6 to really understand this topic.
© 2014 DeVry/Becker Educational Development Corp. All rights reserved. 18-1

Session 18 • Performance Measurement F2 Management Accounting
1 Overview
1.1 Mission Statements

The mission of an organisation can be described as the reason for
the organisation's existence.
 In the case of commercial organisations, the mission is
normally to maximise the wealth of shareholders.
 Non-profit organisations' missions will be based on achieving
some other aim.
Illustration 1 Greenpeace US
Mission Statement
"Greenpeace is the leading independent campaigning organization
that uses peaceful protest and creative communication to expose
global environmental problems and to promote solutions that are
essential to a green and peaceful future."
1.1.1 Purposes
 To provide all managers involved in the decision-making process
with a clear indication on the organisation's raison d'être.
 To assist those responsible for the formulation of strategic
plans by focussing on critical issues to help ensure that
strategic plans are prepared in accordance with desired norms
within the organisation.
 To specify the domain in which the organisation is to operate,
thereby facilitating planning activities.
 To improve decision-making processes by clarifying the overall
direction of the organisation.
 To motivate employees by communicating to them what is
important from the standpoint of executive management.
1.1.2 Typical Contents

 Reason why the entity exists.
 Type of business (i.e. products and/or services offered and the
method of competing).
 Policies and standards of behaviour.
 Values and culture.
1.1.3 Role in Performance Measurement*
 Mission statements provide a clear focus for developing the *Various studies have
strategy of the organisation by providing a benchmark against concluded that having
which to measure proposed strategies. a mission statement
does improve the
 A mission statement provides guidance to departments and profitability of the
individuals within the organisation. They will ensure that they organisation.
work towards achieving the organisation's mission rather than
working towards some other objectives.
18-2 © 2014 DeVry/Becker Educational Development Corp. All rights reserved.

F2 Management Accounting Session 18 • Performance Measurement
1.2 Performance Hierarchy

There are three common layers of objectives in any organisation's
hierarchy. This hierarchy of objectives is sometimes referred to as
the "performance hierarchy".
 Strategic objectives: set out the organisation's aims,
typically for the next two to five years. They describe
intended outcomes and are results-oriented.
 Tactical objectives: provide the focus for what results
matter the most now. They describe how a strategic objective
will be accomplished and are product-oriented or productivity
-oriented (i.e. concerning output).
 Operational objectives: describe intended processes or
procedures to deliver on the tactical objectives.
Because there is a hierarchy of objectives, there will also be a
hierarchy of performance measures. Performance targets and
measures will be set at all levels within the organisation.
In a well-designed system, these targets and measures will
be consistent with the organisation's overall goals.
1.3 Economic and Market Conditions

External factors, such as economic and market conditions, often
have a huge influence on an organisation's ability to achieve
objectives.
For example, in an economic downturn or "financial crisis",
organisations may cut back on:
 recruitment;
 investment in training;
 research and development projects; and/or
 discretionary expenditure (e.g. charitable donations).
Organisations which rely on income from such sources will be
affected far more than organisations which provide "staple" goods
and services, which are purchased regularly and out of necessity.
Studies have shown that economic constraints increase pressure
on financial performance measures. However, when a market
becomes more competitive, greater emphasis tends to be placed
on non-financial performance measures such as customer
satisfaction and quality.
1.4 Government Regulation

Government regulation has a huge potential impact on how
organisations are governed and conduct their business.
For example, government regulation affects such areas as:
 corporate governance (e.g. Sarbanes-Oxley Act, 2002);
 anti-competitive or monopolistic measures;
 tax regulation;
 monetary policy (affecting interest and foreign exchange rates);
 transfers of rights;
 health and safety in the workplace/employee welfare; and
 carbon emissions or other environmental factors.
The introduction of government regulation may provide new
indicators for performance measurement (e.g. in the design and
manufacture of low-carbon emission cars).

2 Performance Measures
2.1 Introduction
Traditional performance measurement was based solely on
financial performance measures. This was considered to be
appropriate, because it was assumed that the primary objective
of all organisations was to maximise the wealth of their
shareholders. It seemed natural, therefore, that focusing on
financial measures would help to achieve this objective.*
*Many entities are assessed on financial performance as this

is generally the easiest and most informative basis. Recently,
qualitative factors have become important as well.
The value for money (VFM) framework of "economy, efficiency and

effectiveness" has been widely used to give a financial perspective
on not-for-profit organisations since the 1980s.
More recent approaches (since the early 1990s) include:
 balanced scorecard;
 resource utilization; and *These are described
 benchmarking.* in Session 19.
Performance measures can be considered in broad terms as
those which:
 measure success; or
 ensure success.
2.2 Measuring Success

Success may be measured in terms of competitive performance.
For example:
 Market share or sales growth
 Success or failure in obtaining new business
Primarily, success is measured in terms of financial performance
using accounting ratios including return on investment.
Financial analysis of performance should be linked to those
aspects of performance which ensure success—quality, flexibility
and resource utilisation.
2.3 Ensuring Success

2.3.1 Quality Performance
This may be measured in terms of:
 response time;
 fault rectification (e.g. the number of claims under product
warranty);
 helpfulness; and/or
 customers' praise/complaints (e.g. in post-completion feedback).

2.3.2 Flexibility Performance

This concerns coping with changing volumes of demand, delivery
speed and job specifications.
2.3.3 Resource Utilisation

This is typically measured in terms of the ratio of output to input
hours.
3 Financial Performance Measures
3.1 Measures
Typical measures of financial performance are ratios
categorised as:*
 profitability; *The choice of
performance measures
 liquidity; will be affected
 activity; and by many factors
(e.g. organisational
 gearing.
objectives, type of
A ratio which takes account of the "size" of a business is return on output, nature of
capital employed. cost unit, etc.).
3.2 Return on Capital Employed (ROCE)*

Profit
ROCE = × 100 or
Capital employed
Profit BEFORE interest and tax

= × 100
Shares + reserves + long-term liabilities
*ROCE shows how productively a business is using its available

resources. It relates overall profit performance to the amount of
capital employed in the business.
Because capital employed equates to total assets:
ROCE = Gross profitability × Asset turnover
Profitability and Efficiency
• Gross profit % (margin or ratio) • Inventory turnover

• Operating profit margin • Accounts receivable days
• Asset turnover • Accounts payable days

3.3 Profitability Ratios

3.3.1 Gross Profit Margin*
Gross profit
Gross profit margin = × 100 is expressed as a %.
Turnover
*Gross profit margin provides an insight into the relationship

between purchasing/production costs and revenues. A decline in
gross profit is usually a bad sign.
Disadvantages
The ratio can be manipulated by "producing for inventory".
Gross profit depends on the company's policy regarding
what is considered as a direct expense and what is an
administrative expense.
3.3.2 Operating Profit Margin*
Profit before interest and tax

Operating profit margin = × 100 as a %
Turnover
*Operating profit margin, also called "net profit" margin, shows the
overall profit as a percentage of sales. It is sometimes useful to
compare the trend in the gross profit margin with the trend in the
net profit margin. For example, if the gross profit margin is stable
but the net profit margin is falling, this would need investigation to
find out the causes.
3.4 Liquidity Ratios

3.4.1 Current Ratio
Current assets (at period end)

Current ratio = as a number of times (e.g. 2:1)
Current liabilities (at period end)
Purpose
 To measure the adequacy of current assets to meet short-term
liabilities (without having to raise additional finance). It is an
overall measure of liquidity.*
*If low/declining, an enterprise may be unable to meet its short-

term obligations as they become due. If high/increasing, this might
suggest over-investment in current assets such as inventories or
receivables or cash.

3.4.2 Quick Ratio (Acid-Test Ratio)
Current assets – inventory (at period end)

Quick ratio =
Current liabilities (at period end)
Purpose
 To measure immediate liquidity (by eliminating the least liquid
assets, i.e. inventories, from current assets).
3.5 Activity Ratios

These concern asset utilisation and are also called "efficiency" ratios.
3.5.1 Asset Turnover

*Significant
Turnover analysis is needed
Asset turnover = as a number of times. to compare ratios
Assets
between companies.
Where turnover is revenue (net of volume discounts) and assets is For example, two
equivalent to capital employed. companies may be of
equivalent size and
Purpose generate the same
revenue but the one
 To show the efficiency of an entity's ability to use its assets to
with lower asset value
generate sales.
will have a higher
Meaning* asset turnover. Lower
carrying value of
 It is the number of times that the carrying value of assets
assets may simply be
is "turned over" in generating revenue in the period. For
due to tangible assets
businesses in the same industry the higher the ratio the more being written off over
efficiently the assets appear to be used. shorter estimated
useful lives.
3.5.2 Long-Term Asset Turnover ("Fixed-Asset Turnover")*
Revenue
Long-term asset turnover = as a number of times.
Non-current assets
*As with most formulae based on amounts in the statement of

financial position, the denominator may be calculated as an average
for the period.
Meaning
 Shows turnover generated by each $1 of non-current assets.
 If declining, management may consider realising some of the
long-term assets (i.e. if they are excess to requirements and
not generating revenue).
 Possible distortions include low carrying amounts of assets
(increasing the ratio) or revaluations (decreasing the ratio).
3.5.3 Inventory Turnover
Cost of sales
Inventory Turnover = times
Inventories
Inventories
Days Inventory = × 365 (days in period)
Cost of sales

 Inventory is usually closing but may be average;

(i.e. ½ [opening + closing])
 Using closing inventories will highlight the effect of major
changes in the period.
 Using average inventories will dampen the effect.
Purpose
 To show the number of day's inventories, at cost, that is being
held by the business.
Meaning
 A high ratio generally indicates efficiency in selling goods
quickly.
 If declining, inventories are turning over less quickly (e.g. due
to fall in demand for goods).
3.5.4 3.5.4 Accounts Receivable Days ("collection period")
Average trade receivables

Accounts receivable days = × 365
Credit sales
Closing trade receivables
≈ × 365
Sales
 Averaging dampens the effect of a major change

(e.g. deterioration) in the period. Identifying credit sales
makes the analysis more meaningful.
The second formula is an approximation and is more readily
ascertainable from data in the published financial statements.
 Accounts receivable turnover may also be calculated (as for
asset turnover) as a number of times.
Purpose
 To show (average) time it takes to receive payment from
credit customers (i.e. the number of calendar days over which
receivables are uncollected).
Meaning
 As a measure of the liquidity of receivables it should not exceed
a reasonable proportion of sales. The longer the period the
greater the expense in collecting uncontrollable accounts.
3.5.5 Accounts Payable Days ("average payment period")

Average trade payables
Accounts payable days = × 365
Credit purchases
Closing trade payables
≈ × 365
Cost of sales
The second formula is an approximation and is more readily

ascertainable if credit purchases is unknown (though this ratio
will be distorted if opening inventory does not approximate
closing inventory).
 Accounts payable turnover may be expressed as a number
of times.

3.6 Gearing ("leverage")*

Debt
Gearing Ratio =
Equity
Debt Debt
or = =
Capital employed Debt + Equity
*Gearing measures the proportion of borrowed funds (which earn

a fixed return) to equity capital (shareholders funds) and provides
information about the financial risk of a company.
High gearing suits enterprises with relatively stable profits (to meet
interest) and suitable assets for security (e.g. those in the hotel/
leisure service industry).
Illustration 2 Gearing
A B C
$ $ $
Shares and accumulated profit 10,000 3,000 7,500
Debentures – 7,000 2,500
Capital employed 10,000 10,000 10,000
No gearing 70% 25%

highly low
geared gearing
Advantage of debt
Debt is normally cheaper than equity because:
It is less risky than equity. Holders of debt must be paid their
interest. Equity shareholders only receive dividends if there
are sufficient profits.
Interest is often a tax deductible expense, whereas dividends
are not.
Disadvantage of debt
Debt makes the company more risky:
Risk of bankruptcy if the company cannot repay loans when
they become due, or if they cannot pay interest.
The profit after interest becomes more variable with geared
companies.

Example 1 Financial Ratios
A summary of the financial statements of Rosy is shown for the current year just ended along
with comparatives for the previous year:
Income statement Previous Current

$m $m
Sales 742 1,028
Operating profit 22 54
Interest (net) (2) (6)
Taxation (11) (17)
Profit after tax 9 31
Statement of financial position Previous Current

$m $m
Non-current assets 146 233
Current assets
Inventory 43 52
Receivables 18 31
Short-term investments 11 12
Cash 4 6
76 101
Total assets 222 334
Total equity 101 124

Long-term debt 17 47
Current liabilities
Bank overdraft 8 18
Trade payables 66 89
Taxation 7 12
Dividends payable 2 4
Other short-term payables 21 40
104 163
Total liabilities and equity 222 334
Required:
Calculate the following ratios for Rosy.
Solution
Previous Current
1. Net profit margin =
2. Return on equity =
3. Current ratio =
4. Gearing ratio =

4 Unit Costs
Already it is clear that suitable performance measures differ
widely depending on the:
 organisation's objectives (e.g. profit or not-for-profit); and
 "commodity" produced (e.g. goods or services).
It also will differ depending on the nature of each "cost unit".
4.1 Contract Costing

Contract costing is a form of specific order costing on a scale
bigger than job costing (see Session 9). As with job costing, costs
are attributed to individual contracts. Typically the contracted
work will run over more than one accounting period (e.g. building
contracts, civil-engineering works and gas-turbine manufacture).
Although performance measures will include "typical" measures
which might be associated with any manufacturing business
(e.g. proportion of idle time to hours worked), others will be
specific to this type of business operation. For example:
 Levels of inventory held at each site. Is it requisitioned too
soon before it is needed?
 The amount of "shrinkage" of materials (e.g. theft) from
each site.
 Hourly rates of subcontracted labour.
 Costs of rectification.
 Percentage completion of each contract (e.g. as measured by
a quantity surveyor) compared with target and/or contractual
levels of completion.
 Penalties incurred in respect of late completion.
4.2 Process Costing

The determination of unit costs of the output of a process is an
average cost (see Session 10). A specific of process costing is
often the expectation of a loss which is inherent in the process
(i.e. normal loss). Performance measures relating to this might
include the:
 amount of abnormal loss (and inefficiency) or gain
(an efficiency) in absolute and relative terms (e.g. as a
percentage of good output);
 price obtained for any scrap compared with its expected
value; or
 amount of reworking required (where output which fails
quality control testing can be re-input).
In a standard process costing system the control ratios will clearly
be relevant.

5 Cost Reductions and Value Enhancement

5.1 Cost Control vs Cost Reduction
Cost control is primarily concerned with regulating the costs of
operating a business to keep them within acceptable limits
(e.g. below budget or within standards).*
*Areas of cost
Techniques include: control typically
include materials,
 budgeting (Session 14);
labour and overheads.
 standard costing and variance analysis (Session 16); and
 responsibility accounting (Session 15).
Cost reduction—the achievement of real and permanent

reductions in the unit costs of goods manufactured or services
rendered without impairing their suitability for the use
intended.
Cost reduction is:
 a planned and positive approach to reducing expenditure;
 a continual assessment of costs and efficiency savings;
 confined to savings brought about by the elimination of
wasteful and inessential elements from the product design.
5.2 Cost Reduction Methods
5.2.1 Assumptions
 Unnecessary costs can be identified.
 Costs can be saved.
 Proposals can be agreed.
 Proposals will work and result in cost reduction.
5.2.2 Methodology
Cost reduction involves the search for better and economical ways
of completing each operation. Reduction in specific expenses
might include:
 Product standardisation—a range of products may be basically
standardised but with minor differences between models.
 Reducing material costs:
 improved usage/reduced costs of wastage;
 obtaining lower prices for purchases;
 improved inventory control; and/or
 use of alternative materials.
 Labour productivity:
 change in working methods;
 use of "cheap labour"; and/or
 investment in new technology (e.g. more advanced
equipment).
5.2.3 Necessary Conditions for Success

Every employee recognizes his responsibility.
Employee resistance to change should be minimized.

Efforts should concentrate on the areas where the greatest

savings are likely to be made.
Cost reduction efforts should be continuously maintained.
5.2.4 Factors Hampering a Successful Programme

High cost of raw materials and other intermediate products.
Difficulties with inventory control (e.g. regular shortages of
raw materials).
The effect of indirect taxes (raising overall production costs).
Under capacity due to lack of raw materials and power
shortages.
5.2.5 Other Difficulties

Employees will generally perceive a threat in cost reduction
exercises.
Confidence in established systems for estimating material
usage and labour efficiency may be eroded.
When cash flow is a major issue such programmes may be
rushed and "desperate".
5.3 Value Analysis
Value analysis—a planned, scientific approach to cost

reduction which reviews the material composition of a product
and its design so improvements can be made without reducing
the value of the product to the customer (or user). The aim is
to get rid of all unnecessary costs (i.e. costs that do not add
value).
5.3.1 Aspects of Value

 Cost value: the cost of producing and selling an item.
 Exchange value: the market value of the product.
 Use value: what it does (i.e. the function or purpose it fulfils).
 Esteem value: the prestige a customer attaches to the product.
5.3.2 Stages in Value Analysis

 Select a product, raw material or item of equipment.
 Obtain information about it: what purpose does it serve?
 Evaluate the product: identify any costs that do not in any way
contribute to its specification or functional value.
 Consider alternatives.
 Select the least-cost alternative.
 Make a recommendation.
 Implement recommendation.
 After a time, evaluate outcome and measure cost savings.
5.3.3 Possible Outcomes

 Tailored products may be replaced with standardised
components.
 Features that are not required by customers may be dispensed
with.

 Traditional materials may be replaced with newly developed,

better and/or cheaper materials.
5.3.4 Benefits
Economic and financial benefits arise from the elimination of
unnecessary complexity and the better use of resources.
Firms which adopt this approach are more likely to attract
better staff.
Customers may be impressed by the interest shown in their
requirements (resulting in increased sales).
6 Economy, Efficiency and Effectiveness
6.1 Concepts
The concept of "value for money":
 concerns the benefit ("utility") that is obtained from every
purchase or every amount of money spent;
 assesses the cost of a product or service against the quality of
provision; and
 is based not only on the minimum purchase price (economy),
but also on the efficiency and effectiveness of the purchase.
Achieving value for money also is often described in terms of
economy, efficiency and effectiveness (the "three Es"):
 Economy: careful use of resources to save expense, time
or effort. This includes procuring resources at the lowest
possible cost without compromising on standards of quality
and service levels.
 Efficiency: delivering the same level of service for less cost,
time or effort. Efficiency is improved by minimising the inputs
required to achieve the outputs.
 Effectiveness: delivering a better service or getting a better
return for the same amount of expense, time or effort.
An organisation maximises its effectiveness by achieving its
goals and objectives.*
*The three Es can be
6.2 Performance Indicators thought of as "cheap",
"quick" and "good".
Performance measures of economy will be in financial terms
(being concerned with cost) and, for example, may draw on the
comparison of actual cost against targets or budgets.
Efficiency in a manufacturing business means making the best use
of (i.e. getting the highest "yield" out of) raw materials, labour,
etc which can be measured in terms of efficiency variances.
However, performance indicators of efficiency are generally more
difficult to establish in service industries and often are based on
consumer surveys and feedbacks.
Effectiveness is measured by comparing outputs with targets. A
car manufacturing plant which achieves it target of producing 500
cars in a month will be considered effective. One which has a
target of 600 but produces only 550 would be ineffective.

Illustration 3 Performance
Indicators
Performance indicators for a food-safety division of a hospital trust:

 Economy—the cost of programmed food hygiene inspections per
inspection for high risk and other premises.
 Efficiency—the percentage of consumer complaints dealt with
within four, six and eight weeks of being made.
 Effectiveness:
● Customer satisfaction (assessed through patient surveys).

● Actual number of (i) food hygiene and (ii) food standard
inspections carried out as percentage of those planned.
Example 2 The 3 Es
Suggest THREE performance measures under each of the following for a hospital:
Solution
Economy
1.
2.
3.
Efficiency
1.
2.
3.
Effectiveness
1.
2.
3.
6.3 Control Ratios

Three control ratios are widely used to make a comparison of
actual performance against budgeted performance.
6.3.1 Efficiency Ratio

This ratio measures the degree of efficiency attained in production:
Standard hours of production achieved

× 100
Actual hours worked

Hours may be for manual labour, for machine operatives or for

items of equipment.
6.3.2 Capacity Ratio

This ratio measures the extent to which budgeted hours of activity
were actually utilised.
Actual hours worked

× 100
Budgeted hours
It answers the question, "Did we operate at full capacity?"
6.3.3 Activity (or "Volume") Ratio

Measures volume of output ("activity") achieved against budget
(expressed in terms of standard hours).
Standard hours of production achieved

× 100
Standard hours budgeted
A standard hour = output (production units) achievable in an hour

under normal efficient working conditions.
Example 3 Control Ratios
A factory is budgeted to produce 40,000 units in the year. Actual production was 34,000 units
and 16,000 hours were worked. Standard production is two units per hour.
Required:
Calculate the efficiency, capacity and activity ratios.
Solution
Standard hours for actual production achieved are ÷ = hours
Standard hours for budgeted production are ÷ = hours
Efficiency ratio = × =
Capacity ratio = × =
Activity ratio = × =
Check:

7 Performance Utilisation
7.1 Manufacturing Environment

When assessing performance utilization in a manufacturing
environment, management is likely to be interested in the
performance of its assets in terms of:
 availability;
 utilisation (use);
 yield (output); and
 reliability.
Suitable performance measures may include:
 inventory levels for replacement parts;
 amount and value of wastage;
 quality of output (e.g. proportion of "seconds"); and
 hours of "downtime" (e.g. for re-calibration, repairs and
maintenance or major overhauls) associated costs.
7.2 Service Environment

7.2.1 Characteristics
Service sector businesses exhibit certain characteristics which
make it difficult to apply "conventional" performance measures:
 Intangibility—customer perceptions are influenced by
intangible factors.
 Heterogeneity (or variability)— service performance standards
may differ from firm to firm.
 Simultaneity—production and consumption takes place at the
same time.
 Perishability—services cannot be stored
7.2.2 Performance Aspects
Service performance can be considered in terms of the following
properties:
 Utilisation—the level of service activity relative to the total
potential demand for that service (as a percentage).
 Quality—the way and the environment in which the service
is delivered (e.g. at the least inconvenience to the customer).
The customer will be the ultimate judge of quality.
 Flexibility—the ability to adapt the service process in
response to change (e.g. seasonal changes or changes in
agreed service levels).
 Innovation—the application of new ideas and knowledge
to bring about some business/competitive advantage and
customer benefit.
 Cost per occasion of service—the total cost (direct and
indirect) including materials, labour and overheads. If the
cost of delivering a service outweighs the potential financial
revenue to be generated, the organisation must review its
strategy and the promises made to its customers.

Illustration 4 Resource Utilisation
The owners of the Eatwell Restaurant have diversified business interests and operate in a range
of commercial areas. Since buying the restaurant in 2007, they have carefully recorded the
following data:
2008 2009 2010 2011

Total meals served 3,750 5,100 6,200 6,700
Regular customers attending
5 11 15 26
weekly
Number of items on offer per day 4 4 7 9
Reported cases of food poisoning 4 5 7 7
Special theme evenings introduced 0 3 9 13
Operating hours with no customers 380 307 187 126
Proposals submitted to cater for
10 17 29 38
special events
Contracts won for special events 2 5 15 25
Complimentary letters from
0 4 3 6
satisfied customers
Average number of peak-time
18 23 37 39
customers
Average service delay at peak
32 47 15 35
times (mins)
Maximum seating capacity 25 25 40 40
Weekly opening hours 36 36 40 36
Written complaints received 8 12 14 14
Idle time of waiters (hours) 570 540 465 187
New meals introduced to the menu 16 8 27 11
Financial data $ $ $ $
Average customer spend on wine 3 4 4 7
Total revenue 83,000 124,500 137,000 185,000
Revenue from special events 2,000 13,000 25,000 55,000
Profit 11,600 21,400 43,700 57,200
Value of food wasted
1,700 1,900 3,600 1,450
in preparation
Total revenue of all local
895,000 1,234,000 980,000 1,056,000
restaurants
Commentary on resource utilisation

The business activity level continually increased over the period (meals served) with a decline
in non-productive time and the hours of operation with no customers. All these suggest an
improvement in resource utilisation. It is not known whether the increase in seating capacity in
2010 arose from extending the available floor area or providing more seating in the same space.
Although this capacity increase permitted more customers to be fed at peak times, it did result
in a fluctuation in the annual number of meals served at each seat, 150 (2008), 204 (2009), 155
(2010) and 167 (2011). A brief attempt was made in 2010 to extend the opening hours and
increase the hourly utilisation of the premises.

8 Investment Centres
8.1 Profitability
There are two measures of profitability which relate specifically to
investment centres:
 Return on investment (ROI) *The only real
difference being
 Residual income (RI) that ROI is a relative
These measures are both based on the same profit and capital measure and RI is an
absolute measure.
employed (assets) figures.*
When calculating these measures, it is important to distinguish
between the assessment of a:
1. Division manager—based on controllable profit
(see Session 15).
2. Division—based on traceable profit (i.e. divisional costs
and revenues). These are not necessarily controllable by the
manager (e.g. including centrally provided services such as
audit fees, notional rent, head office management charges,
etc).* *The first considers
whether the manager
8.2 Return on Investment (ROI) is worth having;
the second, whether
This is an accounting rate of return: the division is worth
having.
Annual controllable/traceable profit
× 100
Capital employed
 Profit should be controllable if the manager is being evaluated,

but traceable if the division is being assessed.
 Calculated ROI is compared with a target or hurdle rate.
8.3 Residual Income (RI)

This is an absolute measure, which is calculated as follows:
$000
Direct controllable profit x

Less: an imputed interest charge based on investment in assets
(x)
(Capital employed × required rate of return)
Residual income x

8.4 Comparison
Example 4 RI Versus ROI
Department 1 Department 2
$000 $000
Capital employed 1,000 100

Profits Year 1 200 20
Year 2 220 40
Target ROI = 20%
Required
Determine which department is performing better using:
(a) Residual income
(b) Return on investment.
Solution
(a) Residual income
$000 $000
Year 1
Profit
Less capital charge
Residual income
Year 2
Profit
Less capital charge
Residual income
(b) Return on Investment
Year 1
Year 2

Illustration 5 Assessing
Investment Opportunity
Two divisions each have an investment opportunity as follows:
Division X Division Y
$000 $000
Investment in project 100 100
Returns 20 15
ROI of investment 20% 15%
Current ROI 25% 12%
Company's cost of capital 18%
Using ROI
For Division X, the ROI of the investment exceeds the company's cost of
capital (and is therefore acceptable to the company), but below current
divisional performance. Hence, division-level management might reject
the project even though it appears to be in the shareholders' interests to
accept it.
For Division Y, the ROI of the investment is not worthwhile from the
company's perspective, but the divisional manager may wish to accept it
because it will improve divisional ROI.
Conclusion—ROI is not a reliable measure for decision-making purposes
because it may impair goal congruence.
Using RI
Division X: RI = $20,000 − 18,000 (18% × $100,000) = $2,000
Therefore, the manager would probably make the investment.
Division Y: RI = $15,000 − 18,000 (18% × $100,000) = ($3,000)
Therefore, the manager would not accept the investment.
Conclusion—RI is a better measure for goal congruent decisions.
Although RI is a theoretically superior performance measure, ROI

is still the most popular performance measure in practice because:
managers generally prefer percentage rates to absolute
figures (RI is less useful as a comparative measure because it
is absolute);
management may be hesitant about setting a specific cost of
capital figure; and
financial analysts often use ROI to assess relative company
performance.

Example 5 ROI and Decision-Making
Division Project
$000 $000
Capital employed 1,000 100

Controllable profit 300 25
Target ROI 20%
Required
(a) Calculate ROI and RI for the division:
(i) Pre-project
(ii) Post-project
(b) Explain whether or not the divisional manager would accept the project if he is
paid a bonus based on:
(i) ROI
(ii) RI
Solution
(a)
ROI RI
(i) Pre-project (000s)
(ii) Post-project (000s)
(b)
(i) ROI
(ii) RI

8.5 Limitations
Limitations and problems common to both measures, ROI and RI,
concern:
 Capital employed
 Use of profit before tax
 Target rate of return.
8.5.1 Capital Employed
 Which assets should be included in capital employed?
In particular, a decision needs to be taken on leased assets,
shared assets and idle assets.
 Year-end capital employed may be misleading. There are
arguments for using opening capital employed on the grounds
that that is what has been generating the year's profits.
Average capital employed may also be used.
 The basis of valuation of the assets. The use of both historical
cost and net book value may be misleading, when making
comparisons, if:
 assets are purchased at different times and prices change
due to inflation;
 older assets are written down to a lower value (but, for
the period under review, have the same revenue-earning
capacity);
 different depreciation policies are applied to different
segments.
 It may be better to use current replacement cost (to compare
"like with like").
Illustration 6 ROI Using Gross

Book Value
Year 1 Year 2 Year 3 Year 4

Profit 20 15 10 5
Gross book value 100 100 100 100
ROI 20% 15% 10% 5%
Using a target ROI of 12% per annum, a manager might wish to dispose of
the asset after just two years.

Example 6 ROI and Capital Employed

An asset's cost is $100,000, its life is four years and its scrap value is nil. The asset will generate
annual cash flows of $34,000 and it will be depreciated using straight-line depreciation.
Required
Calculate annual ROI using:
(i) Opening net book value
(ii) Gross book value.
Comment on any problems identified by these calculations.
Solution
(a) ROI using opening net book value
Year 1 =
Year 2 =
Year 3 =
Year 4 =
Comment:
(b) ROI using gross book value
Year 1 =
Year 2 =
Year 3 =
Year 4 =
Comment:
8.5.2 Profit before Tax

Profit before tax is after depreciation and therefore may be
distorted (as described above).
Pre-tax profit is used because the profits tax charge is not
generally controllable at operational manager level. (However,
managers need to be aware of the tax implications of their
operational decisions.)
8.5.3 Target Rate of Return*

 A target rate of return is needed:
 as target/hurdle (against which to compare ROI); or
*Setting a target
 to calculate the capital charge (for RI). percentage for ROI
may not recognise
8.6 Advantages of ROI and RI the risks inherent in
Both ROI and RI are quantitative and easily found from a particular division.
existing figures. However, how to
calculate a suitable
Target-setting becomes possible. rate is not examinable
They should, in the long run, encourage good-quality at this level.
investment.

Session 18
Summary
 A mission statement sets out an organisation's reason for existing.
 The objectives of an organisation to support its mission can be ranked as strategic, tactical
and operational. This hierarchy creates a "performance pyramid".
 Government regulation has a huge potential effect on how organisations are governed and
conduct their business.
 Traditional performance measurement systems focus on financial measures:
• Proﬁtability ratios
• Liquidity ratios
• Efﬁciency (activity) ratios
• Position (gearing) ratios.
 "Suitable" performance measures depend on many factors (e.g. organisational objectives,
"products" and cost unit).
 Cost control is primarily concerned with regulating the costs of operating a business to keep
them within acceptable limits.
 Cost reduction is a planned approach to reducing expenditure. Value analysis is a scientific
approach to cost reduction.
 The "three Es" are particularly relevant in assessing value for money. Efficiency, capacity
and activity ratios are widely used "control ratios".
 Service industries have unique characteristics which are not found in manufacturing industries.
 ROI and RI are two measures of profitability specific to investment centres.

Session 18 Quiz
Estimated time: 15 minutes
1. State the main use/purpose of an entity's mission statement. (1.1)

2. State and describe the THREE fundamental levels of planning. (1.2)
3. Give THREE means by which quality performance can be measured. (2.3.1)
4. State what is meant by "financial leverage". (3.6)
5. List and define the "three Es". (6.1)
6. Distinguish between effectiveness and efficiency. (6.2)
7. State the FOUR characteristics of services. (7.2.1)
8. True or false? Residual income (RI) is an absolute measure of performance. (8.3)
Study Question Bank

Estimated time: 45 minutes
Priority Estimated Time Completed
Q82 Falco 15 minutes
Q86 Two-minds 30 minutes

Additional
Q81 Types of measures
Q84 Define terms
Q85 Divisional assessment

EXAMPLE SOLUTIONS
Solution 1—Financial Ratios
Previous Current
Profit before tax and interest 22 54

1. Net profit % = = 3.0% = 5.3%
Revenue 742 1,028
Profit after interest and tax 9 31

2. Return on equity = = 8.9% = 25.0%
Ordinary share capital + reserves 101 124
Current assets 76 101

3. Current ratio = = 0.73 = 0.62
Current liabilities 104 163
Debt (including overdraft) 17 + 8 47 + 18

4. Gearing ratio = = 20% = 34%
Debt + Equity 17 + 8 + 101 47 + 18 + 124
Solution 2—The 3 Es
Note: Only three answers are required for each
Economy
1. Cost of procuring drugs, medical equipment, etc.
2. Cost per patient per day for each type of treatment.
3. Cost per bed per overnight stay.
4. Average salary of doctors, anaesthetists, pharmacists, nurses, etc.
Efficiency
1. Average waiting times on lists for operations, by type.
2. Number of outpatients treated per day.
3. Number of operations, by type, performed each month.
4. Percentage occupancy of beds, by hospital ward.
Effectiveness
1. Number of patients’ complaints about treatment per month.
2. Proportion of readmissions for the same ailment.
3. Number of legal actions brought by patients or their families (e.g. for negligence).
4. Average life expectancy, post-operation, for each type of major surgery.

Solution 3—Control Ratios
Standard hours for actual production achieved are 34,000 ÷ 2 = 17,000 hours
Standard hours for budgeted production are 40,000 ÷ 2 = 20,000 hours
17,000
Efficiency ratio = × 100 = 106%
16,000
16,000
Capacity ratio = × 100 = 80%
20,000
17,000
Activity ratio = × 100 = 85%
20,000
Check: 85% = 106% × 80%
Solution 4—RI Versus ROI

(a) Residual income
$000 $000
Year 1
Profit 200 20
Less capital charge 200 (20% × 1,000) 20 (20% × 100)
Residual income 0 0
Year 2
Profit 220 40
Less capital charge 200 (20% × 1,000) 20 (20% × 100)
Residual income 20 20
(b) Return on Investment
$000 $000
200 20
Year 1 = 20% = 20%
1,000 100
220 40
Year 2 = 22% = 40%
1,000 100
It is easier for the larger division to generate a further $20,000 of residual

income, so using RI to make comparisons between departments/managers
controlling different sizes of asset base is misleading. Therefore, ROI is the better
performance indicator.

Solution 5—ROI and Decision-Making

(a)
ROI RI
300
(i) Pre-project (000s) = 30% 300 – (20% × 1,000) = 100
1,000
325
(ii) Post-project (000s) = 29.5% 325 – (20% × 1,100) = 105
1,100
(b)
(i) ROI
The project’s ROI is acceptable to the company (as it is greater than 20%) but the
manager would not be motivated to accept the project (as it lowers divisional ROI).
(ii) RI
The manager would be motivated to accept the project. This decision would be
congruent with the goals of the company.
Solution 6—ROI and Capital Employed

(a) ROI using opening net book value
Year 1 = (34 − 25) ÷ 100 = 9%
Year 2 = (34 − 25) ÷ 75 = 12%
Year 3 = (34 − 25) ÷ 50 = 18%
Year 4 = (34 − 25) ÷ 25 = 36%
Comment: ROI improves despite constant annual profits. Divisional managers might hang on
to assets for too long. Hence, it discourages investment in new assets (RI would also improve,
giving the same problem.)
(b) ROI using gross book value
Year 1 = (34 − 25) ÷ 100 = 9%
Year 2 = (34 − 25) ÷ 100 = 9%
Year 3 = (34 − 25) ÷ 100 = 9%
Year 4 = (34 − 25) ÷ 100 = 9%
Comment: ROI using gross book value overcomes the increasing return problem of net book
value. (RI would also be constant.)

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Session 18

(see ACCA Study Guide for expanded learning objectives)

Sadia sadia Afzal - gentledove004@gmail.com

FINANCIAL ECONOMY, PERFORMANCE INVESTMENT

COST REDUCTIONS AND VALUE ENHANCEMENT

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1.1 Mission Statements

1.1.2 Typical Contents

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1.2 Performance Hierarchy

1.3 Economic and Market Conditions

1.4 Government Regulation

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*Many entities are assessed on financial performance as this

The value for money (VFM) framework of "economy, efficiency and

2.2 Measuring Success

2.3 Ensuring Success

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2.3.2 Flexibility Performance

2.3.3 Resource Utilisation

3 Financial Performance Measures

3.2 Return on Capital Employed (ROCE)*

Profit BEFORE interest and tax

*ROCE shows how productively a business is using its available

Because capital employed equates to total assets:

ROCE = Gross profitability × Asset turnover

Profitability and Efficiency

• Gross profit % (margin or ratio) • Inventory turnover

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3.3 Profitability Ratios

*Gross profit margin provides an insight into the relationship

3.3.2 Operating Profit Margin*

Profit before interest and tax

3.4 Liquidity Ratios

Current assets (at period end)

*If low/declining, an enterprise may be unable to meet its short-

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3.4.2 Quick Ratio (Acid-Test Ratio)

Current assets – inventory (at period end)

3.5 Activity Ratios

3.5.1 Asset Turnover

*As with most formulae based on amounts in the statement of

3.5.3 Inventory Turnover

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 Inventory is usually closing but may be average;

3.5.4 3.5.4 Accounts Receivable Days ("collection period")

Average trade receivables

 Averaging dampens the effect of a major change

3.5.5 Accounts Payable Days ("average payment period")

The second formula is an approximation and is more readily

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3.6 Gearing ("leverage")*

*Gearing measures the proportion of borrowed funds (which earn

No gearing 70% 25%

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